MACROECONOMICS CLASS NOTES
MONETARY POLICY
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CHAPTER
FIFTEEN
- MONETARY POLICY
CHAPTER OVERVIEW
The objectives and the mechanics of monetary policy are covered in this chapter. It is organized around seven major topics: (1) the balance sheet of the Federal Reserve Banks; (2) the techniques of monetary policy; (3) a graphic restatement of monetary policy; (4) the cause‑effect chain of monetary policy; (5) a survey of the advantages and disadvantages of monetary policy; (6) the dilemma of which targets should be the goal of monetary policy, interest rates, or money supply; and (7) the impact of monetary policy operating in a world economy. Finally, there is a brief, but important, synopsis of mainstream theory and policies. The purpose of the concluding sections is to summarize all the macro theory developed so far and fit the pieces together as an integrated whole for students.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Identify the goals of monetary policy.
2. List the principal assets and liabilities of the Federal Reserve Banks.
3. Explain how each of the three tools of monetary policy may be used by the Fed to expand and to contract the money supply.
4. Describe three monetary policies the Fed could use to reduce unemployment.
5. Describe three monetary policies the Fed could use to reduce inflationary pressures in the economy.
6. Explain the cause‑effect relationship between monetary policy and changes in equilibrium GDP.
7. Demonstrate the money market graphically and show how a change in the money supply will affect the interest rate.
8. Show the effects of interest rate changes on investment spending.
9. Describe the impact of changes in investment on aggregate demand and equilibrium GDP.
10. Contrast the effects of an easy money policy with the effects of a tight money policy.
11. Identify the federal funds rate, its relation to the prime interest rate, and its importance for monetary policy.
12. List two strengths and three shortcomings of monetary policy.
13. Describe the arguments for and against “inflation targeting” versus a more discretionary “artful management” approach to monetary policy.
14. Explain the net export effect of an expansionary and a contractionary monetary policy.
15. Define and identify the terms and concepts at the end of the chapter.
LECTURE NOTES
I.
Introduction to Monetary Policy
A. Reemphasize Chapter 13’s points: The Fed’s Board of Governors formulates policy, and the twelve Federal Reserve Banks implement that policy.
B. The fundamental objective of monetary policy is to aid the economy in achieving full‑employment output with stable prices.
1. To do this, the Fed changes the nation’s money supply.
2. To change the money supply, the Fed manipulates the size of excess reserves held by banks.
C. Monetary policy has a very powerful impact on the economy, and the Chairman of the Fed’s Board of Governors, Alan Greenspan currently, is sometimes called the second most powerful person in the U.S.
II.
Consolidated Balance Sheet of the Federal Reserve Banks
A. The assets column on the Fed’s balance sheet contains two major items.
1. Securities, which are federal government bonds purchased by the Fed
2. Loans to commercial banks (Note: again commercial banks term is used even though the chapter analysis also applies to other thrift institutions.)
B. The liability side of the balance sheet contains three major items.
1. Reserves of banks held as deposits at Federal Reserve Banks
2. U.S. Treasury deposits of tax receipts and borrowed funds
3. Federal Reserve Notes outstanding, our paper currency
III.
The Fed has Three Major “Tools” of Monetary Policy
A. Open‑market operations refer to the Fed’s buying and selling of government bonds.
1. Buying securities will increase bank reserves and the money supply (see Figure 15‑1).
a. If the Fed buys directly from banks, then bank reserves go up by the value of the securities sold to the Fed. See impact on balance sheets using text example.
b. If the Fed buys from the general public, people receive checks from the Fed and then deposit the checks at their bank. Bank customer deposits rise and therefore bank reserves rise by the same amount. Follow text example to see the impact.
i. Banks’ lending ability rises with new excess reserves.
ii. The money supply rises directly with increased deposits by the public.
When the Fed buys bonds from bankers, reserves rise and excess reserves rise by same amount since no checkable deposit was created.
When Fed buys from public, some of the new reserves are required reserves for the new checkable deposits.
e. Conclusion: When the Fed buys securities, bank reserves will increase and the money supply potentially can rise by a multiple of these reserves.
f. Note: When the Fed sells securities, points a‑e above will be reversed. Bank reserves will go down, and eventually the money supply will go down by a multiple of the banks’ decrease in reserves.
g. How the Fed attracts buyers or sellers.
i. When the Fed buys, it raises demand and price of bonds, which in turn lowers effective interest rate on bonds. The higher price and lower interest rates make selling bonds to Fed attractive.
ii. When the Fed sells, the bond supply increases and bond prices fall, which raises the effective interest rate yield on bonds. The lower price and higher interest rates make buying bonds from Fed attractive.
B. The reserve ratio is another “tool” of monetary policy. It is the fraction of reserves required relative to their customer deposits.
1. Raising the reserve ratio increases required reserves and shrinks excess reserves. Any loss of excess reserves shrinks banks’ lending ability and, therefore, the potential money supply by a multiple amount of the change in excess reserves.
2. Lowering the reserve ratio decreases the required reserves and expands excess reserves. The gain in excess reserves increases banks’ lending ability and, therefore, the potential money supply by a multiple amount of the increase in excess reserves.
3. Changing the reserve ratio has two effects.
a. It affects the size of excess reserves.
b. It changes the size of the monetary multiplier. For example, if ratio is raised from 10 percent to 20 percent, the multiplier falls from 10 to 5.
4. Changing the reserve ratio is very powerful since it affects banks’ lending ability immediately. It could create instability, so the Fed rarely changes it.
