macro CHAPTER NINE

Macroeconomics
Policy Debates
 Content
 Should the policy be active or
passive?
 Should the policy be conducted by
rule or by discretion?
 Perspectives on Government Debt

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 Stabilization Policy (pros)
 Some economists view the
economy as unstable
=> macroeconomic policy should
– stimulating the economy when it is
depressed
– slowing the economy when it is
overheated.

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 Stabilization Policy (Cons)
 Other economists (ex. Milton
Friedman) view the economy as
naturally stable.
=> economic policymakers should
admit their limited abilities and be
satisfied if they do no harm.

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 9.1 Should Policy be
Active or Passive?
 Reasons for Passive Policy
– Policy’s lags:
• inside lag: the time between a shock
to the economy and the policy action
responding to that shock;
• outside lag: the time between a policy
action and its influence on the
economy
=> Recommendation: automatic stabilizers

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 9.1 Should Policy be
Active or Passive?
 Reasons for Passive Policy
– The Difficult Job of Economic
Forecasting
• B/c of lags => policymakers need
accurate predictions;
• economic forecasts are much alike
weather forecasts

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Economic Forecasting

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9.2 Should Policy be conducted by
Rule or by Discretion?
 Policy is conducted by rule if
policymakers announce in advance
how policy will respond to various
situations and commit themselves to
following the announcement
 Policy is conducted by discretion if
policymakers are free to size up events
as they occur and choose whatever
policy they consider appropriate at the
time
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9.2 Should Policy be conducted by
Rule or by Discretion?
 The debate over rules versus discretion
is distinct from the debate over passive
versus active policy.
– A passive policy rule: the money
supply grows 3%/year.
– An active policy rule:
Money Growth = 3% + (U Rate − 6%).

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9.2 Should Policy be conducted by
Rule or by Discretion?
 Some economists believe that
economic policy is too important to be
left to the discretion of policymakers
 Some policymaker is incompetent or
opportunistic => shouldn’t be
discretion
 The time inconsistency of discretionary
policy (ex: policy against terrorists,
etc.)

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 Rules for Monetary Policy
 Keeping the money supply growing at
a steady rate.
– It would yield stable output,
employment, and prices
– But it stabilizes AD only if the velocity
of money is stable

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 Rules for Monetary Policy
 Adjusting money growth base on
targeting GDPn
– The CB announces the targeting GDPn
– GDPn > targeting GDPn: ↓MS => ↓AD
– GDPn < targeting GDPn: ↑MS => ↑AD
– It can adjust to changes changes in the
velocity of money.

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 Rules for Monetary Policy
 Adjusting money growth base on
targeting inflation
– The CB announces the targeting
inflation rate;
– adjusts the MS when the actual
inflation rate deviates from the target.
– the policy can adjust to changes in the
velocity of money;
– is easy to explain to the public

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 Rules for Fiscal Policy
 Keep the budget balance

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9.3 Perspectives on Government
Debt & Budget Deficit
 When T<G, the Gov has a budget deficit =>
borrowing from the private sector.
 The accumulation of past borrowing is the
government debt.

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 The size of Government Debt
http://www.economist.com/content/global_debt_clock - 11/11/13

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The size of Government Debt

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The size of US Government Debt

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 The size of Government Debt
http://www.economist.com/content/global_debt_clock - 11/11/13

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The size of Government Debt –
Mankiw p. 469

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 Problems in Measurement
Inflation
 The measured deficit should equal the
change in the government’s real debt, not
the change in its nominal debt
 Assuming that the real Gov debt is
unchanged (the budget is balanced), D is
the nominal debt
∆D = ∏D.
=> The Gov would report a budget deficit of
∏D
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 Problems in Measurement
Capital Assets
 Many economists: the Gov’s budget deficit
requires taking into account the Gov’s assets &
liabilities.
 Individual: borrows to buy a house = not running
a deficit
 A budget procedure that accounts for assets &
liabilities => capital budgeting
 Under capital budgeting, Gov borrowing to finance
a capital good = not raise the deficit.
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 Problems in Measurement
Uncounted Liabilities
 The measured budget deficit is misleading b/c it
excludes some important Gov liabilities
– the pensions of Gov employee
– the contingent liability—the liability that is due
only if a specified event occurs. Ex: the Gov
guarantees for enterprises...

