fiscal policy and macroeconomic debates chapters 11 and 17

Fiscal Policy and Macroeconomic Debates

Chapters 11 and 17

HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND

• Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes.– Controlled by Congress and the President

• Fiscal policy influences saving, investment, and growth in the long run.

• In the short run, fiscal policy primarily affects the aggregate demand.

Changes in Government Purchases

• When policymakers change the money supply or taxes, the effect on aggregate demand is indirect—through the spending decisions of firms or households.

• When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly.


• Expansionary Policy– Lower Taxes

• What will be the effect on AD?• What will be the effect on GDP?

– Raise Government Spending• What will be the effect on AD?• What will be the effect on GDP?

– Effect on Budget?


• Contractionary Policy– Raise Taxes

• What will be the effect on AD?• What will be the effect on GDP?

– Lower Government Spending?• What will be the effect on AD?• What will be the effect on GDP?

– Effect on Budget?

The Federal Government

• Federal Government Spending– Government spending includes transfer payments

and the purchase of public goods and services.• Transfer payments are government payments not

made in exchange for a good or a service.• Transfer payments are the largest of the government’s

expenditures. • Entitlements

– Discretionary VS Non-discretionary

Discretionary Fiscal Policy• When the government chooses to change G or

T, it is called discretionary fiscal policy (i.e., it is done at the discretion of Congress and the president).

Automatic Stabilizers

• In addition to Congress and the President choosing to change G ot T, there are also automatic stabilizers in the economy.

• Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

• Automatic stabilizers include the tax system and some forms of government spending.

USING POLICY TO STABILIZE THE ECONOMY

• Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946.

The Case for Active Stabilization Policy

• The Employment Act has two implications:– The government should avoid being the cause of

economic fluctuations.– The government should respond to changes in the

private economy in order to stabilize aggregate demand.

The Case against Active Stabilization Policy

• Some economists argue that monetary and fiscal policy destabilizes the economy.

• Monetary and fiscal policy affect the economy with a substantial lag.

• They suggest the economy should be left to deal with the short-run fluctuations on its own.

• Classical VS. Keynesian

Changes in Government Purchases

• There are two macroeconomic effects from the change in government purchases: – The multiplier effect– The crowding-out effect

The Multiplier Effect

• Government purchases are said to have a multiplier effect on aggregate demand.– Each dollar spent by the government can raise the

aggregate demand for goods and services by more than a dollar.

The Multiplier Effect

• The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Figure 4 The Multiplier Effect

Quantity ofOutput

PriceLevel

0

Aggregate demand, AD1

$20 billion

AD2

AD3

1. An increase in government purchasesof $20 billion initially increases aggregatedemand by $20 billion . . .

2. . . . but the multipliereffect can amplify theshift in aggregatedemand.

Copyright © 2004 South-Western

A Formula for the Spending Multiplier

• The formula for the multiplier is:Multiplier = 1/(1 - MPC)

• An important number in this formula is the marginal propensity to consume (MPC).– It is the fraction of extra income that a household

consumes rather than saves.

A Formula for the Spending Multiplier

• If the MPC is 3/4, then the multiplier will be:Multiplier = 1/(1 - 3/4) = 4

• In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

CASE STUDY: The Laffer Curve and Supply-side Economics

• The Laffer curve depicts the relationship between tax rates and tax revenue.

• Supply-side economics refers to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues.


• The U.S. federal government collects about two-thirds of the taxes in our economy.– The largest source of revenue for the federal

government is the individual income tax.


• Other taxes – Payroll Taxes: tax on the wages that a firm pays its

workers.• Social Insurance Taxes: taxes on wages that is

earmarked to pay for Social Security and Medicare.

– Excise Taxes: taxes on specific goods like gasoline, cigarettes, and alcoholic beverages.

TAXES AND EFFICIENCY

• Policymakers have two objectives in designing a tax system...

– Efficiency – Equity


• One tax system is more efficient than another if it raises the same amount of revenue at a smaller cost to taxpayers.

• An efficient tax system is one that imposes small deadweight losses and small administrative burdens.


• The Cost of Taxes to Taxpayers– The tax payment itself– Deadweight losses– Administrative burdens

Administrative Burdens

• Complying with tax laws creates additional deadweight losses. – Taxpayers lose additional time and money

documenting, computing, and avoiding taxes over and above the actual taxes they pay.

