MACROECONOMICS cover art ROW 1 (90) C H A P T E R © 2008 Worth Publishers, all rights reserved SIXTH EDITION PowerPoint® Slides by Ron Cronovich N. GREGORY MANKIW Stabilization Policy 14 Chapter 14 is less difficult than the preceding chapters, and a bit shorter, so you should be able to cover it fairly quickly. Students find the material very interesting, as it deals with important real-world policy issues related to the theories they learned in the immediately preceding chapters (9-13). cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy In this chapter, you will learn… §…about two policy debates: §1. Should policy be active or passive? §2. Should policy be by rule or discretion? > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Question 1: §Should policy be active or passive? ? Growth rate of U.S. real GDP -4 -2 0 2 4 6 8 10 1970 1975 1980 1985 1990 1995 2000 2005 Average growth rate Percent change from 4 quarters earlier This graph is from Chapter 9. I include it here as it shows that GDP is very volatile. Question 1 asks whether policymakers should attempt to smooth out these fluctuations by using fiscal and monetary policy to alter aggregate demand. The pink shaded vertical bars denote recessions. Source of data: See Figure 9-1, p.254 cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Increase in unemployment during recessions peak trough increase in no. of unemployed persons (millions) July 1953 May 1954 2.11 Aug 1957 April 1958 2.27 April 1960 February 1961 1.21 December 1969 November 1970 2.01 November 1973 March 1975 3.58 January 1980 July 1980 1.68 July 1981 November 1982 4.08 July 1990 March 1991 1.67 March 2001 November 2001 1.50 During a recession, many people lose their jobs (the average for the recessions shown in this table is 2.2 million). Advocates for activist policy believe that policymakers should use the fiscal and monetary policy tools at their disposal to try to reduce the length and severity of recessions, or prevent them if possible. Source: Business cycle dates from nber.org Increase in unemployment from U.S. Department of Labor, Bureau of Labor Statistics (via FRED, the St Louis Fed’s online database) cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Arguments for active policy §Recessions cause economic hardship for millions of people. §The Employment Act of 1946: “It is the continuing policy and responsibility of the Federal Government to…promote full employment and production.” §The model of aggregate demand and supply (Chaps. 9-13) shows how fiscal and monetary policy can respond to shocks and stabilize the economy. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Arguments against active policy §Policies act with long & variable lags, including: §inside lag: the time between the shock and the policy response. §takes time to recognize shock §takes time to implement policy, especially fiscal policy §outside lag: the time it takes for policy to affect economy. If conditions change before policy’s impact is felt, the policy may destabilize the economy. Opponents of policy activism argue that long & variable lags hinder the effectiveness of policy. Fiscal policy requires an act of Congress. As your students may be aware, the process by which a bill becomes a law is lengthy and involved, and often fraught with political difficulty. Monetary policy has a much shorter inside lag. However, firms make their investment plans in advance, so it takes time for interest rate changes to affect investment and aggregate demand. Opponents of policy activism note that the lags are long and uncertain, making it very difficult to predict the impact of policy, which makes it difficult to determine the appropriate policy. If you have a blackboard or whiteboard handy, you might draw for students the AD/AS diagram with the economy initially in a full-employment equilibrium. Then: 1.Show the short-run effects of a negative AD shock. 2.From the new short-run equilibrium, illustrate how an activist policy of increasing AD can get the economy back to full-employment. 3.Finally, repeat step 2, but assume that the policy acts with a lag, during which time the economy’s “self-correcting” mechanism is already well underway. The result should be that the AD shift actually pushes the economy over too far to the right, so that Y is greater than the full-employment level. Thus, policy meant to reduce a negative demand shock actually causes a positive shock. Of course, after this positive shock occurs, activist policymakers might try to contract aggregate demand; but again, if there’s a lag, then they might put the economy back into recession. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Automatic stabilizers §definition: policies that stimulate or depress the economy when necessary without any deliberate policy change. §Designed to reduce the lags associated with stabilization policy. §Examples: §income tax §unemployment insurance §welfare > Why the income tax is an automatic stabilizer: Each person’s tax bill depends on her income. In a recession, average incomes fall, so the average person pays less taxes. It’s as if the government automatically gives people a tax cut in recessions. Why unemployment insurance is an automatic stabilizer: In a recession, people who become unemployed experience a fall in their income, and therefore reduce their spending, which further reduces aggregate demand. Unemployment insurance reduces the fall in the income of the unemployed, and so helps to reduce the drop in aggregate demand during a recession. Welfare performs a similar function. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Forecasting the macroeconomy §Because policies act with lags, policymakers must predict future conditions. §Two ways economists generate forecasts: §Leading economic indicators data series that fluctuate in advance of the economy §Macroeconometric models Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies > The macroeconometric models are, in many cases, more elaborate versions of the IS-LM-AD-AS model that students have just learned in the preceding 5 chapters. The parameters of each equation (e.g., the MPC or the interest rate sensitivity of investment) are estimated with real-world data; then, by changing the values of the exogenous variables, or by specifying price shocks or other changes, the macroeconometric models generate forecasts of all the endogenous variables (GDP, interest rates, unemployment, inflation) at various time horizons following the shock or or policy change. