978-1305971509 Chapter 36_23 Lecture Notes

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WHAT’S NEW IN THE EIGHTH EDITION:

Two new features have been added, In the News on “On Kiwis and Currencies” and Ask the

Experts on “Taxing Capital and Labor.”

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

 the debate concerning whether policymakers should try to stabilize the economy.

the debate concerning whether the government should %ght recessions with spending

hikes or tax cuts.

the debate concerning whether monetary policy should be made by rule rather than by

discretion.

611

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

36 SIX DEBATES OVER

MACROECONOMIC

POLICY

612 ❖ Chapter 36/Six Debates over Macroeconomic Policy

 the debate concerning whether the central bank should aim for zero in?ation.

 the debate concerning whether the government should balance its budget.

 the debate concerning whether the tax laws should be reformed to encourage saving.

CONTEXT AND PURPOSE:

Chapter 36 is the %nal chapter in the text. It addresses six unresolved issues in

macroeconomics, each of which is central to current political debates. The chapter can be

studied all at once, or portions of the chapter can be studied in conjunction with prior

chapters that deal with the related material.

The purpose of Chapter 36 is to provide both sides of six leading debates over

macroeconomic policy. It employs information and tools that students have accumulated in

their study of this text. This chapter may help students take a position on the issues

addressed or, at least, it may help them understand the reasoning of others who have taken

a position.

KEY POINTS:

 Advocates of active monetary and %scal policy view the economy as inherently unstable

and believe that policy can manage aggregate demand in order to oAset the inherent

instability. Critics of active monetary and %scal policy emphasize that policy aAects the

economy with a lag and that our ability to forecast future economic conditions is poor. As

a result, attempts to stabilize the economy can end up being destabilizing.

Advocates of increased government spending to %ght recessions argue that because tax

cuts may be saved rather than spent, direct government spending does more to increase

aggregate demand, which is key to promoting production and employment. Critics of

spending hikes argue that tax cuts can expand both aggregate demand and aggregate

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Chapter 36/Six Debates over Macroeconomic Policy ❖ 613

supply and that hasty increases in government spending may lead to wasteful public

projects.

 Advocates of rules for monetary policy argue that discretionary policy can suAer from

incompetence, abuse of power, and time inconsistency. Critics of rules for monetary

policy argue that discretionary policy is more ?exible in responding to changing

economic circumstances.

 Advocates of a zero-in?ation target emphasize that in?ation has many costs and few if

any bene%ts. Moreover, the cost of eliminating in?ation—depressed output and

employment―is only temporary. Even this cost can be reduced if the central bank

announces a credible plan to reduce in?ation, thereby directly lowering expectations of

in?ation. Critics of a zero-in?ation target claim that moderate in?ation imposes only

small costs on society, whereas the recession necessary to reduce the in?ation is quite

costly. The critics also point out several ways in which moderate in?ation may be helpful

to an economy.

 Advocates of a balanced government budget argue that budget de%cits impose an

unjusti%able burden on future generations by raising their taxes and lowering their

incomes. Critics of a balanced government budget argue that the de%cit is only one small

piece of %scal policy. Single-minded concern about the budget de%cit can obscure the

many ways in which policy, including various spending programs, aAects diAerent

generations.

 Advocates of tax incentives for saving point out that our society discourages saving in

many ways, such as by heavily taxing capital income and by reducing bene%ts for those

who have accumulated wealth. They endorse reforming the tax laws to encourage

saving, perhaps by switching from an income tax to a consumption tax. Critics of tax

incentives for saving argue that many proposed changes to stimulate saving would

primarily bene%t the wealthy, who do not need a tax break. They also argue that such

changes might have only a small eAect on private saving. Raising public saving by

decreasing the government’s budget de%cit would provide a more direct and equitable

way to increase national saving.

CHAPTER OUTLINE:

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Provide supporting facts and %gures for each side of the debates.

Emphasize that there are no clear right or wrong answers. Do not forget to

mention the political dimensions involved with these debates. At the heart

of these debates is that there is a great deal of wealth and power at stake,

and these considerations often are more important than the consensus of

614 ❖ Chapter 36/Six Debates over Macroeconomic Policy

I. Should Monetary and Fiscal Policymakers Try to Stabilize the Economy?

A. Pro: Policymakers Should Try to Stabilize the Economy

1. When households and %rms feel pessimistic, aggregate demand falls. This causes

output to fall and unemployment to rise.

2. There is no reason for the economy to suAer through a recession when

policymakers can reduce the severity of economic ?uctuations.

