Macroeconomic Issues and Policy: Fernando & Yvonn Quijano

Chapter
28
Macroeconomic Issues
and Policy
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
CHAPTER 28: Macroeconomic Issues and Policy
Macroeconomic Issues
and Policy 28
Chapter Outline
Time Lags Regarding Monetary and

Fiscal Policy
Stabilization: “The Fool in the Shower”
Recognition Lags
Implementation Lags
Response Lags
Monetary Policy
Controlling the Interest Rate
The Fed’s Response to the State
of the Economy
Monetary Policy Since 1990
Inflation Targeting
Fiscal Policy: Deficit Targeting
The Effects of Spending Cuts
on the Deficit
Economic Stability and Deficit
Reduction
Summary
Fiscal Policy Since 1990
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 30
TIME LAGS REGARDING MONETARY
AND FISCAL POLICY
FIGURE 15.1 Two Possible Time Paths for GDP
AND FISCAL POLICY
stabilization policy Describes both

monetary and fiscal policy, the goals of
which are to smooth out fluctuations
in output and employment and to keep
prices as stable as possible.
time lags Delays in the economy’s

response to stabilization policies.
AND FISCAL POLICY
STABILIZATION: “THE FOOL IN THE SHOWER”
FIGURE 15.2 “The Fool in the Shower”—How Government

Policy Can Make Matters Worse
AND FISCAL POLICY
RECOGNITION LAGS
recognition lag The time it takes for

policy makers to recognize the existence
of a boom or a slump.
AND FISCAL POLICY
IMPLEMENTATION LAGS
implementation lag The time it takes to

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

the economy to adjust to the new
conditions after a new policy is
implemented; the lag that occurs
because of the operation of the economy
itself.
What is most important is the total lag between the time a problem first occurs and the
time the corrective policies are felt.
AND FISCAL POLICY
Response Lags for Fiscal Policy
Neither individuals nor firms revise their spending plans instantaneously. Until they
can make those revisions, extra government spending does not stimulate extra private
spending.
Response Lags for Monetary Policy
Monetary policy works by changing interest

rates, which then change planned investment.
The response of consumption and investment to

interest rate changes takes time.
AND FISCAL POLICY
Summary
Stabilization is not easily achieved. It takes time

for policy makers to recognize the existence of
a problem, more time for them to implement a
solution, and yet more time for firms and
households to respond to the stabilization
policies taken.
MONETARY POLICY
There are two key points that we must add to

the monetary policy story to make the story
realistic, as we do in this section.
The first point is that in practice the Fed

controls the interest rate rather than the money
supply.
The second point is that the interest rate value

that the Fed chooses depends on the state of
the economy.
MONETARY POLICY
FIGURE 15.3 Fed Behavior
MONETARY POLICY
CONTROLLING THE INTEREST RATE

The Fed can pick a money supply value and
accept the interest rate consequences, or it can
pick an interest rate value and accept the
money supply consequences.
The first key point is that in practice the Fed chooses the interest rate value and accepts
the money supply consequences, rather than vice versa.
MONETARY POLICY
THE FED’S RESPONSE TO THE STATE OF THE

ECONOMY
FIGURE 15.4 The Fed’s Response
to Low Output/Low
Inflation
The Fed is likely to lower the interest rate (and thus increase the money supply) during
times of low output and low inflation.
MONETARY POLICY
FIGURE 15.5 The Fed’s Response

to High Output/High
Inflation
The Fed is likely to increase the interest rate (and thus decrease the money supply) during
times of high output and high inflation.
MONETARY POLICY
MONETARY POLICY SINCE 1990