– The administrative burden of any tax system is part of the inefficiency it creates.

Lump-Sum Taxes

• A lump-sum tax is a tax that is the same amount for every person, regardless of earnings or any actions that the person might take.

TAXES AND EQUITY

• How should the burden of taxes be divided among the population?

• How do we evaluate whether a tax system is fair?

Benefits Principle

• The benefits principle is the idea that people should pay taxes based on the benefits they receive from government services.

• An example is a gasoline tax:– Tax revenues from a gasoline tax are used to

finance our highway system.– People who drive the most also pay the most

toward maintaining roads.

Ability-to-Pay Principle

• The ability-to-pay principle is the idea that taxes should be levied on a person according to how well that person can shoulder the burden.

• The ability-to-pay principle leads to two corollary notions of equity.– Vertical equity– Horizontal equity


• Vertical equity is the idea that taxpayers with a greater ability to pay taxes should pay larger amounts.– For example, people with higher incomes should

pay more than people with lower incomes.


• Vertical Equity and Alternative Tax Systems– A proportional tax is one for which high-income

and low-income taxpayers pay the same fraction of income.

– A regressive tax is one for which high-income taxpayers pay a smaller fraction of their income than do low-income taxpayers.

– A progressive tax is one for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers.


• Horizontal Equity– Horizontal equity is the idea that taxpayers with

similar abilities to pay taxes should pay the same amounts.

– For example, two families with the same number of dependents and the same income living in different parts of the country should pay the same federal taxes.

Three Tax Systems

Copyright©2004 South-Western

Tax Incidence and Tax Equity

• The difficulty in formulating tax policy is balancing the often conflicting goals of efficiency and equity.

• The study of who bears the burden of taxes is central to evaluating tax equity.

• This study is called tax incidence.

Changes in Taxes

• When the government cuts personal income taxes, it increases households’ take-home pay.– Households save some of this additional income.– Households also spend some of it on consumer goods.

• MPC VS MPS• Tax Credits

– Increased household spending shifts the aggregate-demand curve to the right.

– Which would be bigger change in AD?• Taxes or Gov. Spending?

POLICY EFFECTS ON AGGREGATE SUPPLY

Goals of Monetary and Fiscal Policies

• What are the goals of monetary and fiscal policy?

• How are they designed to achieve that goal by shifting the AD curve?


• Given the goals of economic growth, employment, and stable prices, how could a shift in AS lead to the desired outcomes?

Shifting Aggregate Supply

• Policies that increase the quantity or quality of resources

• Decreased price of economy-wide inputs (like labor and energy)

• Improvements in productivity (e.g., a technological advancement)

Long-Run Effects of Policies Shifting AD

• Assume the economy starts in long-run equilibrium

• Let’s say there’s a policy change, for example, the Federal Reserve increases the money supply.

• The increase in the money supply decreases interest rates and therefore investment and interest-sensitive consumption increase, which increases aggregate demand.


• This leads to an increase in both the equilibrium level of output and price level.

• This is a new short-run equilibrium with a level of real GDP above the full-employment level of real GDP.

• As a result, nominal wages will rise (the demand for more workers to increase output allows workers to bargain for higher wages).


• The higher wages lead to a leftward shift of the AS curve until a new long-run equilibrium is reached at the full-employment level of output (but with a higher price level).

• In the long run, the increase in the money supply has not changed real GDP, but has only led to an increase in the price level.

Long-Run Adjustment of Aggregate Supply

Let’s do an old FRQ…

THE DEFICIT AND THE DEBT

Discretionary Fiscal Policy

• Recall that the two primary tools of discretionary fiscal policy are government spending (G) and taxes (T).

• When government conducts expansionary fiscal policy to counteract recession, government spending increases and/or taxes decrease.

• When the government conducts contractionary fiscal policy to alleviate inflationary pressures, government spending decreases and/or taxes increase.

An Unbalanced Budget

• The gov’t budget is balanced when G = T.• When G increases and/or T decreases, the gov’t budget

moves toward deficit.– A budget deficit occurs when the gov’t spends more than it

collects in taxes and borrows to cover the difference (when G > T).

