Chapter 15 Macro Stabilization Policy

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1 Chapter 15 Macro Stabilization Policy After reading Chapter 15, MACRO STABILIZATION POLICY, you should be able to: Describe how stabilization policy works and the arguments for and against Activism. Define Inflationary and Deflationary Gaps. Explain how Fiscal Policy may be used to stabilize the economy and the difference between Automatic Stabilizers and Discretionary Policy Explain how Monetary Policy may be used to stabilize the economy. Explain what is meant by the Policy Dilemma. Understand the difference between the Keynesian Budget Philosophy and Supply Side Economics. Describe how Nonactivists counter the case for activist policy. Relate why nonactivists believe the major causes of the Great Depression were government policies and list other reasons about why activist policy should not be used. Understand the Rational Expectations and Real Business Cycle objection to activist policy. Discuss the Phillips Curve and explain how it is consistent with Stagflation. Describe why Keynesian economists contend that activist policy should be used to limit the GDP Gap. Outline I. Macroeconomic Stabilization A) Fiscal Policy is changes in government spending or taxes designed to achieve macroeconomic goals. Monetary Policy is changes in the money supply or credit conditions designed to achieve macroeconomic goals. The three main goals are full employment, price stability, steady economic growth. B) Policy Activism is the use of fiscal and monetary policy to smooth fluctuations in the business cycle. Discretionary Policy is the setting of monetary and fiscal targets by policymakers, based on their best judgments.

2 148 Gregory Essentials of Economics, Sixth Edition II. Deflationary and Inflationary GAPs A) When the equilibrium level of output is less than the natural rate, as shown below, a Deflationary GAP exists. In the figure, the equilibrium level of output, Y, is less than the natural level of output, Y n. A deflationary gap calls for an Expansionary Fiscal Policy, such as an increase in government spending or reduction in taxes, or an Expansioanry Monetary Policy. Such an expansionary policy shifts the AD curve to the right and increases the equilibrium level of real GDP. B) When the equilibrium level of output is greater than the natural rate, an Inflationary GAP exists. This is illustrated above, where the equilibrium level of output, Y, exceeds the natural level of output, Y n. When the economy experiences an inflationary gap, a Contractionary Fiscal Policy, such as a decrease in government spending or increase in taxes, or a Contractionary Monetary Policy is appropriate. These policies shift the AD curve to the left.

3 Chapter 15 Macro Stabilization Policy 149 III. Fiscal Policy A) An Entitlement Program requires the federal government to pay benefits to anyone who meets the eligibility requirements. Examples include Social Security payments and unemployment benefits. B) Automatic Stabilizers are government spending or taxation actions that take place without any deliberate government control and that automatically dampen the business cycle. C) Autonomous Changes in taxes and government spending are changes in the tax rates or government spending that do not automatically occur because of changes in income. Discretionary fiscal policy works through changes in tax rates and government spending. IV. Monetary Policy A) Monetary Policy is the deliberate control of the money supply for the purpose of achieving macroeconomic goals. B) If the economy is producing at a level of output below full employment output, the Fed would want to increase the money supply. An increase in the money supply would cause interest rates to fall. Lower interest rates would stimulate investment spending, which would shift the aggregate demand curve out. C) If the economy is producing at a level of output above full employment output, the Fed would want to decrease the money supply. A decrease in the money supply would cause interest rates to rise. Higher interest rates would reduce investment spending, which would shift the aggregate demand curve in. V. Self Correction or Activism? A) Nonactivism means that no government policy is pursued to smooth the fluctuations of the business cycle; instead, the economy s self-correcting mechanism is relied upon to drive the economy back to the natural level of output. B) Nonactivists suggest the government follow two fixed rules. 1. The money supply should grow at a constant rate every year. The rate should approximate the long-run growth rate of real GDP. 2. The federal budget should be balanced over the business cycle. Surpluses in the recovery phase should equal deficits in the recession phase. C) Nonactivists make several arguments for their position. 1. They claim that the economy is naturally stable and that activist policies have been a major cause of business cycles. According to this view, inappropriate monetary and fiscal policies were the cause of the Great Depression. 2. They point out that it is difficult to devise proper activist policies, because economists do not possess enough information about how the economy operates. Monetary policy may work after long and variable lags, and may end up being destabilizing. 3. The Rational Expectations school asserts that predictable activist counter-cyclical policies have no effect on output. 4. Real Business Cycle theorists argue that business cycles are caused by random shocks to aggregate supply that cannot be controlled by monetary or fiscal policy.