5. Table 15-2 provides illustrations.
C. The third “tool” is the discount rate, which is the interest rate that the Fed charges to commercial banks that borrow from the Fed.
1. An increase in the discount rate signals that borrowing reserves is more difficult and will tend to shrink excess reserves.
2. A decrease in the discount rate signals that borrowing reserves will be easier and will tend to expand excess reserves.
D. “Easy” monetary policy occurs when the Fed tries to increase the money supply by expanding excess reserves in order to stimulate the economy. The Fed will enact one or more of the following measures:
1. The Fed will buy securities.
2. The Fed may lower the reserve ratio, although this is rarely done because of its powerful impact.
3. The Fed could reduce the discount rate. Although this has little direct impact on the money supply, it is a way for the Fed to “announce” policy direction.
E. “Tight” monetary policy occurs when Fed tries to the decrease money supply by decreasing excess reserves in order to slow spending in the economy during an inflationary period. The Fed will enact one or more of the following policies:
1. The Fed will sell securities.
2. The Fed may raise the reserve ratio, although this is rarely done because of its powerful impact.
3. The Fed could raise the discount rate. Although it has little direct impact on money supply, the Fed may use it to “announce” a policy change.
For several reasons, open‑market operations give the Fed most control of the three “tools.”
1. Open‑market operations are most important. This decision is flexible because securities can be bought or sold quickly and in great quantities. Reserves change quickly in response.
2. The reserve ratio is rarely changed since this could destabilize bank’s lending and profit positions.
3. Changing the discount rate has little direct effect, since only 2‑3 percent of bank reserves are borrowed from Fed. At best it has an “announcement effect” that signals the direction of monetary policy. The strength of this announcement effect will depend on the credibility of the Fed to back up its “announcement” with the other policy tools if necessary.
IV.
Monetary Policy, Real GDP, and the Price Level:
How Policy Affects the Economy
A.
A cause‑effect chain.
1. Money market impact is shown in Key Graph 15‑2.
a. Demand for money is comprised of two parts (recall Chapter 13).
i. Transactions demand is directly related to GDP.
ii. Asset demand is inversely related to interest rates, so total money demands is inversely related to interest rates.
b. Supply of money is assumed to be set by the Fed.
c. Interaction of supply and demand determines the market rate of interest, as seen in Figure 15‑2(a).
d. Interest rate determines amount of investment businesses will be willing to make. Investment demand is inversely related to interest rates, as seen in Figure 15‑2(b).
e. Effect of interest rate changes on level of investment is great because interest cost of large, long-term investment is a sizable part of investment cost.
f. As investment rises or falls, equilibrium GDP rises or falls by a multiple amount, as seen in Figure 15‑2(c).
2. Expansionary or easy money policy: The Fed takes steps to increase excess reserves, which lowers the interest rate and increases investment which, in turn, increases GDP by a multiple amount. (See Column 1, Table 15-3.)
3. Contractionary or tight money policy is the reverse of an easy money policy: Excess reserves fall, which raises interest rate, which decreases investment, which, in turn, decreases GDP by a multiple amount of the change in investment. (See Column 2, Table 15-3.)
4. Aggregate supply and monetary policy.
Easy monetary policy may be inflationary if initial equilibrium is at or near full-employment.
If the economy is below full employment, easy monetary policy can shift aggregate demand and GDP toward full-employment equilibrium.
Likewise a tight monetary policy can reduce inflation if the economy is near full employment, but can make unemployment worse in a recession.
5. Try Quick Quiz 15-2.
V.
Monetary Policy in Action
A. Strengths of monetary policy.
1. It is speedier and more flexible than fiscal policy since the Fed can buy and sell securities daily.
2. It is less political. Fed Board members are isolated from political pressure, since they serve 14‑year terms, and policy changes are subtler and not noticed as much as fiscal policy changes. It is easier to make good, if unpopular decisions.
B. Focus on the Federal Funds Rate.
1. Currently the Fed communicates changes in monetary policy through changes in its target for the Federal funds rate. (Key Question 6)
2. The Fed does not set either the Federal funds rate or the prime rate; (see Figure 15-3) each is established by the interaction of lenders and borrowers, but rates generally follow the Fed funds rate.
3. The Fed acts through open market operations, selling bonds to raise interest rates and buying bonds to lower interest rates.
C. Recent monetary policy.
1. Easy money policy in the early 1990s helped produce a recovery from the 1990-1991 recession and the expansion that lasted until 2001. Tightening in 1994, 1995, and 1997 helped ease inflationary pressure during the expansion.
2. To counter the recession that began in March 2001, the Fed pursued an easy money policy that saw the prime interest rate fall from 9.5 percent at the end of 2000 to 4.25 percent in December 2002.
3. The Fed has been praised for helping the U.S. economy maintain simultaneously full employment, price stability, and economic growth for over four years. They have also received credit for swift and strong responses to the September 11, 2001, terrorist attacks, significant declines in the stock market, and the overall recessionary conditions.
D. Problems and complications.
1. Recognition and operational lags impair the Fed’s ability to quickly recognize the need for policy change and to affect that change in a timely fashion. Although policy changes can be implemented rapidly, there is a lag of at least 3 to 6 months before the changes will have their full impact.
2. The velocity of money (number of times the average dollar is spent in a year) may be unpredictable, especially in the short run, and can offset the desired impact of changes in the money supply. Tight money policy may cause people to spend faster; velocity rises and the contractionary effect is offset.
3. Cyclical asymmetry may exist: a tight monetary policy works effectively to break inflation, but an easy monetary policy is not always as effective in stimulating the economy from recession. “You can lead a horse to water, but you can’t make it drink.”
