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Chapter Outline

15. Macroeconomic Issues and Policy. Chapter Outline.

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Chapter Outline

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  1. 15 Macroeconomic Issuesand Policy Chapter Outline Time Lags Regarding Monetary and Fiscal PolicyStabilization: “The Fool in the Shower”Recognition LagsImplementation LagsResponse LagsMonetary PolicyControlling the Interest RateThe Fed’s Response to the State of the EconomyMonetary Policy Since 1990Inflation TargetingFiscal Policy: Deficit TargetingThe Effects of Spending Cuts on the DeficitEconomic Stability and Deficit ReductionSummaryFiscal Policy Since 1990

  2. TIME LAGS REGARDING MONETARYAND FISCAL POLICY FIGURE 15.1 Two Possible Time Paths for GDP

  3. TIME LAGS REGARDING MONETARYAND FISCAL POLICY stabilization policy Describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible. time lags Delays in the economy’s response to stabilization policies.

  4. The main goal of stabilization policy is to: a. Take economic measures that enhance the credibility of government institutions. b. Be prepared to handle destabilizing economic situations, such as a bank run. c. Use monetary and fiscal policy to smooth out fluctuations in output, employment, and prices. d. Use economic policy to solve social problems such as crime or child neglect.

  5. The main goal of stabilization policy is to: a. Take economic measures that enhance the credibility of government institutions. b. Be prepared to handle destabilizing economic situations, such as a bank run. c. Use monetary and fiscal policy to smooth out fluctuations in output, employment, and prices. d. Use economic policy to solve social problems such as crime or child neglect.

  6. TIME LAGS REGARDING MONETARYAND FISCAL POLICY STABILIZATION: “THE FOOL IN THE SHOWER” FIGURE 15.2 “The Fool in the Shower”—How Government Policy Can Make Matters Worse

  7. A leading critic of stabilization policy that likened government attempts to stabilize the economy to a “fool in the shower” is: a. John Maynard Keynes. b. Adam Smith. c. Milton Friedman. d. Jean-Paul Sartre.

  8. A leading critic of stabilization policy that likened government attempts to stabilize the economy to a “fool in the shower” is: a. John Maynard Keynes. b. Adam Smith. c. Milton Friedman. d. Jean-Paul Sartre.

  9. TIME LAGS REGARDING MONETARYAND FISCAL POLICY RECOGNITION LAGS recognition lag The time it takes for policy makers to recognize the existence of a boom or a slump.

  10. TIME LAGS REGARDING MONETARYAND FISCAL POLICY IMPLEMENTATION LAGS implementation lag The time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump. The implementation lag for monetary policy is generally much shorter than for fiscal policy.

  11. TIME LAGS REGARDING MONETARYAND FISCAL POLICY RESPONSE LAGS response lag The time that it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself. What is most important is the total lag between the time a problem first occurs and the time the corrective policies are felt.

  12. Which lag occurs because of the operation of the economy, or the time it takes for the multiplier to reach its full value? a. The recognition lag. b. The implementation lag. c. The response lag. d. All of the above refer to how the economy adjusts after a new policy is implemented.

  13. Which lag occurs because of the operation of the economy, or the time it takes for the multiplier to reach its full value? a. The recognition lag. b. The implementation lag. c. The response lag. d. All of the above refer to how the economy adjusts after a new policy is implemented.

  14. TIME LAGS REGARDING MONETARYAND FISCAL POLICY Response Lags for Fiscal Policy Neither individuals nor firms revise their spending plans instantaneously. Until they can make those revisions, extra government spending does not stimulate extra private spending. Response Lags for Monetary Policy Monetary policy works by changing interest rates, which then change planned investment. The response of consumption and investment to interest rate changes takes time.

  15. TIME LAGS REGARDING MONETARYAND FISCAL POLICY Summary Stabilization is not easily achieved. It takes time for policy makers to recognize the existence of a problem, more time for them to implement a solution, and yet more time for firms and households to respond to the stabilization policies taken.

  16. Which of the following changes in fiscal policy has a shorter response lag than the others? a. An increase in government spending. b. A cut in personal taxes. c. A cut in business taxes. d. All of the above measures have about the same response lag.

  17. Which of the following changes in fiscal policy has a shorter response lag than the others? a. An increase in government spending. b. A cut in personal taxes. c. A cut in business taxes. d. All of the above measures have about the same response lag.

  18. MONETARY POLICY There are two key points that we must add to the monetary policy story to make the story realistic, as we do in this section. The first point is that in practice the Fed controls the interest rate rather than the money supply. The second point is that the interest rate value that the Fed chooses depends on the state of the economy.

  19. MONETARY POLICY FIGURE 15.3 Fed Behavior

  20. MONETARY POLICY CONTROLLING THE INTEREST RATE The Fed can pick a money supply value and accept the interest rate consequences, or it can pick an interest rate value and accept the money supply consequences. The first key point is that in practice the Fed chooses the interest rate value and accepts the money supply consequences, rather than vice versa.

  21. How much the interest rate changes when the money supply changes depends on the shape of the demand for money curve. More precisely: a. The steeper the money demand curve, the larger is the change in the interest rate for a given size change in government securities. b. The steeper the money demand curve, the smaller is the change in the interest rate for a given size change in government securities. c. The steeper the money demand curve, the greater the effectiveness of monetary policy. d. The steeper the money supply curve, the greater its control over the demand for money.