4 150 Gregory Essentials of Economics, Sixth Edition VI. Phillips Curve A) Stagflation is the combination of high inflation and high unemployment. Stagflation first occurred in the 1970s. The Misery Index is the sum of the inflation rate and the unemployment rate. B) The Phillips Curve shows an inverse relationship between the rate of inflation and the unemployment rate. This negative trade-off between inflation and unemployment suggested society faced a hard decision: to reduce inflation, unemployment would have to increase, or to reduce unemployment, inflation would have to increase. C) This tradeoff existed when inflationary expectations are constant. Stagflation will be present when inflationary expectations are rising. D) When inflation is not anticipated increases in aggregate demand can cause output to increase and unemployment to fall. When inflation is anticipated an increase in aggregate demand will have no effect on output and employment. VII. Case For Activism A) The GDP Gap is the difference between actual output and full employment output. Keynesian economists suggest the government use activist policies to eliminate the GDP gap. B) Keynesian economists believe activist policy is desirable because they contend that the self-correcting mechanism takes too long to work because of wage and price inflexibilities. C) Activist policies have been pursued since at least the mid-1960s. As evidence in favor of activism, Keynesian economists use the observation that business cycles have moderated since the advent of activist policies. Review Questions True/False If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question give a short statement that supports your answer. 1. Economists are in general agreement that the government should conduct activist fiscal and monetary policies. 2. A goal of activist policy is to increase employment during a recession. 3. Nonactivists contend that the Great Depression was the result of ill-advised government policies. 4. Keynesian economists believe the government should conduct activist policies. 5. Nonactivists believe that the private sector is prone to large fluctuations and needs government policies to provide stability. 6. The growth rate of GDP has been less variable after World War II.

5 Chapter 15 Macro Stabilization Policy There is general agreement among economists that the self-correcting mechanism works. 8. Some economists believe that the 25 percent fall in the money supply from 1929 to 1933 was a cause of the Great Depression. 9. Rational-expectations economists argue that predictable policies have the greatest effect on output and employment. 10. Nonactivist economists suggest that the money supply should grow at a constant rate each year without regard to the prevailing economic conditions. 11. There is general agreement among economists that the economy tends to return to the natural rate of unemployment. 12. The GDP gap is the difference between actual GDP and full employment GDP. 13. If actual GDP exceeds the natural level of GDP, a deflationary gap exists. 14. The Phillips curve shows that unemployment can be lowered if inflation is raised. Multiple Choice Questions Circle the letter corresponding to the correct answer. 1. Which school of thought believes the self-correcting mechanism works slowly? (a) Keynesian (b) Monetarist (c) Rational expectations (d) Keynesian and monetarist only (e) All schools believe the self-correcting mechanism is slow. 2. Nonactivists believe that (a) the private sector is not stable. (b) it is easy to conduct correct activist policy. (c) government policy is necessary to stabilize the economy. (d) activist policies are the reason why business cycles have been milder after World War II. (e) activist policies may destabilize the economy. 3. There is currently general agreement about which of the following? (a) The government should not use activist policies. (b) The economy eventually returns to the natural rate of unemployment. (c) The Great Depression is proof that activist policies are desirable. (d) The self-correcting mechanism works rapidly. (e) Running government policy according to rules is better than trying to use discretionary policy.

6 152 Gregory Essentials of Economics, Sixth Edition 4. Monetarists contend that a cause of the Great Depression was (a) the doubling of reserve requirements by the Fed in (b) the large tax increases passed in 1932 and (c) New Deal policies that raised the monopoly power of firms and unions. (d) the Fed allowing the money supply to fall by 25 percent between 1929 and (e) All of the above 5. In part, Keynesian economists base their claim that activism is beneficial on (a) the difficulty of devising activist policies. (b) the rational expectations view that anticipated policies may have no effect on output. (c) the ease with which government spending may be used for activist purposes. (d) the milder business cycles experienced after World War II. (e) the historical record of performance during the Great Depression. 6. Real business cycle theorists argue that business cycles are (a) not real, simply a statistical illusion. (b) caused by fluctuations in real aggregate demand. (c) caused by unemployment and inflation together. (d) caused by fluctuations in aggregate supply. (e) All of the above 7. The Phillips curve (a) claims that only unanticipated inflation changes the unemployment rate. (b) suggested that higher inflation caused higher unemployment. (c) has been well supported by the data. (d) claimed that policymakers could achieve both lower inflation and unemployment. (e) was discredited by economic experiences of the 1970s and 1980s. 8. The misery index (a) was a term used by Marx. (b) is the sum of inflation and economic growth. (c) refers to a period of declining real GDP. (d) is the sum of inflation and unemployment rates. (e) does not exist. Essay Questions Write a short essay answering each question. 1. Activist policies have been followed by the government only after World War II. The business cycles since that time have been much milder than those before the war. Therefore, activist policies have successfully stabilized the economy. How would an economist favoring nonactivism respond to this claim? 2. Why is it important for society to determine whether the activist or nonactivist beliefs are correct? 3. What role does the self-correcting mechanism play in the debate between activists and nonactivists? 4. What did Keynes mean with his comment that In the long run, we are all dead?