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 Problems in Measurement
The Business Cycle
 When the biz cycle is in the downturn, automatic
stabilizers come to effect => B << 0
 These deficits make it more difficult to measure
the FP effectiveness
Þ Gov calculates a cyclically adjusted budget deficit
(full-employment budget deficit) – based on the
estimated T & G if the economy were at the Yp.
Þ Reflects policy changes, not the current stage of
the biz cycle.
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The Traditional view of Government
Debt
 T↓: close-economy
– Long run: S↓ => r↑ => I↓ => k*↓ & y*↓
(Solow Model)
– Short run: C↑ => AD↑ => P↑ & U↓
 T↓: open-economy
– Long run: S↓ => B<0, r↑ => Kin↑
• ε↑ => NX↓: domestic firms competence↓
• NCO↓ => indebted to foreign countries
– Short run & floating e: IS* ↑ => e ↑ =>
NX↓ => offset the original increase in Y
caused by EFP => Y unchanges.

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The Traditional view of Government
Debt
 Current generations: benefit from
the EFP at first (C↑ and U↓)
 Future generations: bear the
budget deficit burden, and get
lower k as well as higher foreign
debt.

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 The Ricardian View of
Government Debt
 Consumers are forward-looking => spending
base on
– the current income
– the expected future income
 T↓ (but if G is not ↓ too) => a tax cut today
coupled with a tax hike in the future =>
consumers: C unchanges (instead of
increases when the current Yd↑)

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 The Ricardian View of
Government Debt
 The general principle:
– Gov debt is equivalent to future
taxes
– If consumers are sufficiently
forward-looking, future taxes are
equivalent to current taxes.
Þ financing the government by debt is
equivalent to financing it by taxes.
Þ this is called Ricardian equivalence

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 The Ricardian View of
Government Debt
 T↓:
– B↓ => SG↓
– YD↑ => C unchanges (instead of ↑),
SP↑
– ∆SP↑ = ∆SG↓ => S unchanges
=> T↓ doesn’t have effects as the
Traditional View predicts.

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 The Ricardian View of
Government Debt
 Changes in tax do influence C if they
influence present or future G.
 If T↓, and the Gov plans to ↓G in the
future => future taxes won’t ↑ => the
consumers feels richer => C↑
 Note: a ↓G (rather than ↓T) stimulates
the current C (even if ↓G while T
unchanges), b/c it imply lower taxes in
the future.

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 How forward-looking are
consumers?
 The Ricardian view predicts that people
have substantial knowledge and
foresight.
 It is possible that some people is
shortsighted => they assume that
future T = current T
=> A debt-financed tax cut will lead this
person to believe that his lifetime
income has increased, even if it hasn’t

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 How forward-looking are
consumers?
 A person who expects higher income in
the future — will ↑C
 A person who faces a borrowing
constraints: ↓T = giving them a loan =>
C↑
 A borrowing constraint is a limit on how
much an individual can borrow from
banks or other financial institutions.

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 How forward-looking are
consumers?
 Another argument: consumers expect
the future T to fall not on them but on
future generations.
 Criticizes: future generations are our
children/grandchildren => people are
not eager to take this advantage at their
children’s expense.

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 How forward-looking are
consumers?
 History data: Reagan tax cut from 1981 =>
B↓, S↓, r↑, NX↓
– Traditional view: this confirms their
position.
– Ricardian view: S↓ b/c
• people were optimistic about future
growth (reflected in a booming stock
market)
• people expected the T↓ to ↓G as
Reagan promised
 which view do you agree?
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 Other Perspectives on
Government Debt
Balanced Budgets Versus Optimal
Fiscal Policy:
Most economists oppose a strict
rule requiring the government to
balance its budget

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Balanced Budgets & Optimal FP
 03 reasons for optimal fiscal policy
– Stabilization
– Tax Smoothing
• high tax rates => discourages economic
activity => society cost
=> should keep tax rates relatively stable
rather than ↑ (or ↓) in some years
– Intergenerational Redistribution

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Fiscal Effects on Monetary Policy
 One way to finance a budget deficit is
printing money => high inflation =>
to end the hyperinflations ~ fiscal
reforms: large G↓.
 High level of debt (in DC) =>
encourage the Gov to create inflation:
redistribution between creditors and
debtors

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Fiscal Effects on Monetary Policy
 However, there is little evidence confirming
this link b/c:
– most Gov can finance deficits by selling
debt
– CB often have enough independence to
resist political pressure for EMP
– Policymakers know that inflation is a poor
solution to fiscal problems

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Debt and the Political Process
 When approving the debt issuing, “the
interests [of future taxpayers] are not
represented (or are represented
inadequately) in the approving assembly.”
 Some economists argues that “only the hard
budget constraint” can force politicians to
judge “benefits really justify its costs.”

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 International Dimensions
 B↓ => S↓ => NX < 0 => NCO < 0:
international debtor => further effects of
government debt
– capital flight
– reduce a nation’s political strength in world
affairs
– Debt burden in foreign currency

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 Case study
 The European debt crisis

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