– It does this by issuing bonds.

• The sum of past deficits is the debt.– The debt incurs annual interest charges.

• A gov’t budget deficit results in an increase in the D for loanable funds.

An Unbalanced Budget

• A budget surplus occurs when the gov't taxes more than it spends (T > G).

• A budget surplus reduces the demand for loanable funds.

• It results in an increase in the supply of loanable funds if gov’t pays off the debt.

Effects of Gov’t Deficit on Loanable Funds Market

• I and i are the initial equilibrium values.

• D = private sector demand for funds (investment).

• D + (G – T) = private + government demand for funds.

• I1 and i1 are the new equilibrium values.

• I2 = new level of private investment.

• I1 – I2 = government demand for funds (G – T).

POLICY LAGS AND THE CROWDING-OUT EFFECT

• Two lags:– Inside lag: time it takes for data to be collected,

for policy makers to recognize that policy action is necessary, make a decision about which policy should be taken and then implement the policy

– Outside Lag: time it takes the economy to respond to the new policy

• These lags differ in length for monetary and fiscal policies

Lags Associated with Policy Making

• How can government increase its spending?– EXPANSIONARY POLICY

• What happens to the government’s budget when it increases spending?– DEFICIT

Monetary and Fiscal Policies

Effects of Monetary/Fiscal Policies

• What happens when Fed buys/sells bonds?

• What happens when gov’t lowers/raises taxes?

• Should gov’t borrow money or increase taxes?• Remember the multiplier effect!

– Government spending multiplier = 1/MPS– Tax multiplier = -MPC/MPS

• Which has a greater effect, and why?

How should money for spending be acquired?

• Through sale of treasury bills, notes, or bonds• What is the impact of government borrowing

to finance an increase in spending?– When the government borrows money to finance

its deficit, this results in an increase in the demand for money, or, alternatively, the demand for loanable funds.

– This in turn results in an increase in the interest rate.

How does government borrow money?

Government Demand for Funds Increases the Demand for Money

• What happens to investment or other interest-sensitive components of aggregate demand when the gov’t demand for funds increases?

Government Demand for Funds Increases the Demand for Money

The Crowding-Out Effect

• Fiscal policy may not affect the economy as strongly as predicted by the multiplier.

• An increase in government purchases causes the interest rate to rise.

• A higher interest rate reduces investment spending.


• This increase in demand that results when a expansionary fiscal policy raises the interest rate is called the crowding-out effect.

• The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

Figure 5 The Crowding-Out Effect

Quantityof Money

Quantity fixedby the Fed

0

InterestRate

r

Money demand, MD

Moneysupply

(a) The Money Market

3. . . . whichincreasestheequilibriuminterestrate . . .

2. . . . the increase inspending increasesmoney demand . . .

MD2

Quantityof Output

0

PriceLevel

Aggregate demand, AD1

(b) The Shift in Aggregate Demand

4. . . . which in turnpartly offsets theinitial increase inaggregate demand.

AD2

AD3

1. When an increase in government purchases increases aggregatedemand . . .

r2

$20 billion



• When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.

• Remember, gov’t needs to increase its spending

• No monetary policies have been implemented yet

• What can monetary authorities do to prevent a reduction in investment?

Back to our example…

Loanable Funds Market• I and i are the initial

equilibrium values• D = private sector demand

for funds (Investment)• D + (G–T) = private +

government demand for funds

• I1 and i1 are the new equilibrium values.

• I2 = new level of private investment

• I1 – I2 = government demand for funds (G–T)

Barro-Ricardo Effect• What is it?

– Possibility that gov’t budget deficits will lead to an increase in private savings and a decrease in consumption that will offset the predicted expansionary effects of expansionary fiscal policy

• How will this affect loanable funds market?

• The supply curve for funds will shift rightward.• The rightward shift in the supply curve reduces the

increase in the interest rate and reduces the decrease in the private sector demand for funds.

• Thus, the crowding-out effect is reduced if there is a Barro-Ricardo effect.

• There is little evidence that the Barro-Ricardo effect is very large.

• However, crowding-out can be significant, depending on the elasticity of investment and interest-sensitive components of aggregate demand.