7 Chapter 15 Macro Stabilization Policy Using the Phillips curve, complete the following table by telling whether unemployment rises, falls, or does not change. Actual Inflation Anticipated Inflation Effect on Unemployment 8% 12% 8% 8% 8% 5% 3% 5% 6. The Phillips curve often was said to confront policymakers with a cruel dilemma between inflation and unemployment. What was this cruel choice? Does the short run Phillips curve have the same difficult choice? Answers to Review Questions True/False 1. False. The question whether the government should follow activist policies is one of the major disagreements among economists. 2. True. A recession occurs when there is a deflationary gap so that the actual level of GDP is less than its natural level, which means that the unemployment rate exceeds the natural rate. 3. True. Keynesian economists assert that the Great Depression was the result of instability in the private sector and, as such, is evidence of the desirability of activist policies; nonactivists disagree by tracing blame for the Depression to government policies. 4. True. Monetarist and rational-expectations are nonactivist economists, and they disagree with the Keynesian belief that discretionary policy is desirable. 5. False. Monetarists believe the private sector is stable and that most of the economy s instability is the result of poor government policies. 6. True. Keynesian economists view this as evidence in favor of activism. 7. True. While economists agree that the self-correcting mechanism works, there is disagreement over its speed. 8. True. This is one of the government policies that monetarists hold responsible for the Great Depression. 9. False. Rational-expectations economists claim that predictable policies have no effect on output or employment. 10. True. To minimize inflation, nonactivists suggest that the money supply s growth should be near the long-run growth rate of real GDP. 11. True. This reflects the fact that most economists believe that the self-correcting mechanism eventually restores the economy to its long-run equilibrium. 12. True. This is the definition of the GDP gap.

8 154 Gregory Essentials of Economics, Sixth Edition 13. False. When actual GDP exceeds the natural level of GDP, there is an inflationary gap and not a deflationary gap. 14. True. The Phillips curve claimed that any time inflation was raised, unemployment would fall. Multiple Choice Questions 1. (a) Because Keynesians think the self-correcting mechanism is slow, they argue that the government should conduct activist policies designed to move the economy more rapidly to its natural level of output. 2. (e) Indeed, nonactivists contend that activist policy worsens business cycle fluctuations. 3. (b) While economists generally agree that the economy returns to the natural rate of unemployment and GDP, the key question is the speed of the return. Activists contend that the economy s return is slow, while nonactivists tend to suggest that the economy returns quickly. 4. (e) Monetarists think that all these (inappropriate!) policies helped create the Great Depression. 5. (d) Keynesians believe that business cycles have been less variable because of the government s activist policies. 6. (d) Real business cycles theorists say that business cycles are caused by shocks to supply. 7. (e) The 1970s and 1980s brought stagflation, an experience that could not be explained by the Phillips curve. 8. (d) The misery index is the sum of inflation and unemployment rates. Essay Questions 1. Economists favoring nonactivism dispute this statement. They claim that the milder business cycles are the result of more steady growth in the money supply. In fact, they assert that business cycles would be even less variable if the government stopped following any sort of activist policy. 2. It is important to determine which view is correct because following the wrong view harms society. If the Keynesian (activist) view is right, the GDP gap measures the gain to society if activist policies designed to eliminate the gap are followed. If the monetarist or rational expectations (nonactivist) view is correct, the GDP gap again can measure, in part, the harm inflicted on society by following the wrong view. Nonactivists believe that most of the fluctuations in GDP, the GDP gap, are caused by the government s use of activist policies. 3. The speed with which the self-correcting mechanism takes to return the economy to its natural rate of output plays an important part in the activist/nonactivist debate. Economists who favor activist policies believe the self-correcting mechanism is slow. Thus, there are large potential gains to society if the government, by using activist policies, helps speed up the process through which the economy returns to its long-run equilibrium. (These gains are especially large if the unemployment rate is above the natural rate so that activist policies can help lower it rapidly to its long-run equilibrium.) Nonactivists generally think that the self-correcting mechanism is reasonably fast. As a result, the potential gains from activist policies are small.