4. CONSIDER THIS … Pushing on a String
Japan’s ineffective easy money policy illustrates the potential inability of monetary policy to bring an economy out of recession. While pulling on a string (tight money policy) is likely to move the attached object to its desired destination, pushing on a string is not.
5. The impact on investment may be less than traditionally thought. Japan provides a good example. Despite interest rates of zero, investment spending remained low during the recession.
E. “Artful Management” or “Inflation Targeting”?
1. The Fed under Alan Greenspan has managed the money supply such that the U.S. economy has enjoyed price stability, high levels of employment, and strong economic growth. This leads some to argue that the Fed should take an active policy role and attempt to pursue all of those objectives in setting policy.
2. Out of concern that the Fed’s success may not be reproducible, some argue for inflation targeting. This narrower policy objective would make monetary policy more predictable and “transparent” to those in the economy making decisions based on Fed action.
F. Monetary policy and the international economy.
1. Net export effect occurs when foreign financial investors respond to a change in interest rates.
a. Tight monetary policy and higher interest rates lead to appreciation of dollar value in foreign exchange markets; lower interest rates from an easy monetary policy will lead to dollar depreciation in foreign exchange markets (see Figure 12-5c).
b. When the dollar appreciates, American goods become more costly to foreigners, and this lowers demand for U.S. exports, which tends to lower GDP. This is the desired effect of a tight money policy. Conversely, an easy money policy leads to depreciation of dollar, greater demand for U.S. exports and higher GDP. This policy has the desired outcome for expanding GDP.
2. Monetary policy works to correct both trade balance and GDP problems together. An easy monetary policy leads to increased domestic spending and increased GDP, but it also leads to a depreciated dollar and higher U.S. export demand, which enhances GDP and erases a trade deficit. The reverse is true for a tight monetary policy, which would tend to reduce net exports and worsen a trade deficit.
3. Table 15-4 illustrates these points.
VI.
The Big Picture (see Key Graph, Figure 15-4)
Shows Many Interrelationships
A. Fiscal and monetary policy are interrelated. The impact of an increase in government spending will depend on whether it is accommodated by monetary policy. For example, if government spending comes from money borrowed from the general public, it may be offset by a decline in private spending, but if the government borrows from the Fed or if the Fed increases the money supply, then the initial increase in government spending may not be counteracted by a decline in private spending.
Study Key Graph 15-4 and you will see that the levels of output, employment, income, and prices all result from the interaction of aggregate supply and aggregate demand. In particular, note the items shown in red that constitute, or are strongly influenced by, public policy.
Try Quick Quiz 15-4.
CHAPTER
SEVENTEEN - ECONOMIC GROWTH
In
Chapter 8 we looked at the impact of economic growth in general and concentrated
on the causes of short‑run fluctuations in employment and price levels and
on policies that might mitigate such instability.
The issue of long‑run economic growth is equally important.
Although punctuated by periods of cyclical instability, economic growth
in the United States has been impressive. For
example, during the last half century, real output increased 450 percent while
population increased only 80 percent, to yield approximately a tripling of the
goods and services available to the average American.
The
discussion of growth in this chapter explores economic growth in more depth than
in Chapter 8. We question whether
the United States is achieving a “new economy” which might deliver a
stronger future rate of growth. Finally,
we explore both positive and negative aspects of growth.
After completing this chapter, students should be able to
1. Identify six main ingredients in economic growth.
2. Show economic growth using production possibilities analysis and aggregate demand‑aggregate supply analysis.
3. Describe the growth record of the U.S. economy since 1950, including two measures of its long‑term growth rates.
4. Identify six major factors that contributed to U.S. economic growth according to empirical studies.
5. List three primary reasons for productivity acceleration in the United States since 1995.
6. List five reasons for increasing returns during the period of productivity acceleration.
7. Identify three macroeconomic implications of stronger productivity growth and more intense global competition.
8. Evaluate the potential for the productivity acceleration to be a permanent phenomenon.
9. Identify and explain the arguments for and against economic growth.
10. Define and identify the terms and concepts at the end of the chapter.
I.
Introduction
A. Two definitions of economics growth were given in Chapter 8.
1. The increase in real GDP, which occurs over a period of time.
2. The increase in real GDP per capita, which occurs over time. This definition is superior if comparison of living standards is desired.
B. Growth has been impressive in capitalist countries during the past half century. Real GDP in the U.S. increased by 450 percent.
C. This chapter explores economic growth in more depth than Chapter 8.
II. Six Main Ingredients of Growth
A. Four supply factors relate to the ability to grow.
1. The quantity and quality of natural resources
2. The quantity and quality of human resources
3. The supply or stock of capital goods
4. Technology
B. Two demand and efficiency factors are also related to growth.
1. Aggregate demand must increase for production to expand.
2. Full employment of resources and both productive and allocative efficiency are necessary to get the maximum amount of production possible.
III. Production Possibilities Analysis (Figure 17-1)
A. Growth can be illustrated with a production possibilities curve (Figure 17-1), where growth is indicated as an outward shift of the curve from AB to CD.
1. Aggregate demand must increase to sustain full employment at each new level of production possible.
2. Additional resources that shift the curve outward must be employed efficiently to make the maximum possible contribution to domestic output.
3. For the economy to achieve the maximum increase in value, the optimal combination of goods must be achieved (allocative efficiency).
B. Focus on the supply side is illustrated in Figure 17-2, where growth depends on labor inputs multiplied by labor productivity.
1. Increased labor inputs depend on size of population and labor force participation rate (the percent of population actually in the labor force).