Barro-Ricardo Effect

• Suppose that, in response to the economic situation, the federal government decides to increase its spending without increasing taxes and the Fed keeps the money supply constant.

• There is no Barro-Ricardo effect.• Explain what would happen in the three

markets shown on the following slide.

The Effects of Policy Changes in Multiple Markets

Unit 5 : MacroeconomicsNational Council on Economic EducationVisual 5.3

http//apeconomics.ncee.net


Unit 5 : MacroeconomicsNational Council on Economic EducationVisual 5.3

http//apeconomics.ncee.net


AD1 D1

MD1

i1

i

• What happens?– The aggregate demand curve should shift to the right.– As a result, the demand for loanable funds increases,

shifting that curve to the right.• Rightward shift of loanable funds’ demand curve means a

new, higher interest rate.

– Increased demand for loanable funds causes an increase in the demand for money, meaning that curve shifts to the right as well, intersecting the MS curve at the new higher interest rate set by the changes in the loanable funds market.


• Output (real GDP): – Increased. Aggregate demand increased because of the increase

in government spending.• Employment:

– Increased. Aggregate demand increased because of the increase in government spending.

• Price level: – Increased. Aggregate demand increased because of the increase

in government spending.• Interest rates:

– Increased. With the money supply held constant, the demand for money increased or the demand for loanable funds increased.

• Investment: – Decreased because of the increase in interest rates

In the previous scenario, what happened to the following variables,

and why?

Crowding-Out• In the given scenario,

how do we know crowding out has occurred?

• Assuming there was no gov’t borrowing prior to their decision to increase spending, how does the loanable funds market graph indicate the quantity of gov’t borrowing?

• The Fed could use expansionary monetary policy; thus the government’s demand for funds would not result in an increase in interest rates.

What could the Fed have done to prevent

crowding-out?

• If the economy were experiencing a recession, the Fed would want to prevent crowding-out, but if the economy were at or near full employment and government spending increased, the Fed might not want to prevent crowding-out.

Are there certain conditions when the Fed should or should not prevent

crowding-out?

THE PHILLIPS CURVE

• Society faces a short-run tradeoff between unemployment and inflation.

• If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation.

• If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

• The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed.– Think MV = PQ

Unemployment and Inflation

• The Phillips curve illustrates the short-run relationship between inflation and unemployment.

THE PHILLIPS CURVE

The Phillips Curve

UnemploymentRate (percent)

0

InflationRate

(percentper year)

Phillips curve

4

B6

7

A2


• The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.

Aggregate Demand, Aggregate Supply, and the Phillips Curve

• The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level.

• A higher level of output results in a lower level of unemployment.

Aggregate Demand, Aggregate Supply, and the Phillips Curve

How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply

Quantityof Output

0

Short-runaggregate

supply

(a) The Model of Aggregate Demand and Aggregate Supply


0

InflationRate

(percentper year)

PriceLevel

(b) The Phillips Curve

Phillips curveLow aggregate

demand

Highaggregate demand

(output is8,000)

B

4

6

(output is7,500)

A

7

2

8,000(unemployment

is 4%)

106 B

(unemploymentis 7%)

7,500

102 A


• The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF EXPECTATIONS

• In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run.– As a result, the long-run Phillips curve is vertical at

the natural rate of unemployment.– Monetary policy could be effective in the short

run but not in the long run.

The Long-Run Phillips Curve

The Long-Run Phillips Curve

UnemploymentRate

0 Natural rate ofunemployment

InflationRate Long-run

Phillips curve

BHighinflation

Lowinflation

A

2. . . . but unemploymentremains at its natural ratein the long run.

1. When the Fed increases the growth rate of the money supply, the rate of inflation increases . . .


How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply

Quantityof Output

Natural rateof output

Natural rate ofunemployment

0

PriceLevel

P

Aggregatedemand, AD

Long-run aggregatesupply

Long-run Phillipscurve


UnemploymentRate

0

InflationRate


2. . . . raisesthe pricelevel . . .

1. An increase in the money supplyincreases aggregatedemand . . .

AAD2

B

A

4. . . . but leaves output and unemploymentat their natural rates.

3. . . . andincreases theinflation rate . . .

P2B


• Expected inflation measures how much people expect the overall price level to change.

• In the long run, expected inflation adjusts to changes in actual inflation.