  22. How much the interest rate changes when the money supply changes depends on the shape of the demand for money curve. More precisely: a. The steeper the money demand curve, the larger is the change in the interest rate for a given size change in government securities. b. The steeper the money demand curve, the smaller is the change in the interest rate for a given size change in government securities. c. The steeper the money demand curve, the greater the effectiveness of monetary policy. d. The steeper the money supply curve, the greater its control over the demand for money.

  23. MONETARY POLICY THE FED’S RESPONSE TO THE STATE OF THE ECONOMY FIGURE 15.4 The Fed’s Response to Low Output/Low Inflation The Fed is likely to lower the interest rate (and thus increase the money supply) during times of low output and low inflation.

  24. MONETARY POLICY FIGURE 15.5 The Fed’s Response to High Output/High Inflation The Fed is likely to increase the interest rate (and thus decrease the money supply) during times of high output and high inflation.

  25. Which of the following statements is entirely correct? a. The Fed is likely to increase the interest rate during times of high output and low inflation. b. The Fed is likely to lower the interest rate during times of low output and low inflation. c. The Fed is likely to lower the interest rate during times of high output and low inflation. d. The Fed is likely to increase the interest rate during times of low output and low output and inflation.

  26. Which of the following statements is entirely correct? a. The Fed is likely to increase the interest rate during times of high output and low inflation. b. The Fed is likely to lower the interest rate during times of low output and low inflation. c. The Fed is likely to lower the interest rate during times of high output and low inflation. d. The Fed is likely to increase the interest rate during times of low output and low output and inflation.

  27. MONETARY POLICY MONETARY POLICY SINCE 1990

  28. MONETARY POLICY

  29. MONETARY POLICY

  30. MONETARY POLICY INFLATION TARGETING inflation targeting When a monetary authority chooses its interest rate values with the aim of keeping the inflation rate within some specified band over some specified horizon.

  31. FISCAL POLICY: DEFICIT TARGETING Gramm-Rudman-Hollings Act Passed by the U.S. Congress and signed by President Reagan in 1986, this law set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991. FIGURE 15.6 Deficit Reduction Targets under Gramm-Rudman-Hollings

  32. FISCAL POLICY: DEFICIT TARGETING THE EFFECTS OF SPENDING CUTS ON THE DEFICIT A cut in government spending causes the economy to contract. Both the taxable income of households and the profits of firms fall. The deficit tends to rise when GDP falls, and tends to fall when GDP rises. deficit response index (DRI) The amount by which the deficit changes with a $1 change in GDP.

  33. Fill in the blank. When there is a contraction in the economy, automatic spending cuts to reduce the deficit would have to be ___________ the corresponding increase in government expenditures. a. exactly equal to b. greater than c. less than d. exactly twice as large as

  34. Fill in the blank. When there is a contraction in the economy, automatic spending cuts to reduce the deficit would have to be ___________ the corresponding increase in government expenditures. a. exactly equal to b. greater than c. less than d. exactly twice as large as

  35. FISCAL POLICY: DEFICIT TARGETING Monetary Policy to the Rescue? A zero multiplier can come about through renewed optimism on the part of households and firms or through very aggressive behavior on the part of the Fed, but because neither of these situations is very plausible, the multiplier is likely to be greater than zero. Thus, it is likely that to lower the deficit by a certain amount, the cut in government spending must be larger than that amount.

  36. To prevent the change in output arising from a cut in government spending, the Fed could try to: a. decrease the interest rate, but the amount of intervention would have to be substantial. b. decrease the interest rate, which would require only a slight increase in the money supply. c. increase the interest rate substantially by lowering the money supply only slightly. d. shift the AD curve to the left.

  37. To prevent the change in output arising from a cut in government spending, the Fed could try to: a. decrease the interest rate, but the amount of intervention would have to be substantial. b. decrease the interest rate, which would require only a slight increase in the money supply. c. increase the interest rate substantially by lowering the money supply only slightly. d. shift the AD curve to the left.

  38. FISCAL POLICY: DEFICIT TARGETING ECONOMIC STABILITY AND DEFICIT REDUCTION negative demand shock Something that causes a negative shift in consumption or investment schedules or that leads to a decrease in U.S. exports.

  39. FISCAL POLICY: DEFICIT TARGETING automatic stabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize GDP. automatic destabilizers Revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize GDP.

  40. FISCAL POLICY: DEFICIT TARGETING FIGURE 15.7 Deficit Targeting as an Automatic Destabilizer

  41. In a world without deficit targeting, the deficit is: a. An automatic stabilizer. b. An automatic destabilizer. c. A negative demand shock. d. Maximized.

  42. In a world without deficit targeting, the deficit is: a. An automatic stabilizer. b. An automatic destabilizer. c. A negative demand shock. d. Maximized.

  43. FISCAL POLICY SINCE 1990 FIGURE 15.8 Federal Personal Income Taxes as a Percentage of Taxable Income, 1990 I–2005 II

  44. FISCAL POLICY SINCE 1990 FIGURE 15.9 Federal Government Consumption Expenditures as a Percentage of GDP, 1990 I–2005 II

  45. FISCAL POLICY SINCE 1990 FIGURE 15.10 Federal Transfer Payments and Grants-in-aid as a Percentage of GDP, 1990 I–2005 II

  46. FISCAL POLICY SINCE 1990 FIGURE 15.11 Federal Interest Payments as a Percentage of GDP, 1990 I–2005 II

  47. REVIEW TERMS AND CONCEPTS • automatic destabilizer • automatic stabilizer • deficit response index (DRI) • Gramm-Rudman-Hollings Act • implementation lag inflation targeting negative demand shock recognition lag response lag stabilization policy time lags

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