TABLE 15.1 Data for Selected Variables for the 1989 I–2005 II Period
REAL GDP AAA SURPLUS
GROWTH UNEMPL. INFL. 3-MONTH BOND AS %
DATE RATE (%) RATE (%) RATE (%) T-BILL RATE RATE OF /GDP
1989 I 4.1 5.2 4.6 8.5 9.7 -2.1
II 2.7 5.2 3.9 8.4 9.5 -2.4
III 2.9 5.3 2.9 7.8 9.0 -2.5
IV 1.0 5.4 2.8 7.6 8.9 -2.5
1990 I 4.7 5.3 4.9 7.8 9.2 -2.9
II 1.0 5.3 4.7 7.8 9.4 -3.0
III 0.0 5.7 3.6 7.5 9.4 -2.8
IV -3.0 6.1 3.0 7.0 9.3 -3.1
1991 I -2.0 6.6 4.8 6.1 8.9 -2.7
II 2.6 6.8 2.6 5.6 8.9 -3.6
III 1.9 6.9 2.8 5.4 8.8 -3.9
IV 1.9 7.1 2.2 4.6 8.4 -4.1
1992 I 4.2 7.4 2.5 3.9 8.3 -4.7
II 3.9 7.6 2.1 3.7 8.3 -4.6
III 4.0 7.6 1.8 3.1 8.0 -5.0
IV 4.5 7.4 2.1 3.1 8.0 -4.5
1993 I 0.5 7.1 3.2 3.0 7.7 -4.6
II 2.0 7.1 2.2 3.0 7.4 -4.1
III 2.1 6.8 1.7 3.0 6.9 -4.1
IV 5.5 6.6 2.1 3.1 6.8 -3.7
MONETARY POLICY
TABLE 15.1 Data for Selected Variables for the 1989 I–2005 II Period (cont’d.)
1994 I 4.1 6.6 2.4 3.2 7.2 -3.4
II 5.3 6.2 1.7 4.0 7.9 -2.7
III 2.3 6.0 2.6 4.5 8.2 -3.0
IV 4.8 5.6 1.9 5.3 8.6 -3.0
1995 I 1.1 5.5 2.6 5.8 8.3 -2.9
II 0.7 5.7 1.4 5.6 7.7 -2.7
III 3.3 5.7 1.9 5.4 7.4 -2.7
IV 3.0 5.6 1.9 5.3 7.0 -2.4
1996 I 2.9 5.5 2.4 5.0 7.0 -2.4
II 6.7 5.5 1.6 5.0 7.6 -1.8
III 3.4 5.3 1.3 5.1 7.6 -1.7
IV 4.8 5.3 2.1 5.0 7.2 -1.4
1997 I 3.1 5.2 2.6 5.1 7.4 -1.1
II 6.2 5.0 0.7 5.1 7.6 -0.8
III 5.1 4.9 1.4 5.1 7.2 -0.4
IV 3.0 4.7 1.3 5.1 6.9 -0.4
1998 I 4.5 4.6 1.0 5.1 6.7 0.2
II 2.7 4.4 0.7 5.0 6.6 0.3
III 4.7 4.5 1.5 4.8 6.5 0.7
IV 6.2 4.4 1.4 4.3 6.3 0.6
1999 I 3.4 4.3 1.6 4.4 6.4 0.9
II 3.4 4.2 1.4 4.5 6.9 1.1
III 4.7 4.2 1.4 4.7 7.3 1.2
IV 7.3 4.1 1.7 5.0 7.5 1.3
MONETARY POLICY
TABLE 15.1 Data for Selected Variables for the 1989 I–2005 II Period (cont’d.)
2000 I 1.0 4.1 3.6 5.5 7.7 2.2
II 6.4 3.9 1.7 5.7 7.8 1.8
III -0.5 4.0 2.1 6.0 7.6 1.9
IV 2.1 3.9 1.6 6.0 7.4 1.7
2001 I -0.5 4.2 3.3 4.8 7.1 1.6
II 1.2 4.4 3.3 3.7 7.2 1.2
III -1.4 4.8 1.5 3.2 7.1 -0.9
IV 1.6 5.5 2.0 1.9 6.9 0.0
2002 I 2.7 5.7 1.5 1.8 6.6 -2.0
II 2.2 5.8 1.4 1.7 6.7 -2.3
III 2.4 5.7 1.5 1.6 6.3 -2.3
IV 0.2 5.9 2.2 1.3 6.3 -2.8
2003 I 1.7 5.8 3.1 1.2 6.0 -2.8
II 3.7 6.1 1.1 1.0 5.3 -3.4
III 7.2 6.1 1.9 0.9 5.7 -4.1
IV 3.6 5.9 1.8 0.9 5.7 -3.6
2004 I 4.3 5.6 3.7 0.9 5.5 -3.7
II 3.5 5.6 3.9 1.1 5.9 -3.5
III 4.0 5.5 1.3 1.5 5.6 -3.5
IV 3.3 5.4 2.7 2.0 5.5 -3.1
2005 I 3.8 5.3 3.0 2.5 5.3 -2.4
II 3.4 5.1 2.6 2.9 5.1 -2.1
Note: The inflation rate is the percentage change in the GDP price deflator. SURP denotes the federal government surplus (+) or deficit (-).
MONETARY POLICY
INFLATION TARGETING
inflation targeting When a monetary

authority chooses its interest rate values
with the aim of keeping the inflation rate
within some specified band over some
specified horizon.
FISCAL POLICY: DEFICIT TARGETING
Gramm-Rudman-Hollings Act Passed

by the U.S. Congress and signed by
President Reagan in 1986, this law set
out to reduce the federal deficit by $36
billion per year, with a deficit of zero
slated for 1991.
FIGURE 15.6 Deficit Reduction