• The Fed’s ability to create unexpected inflation exists only in the short run.– Once people anticipate inflation, the only way to get

unemployment below the natural rate is for actual inflation to be above the anticipated rate.

• WHY???

Expectations and the Short-Run Phillips Curve

How Expected Inflation Shifts the Short-Run Phillips Curve

UnemploymentRate


InflationRate Long-run

Phillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Expansionary policy movesthe economy up along the short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation rises, and the short-run Phillips curve shifts to the right.

CB

A


• The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis.

• Historical observations support the natural-rate hypothesis.

The Natural Experiment for the Natural-Rate Hypothesis

• The concept of a stable Phillips curve broke down in the in the early ’70s.– Stagflation

• During the ’70s and ’80s, the economy experienced high inflation and high unemployment simultaneously.

The Natural Experiment for the Natural Rate Hypothesis

The Phillips Curve in the 1960s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10


Inflation Rate(percent per year)

1968

1966

19611962

1963

1967

19651964


The Breakdown of the Phillips Curve

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1973

1966

1972

1971

19611962

1963

1967

19681969 1970

19651964


• The short-run Phillips curve can shift due to changes in expectations.

• The short-run Phillips curve also shifts because of shocks to aggregate supply. – Major adverse changes in aggregate supply can

worsen the short-run tradeoff between unemployment and inflation.

– An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS

• A supply shock is an event that directly alters the firms’ costs, and, as a result, the prices they charge.

• This shifts the economy’s aggregate supply curve. . .

• . . . and as a result, the Phillips curve.


An Adverse Shock to Aggregate Supply

Quantityof Output

0

PriceLevel

Aggregatedemand


UnemploymentRate

0

InflationRate


3. . . . andraises the price level . . .

AS2 Aggregatesupply, AS

A

1. An adverseshift in aggregate supply . . .

4. . . . giving policymakers a less favorable tradeoffbetween unemploymentand inflation.

BP2

Y2

PA

Y

Phillips curve, PC

2. . . . lowers output . . .

PC2

B


• In the 1970s, policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum.– Fight the unemployment battle by expanding

aggregate demand and accelerate inflation.– Fight inflation by contracting aggregate demand

and endure even higher unemployment.


The Supply Shocks of the 1970s

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1972

19751981

1976

1978

1979

1980

1973

1974

1977


• To reduce inflation, the Fed has to pursue contractionary monetary policy policy.

• When the Fed slows the rate of money growth, it contracts aggregate demand.

• This reduces the quantity of goods and services that firms produce.

• This leads to a rise in unemployment.

THE COST OF REDUCING INFLATION

Disinflationary Monetary Policy in the Short Run and the Long Run

UnemploymentRate


InflationRate

Long-runPhillips curve

Short-run Phillips curvewith high expected

inflation

Short-run Phillips curvewith low expected

inflation

1. Contractionary policy movesthe economy down along the short-run Phillips curve . . .

2. . . . but in the long run, expectedinflation falls, and the short-run Phillips curve shifts to the left.

BC

A


• To reduce inflation, an economy must endure a period of high unemployment and low output.– When the Fed combats inflation, the economy

moves down the short-run Phillips curve.– The economy experiences lower inflation but at

the cost of higher unemployment.


• The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point.– An estimate of the sacrifice ratio is five.– To reduce inflation from about 10% in 1979-1981

to 4% would have required an estimated sacrifice of 30% of annual output!


• The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future.

Rational Expectations and the Possibility of Costless Disinflation

• Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run but not in the long run.

• How quickly the short-run tradeoff disappears depends on how quickly expectations adjust.


• The theory of rational expectations suggests that the sacrifice-ratio could be much smaller than estimated.


• When Paul Volcker was Fed chairman in the 1970s, inflation was widely viewed as one of the nation’s foremost problems.

• Volcker succeeded in reducing inflation (from 10 percent to 4 percent), but at the cost of high employment (about 10 percent in 1983).

The Volcker Disinflation

Figure 11 The Volcker Disinflation

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



1980 1981

1982

1984

1986

1985

1979A

1983B

1987

C


• Alan Greenspan’s term as Fed chairman began with a favorable supply shock. – In 1986, OPEC members abandoned their

agreement to restrict supply.– This led to falling inflation and falling

unemployment.