3. Thus, policymakers should take an active role in leading the economy to stability.

4. When aggregate demand is inadequate to ensure full employment, policymakers

should act to boost spending in the economy. When aggregate demand is

excessive and there is a risk of in?ation, policymakers should act to reduce

spending.

5. Such policy actions put macroeconomic theory to its best use by leading to a

more stable economy.

B. Con: Policymakers Should Not Try to Stabilize the Economy

1. There are substantial diLculties associated with running %scal and monetary

policy. One of the most important problems to remember is the time lag that often

occurs with policy.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Instead of lecturing, divide the students into groups and have them

present the debates discussed in the chapter. Ask them to provide facts

and %gures to support their positions.

Chapter 36/Six Debates over Macroeconomic Policy ❖ 615

2. Economic conditions change over time. Thus, policy eAects that occur with a lag

may hit the economy at the wrong time, leading to a more unstable economy.

3. Therefore, policymakers should refrain from intervening and be content with

“doing no harm.”

II. Should the Government Fight Recessions with Spending Hikes Rather than Tax Cuts?

A. Pro: The Government Should Fight Recessions with Spending Hikes

1. Traditional Keynesian analysis indicates that increases in government spending

are a more potent tool than cuts in taxes.

a. Tax cuts can lead to increases in spending and saving.

b. Increases in government spending raise spending directly.

2. Estimates from the Obama administration suggest that $1 of tax cuts raises GDP

by $0.99, but a $1 increase in government spending raises GDP by $1.59.

B. Con: The Government Should Fight Recessions with Tax Cuts

1. Policymakers can target particular types of spending (such as investment) with

the right tax incentives.

2. Tax cuts may also increase aggregate supply.

a. Reducing marginal tax rates may provide greater incentive to work.

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616 ❖ Chapter 36/Six Debates over Macroeconomic Policy

b. Increases in aggregate supply that accompany an increase in aggregate

demand will keep the price level more stable.

III. Should Monetary Policy Be Made by Rule Rather than by Discretion?

A. Pro: Monetary Policy Should Be Made by Rule

1. Discretionary monetary policy leads to two problems.

a. It does not limit incompetence and abuse of power. For example, a central

banker may choose to create a political business cycle to help out a particular

candidate.

b. It may lead to a greater amount of in?ation than is desirable. Policymakers

often renege on the actions that they promise. If individuals do not believe

that the central bank will follow a low in?ation policy, the short-run Phillips

curve will shift, resulting in a less favorable trade-oA between in?ation and

unemployment.

2. One way to avoid these problems is to force the central bank to follow a monetary

rule. This rule could be ?exible enough to allow for some information on the state

of the economy.

B. Con: Monetary Policy Should Not Be Made by Rule

1. Discretionary monetary policy allows ?exibility. This gives the Fed the ability to

react to unforeseen situations quickly.

2. It is also unclear that Fed central bankers use policy to help political candidates.

Often, the policy used is one that actually lowers the candidate’s popularity (such

as during the Carter administration).

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Chapter 36/Six Debates over Macroeconomic Policy ❖ 617

3. The Fed can gain the con%dence of people by following through on its promises. If

it promises to %ght in?ation and then runs policies that keep the growth of the

money supply low, there is no reason why in?ation expectations would be high.

Thus, the economy can achieve low in?ation without a policy rule. (This was

shown to be the case in the United States in the 1990s.)

4. It would also be very diLcult to specify a precise rule.

C. FYI: Ination Targeting

1. Many central banks around the world have adopted explicit targets for in?ation.

2. The Federal Reserve has not adopted a formal policy of in?ation targeting.

IV. Should the Central Bank Aim for Zero In?ation?

A. Pro: The Central Bank Should Aim for Zero In?ation

1. In?ation confers no bene%ts on society, but it poses real costs.

a. Shoeleather costs

b. Menu costs

c. Increased variability of relative prices

d. Tax distortions

e. Confusion and inconvenience

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618 ❖ Chapter 36/Six Debates over Macroeconomic Policy

f. Arbitrary redistributions of wealth

2. Reducing in?ation usually is associated with higher unemployment in the short

run. However, once individuals see that policymakers are trying to lower in?ation,

in?ation expectations will fall, and the short-run Phillips curve will shift down. The

economy will move back to the natural rate of unemployment at a lower in?ation

rate.

3. Therefore, reducing in?ation is a policy with temporary costs and permanent

bene%ts.

4. It is not clear that a case could be made for any other level of in?ation. Price

stability only occurs if the in?ation rate is zero.

B. Con: The Central Bank Should Not Aim for Zero In?ation

1. The bene%ts of zero in?ation are small relative to the costs. Estimates of the

sacri%ce ratio suggest that lowering in?ation by one percentage point lowers

output in the economy by 5%. These costs are borne by the workers with the

lowest level of skills and experience who lose their jobs.