Targets under
Gramm-Rudman-
Hollings
THE EFFECTS OF SPENDING CUTS ON THE DEFICIT
A cut in government spending causes the

economy to contract. Both the taxable income of
households and the profits of firms fall.
The deficit tends to rise when GDP falls, and tends to fall when GDP rises.
deficit response index (DRI) The

amount by which the deficit changes
with a $1 change in GDP.
Monetary Policy to the Rescue?
A zero multiplier can come about through renewed optimism on the part of households
and firms or through very aggressive behavior on the part of the Fed, but because
neither of these situations is very plausible, the multiplier is likely to be greater than
zero. Thus, it is likely that to lower the deficit by a certain amount, the cut in government
spending must be larger than that amount.
ECONOMIC STABILITY AND DEFICIT REDUCTION
negative demand shock Something

that causes a negative shift in
consumption or investment schedules or
that leads to a decrease in U.S. exports.
automatic stabilizers Revenue and

expenditure items in the federal budget
that automatically change with the
economy in such a way as to stabilize
GDP.
automatic destabilizers Revenue and

expenditure items in the federal budget
that automatically change with the
economy in such a way as to destabilize
GDP.
FIGURE 15.7 Deficit Targeting as an Automatic Destabilizer
FISCAL POLICY SINCE 1990
FIGURE 15.8 Federal Personal Income Taxes as a Percentage

of Taxable Income, 1990 I–2005 II
FIGURE 15.9 Federal Government Consumption Expenditures

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

a Percentage of GDP, 1990 I–2005 II
FIGURE 15.11 Federal Interest Payments as a Percentage of

GDP, 1990 I–2005 II
REVIEW TERMS AND CONCEPTS
automatic destabilizer inflation targeting

automatic stabilizer negative demand shock
deficit response index recognition lag
(DRI) response lag
Gramm-Rudman- stabilization policy
Hollings Act time lags
implementation lag

Macroeconomic Issues and Policy: Fernando & Yvonn Quijano

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Macroeconomic Issues and Policy: Fernando & Yvonn Quijano

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Chapter

Fernando & Yvonn Quijano

Time Lags Regarding Monetary and

FIGURE 15.1 Two Possible Time Paths for GDP

stabilization policy Describes both

time lags Delays in the economy’s

STABILIZATION: “THE FOOL IN THE SHOWER”

FIGURE 15.2 “The Fool in the Shower”—How Government

recognition lag The time it takes for

implementation lag The time it takes to

response lag The time that it takes for

Response Lags for Fiscal Policy

Response Lags for Monetary Policy

Monetary policy works by changing interest

The response of consumption and investment to

Stabilization is not easily achieved. It takes time

There are two key points that we must add to

The first point is that in practice the Fed

The second point is that the interest rate value

FIGURE 15.3 Fed Behavior

CONTROLLING THE INTEREST RATE

THE FED’S RESPONSE TO THE STATE OF THE

FIGURE 15.5 The Fed’s Response

MONETARY POLICY SINCE 1990

inflation targeting When a monetary

Gramm-Rudman-Hollings Act Passed

FIGURE 15.6 Deficit Reduction

THE EFFECTS OF SPENDING CUTS ON THE DEFICIT

A cut in government spending causes the

deficit response index (DRI) The

Monetary Policy to the Rescue?

ECONOMIC STABILITY AND DEFICIT REDUCTION

negative demand shock Something

automatic stabilizers Revenue and

automatic destabilizers Revenue and

FIGURE 15.7 Deficit Targeting as an Automatic Destabilizer

FIGURE 15.8 Federal Personal Income Taxes as a Percentage

FIGURE 15.9 Federal Government Consumption Expenditures

FIGURE 15.10 Federal Transfer Payments and Grants-in-aid as

FIGURE 15.11 Federal Interest Payments as a Percentage of

automatic destabilizer inflation targeting

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