2. Productivity is determined by technological progress, the availability of capital goods, quality of labor itself, and efficiency with which inputs are allocated, combined, and managed.
C. Aggregate demand‑aggregate supply framework can also be used to illustrate growth, as seen in Figure 17-3. Aggregate supply shifts outward with economic growth, and in recent decades aggregate demand has shifted outward by an even greater amount. Nominal GDP rises faster than real GDP. (Key Question 3)
D. An extended AD-AD model is shown in Figure 17-4 where short-term and long-term aggregate supply are differentiated.
1. Long-run potential output is shown at Q1. It depends on resources and productive efficiency.
2. If potential output increases, the long-run supply curve shifts from ASLR1 to ASLR2.
3. If aggregate demand rises from AD1 to AD2, real output rises to Q2 and prices to P2.
4. At P2 there will be a different short-run AS curve, AS2.
5. The result is some mild inflation and increases in real GDP.
IV.
Growth Record of the United States (Table 17-5)
A. Real GDP has increased more than six-fold since 1950, and real per capita GDP has risen by a multiple of three.
B. Rate of growth records shows that real GDP has grown 3.1 percent per year since 1948 and real GDP per capita has grown about 2 percent per year. In last four years of the 20th century, U.S. economic growth surged and averaged more than 4 percent per year. But the arithmetic needs to be qualified.
1. Growth doesn’t measure quality improvements.
2. Growth doesn’t measure increased leisure time.
3. Growth doesn’t take into account adverse effects on the environment.
4. International comparisons are useful in evaluating U.S. performance. For example, Japan has grown more than twice as fast as the U.S. since 1948, but less in the past decade.
V.
Accounting for growth is an attempt to quantify factors contributing to
economic growth.
A. More labor input is one source of growth. The labor force has grown by about 2 million workers per year for past 25 years and accounts for about one-third of total economic growth.
B. Technological advance, the most important factor, has been estimated to contribute to about 26% of the U.S. growth record since 1929.
C. Increases in quantity of capital are estimated to have contributed 18% to economic growth in the U.S. since 1929.
D. Education and training improve the quality of labor. (See Figure 17-6 and Table 17-1.)
E. Improved resource allocation and economies of scale also contribute to growth and explain about 12% of total growth.
1. Improved resource allocation has occurred as discrimination disappears and labor moves where it is most productive, and as tariffs and other trade barriers are lowered.
2. Economies of scale occur as the size of markets and firms that serve them have grown.
F. Other factors influence growth and are more difficult to measure.
1. The social and cultural environment and political stability are “growth friendly” in the U.S.
a. Respect for material success provides incentive to increase incomes.
b. The market system rewards actions that increase output.
c. Property rights and the legal system encourage growth.
2. Positive attitudes toward work and the flow of energetic immigrants also add to growth.
VI.
The Productivity Acceleration: A
New Economy? (Figure 17-7)
A. Improvement in standard of living is linked to labor productivity – output per worker per hour.
B. The U.S. is experiencing a resurgence of productivity growth based on innovations in computers and communications, coupled with global capitalism. Since 1995 productivity growth has averaged 2.8% annually – up from 1.4% over 1973-95 period. The “Rule of 70” projects real income will double in 23 years rather than 50 years.
C. Much of the recent improvement in productivity is due to “new economy” factors.
1. Microchips and information technology are the basis for improved productivity. Many new inventions are based on microchip technology.
2. New firms and increasing returns characterize the new economy.
a. Some of today’s most successful firms didn’t exist 25 years ago: Dell, Compaq, Microsoft, Oracle, Cisco Systems, America Online, Yahoo, and Amazon.com are just a few of many.
b. Economies of sale and increasing returns in new firms encourage rapid growth.
3. Sources of increasing returns include
a. More specialized inputs.
b. The ability to spread development costs over large output quantities since marginal costs are low.
c. Simultaneous consumption by many customers.
d. Network effects make widespread use of information goods more valuable as more people use the products.
e. Learning increases with practice.
4. Global competition encourages innovation and efficiency.
D. Macroeconomic outcomes include increases in aggregate supply (shift to right). (See Figure 17-3.)
E. Faster growth without inflation is possible with higher productivity.
F. The natural rate of unemployment seems to be lower (4.0 – 5.0%).
G. Federal revenues increase with economic growth; a 1995 deficit of $160 billion became a $167 billion surplus in 2000.
H. Skepticism about long-term continued growth remains, and only time will tell.
VII.
Is Growth Desirable and Sustainable?
A. An antigrowth view exists.
1. Growth causes pollution, global warming, ozone depletion, and other problems.
2. “More” is not always better if it means dead-end jobs, burnout, and alienation from one’s job.
3. High growth creates high stress.
B. Others argue in defense of growth.
1. Growth leads to an improved standard of living.
2. Growth helps to reduce poverty in poor countries.
3. Growth has improved working conditions.
4. Growth allows more leisure and less alienation from work.
6. Environmental concerns are important, but growth actually has allowed more sensitivity to environmental concerns and the ability to deal with them.
C. Is growth sustainable? Yes, say proponents of growth.
1. Resource prices are not rising.
2. Growth today has more to do with expansion and application of knowledge and information, so is limited only by human imagination.
CHAPTER
EIGHTEEN - DEFICITS, SURPLUSES AND THE PUBLIC DEBT
Three
interrelated topics of national concern—Federal budget deficits, surpluses,
and the public debt—are the focus of this chapter.
It begins by considering several contrasting budget philosophies. Table 18-1 provides statistical evidence that is useful in
tracing the growth of the debt and assessing its current quantitative
significance.