The Greenspan Era

The Greenspan Era

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10



19841991

1985

19921986

19931994

198819871995

199620021998

1999

20002001

19891990

1997


ECONOMIC GROWTH AND DISPUTES OVER MACRO THEORY AND POLICY

Chapters 16 and 17

• Avg. growth rate of per capita real GDP has been above 2 percent a year for the last four decades.

• However, the annual rate of growth has varied considerably during this same period.– Real GDP growth rate averaged 3.27% from 1947 to 2014

• All-time high of 16.9% in Q1 1950• Record low of -10% Q1 1958• Increased at annual rate of 3.9% in Q3 of this year

• The increase in the average standard of living represented by the increase in per capita real GDP is important.

• The distribution of the increase in real GDP is also important

Long-Term Economic Growth

• For growth to occur, economic agents – producers and consumers – must have the appropriate incentives.

• Growth accounting focuses on three sources of long-run economic growth: supply of labor, supply of capital and the level of technology.

• Increases in any one of these elements will increase real GDP.– The growth in the supply of labor is primarily the

population growth rate.– Increases in capital or in technology increase labor

productivity and thus increase real GDP.

Long-Term Economic Growth

• When the increases in the supply of labor, in the supply of capital stock, or in technological capabilities occur, these three sources act as levers of growth.

Levers of Growth

• Increasing savings will increase the supply of loanable funds, decrease interest rates and spur investment or increases in the capital stock.

• In the United States, tax incentives are the principal method to increase savings.

• IRAs and Roth IRAs are examples.– During the 1970s and 1980s, stockholders in gas

and electric utility companies received a tax break if they reinvested their dividends in the companies.

How do we stimulate the levers of growth?

• Increasing government support for basic research will stimulate research and development.– National Science Foundation grants are one

mechanism used in the United States.


• Getting the most from comparative advantage by encouraging international trade will also stimulate growth throughout the world.


• Growth can also be stimulated by improving the quality and capabilities of the labor force so workers can be more productive with a given level of capital and technology.

• Improving the quality of education is the primary tool used here.

• The United States has focused on improving the quality of public education and, using education IRAs, provides incentives for people to obtain more education.


• How do changes in the labor force and in technological capabilities affect LRAS?

• How do changes in LRAS impact the production possibilities curve?

• Economists today disagree mainly on the following 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?

Contemporary disagreements in macroeconomics

• Classical: Believes that the government SHOULD NOT interfere in the economy. And believes in self-correction of economic problems. Modern classical economists are called “monetarists”.– F. A. Hayek– Milton Friedman

• Keynesian: Believes that GOVERNMENT SHOULD interfere in the economy (taxes, government spending). Most “mainstream” economists are Keynesians.– John Maynard Keynes

Differing Macroeconomic Philosophies

• The classical viewpoint dominated economics from the time of Adam Smith until the 1930s– They maintained that full employment was normal and

gov’t should stick to laissez-faire policies

• Keynes observed in the 1930s that laissez-faire capitalism is subject to recurring recessions and depressions with widespread unemployment, and contended that active government stabilization policies are necessary to avoid wasting idle resources

Some history of both schools of thought…

• Mainstream– Focused on aggregate demand and its components– Main equation of import is C+I+G+NX– AD is unstable from quarter to quarter due to changes in

variability of components

• Monetarists– Money underlies aggregate demand. If money supply is

controlled, aggregate demand will remain stable.– Changes in money supply shift the AD curve.– Equation of exchange (MV=PQ) is fundamental equation for

monetarists.

Differences

• How would Keynes have handled the Great Recession of the late 2000s? What about Hayek?

• Part 1: http://youtu.be/d0nERTFo-Sk

• Part 2: http://youtu.be/GTQnarzmTOc

“Fear the Boom and Bust”

http://youtu.be/d0nERTFo-Sk

http://youtu.be/d0nERTFo-Sk

http://youtu.be/GTQnarzmTOc

http://youtu.be/GTQnarzmTOc

fiscal policy and macroeconomic debates chapters 11 and 17

Documents

government payments

government purchasesthere

government spendingwhat

forms of government

lower government spending

aggregatedemand curve

transfer payments

purchases of goods