CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

PowerPoint Lectures for

Principles of
Macroeconomics, 9e
; ; By
Karl E. Case,
Ray C. Fair &
Sharon M. Oster

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CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

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 PART IV FURTHER MACROECONOMICS ISSUES

Policy Timing,
Deficit 15
Targeting, and
Stock
Market Effects

Prepared by:
Fernando & Yvonn Quijano

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 PART IV FURTHER MACROECONOMICS ISSUES

Policy Timing,
15
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

Deficit
Targeting, and
Stock
CHAPTER
Market Effects OUTLINE
Time Lags Regarding Monetary and
Fiscal Policy
Stabilization
Recognition Lags
Implementation Lags
Response Lags

Fiscal Policy: Deficit Targeting

The Effects of Spending Cuts on the
Deficit
Economic Stability and Deficit Reduction
Summary

The Stock Market and the Economy

Stocks and Bonds
Determining the price of a Stock
The Stock Market Since 1948
Stock Market Effects on the Economy

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 Time Lags Regarding Monetary and Fiscal Policy
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

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.

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 Time Lags Regarding Monetary and Fiscal Policy
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

 FIGURE 15.1 Two Possible Time Paths for GDP

Path A is less stable—it varies more over time—than path B. Other things being equal, society prefers
path B to path A.

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 The main goal of stabilization policy is to:
a. Take economic measures that enhance the credibility of
government institutions.
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

b. Be prepared to handle destabilizing economic situations, such as a

bank run.
c. Use monetary and fiscal policy to smooth out fluctuations in
output, employment, and prices.
d. Use economic policy to solve social problems such as crime or
child neglect.

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 The main goal of stabilization policy is to:
a. Take economic measures that enhance the credibility of
government institutions.
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

b. Be prepared to handle destabilizing economic situations, such as a

bank run.
c. Use monetary and fiscal policy to smooth out fluctuations in
output, employment, and prices.
d. Use economic policy to solve social problems such as crime or
child neglect.

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 Time Lags Regarding Monetary and Fiscal Policy
Stabilization
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

 FIGURE 15.2 Possible Stabilization Timing Problems

Attempts to stabilize the economy can prove destabilizing because of time lags. An expansionary policy that
should have begun to take effect at point A does not actually begin to have an impact until point D, when the
economy is already on an upswing. Hence, the policy pushes the economy to points E1, and F1, (instead of
points E and F). Income varies more widely than it would have if no policy had been implemented.

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 A leading critic of stabilization policy that likened government attempts
to stabilize the economy to a “fool in the shower” is:
a. John Maynard Keynes.
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

b. Adam Smith.
c. Milton Friedman.
d. Jean-Paul Sartre.

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 A leading critic of stabilization policy that likened government attempts
to stabilize the economy to a “fool in the shower” is:
a. John Maynard Keynes.
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

b. Adam Smith.
c. Milton Friedman.
d. Jean-Paul Sartre.

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 Time Lags Regarding Monetary and Fiscal Policy
Recognition Lags
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

recognition lag The time it takes for policy

makers to recognize the existence of a boom or a
slump.

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.

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 Time Lags Regarding Monetary and Fiscal Policy
Response Lags
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

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.

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 Which lag occurs because of the operation of the economy, or the time
it takes for the multiplier to reach its full value?
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

a. The recognition lag.

b. The implementation lag.
c. The response lag.
d. All of the above refer to how the economy adjusts after a new
policy is implemented.

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 Which lag occurs because of the operation of the economy, or the time
it takes for the multiplier to reach its full value?
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

a. The recognition lag.

b. The implementation lag.
c. The response lag.
d. All of the above refer to how the economy adjusts after a new
policy is implemented.

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 Time Lags Regarding Monetary and Fiscal Policy
Response Lags
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

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.

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 Time Lags Regarding Monetary and Fiscal Policy
Response Lags
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

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.

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 Which of the following changes in fiscal policy has a shorter response
lag than the others?
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

a. An increase in government spending.

b. A cut in personal taxes.
c. A cut in business taxes.
d. All of the above measures have about the same response lag.

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 Which of the following changes in fiscal policy has a shorter response
lag than the others?
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

a. An increase in government spending.

b. A cut in personal taxes.
c. A cut in business taxes.
d. All of the above measures have about the same response lag.

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 Fiscal Policy: Deficit Targeting
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

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 15.3 Deficit Reduction

Targets under Gramm-Rudman-
Hollings

The GRH legislation, passed in

1986, set out to lower the federal
deficit by $36 billion per year. If
the plan had worked, a zero deficit
would have been achieved by
1991.

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 Fiscal Policy: Deficit Targeting
The Effects of Spending Cuts on the Deficit
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

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.

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 Fill in the blank. When there is a contraction in the economy, automatic
spending cuts to reduce the deficit would have to be ___________
the corresponding increase in government expenditures.
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

a. exactly equal to
b. greater than
c. less than
d. exactly twice as large as

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 Fill in the blank. When there is a contraction in the economy, automatic
spending cuts to reduce the deficit would have to be ___________
the corresponding increase in government expenditures.
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

a. exactly equal to
b. greater than
c. less than
d. exactly twice as large as

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 Fiscal Policy: Deficit Targeting
The Effects of Spending Cuts on the Deficit
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

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.

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 To prevent the change in output arising from a cut in government
spending, the Fed could try to:
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

a. decrease the interest rate, but the amount of intervention would

have to be substantial.
b. decrease the interest rate, which would require only a slight
increase in the money supply.
c. increase the interest rate substantially by lowering the money
supply only slightly.
d. shift the AD curve to the left.