The
material on the public debt is designed to explode two popular misconceptions as
to the character and problems associated with a large public debt:
(1) the debt will force the U.S. into bankruptcy and (2) the debt imposes
a burden on future generations. The
debt discussion, however, also entails a look at substantive economic issues.
Potential problems of a large public debt include greater income inequality,
reduced economic
incentives, and crowding out of private investment. Now attention turns to what to do about budget surpluses.
The
chapter examines the Federal deficits of the 1990s, the large surpluses of the
late 1990s and early 2000s, and how they quickly turned to deficits.
After completing this chapter, students should be able to
1. Differentiate between deficit and debt.
2. Explain each of the three budget philosophies.
3. Identify three principal causes of the public debt.
4. State the absolute size of the debt and the relative size as a percentage of GDP.
5. Describe the annual interest charges on the debt, who holds the debt, and the impact of inflation on the debt.
6. Explain why the debt can also be considered public credit.
7. Identify and discuss two widely held myths about the public debt.
8. Explain the real or potential effect of the debt on income distribution, economic incentives, fiscal policy, and private investment.
9. State how debt plays a positive role in society.
10. Explain the policy options for when surpluses occur.
11. Explain why the surpluses of the early 2000s turned to deficits beginning in 2002.
12. Describe the long-run budgetary problems facing the Social Security system.
13. Define and identify the terms and concepts at the end of the chapter.
I.
Definitions of deficit, surplus, and debt
A. A budget deficit is the amount by which government’s expenditures exceed its revenues during a particular year. In contrast, a surplus is the amount by which its revenues exceed expenditures.
1. In 2002 there was a Federal deficit of $158 billion.
2. In 2000 there was a surplus of $236 billion.
B.
The national or public debt is the total accumulation of the Federal
government’s total deficits and surpluses that have occurred through time.
State and local governments historically have a collective budget
surplus. In 2002 the public debt
was $6.2 trillion.
II.
Three Budget Philosophies
A. The annually balanced budget was the goal until the 1930s Depression, but this ruled out using fiscal policy as a countercyclical, stabilizing force and even makes recession or depression worse.
1. The balanced budget is not neutral, but is procyclical, that is, it worsens the business cycle.
2. In a recession, the government would have to raise taxes and lower spending to balance the budget as tax revenues fell with recessionary income levels. This policy would worsen recessions.
3. In an inflationary boom period, a balanced budget would intensify the inflation. As tax revenues increased, the government would need to cut taxes or increase spending to avoid a budget surplus. This strategy would make the inflation worse.
4. Those who argue for the annually balanced budget want to limit the growth of government.
B. The cyclically balanced budget is a spending philosophy that allows for some government stabilization policy over the length of the business cycle. Deficit spending is allowed during a recession, and surpluses during an inflationary period. Over the business cycle, deficits would be offset by surpluses. But in reality, surpluses and deficits do not offset each other.
C. Functional finance is the third budget philosophy. Advocates argue that the budget is secondary, but the primary purpose of Federal finance is to achieve noninflationary full employment. Government should do what is necessary to achieve this goal regardless of the deficit or surplus in the budget.
The
Public Debt: Facts and Figures
A.
The public debt in 2002 was $6.2 trillion.
This is a large number. One
million seconds ago was 12 days back. One
trillion seconds ago was around 30,000 B.C.
B. Causes of the expansion in debt.
1. National defense and military spending have soared, especially during wartime. During World Wars I and II, debt grew rapidly. See Table 18-1 for facts that show World War II debt exceeded GDP.
2. Recessions cause a decline in revenues and growth in government spending on programs for income maintenance. Such periods included 1974-75, 1980-82, 1990-91, and 2001.
3. Tax cuts are another cause. Tax cuts in the 1980s without equivalent spending cuts led to increasing debt. The Clinton administration in 1993 is an example of how politically difficult it is to reduce spending and raise taxes to reduce the deficit. An unpopular deficit reduction act was passed in that year and many Democrats lost elections later.
C. Quantitative aspects of the debt are found in Table 18-1. Note that the absolute level in column 2 is not meaningful without comparison of the relative size of debt and interest payments to the nation’s ability to pay, as estimated by GDP and shown in column 5.
1. Comparing the debt to GDP is more meaningful than the absolute level of debt by itself. Use the example of a family or corporate borrowing. For a prosperous family or firm, $100,000 worth of debt may be a small fraction of its income; for others, $100,000 worth of debt may mean they’re unable to make payments on the debt. The amount is not as important as the amount relative to the ability to pay. Also, most borrowing is made to purchase physical assets such as buildings, equipment, etc. Another way to judge government debt is to compare it to an estimate of public assets.
2. International comparisons show that other nations have relative public debts as great or greater than that of the U.S. when compared to their GDPs. See Global Perspective 18-1.
3. Interest charges as a percentage of GDP represent the primary burden of the debt today.
4. Who owns the debt is also an important question. About 43 percent of U.S. debt is held by government agencies and the Federal Reserve; the rest is held by individuals, banks, investment and insurance companies, and about 18 percent was held by foreign investors in 2002. (See Figure 18-1.)
5. Social Security Trust Fund considerations may obscure the true debt picture. Payroll taxes currently exceed social security payments so the fund’s surplus is counted as part of the Federal surplus. Some economists say this fund should not be part of the calculation of Federal deficits or surpluses because social security funds are earmarked for future beneficiaries. For example, the Federal deficit in 2002 would be $318 billion without the fund surplus of $160 billion.
