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Five Debates overMacroeconomicPolicy

Chapter 34

Copyright © 2001 by Harcourt, Inc.

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Five Debates overMacroeconomic Policy

1. Should monetary and fiscalpolicymakers try to stabilize theeconomy?

2. Should monetary policy be made byrule rather than by discretion?

3. Should the central bank aim for zeroinflation?


Five Debates overMacroeconomic Policy

4. Should the government balance itsbudget?

5. Should the tax laws be reformed toencourage saving?

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1. Should Monetary andFiscal Policymakers Try to

Stabilize the Economy?


Pro: Policymakers should tryto stabilize the economy

u The economy is inherently unstable, andleft on its own will fluctuate.

u Policy can manage aggregate demand inorder to offset this inherent instabilityand reduce the severity of economicfluctuations.


Pro: Policymakers should tryto stabilize the economy

u There is no reason for society to sufferthrough the booms and busts of thebusiness cycle.

u Monetary and fiscal policy can stabilizeaggregate demand and, thereby,production and employment.

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Con: Policymakers should nottry to stabilize the economy

u Monetary policy affects the economy withlong and unpredictable lags between theneed to act and the time that it takes forthese policies to work.

u Many studies indicate that changes inmonetary policy have little effect onaggregate demand until about six monthsafter the change is made.



u Fiscal policy works with a lag because ofthe long political process that governschanges in spending and taxes.

u It can take years to propose, pass, andimplement a major change in fiscalpolicy.



u All too often policymakers caninadvertently exacerbate rather thanmitigate the magnitude of economicfluctuations.

u It might be desirable if policy makerscould eliminate all economic fluctuations,but this is not a realistic goal.

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2. Should Monetary PolicyBe Made by Rule Rather

Than by Discretion?


Pro: Monetary policy should bemade by rule

u Discretionary monetary policy can sufferfrom incompetence and abuse of power.

u To the extent that central bankers allythemselves with politicians, discretionarypolicy can lead to economic fluctuationsthat reflect the electoral calendar – thepolitical business cycle.



u There may be a discrepancy between whatpolicymakers say they will do and whatthey actually do – called time inconsistencyof policy.

u Because policymakers are so often timeinconsistent, people are skeptical whencentral bankers announce their intentionsto reduce the rate of inflation.

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u Committing the Fed to a moderate andsteady growth of the money supply wouldlimit incompetence, abuse of power, andtime inconsistency.


Con: Monetary policy shouldnot be made by rule

u An important advantage of discretionarymonetary policy is its flexibility.

u Inflexible policies will limit the ability ofpolicymakers to respond to changingeconomic circumstances.


Con: Monetary policy shouldnot be made by rule

u The alleged problems with discretion andabuse of power are largely hypothetical.

u Also, the importance of the politicalbusiness cycle is far from clear.

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3. Should The Central BankAim for Zero Inflation?


Pro: The central bank shouldaim for zero inflation

u Inflation confers no benefit to society, butit imposes several real costs.u Shoeleather costs

u Menu costs

u Increased variability of relative prices

u Unintended changes in tax liabilities

u Confusion and inconvenience

u Arbitrary redistribution of wealth


Pro: The central bank shouldaim for zero inflation

u Reducing inflation is a policy withtemporary costs and permanent benefits.

u Once the disinflationary recession is over,the benefits of zero inflation wouldpersist.

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Con: The central bank shouldnot aim for zero inflation

u Zero inflation is probably unattainable,and to get there involves output,unemployment, and social costs that aretoo high.

u Policymakers can reduce many of thecosts of inflation without actuallyreducing inflation.


4. Should FiscalPolicymakers reduce the

Government Debt?


Pro: The government shouldbalance its budget

u Budget deficits impose an unjustifiableburden on future generations by raisingtheir taxes and lowering their incomes.

u When the debts and accumulated interestcome due, future taxpayers will face adifficult choice:u They can pay higher taxes, enjoy less

government spending, or both.

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Pro: The government shouldbalance its budget

u By shifting the cost of current governmentbenefits to future generations, there is abias against future taxpayers.

u Deficits reduce national saving, leading to asmaller stock of capital, which reducesproductivity and growth.


Con: The government shouldnot balance its budget

u The problem with the deficit is oftenexaggerated.

u The transfer of debt to the future may bejustified because some governmentpurchases produce benefits well into thefuture.


Con: The government shouldnot balance its budget

u The government debt can continue to risebecause population growth andtechnological progress increase thenation’s ability to pay the interest on thedebt.

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5. Should The Tax Laws BeReformed to Encourage

Saving?


Pro: Tax laws should bereformed to encourage saving

u A nation’s saving rate is a key determinantof its long-run economic prosperity.

u A nation’s productive capability isdetermined largely by how much it savesand invests for the future.

u When the saving rate is higher, moreresources are available for investment innew plant and equipment.


Pro: Tax laws should be reformedto encourage saving

u The U.S. tax system discourages saving inmany ways, such as by heavily taxing theincome from capital and by reducingbenefits for those who have accumulatedwealth.

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Pro: Tax laws should be reformedto encourage saving

u The consequences of high capital incometax policies are reduced saving, reducedcapital accumulation, lower laborproductivity, and reduced economicgrowth.


Pro: Tax laws should bereformed to encourage saving

u An alternative to current tax policiesadvocated by many economists is aconsumption tax.

u With a consumption tax, a household paystaxes based on what it spends not on what itearns.u Income that is saved is exempt from taxation

until the saving is later withdrawn and spent onconsumption goods.


Con: Tax laws should not bereformed to encourage saving

u Many of the changes in tax laws tostimulate saving would primarily benefitthe wealthy.u High-income households save a higher

fraction of their income than low-income households.

u Any tax change that favors people who savewill also tend to favor people with highincomes.

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u Reducing the tax burden on the wealthywould lead to a less egalitarian society.

u This would also force the government toraise the tax burden on the poor.



u Raising public saving by eliminating thegovernment’s budget deficit wouldprovide a more direct and equitable wayto increase national saving.


Summary

u Advocates of active monetary and fiscalpolicy view the economy as inherentlyunstable and believe policy can be used tooffset this inherent instability.

u Critics of active policy emphasize that policyaffects the economy with a lag and ourability to forecast future economic conditionsis poor, both of which can lead to policybeing destabilizing.

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Summary

u Advocates of rules for monetary policyargue that discretionary policy can sufferfrom incompetence, abuse of power, andtime inconsistency.

u Critics of rules for monetary policy arguethat discretionary policy is more flexiblein responding to economic circumstances.


Summary

u Advocates of a zero-inflation targetemphasize that inflation has many costsand few if any benefits.

u Critics of a zero-inflation target claimthat moderate inflation imposes onlysmall costs on society, whereas therecession necessary to reduce inflation isquite costly.


Summary

u Advocates of reducing the governmentdebt argue that the debt imposes aburden on future generations by raisingtheir taxes and lowering their incomes.

u Critics of reducing the government debtargue that the debt is only one small pieceof fiscal policy.

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Summary

u Advocates of tax incentives for saving pointout that our society discourages saving inmany ways such as taxing income from capitaland reducing benefits for those who haveaccumulated wealth.

u Critics of tax incentives argue that manyproposed changes to stimulate saving wouldprimarily benefit the wealthy and also mighthave only a small effect on private saving.

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