2. There is no evidence that the costs of in?ation are large. Also, policymakers may

be able to lower the costs of in?ation (by changing tax laws, for example) without

actually lowering the in?ation rate.

3. Although, in the long run, the economy will move back to the natural rate of

unemployment, there is no certainty that this will occur quickly. It may take time

for the central bank to gain the trust of the people.

4. Moreover, recessions have permanent eAects. Investment falls, lowering the

future capital stock. When workers become unemployed, they lose valuable job

skills.

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Chapter 36/Six Debates over Macroeconomic Policy ❖ 619

5. A small amount of in?ation may actually bene%t the economy.

C. In the News: On Kiwis and Currencies

1. In 1989, New Zealand announced a targeted in?ation rate of zero to two percent

and gave the central bank the independent authority to reach that goal. Many

other countries proceeded to adopt this plan.

2. This New York Times article questions whether the targeted rate is the best rate

to balance the pros of low in?ation with the limitations it places on the central

banks’ ability to spur the economy in a downturn.

V. Should the Government Balance Its Budget?

A. Pro: The Government Should Balance Its Budget

1. Future generations of taxpayers will be burdened by the federal government’s

debt. This will lower the standard of living for these future generations.

2. Budget de%cits cause crowding out. Reduced national saving raises interest rates

and lowers investment. A lower capital stock reduces productivity and thus leads

to a smaller amount of economic growth than would have occurred in the absence

of this budget de%cit.

3. While it is sometimes justi%able to run budget de%cits (such as in times of war or

recession), recent budget de%cits are not easily justi%ed. It appears that Congress

simply found it easier to borrow to pay for its spending instead of raising taxes.

B. Con: The Government Should Not Balance Its Budget

1. The problems caused by the government debt are overstated. The future

generation’s burden of debt is relatively small when compared with their lifetime

incomes.

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620 ❖ Chapter 36/Six Debates over Macroeconomic Policy

2. It is important that any change in government spending is examined for external

eAects. If education spending is cut, for example, this will likely lead to lower

economic growth in the future. This will certainly not make future generations

better oA.

3. To some extent, parents who leave a bequest to their children can oAset the

eAects of the budget de%cits on future generations.

VI. Should the Tax Laws Be Reformed to Encourage Saving?

A. Pro: The Tax Laws Should Be Reformed to Encourage Saving

1. The greater the amount of saving in an economy, the more funds there are

available for investment. This increases productivity, raising the nation’s standard

of living.

2. Because people respond to incentives, changing the tax laws to make saving

more attractive will raise the amount of funds saved. Current laws tax the return

on saving fairly heavily. Some forms of capital income (such as corporate pro%ts)

are taxed twice: %rst at the corporate level and then at the stockholder level.

Large bequests are also taxed, limiting the amount of incentive parents have to

save for their children.

3. Tax laws are not the only government policy that discourage saving. Transfer

programs such as welfare and Medicaid are reduced for those who have saved

past income. College %nancial aid policies also are a function of income and

wealth, penalizing those who have saved.

4. There are various ways to change the tax laws to encourage saving.

a. Expand the ability of households to use tax-advantaged savings accounts

such as Individual Retirement Accounts.

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Chapter 36/Six Debates over Macroeconomic Policy ❖ 621

b. Replace the current income tax system with a tax on consumption.

B. Con: The Tax Laws Should Not Be Reformed to Encourage Saving

1. Increasing saving is not the only goal of tax policy. Policymakers are interested in

using tax policy to redistribute income, making sure that the burden of taxation

falls on those who can most aAord it. Any tax change that encourages saving will

favor high-income households as they are more likely to be saving in the %rst

place.

2. Changes in tax rates have con?icting substitution and income eAects.

3. Saving can be increased in other ways. For example, governments could lower

budget de%cits (or increase budget surpluses) to raise public saving.

4. Lowering the tax on capital income lowers the revenue of the government. This

may increase the budget de%cit, lower public saving, and push national saving

down as well.

C. Ask the Experts: Taxing Capital and Labor

1. 96 percent of economic experts agree that setting lower tax rates for capital

income than for labor income gives people the incentive to relabel income as

capital income rather than labor income.

2. Economic experts are divided on whether permanently taxing capital income at a

lower rate than labor income would result in higher average long term prosperity

than setting tax rates for capital and labor income equal while generating the

same amount of tax revenue.

3. 98 percent of economic experts agree that economists disagree on tax policy

because they hold diAering views about choices between raising average

prosperity and redistributing income.

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622 ❖ Chapter 36/Six Debates over Macroeconomic Policy

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

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