C. False concerns about the federal debt include several popular misconceptions.
1. Can the federal government go bankrupt? There are reasons why it cannot.
a. The government does not need to raise taxes to pay back the debt, and it can borrow more (i.e., sell new bonds) to refinance bonds when they mature. Corporations use similar methods—they almost always have outstanding debt.
b. The government has the power to tax, which businesses and individuals do not have when they are in debt.
2. Does the debt impose a burden on future generations? In 2002 the per capita federal debt in the U.S. was $21,476. But the public debt is a public credit—your grandmother may own the bonds on which taxpayers are paying interest. Some day you may inherit those bonds that are assets to those who have them. The true burden is borne by those who pay taxes or loan government money today to finance government spending. If the spending is for productive purposes, it will enhance future earning power and the size of the debt relative to future GDP and population could actually decline. Borrowing allows growth to occur when it is invested in productive capital.
D. Substantive issues do exist.
1. Repayment of the debt affects income distribution. If working taxpayers will be paying interest to the mainly wealthier groups who hold the bonds, this probably increases income inequality.
2. Since interest must be paid out of government revenues, a large debt and high interest can increase the tax burden and may decrease incentives to work, save, and invest for taxpayers.
3. A higher proportion of the debt is owed to foreigners (about 18 percent) than in the past, and this can increase the burden since payments leave the country. But Americans also own foreign bonds and this offsets the concern.
4. Some economists believe that public borrowing crowds out private investment, but the extent of this effect is not clear (see Figure 18-2).
5. There are some positive aspects of borrowing even with crowding out.
a. If borrowing is for public investment that causes the economy to grow more in the future, the burden on future generations will be less than if the government had not borrowed for this purpose.
b. Public investment makes private investment more attractive. For example, new Federal buildings generate private business; good highways help private shipping, etc.
IV. Deficits and Surpluses: 1992-2012
A. Figure 18-3 shows huge absolute deficits in the early 1990s.
B. In 1993 Congress passed the Deficit Reduction Act to increase tax revenues by $250 billion over 5 years and to reduce spending by a similar amount.
1. The top marginal tax rate went from 31 to 39.6%.
2. The corporate income tax rate went up 1%, from 34% to 35%.
3. Gasoline excise taxes rose by 4.3 cents per gallon.
4. Spending was held at 1993 levels (unless increases already mandated by law).
C. By 1998 there was a budget surplus for the first time since 1969.
D. There are three main options for the surpluses.
1. Pay off part of the public debt.
a. Less government borrowing could mean more private investment.
b. Critics contend that the debt is shrinking relative to GDP and we need government securities as safe investments, for monetary policy, and for Social Security trust fund assets.
c. Use interest savings to boost the Social Security trust fund.
2. Reduce taxes and reduce surplus.
a. Returns money directly to those who earned it.
b. Helps to limit the size of government.
c. Critics fear this surplus may be temporary and tax reduction may be poorly timed if the economy is prosperous anyway.
3. Increase government spending and reduce the surplus.
a. Several areas of need exist where federal spending programs could help, especially Medicare drug coverage.
b. Critics say new spending could be inflationary and interfere with private investment.
E. Back to Deficits in 2002
1. A series of policy actions and unforeseen events turned the surpluses of the early 2000s into deficits beginning in 2002.
a. The Bush tax cuts of 2001, designed to return some of the surplus to the public, began a series of reductions in marginal income tax rates.
b. The recession that began March 2001 reduced tax revenue and increased payouts for income assistance programs (unemployment and welfare).
c. The events of September 11, 2001, and the subsequent “war on terrorism,” increased Federal spending by more than $100 billion.
2. In response to a weak recovery, taxes were cut further in 2003, and phased reductions from the 2001 tax cut were accelerated.
CHAPTER NINETEEN - DISPUTES OVER MACRO THEORY AND POLICY
One
of the great traditions in scholarship is the challenge to mainstream thinking.
Many such challenges to the “conventional wisdom” fail; either the
new theories are not logical or they don’t conform to the facts.
At the opposite extreme, some new theories gain full support and replace
the existing theories. More often,
the new ideas modify mainstream thinking, which thereafter is improved or
extended. This is true in economics.
In
this chapter we examine some of the major disputes in macro theory and policy.
We initially provide historical background by contrasting classical and
Keynesian macroeconomic theories. Then
we turn to contemporary disagreements on three interrelated questions:
(1) What causes instability in the economy? (2) Is the economy
self-correcting? (3) Should government adhere to rules or use discretion in
setting economic policy?
After completing this chapter, students should be able to
1. Contrast the classical and Keynesian views of the aggregate supply curve.
2. Compare the classical and Keynesian views of the stability of the aggregate demand curve.
3. Give two reasons for macroeconomic instability according to mainstream economists.
4. Explain the equation of exchange.
5. Identify the single most important cause of macroeconomic instability according to the monetarists.
6. Explain the main reasons for macroeconomic instability according to the real-business-cycle theory.
7. Construct an example to demonstrate a coordination failure.
8. Explain the view of self-correction held by mainstream economists.
9. List three reasons why a higher wage could result in greater efficiency.
10. Explain how insider-outsider relationships contribute to downward wage inflexibility.
11. Describe the monetary rule and explain why monetarists prefer it to discretionary monetary policy.
12. Compare the views of mainstream economists with monetarists and RET economists regarding the use of discretionary fiscal policy and the need for an annually balanced budget.
13. Compare and contrast the Taylor Rule with the Monetary Rule advocated by monetarists.
14.
Define and explain the terms and concepts listed at the end of the
chapter.