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 To prevent the change in output arising from a cut in government
spending, the Fed could try to:
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

a. decrease the interest rate, but the amount of intervention

would have to be substantial.
b. decrease the interest rate, which would require only a slight
increase in the money supply.
c. increase the interest rate substantially by lowering the money
supply only slightly.
d. shift the AD curve to the left.

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 Fiscal Policy: Deficit Targeting
Economic Stability and Deficit Reduction
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

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.

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 Fiscal Policy: Deficit Targeting
Economic Stability and Deficit Reduction
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

 FIGURE 15.4 Deficit Targeting as an Automatic Destabilizer

Deficit targeting changes the way the economy responds to negative demand shocks because it does not
allow the deficit to increase. The result is a smaller deficit but a larger decline in income than would have
otherwise occurred.
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 In a world without deficit targeting, the deficit is:
a. An automatic stabilizer.
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

b. An automatic destabilizer.
c. A negative demand shock.
d. Maximized.

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 In a world without deficit targeting, the deficit is:
a. An automatic stabilizer.
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

b. An automatic destabilizer.
c. A negative demand shock.
d. Maximized.

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 Fiscal Policy: Deficit Targeting
Summary
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

It is clear that the GRH legislation, the balanced-

budget amendment, and similar deficit targeting
measures have some undesirable macroeconomic
consequences.

Locking the economy into spending cuts during

periods of negative demand shocks, as deficit-
targeting measures do, is not a good way to
manage the economy.

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 The Stock Market and the Economy
Stocks and Bonds
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

stock A certificate that certifies ownership of a

certain portion of a firm.

capital gain An increase in the value of an asset.

realized capital gain The gain that occurs when

the owner of an asset actually sells it for more than
he or she paid for it.

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 The Stock Market and the Economy
Determining the Price of a Stock
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

Things that are likely to affect the price of a stock

include:

• What people expect its future dividends will

be.

• When the dividends are expected to be paid.

• The amount of risk involved.

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 The Stock Market and the Economy
The Stock Market Since 1948
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

Dow Jones Industrial Average An index based

on the stock prices of 30 actively traded large
companies. The oldest and most widely followed
index of stock market performance.

NASDAQ Composite An index based on the

stock prices of over 5,000 companies traded on
the NASDAQ Stock Market. The NASDAQ market
takes its name from the National Association of
Securities Dealers Automated Quotation System.

Standard and Poor’s 500 (S&P 500) An index

based on the stock prices of 500 of the largest
firms by market value.

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 The Stock Market and the Economy
The Stock Market Since 1948
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

 FIGURE 15.5 The S&P 500 Stock Price Index, 1948 I–2007 IV

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 The Stock Market and the Economy
The Stock Market Since 1948
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

 FIGURE 15.6 Ratio of After-Tax Profits to GDP, 1948 I–2007 IV

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 The Stock Market and the Economy
Stock Market Effects on the Economy
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

An increase in stock prices causes an increase in

wealth, and consequently an increase in consumer
spending.

Investment is also affected by higher stock prices.

With a higher stock price, a firm can raise more
money per share to finance investment projects.

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 The Stock Market and the Economy
Stock Market Effects on the Economy
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

The Crash of October 1987

The value of stocks in the United States fell by

about a trillion dollars between August 1987 and
the end of October 1987.

If the multiplier is 1.4, the total decrease in GDP

would be about 1.4 x $40 billion = $56 billion, or
about 1.4 percent of GDP.

The stock market crash of 1987 did not result in a

recession in 1988 because households and
business firms did not lower their expectations
drastically.

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 The Stock Market and the Economy
Stock Market Effects on the Economy
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

The Boom of 1995–2000

 FIGURE 15.7 Personal Saving Rate, 1995 I–2002 III

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 The Stock Market and the Economy
Stock Market Effects on the Economy
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

The Boom of 1995–2000

 FIGURE 15.8 Investment-Output Ratio, 1995 I–2002 III

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 The Stock Market and the Economy
Stock Market Effects on the Economy
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

The Boom of 1995–2000

 FIGURE 15.9 Ratio of Federal Government Budget Surplus to GDP, 1995 I–2002 III

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 The Stock Market and the Economy
Stock Market Effects on the Economy
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

The Boom of 1995–2000

 FIGURE 15.10 Growth Rate of Real GDP, 1995 I–2002 III

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 The Stock Market and the Economy
Stock Market Effects on the Economy
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

The Boom of 1995–2000

 FIGURE 15.11 The Unemployment Rate, 1995 I–2002 III

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 The Stock Market and the Economy
Stock Market Effects on the Economy
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

The Boom of 1995–2000

 FIGURE 15.12 Inflation Rate, 1995 I–2002 III

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 The Stock Market and the Economy
Stock Market Effects on the Economy
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

Fed Policy and the Stock Market

 FIGURE 15.13 3-Month Treasury Bill Rate, 1995 I–2002 III

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 The Stock Market and the Economy
Stock Market Effects on the Economy
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

The Post-Boom Economy

Both stock market wealth and housing wealth have

important effects on the economy.

Bubbles or Rational
Investors?
Bernanke’s Bubble Laboratory:
Princeton Protégés of Fed
Chief Study the Economics of
Manias
Wall Street Journal

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 REVIEW TERMS AND CONCEPTS
CHAPTER 15 Policy Timing, Deficit Targeting, and Stock Market Effects

automatic destabilizers negative demand shock

automatic stabilizers realized capital gain
capital gain recognition lag
deficit response index (DRI) response lag
Dow Jones Industrial Average stabilization policy
Gramm-Rudman-Hollings Act Standard and Poor’s 500 (S&P 500)
implementation lag stock
NASDAQ Composite time lags

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