9 Chapter 15 Macro Stabilization Policy Keynes s comment was an expression of his contention that the self-correcting mechanism worked slowly. Keynes, like almost all economists, believed that the self-correcting mechanism will restore the economy to the natural level of output. However, Keynes, viewing the situation in the 1930s when the unemployment rate seemed to be permanently stuck at excessively high levels, concluded that the self-correcting mechanism was exceedingly slow. Hence, when others suggested that the government should do nothing because in the long run the self-correcting mechanism would restore the economy to its natural rate of output, Keynes commented that by the time the long run finally was reached, we would all be dead. 5. Actual Inflation Anticipated Inflation Effect on Unemployment 8% 12% Rise 8% 8% Not Change 8% 5% Fall 3% 5% Rise Whenever the actual inflation exceeds the expected inflation, unexpected inflation is positive so unemployment falls. If actual inflation is less than expected inflation, unemployment rises. If the two are equal, there is no change in unemployment. It is important to notice that the first three parts of this question demonstrate how a given amount of actual inflation (8%) can be consistent with a rise, fall, or no change in unemployment, depending on the level of expected inflation. 6. The cruel choice forced on policymakers was that to lower either unemployment or inflation, the other must be raised. Thus, if the public disliked both unemployment and inflation, to have less of one meant that it must suffer more of the other. The short-run Phillips curve does not confront policymakers with this problem. According to the short-run Phillips curve, in the long run, unemployment does not depend on the inflation rate. So policymakers can lower the inflation rate confident that in the long run they are not causing the unemployment rate to rise. Additional Questions 1. Consider the three tools the Fed can use to influence the money supply. How would it use these tools if it wanted to pursue an expansionary monetary policy? What if they wanted to pursue a contractionary policy? 2. How is the Keynesian budget philosophy and supply side economics similar in regards to the relationship between tax cuts and deficits? How are they different? 3. How may the Federal Reserve have contributed to the recession of 2000? 4. Consider two of the goals of macroeconomic policy: stable prices and full employment. If the economy initially operates at full employment and there is an adverse supply shock, what is the problem with using activist policy to meet these goals?

10 156 Gregory Essentials of Economics, Sixth Edition Answers 1. If the Fed pursued an expansionary policy it would want the money supply to increase. Therefore, it could make an open market purchase, lower the required reserve ratio, or lower the discount rate. If the Fed wanted to pursue a contractionary policy it would do the opposite: open market sale, increase required reserve ratio, and increase the discount rate. 2. Both would argue that tax cuts will increase output and reduce unemployment and eventually lead to an increase in tax revenues. Keynesian budget philosophy argues that the increased tax revenues from higher incomes would not be large enough to offset the loss in revenue from tax cuts. Supply side economists argue the opposite. They believe that tax cuts would create such a stimulus to income that the increases in tax revenues from the higher income would be larger than the loss in revenue from the tax cuts. 3. Your textbook argues that as both unemployment and inflation fell during the 1990 s the Fed had to decide at what unemployment rate inflation would start to rise again. Historically, they believed inflation would start to increase when the unemployment rate was around 5 5.5%. To avoid inflationary pressures they started increasing interest rates to prevent the economy from overheating. Even with higher interest rates the unemployment rate continued to fall at its lowest point unemployment was 4% as well as inflation. 4. If the economy currently operates at full employment and there is an adverse supply shock, the SRAS will decrease. This will lead to a higher price level and an unemployment level above the natural rate of unemployment. If the government wanted to reduce the unemployment rate it would need to pursue and expansionary policy, fiscal or monetary, which would increase aggregate demand. Although unemployment would fall back to its natural rate, the price level would increase more. If the government wanted to maintain price stability it would need to pursue a contractionary policy, which would reduce aggregate demand. Although the price level would fall back down, unemployment would increase even more. In response to an adverse supply shock activist policy can t be used to maintain both stable prices and full employment.

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