I.
Introduction: Disagreements
about Macro Theory and Policy
A. This chapter contrasts the classical and Keynesian macroeconomic theories.
B. Contemporary disagreements on three interrelated questions are considered.
1. What causes instability in the economy?
2. Is the economy self-correcting?
3. Should government adhere to rules or use discretion in setting economic policy?
II.
Some History: Classical Economics
A. Classical economics dominated the discipline from Adam Smith (1776) until the 1930s. It maintained that full employment was normal and that a “laissez-faire” (let it be) policy by government is best.
B. Keynes observed in the 1930s that laissez-faire capitalism is subject to recurring recessions or depressions with widespread unemployment, and contended that active government stabilization policy is required to avoid the waste of idle resources.
C. Classical View.
1. The aggregate supply curve is vertical and located at the full-employment level of real output.
2. Stress that classical economists believed that real output does not change in response to changes in the price level because wages and other input prices would be flexible.
3. The economy would operate at its full-employment level of output because of
a. Say’s law (See Last Word Chapter 10), which states that “supply creates its own demand.”
b. Responsive, flexible prices and wages in cases where there might be temporary over-supply.
4. Money underlies aggregate demand. Classical economists theorize that aggregate demand will be stable as long as the supply of money is controlled with limited growth.
5. The downward-sloping demand curve is stable and is solely responsible for setting the price level. (See Figure 19-1a)
6. Changes in the money supply would shift AD right for an increase and left for a decrease, but responsive, flexible prices and wages will ensure that full employment output is maintained.
D. Keynesian View.
1. The core of Keynesianism is that product prices and wages are downwardly inflexible (don’t fall easily). This is graphically represented as a horizontal aggregate supply curve. (See Figure 19-1b.)
2. A decline in real output will have no impact on the price level. Once full employment is reached at Qf, the aggregate supply curve is vertical.
3. Keynesian economists view aggregate demand as unstable from one period to the next, even without changes in the money supply.
4. The investment component of aggregate demand is especially likely to fluctuate and the sole impact is on output and employment, while the price level remains unchanged. (See shift AD1, to AD2 in Figure 19-1.)
5. Active government policies are essential to increase aggregate demand and move the economy back toward full employment.
III.
What Causes Macro Instability such as Great Depression, Recessions,
Inflationary Periods?
A. Mainstream View: This term is used to characterize the prevailing perspective of most economists.
1. Mainstream macroeconomics is Keynesian based, and focuses on aggregate demand and its components. C(a) + I(g) + X(n) + G = GDP (Aggregate expenditures) = (real output)
2. Any change in one of the spending components in the aggregate expenditure equation shifts the aggregate demand curve. This, in turn, changes equilibrium real output, the price level or both.
a. Investment spending is particularly subject to variation.
b. Instability can also arise from the supply side. Artificial supply restriction, wars, or increased costs of production can decrease supply, destabilizing the economy by simultaneously causing cost-push inflation and recession.
B. Monetarist View: This label is applied to a modern form of classical economics.
1. The money supply is the focus of monetarist theory.
2. Monetarism argues that the price and wage flexibility provided by competitive markets cause fluctuations in product and resource prices, rather than output and employment.
3. Therefore, a competitive market system would provide substantial macroeconomic stability if there were no government interference in the economy.
a It is government that has caused downward inflexibility through the minimum wage law, prounion legislation, and guaranteed prices for some products as in agriculture.
b. Monetarists say that government also contributes to the economy’s business cycles through clumsy, mistaken, monetary policies.
4. The fundamental equation of monetarism is the equation of exchange. MV = PQ
a. The left side, MV, represents the total amount spent [M, the money supply x V, the velocity of money, (the number of times per year the average dollar is spent on final goods and services)].
b. The right side, PQ, equals the nation’s nominal GDP [P is the price level or more specifically, the average price at which each unit of output is sold; Q is the physical volume of all goods and services produced (real output)].
c. Monetarists say that velocity, V, is stable, meaning that the factors altering velocity change gradually and predictably. People and firms have a stable pattern to holding money.
d. If velocity is stable, the equation of exchange suggests there is a predictable relationship between the money supply and nominal GDP (PQ).
5. Monetarists say that inappropriate monetary policy is the single most important cause of macroeconomic instability. An increase in the money supply will increase aggregate demand.
6. Mainstream economists view instability of investment as the main cause of the economy’s instability. They see monetary policy as a stabilizing factor since it can adjust interest rates to keep investment and aggregate demand stable.
C. Real Business Cycle View: A third perspective on macroeconomic stability focuses on an aggregate supply. (See Figure 19-2.)
1. This takes the view that business cycles are caused by real factors affecting aggregate supply such as a decline in productivity, which causes a decline in AS.
2. In the real‑business cycle theory, declines in GDP mean less demand for money. Here, the supply of money is decreased after the demand declines. AD falls, but price level is the same because AS also declined.
D. Coordination Failures: A fourth view relates to so-called coordination failures.
1. Macroeconomic instability can occur “when people do not reach a mutually beneficial equilibrium because they lack some way to jointly coordinate their actions.”
2. There is no mechanism for firms and households to agree on actions that would make them all better off if such a failure occurs. The initial problem may be due to expectations that are not justified, but if everyone believes that a recession may come, they reduce spending, firms reduce output, and the recession occurs. The economy can be stuck in a recession because of a failure of households and businesses to coordinate positive expectations.
IV.
Does the Economy “Self-Correct”?
A. New Classical View of Self-Correction
1. Monetarist and rational expectation economists believe that the economy has automatic, internal mechanisms for self‑correction.
