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Chapter 16

Macroeconomic Policies

© 2003 South-Western College Publishing

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Macroeconomic Policies

Expansionary PoliciesExpansionary PoliciesMonetary and fiscal policies that are used to try to

increase the equilibrium level of income and output in the economy

Contractionary PoliciesContractionary PoliciesMonetary and fiscal policies that are used to try to

lower aggregate demand for output in the economy to a level that can be achieved with full employment of all resources

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Expansionary Policies Automatic StabilizersAutomatic Stabilizers

Forces within the economy that naturally tend to counteract recessions and inflation; ex., the Social Security system, unemployment compensation, progressive income tax

Fiscal dragFiscal dragSlowing effect on the economy resulting from a

budget surplus Fiscal stimulusFiscal stimulus

Activating effect on on the economy resulting from a budget deficit

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Expansionary Policies

Monetary policyIncrease in the money supply lower interest rates

increases the level of aggregate expenditures during periods of high unemployment

Discretionary fiscal policyTax financingDebt financingFinancing by creating money

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Tax Financing

When taxation used to finance increased government spending, caution must be used so as not to tax funds that would otherwise be used for consumption & investment

Object here should be to design a tax to absorb idle funds

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Debt Financing

If purpose is to increase aggregate spending, borrowing is more desirable method of raising funds for government spending

Source of the borrowing has a direct bearing on the effectiveness of this approach

Crowding outCrowding outOccurs when deficit spending by the government

drives interest rates up and leads to declines in private investment spending

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Debt Financing

Ricardian Equivalence TheoremRicardian Equivalence TheoremProposition that if makes no difference whether

government spending is financed by taxes or a deficit

In either case, the transfer of resources from the private sector to the government leads to having no net effect on the aggregate economy

Based on rational expectations, individuals realize that deficits must be paid off in the future taxes will rise to pay off the debt they will reduce spending just as they would if taxes were increased

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Financing by Creating Money

Treasury sells bonds to the Fed (or to the public) to finance government spending

When Treasury (or public) spends this money to make purchases, the result is an increase in the money supply

This process is referred to as eitherPrinting money because it increases the money

supplyMonetizing the debt

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Methods of Increasing Government Spending

Increase government spending and hold taxes constant

Hold government spending constant and decrease taxes (tax rebate plan)

Increase government spending and increase taxes proportionallyBalanced budget multiplier

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Discretionary Government Spending

Discretionary government spendingTransfer paymentsPublic works

Problems with discretionary spendingDifficult to end a government spending

programProblems balancing when the program is

needed and when it can begin

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Expanding the Economy

The Great Depression The New Deal Expansionary Policies of the 1960s Expansionary Policies of the 1970s, 1980s &

1990sRecession of 1974-75Recessions of 1980 and 1982Recession of 1990-912001 Recession

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Recession and Deflation

DeflationDeflationpersistent decrease in the level of prices

DisinflationDisinflationa slowdown in the rate of inflation

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Inflation & Types of Inflation

InflationInflation Persistent increase in the level of prices

Demand-Pull InflationDemand-Pull Inflation Occurs when the total demand for goods and services exceeds

the available supply of goods and services in the short run

Cost-Push InflationCost-Push Inflation Characterized by a spiral of wage and benefit cost increases

and price increases

StagflationStagflation Inflation and high unemployment occurring at the same time

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Measures to Reduce Total Spending

Automatic Stabilizers Monetary Policy

Use of measures to reduce the money supply Other Measures

Credit restraints, limits on borrowing for stock purchases

Government Surplus Hold taxes and decrease spending Increase taxes and hold or decrease spending Decrease taxes and decrease spending

Borrowing

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Wartime Inflation

Wartime economy entails a significant reallocation of resources

Need for Reducing Consumption and InvestmentTaxationVoluntary SavingsCompulsory SavingsOther Measures

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Trade-Off Between Unemployment and Inflation

Phillips curvePhillips curveCurve showing the relationship between

unemployment and inflationMore accurately describes the short-run

rather than the long-run relationshipNatural rate of unemployment

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Hyperinflation in Latin America

HyperinflationHyperinflation Inflation that feeds on itself to go out of control,

creating severe distortions in an economy and rendering its currency almost worthless

Central and South AmericaBolivia experienced a 11,750% inflation rate in 1985Argentina has experienced inflation rates as high as

3,030% in 1989Inflation rates in Venezuela have ranged from 31%

in 1992 to 61% in 1994

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Contracting the Economy – 1960s

Use of voluntary wage and price guideposts suggested by President Kennedy

President Johnson imposed a temporary 10% surcharge on personal and corporate income taxes

Surtax fell more heavily on savings than consumption with result that little success was achieved in arresting inflation

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Contracting the Economy – 1970s

President Nixon declared a 90-day freeze on all prices, wages, and rents

Imposed surtax on imports Asked Congress to reduce personal taxes and

repeal some excise taxes Wage and price freeze offered only temporary

success Stagflation President Carter once again announced a set of

voluntary wage and price controls that were largely unsuccessful

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Contracting the Economy – 1980s

Reagan shifted from a demand-side approach to dealing with the dual problems of unemployment and inflation to a number of supply side measures

MeasuresEncourage savingStimulate investmentMotivate work effort

Generally successful

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Contracting the Economy – 1990s

Kuwaiti oil Crisis and Gulf War Increased taxes without reducing government

spending Increased money supply President Clinton

Contractionary fiscal policyExpansionary monetary policyPresided over longest peacetime expansion in U.S.