412
WHAT’S NEW IN THE SEVENTH EDITION:
Two new
In the News
features have been added on “How long will the Fed keep interest rates at zero?”
and “What would an American fiscal crisis look like?”
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 fight recessions with spending hikes or tax
cuts.
➢ the debate concerning whether monetary policy should be made by rule rather than by discretion.
➢ the debate concerning whether the central bank should aim for zero inflation.
➢ 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 23 is the final 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.
23
SIX DEBATES OVER
MACROECONOMIC POLICY
Chapter 23/Six Debates over Macroeconomic Policy ❖ 413
KEY POINTS:
• Advocates of active monetary and fiscal policy view the economy as inherently unstable and believe
that policy can manage aggregate demand in order to offset the inherent instability. Critics of active
monetary and fiscal policy emphasize that policy affects 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 fight 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 supply and that hasty increases in government
spending may lead to wasteful public projects.
• Advocates of a zero-inflation target emphasize that inflation has many costs and few if any benefits.
Moreover, the cost of eliminating inflation—depressed output and employment―is only temporary.
Even this cost can be reduced if the central bank announces a credible plan to reduce inflation,
thereby directly lowering expectations of inflation. Critics of a zero-inflation target claim that
moderate inflation imposes only small costs on society, whereas the recession necessary to reduce
the inflation is quite costly. The critics also point out several ways in which moderate inflation may be
helpful to an economy.
• Advocates of a balanced government budget argue that budget deficits impose an unjustifiable
burden on future generations by raising their taxes and lowering their incomes. Critics of a balanced
government budget argue that the deficit is only one small piece of fiscal policy. Single-minded
concern about the budget deficit can obscure the many ways in which policy, including various
spending programs, affects different generations.
CHAPTER OUTLINE:
Provide supporting facts and figures 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 economists.
414 ❖ Chapter 23/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 firms feel pessimistic, aggregate demand falls. This causes output to
fall and unemployment to rise.
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 difficulties associated with running fiscal and monetary policy. One of
the most important problems to remember is the time lag that often occurs with policy.
2. Economic conditions change over time. Thus, policy effects 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.”
C.
In the News: How long will the Fed keep interest rates at zero?
1. After the financial crisis of 2008-2009, the Federal Reserve reduced its target for the federal
funds rate to about zero.
2. This article from The Wall Street Journal describes the Fed’s communication about its current
policy and the conditions under which it may change its policy.
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.
Instead of lecturing, divide the students into groups and have them present the
debates discussed in the chapter. Ask them to provide facts and figures to support
their positions.
Chapter 23/Six Debates over Macroeconomic Policy ❖ 415
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.
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 inflation 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 inflation policy, the short-run Phillips curve will shift, resulting in a less
favorable trade-off between inflation and unemployment.
2. One way to avoid these problems is to force the central bank to follow a monetary rule. This
rule could be flexible 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 flexibility. 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).
4. It would also be very difficult to specify a precise rule.
C.
FYI: Inflation Targeting
416 ❖ Chapter 23/Six Debates over Macroeconomic Policy
1. Many central banks around the world have adopted explicit targets for inflation.
2. The Federal Reserve has not adopted a formal policy of inflation targeting.
IV. Should the Central Bank Aim for Zero Inflation?
A. Pro: The Central Bank Should Aim for Zero Inflation
1. Inflation confers no benefits on society, but it poses real costs.
a. Shoeleather costs
2. Reducing inflation usually is associated with higher unemployment in the short run. However,
once individuals see that policymakers are trying to lower inflation, inflation 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 inflation rate.
3. Therefore, reducing inflation is a policy with temporary costs and permanent benefits.
4. It is not clear that a case could be made for any other level of inflation. Price stability only
occurs if the inflation rate is zero.
B. Con: The Central Bank Should Not Aim for Zero Inflation
1. The benefits of zero inflation are small relative to the costs. Estimates of the sacrifice ratio
suggest that lowering inflation 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 inflation are large. Also, policymakers may be able to
lower the costs of inflation (by changing tax laws, for example) without actually lowering the
inflation rate.
C.
In the News: What is the Optimal Inflation Rate?
Chapter 23/Six Debates over Macroeconomic Policy ❖ 417
1. After the economic downturn of 2008 and 2009, economists began to wonder whether some
inflation might be desirable.
2. This article from
The
Wall Street Journal
describes these considerations.
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.
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.
2. It is important that any change in government spending is examined for external effects. 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 off.
3. To some extent, parents who leave a bequest to their children can offset the effects of the
budget deficits on future generations.
C.
In the News: What would an American fiscal crisis look like?
1. Several European nations recently have experienced fiscal crises.
2. This article from
The New York Times
presents a presidential address to be delivered in 2026
regarding a fiscal crisis in the U.S.
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.
418 ❖ Chapter 23/Six Debates over Macroeconomic Policy
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 financial
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.
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 afford it. Any tax change that encourages saving will favor high-income households as
they are more likely to be saving in the first place.
2. Changes in tax rates have conflicting substitution and income effects.
3. Saving can be increased in other ways. For example, governments could lower budget
deficits (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 deficit, lower public saving, and push national saving down as well.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. Monetary and fiscal policies work with a lag. Monetary policy works with a lag because it
affects spending for residential and business investment, but spending plans for such
Chapter 23/Six Debates over Macroeconomic Policy ❖ 419
4. The benefits of reducing inflation to zero include: (1) reducing shoeleather costs; (2)
reducing menu costs; (3) reducing the variability of relative prices; (4) preventing unintended
Questions for Review
1. The lags in the effect of monetary and fiscal policy on aggregate demand are caused by the
fact that many households and firms set their spending plans in advance, so it takes time for
420 ❖ Chapter 23/Six Debates over Macroeconomic Policy
7. Two situations in which a budget deficit is justifiable are: (1) in wartime, so tax rates will not
Quick Check Multiple Choice
1. b
Problems and Applications
1. a. Figure 1 illustrates the short-run effect of a fall in aggregate demand. The economy
Chapter 23/Six Debates over Macroeconomic Policy ❖ 421
2. It is difficult for policymakers to choose the appropriate strength of their actions because of
422 ❖ Chapter 23/Six Debates over Macroeconomic Policy
4. Issues about whether the costs of inflation are large or small are positive statements, as is
6. If the budget deficit is 12% of GDP and nominal GDP is rising 5% each year, the ratio of
Chapter 23/Six Debates over Macroeconomic Policy ❖ 423
8. The fundamental trade-off that society faces if it chooses to save more is that it will have to