2. Figure 19-3 demonstrates the adjustment process, which retains full employment output according to this view.
3. The disagreement among new classical economists is over the speed of the adjustment process.
a. Monetarists usually hold the adaptive expectations view of gradual change. The supply curve shifts shown in Figure 19‑3 may take 2 or 3 years or longer.
c. Rational expectations theory (RET) holds that people anticipate some future outcomes, making change very quick, even instantaneous.
i. Where there is adequate information, people’s beliefs about future outcomes accurately reflect the likelihood that those outcomes will occur.
ii. RET assumes that new information about events with known outcomes will be assimilated quickly.
4. In RET unanticipated price‑level changes do cause temporary changes in real output. Firms mistakenly adjust their production levels in response to what they perceive to be a relative price change in their product alone. Any change in GDP is corrected as prices are flexible and firms readjust output to its previous level.
5. In RET fully anticipated price‑level changes do not change real output, even for short periods. Firms are able to maintain profit and production levels.
B. Mainstream View of Self‑Correction
1. There is ample evidence that many prices and wages are inflexible downward for long periods of time. However, some aspects of RET have been incorporated into the more rigorous model of the mainstream.
2. Graphical analysis shown in Figure 19‑3b demonstrates the adjustment process along a horizontal aggregate supply curve.
3. Downward wage inflexibility may occur because firms are unable to cut wages due to contracts and the legal minimum wage. Firms may not want to reduce wages if they fear problems with morale, effort, and efficiency.
4. An efficiency wage is one that minimizes the firm’s labor cost per unit of output. Firms may discover that paying higher than market wages lowers wage cost per unit of output.
a. Workers have an incentive to retain an above‑market-wage job and may put forth greater work effort.
b. Lower supervision costs prevail if workers have more incentive to work hard.
d. An above‑market wage reduces job turnover.
5. Some economists believe wages don’t fall easily because already employed workers (insiders) keep their jobs even though unemployed outsiders might accept lower pay. Employers prefer a stable work force. (Key Question 7)
V.
Rules or Discretion?
A. Monetarists and other new classical economists believe that policy rules would reduce instability in the economy.
1. A monetary rule would direct the Fed to expand the money supply each year at the same annual rate as the typical growth of GDP. (See Figure 19‑4.)
a. The rule would tie increases in the money supply to the typical rightward shift of long‑run aggregate supply, and ensure that aggregate demand shifts rightward along with it.
b. A monetary rule, then, would promote steady growth of real output along with price stability.
2. A few economists favor a constitutional amendment to require the federal government to balance its budget annually.
a. Others simply suggest that government be “passive” in its fiscal policy and not intentionally create budget deficits or surpluses.
b. Monetarists and new classical economists believe that fiscal policy is ineffective. Expansionary policy is bad because it crowds out private investment.
c. RET economists reject discretionary fiscal policy for the same reason they reject active monetary policy. They don’t believe it works because the effects are fully anticipated by the private sector.
B. Mainstream economists defend discretionary stabilization policy.
1. In supporting discretionary monetary policy, mainstream economists argue that the velocity of money is more variable and unpredictable and in short-run monetary policy can help offset changes in AD that monetarists contend.
2. Mainstream economists oppose requirements to balance the budget annually because it would require actions that would intensify the business cycle, such as raising taxes and cutting spending during recession and the opposite during booms. They support discretionary fiscal policy to combat recession or inflation even if it causes a deficit or surplus budget.
C. The U.S. economy has been about one‑third more stable since 1946 than in earlier periods. Discretionary fiscal and monetary policies were used during this period and not before, which makes a strong case for its success.
D. A summary of alternative views presents the central ideas and policy implications of four main macroeconomic theories: Mainstream macroeconomics, monetarism, rational expectations theory, and supply side economics. (See Table 19‑1.)
E. CONSIDER THIS … On the Road Again
Keynesian Abba Lerner compared the economy to a car without a steering wheel, and said that the prudent addition and use of a steering wheel (discretionary fiscal and monetary policy) would stabilize the macroeconomy. Monetarist Milton Friedman argued that the steering wheel already exists, and that the discretionary use of monetary policy by the Fed keeps jerking on it, causing the car (the macroeconomy) to swerve. If the Fed would just hold the steering wheel steady, the macroeconomy would be stable.
VI. Last Word: The Taylor Rule: Could a Robot Replace Alan Greenspan?
A. Macroeconomist John Taylor of Stanford University calls for a new monetary rule that would institutionalize appropriate Fed policy responses to changes in real output and inflation.
B. Traditional “monetarist rule” is passive. It required the Fed to expand the money supply at a fixed annual rate regardless of economic conditions.
C. “Discretion” is associated with the opposite: an active monetary policy where the Fed changes the money supply and interest rates in response to changes in the economy or to prevent undesirable results.
D. Taylor’s policy proposal would dictate active monetary actions that are precisely defined. It combines monetarism and the more mainstream view.
E. Taylor’s rule has three parts.
1. If real GDP rises 1% above potential GDP, the Fed should raise the Federal funds rate by 0.5% relative to the current inflation rate.
2. If inflation is 1% above its target of 2%, the Fed should raise the Federal funds rate by 0.5% above the inflation rate.
3. If real GDP equals potential GDP and inflation is 2%, the Federal funds rate should be about 4%, implying real interest rate of 2%.
F. Taylor would retain the Fed’s power to override the rule, so a robot really couldn’t replace the Board. But a rule increases predictability and credibility.
G. Critics of the proposal see no reason for this rule given the success of monetary policy in the past decade.