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The LEI index and real GDP, 1960s source of LEI data: The Conference Board The Index of Leading Economic Indicators includes 10 data series (see p.258 ). In the 6^th edition, Chapter 9 now includes an extensive discussion of the components of the LEI index. In the PowerPoint presentation for Chapter 9, I have added a new time-series graph showing the LEI from 1970 through 2006. This and the next few slides show the annual growth rates of Real GDP and the Index of Leading Economic Indicators; there is one slide for each decade from the 1960s through the 1990s. You can ask your students to identify periods in which the LEI does a good job forecasting real GDP. One thing that becomes clear: the sign and size of the change in the LEI is a very imperfect predictor of the sign and size of the change in real GDP. Note: If you wish to save time, you can probably get the idea across with just one or two of these four slides--pick your favorite decade(s), and “hide” the slides for the other decades. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The LEI index and real GDP, 1970s source of LEI data: The Conference Board cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The LEI index and real GDP, 1980s source of LEI data: The Conference Board cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The LEI index and real GDP, 1990s source of LEI data: The Conference Board Mistakes forecasting the 1982 recession Mankiw6e_FIG This is Figure 14-1 on p.410 of the text. The red line is the actual unemployment rate. Each green line represents the median of 20 forecasts of the unemployment rate at the date shown. The first three forecasts all failed to predict the severity of the recession (each shows unemployment falling after a quarter or two, when in fact the unemployment rate kept rising). The last three forecasts failed to predict the speed of the recovery. The point here is that forecasts are often not accurate, which opponents of activist policy emphasize. And without accurate forecasts, policies that act with uncertain lags may end up destabilizing the economy. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Forecasting the macroeconomy §Because policies act with lags, policymakers must predict future conditions. The preceding slides show that the forecasts are often wrong. This is one reason why some economists oppose policy activism. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The Lucas critique §Due to Robert Lucas who won Nobel Prize in 1995 for rational expectations. §Forecasting the effects of policy changes has often been done using models estimated with historical data. §Lucas pointed out that such predictions would not be valid if the policy change alters expectations in a way that changes the fundamental relationships between variables. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy An example of the Lucas critique §Prediction (based on past experience): An increase in the money growth rate will reduce unemployment. §The Lucas critique points out that increasing the money growth rate may raise expected inflation, in which case unemployment would not necessarily fall. > Remember the expectations-augmented Phillips Curve from Chapter 13: An increase in money growth and inflation only reduces unemployment if expected inflation remains unchanged. Perhaps that was the case in the past. But now, if the money growth increase causes people to raise their expectations of inflation, then unemployment won’t fall. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The Jury’s out… §Looking at recent history does not clearly answer Question 1: §It’s hard to identify shocks in the data. §It’s hard to tell how things would have been different had actual policies not been used. §Most economists agree, though, that the U.S. economy has become much more stable since the late 1980s… > Greg sums it up nicely on p.412: “If the economy has experienced many large shocks to aggregate supply and aggregate demand, and if policy has successfully insulated the economy from these shocks, then the case for active policy should be clear. Conversely, if the economy has experienced few large shocks, and if the fluctuations we have observed can be traced to inept economic policy, then the case for passive policy should be clear….Yet…it is not easy to identify the sources of economic fluctuations. The historical record often permits more than one interpretation. The Great Depression is a case in point….Some economists believe that a large contractionary shock to private spending caused the depression. They assert that policymakers should have responded by stimulating aggregate demand. Other economists believe that the large fall in the money supply caused the Depression. They assert that the Depression would have been avoided if the Fed had been pursuing a passive monetary policy of increasing the money supply at a steady rate.” cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The stability of the modern economy 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Volatility of GDP Volatility of Inflation This graph presents the standard deviation of real GDP growth and of inflation. Since the late 1980s, GDP and inflation have become far less volatile than at any time in many decades. See discussion on p.413 and graphs on p.414. Data: same as in text, see p. 414. The note at the bottom of Figure 14-2 describes how these series were constructed. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Question 2: §Should policy be conducted by rule or discretion? ? cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Rules and discretion: Basic concepts §Policy conducted by rule: Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through. §Policy conducted by discretion: As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Arguments for rules §1. Distrust of policymakers and the political process §misinformed politicians §politicians’ interests sometimes not the same as the interests of society § > Note: these are arguments made by critics of policy by discretion. Please be clear that it is not our intention to say that politicians are misinformed or acting against society; rather, this is what is alleged by proponents of policy by rules. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Arguments for rules §2. The time inconsistency of discretionary policy §def: A scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement. §Destroys policymakers’ credibility, thereby reducing effectiveness of their policies. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Examples of time inconsistency §1. To encourage investment, govt announces it will not tax income from capital. § But once the factories are built, govt reneges in order to raise more tax revenue. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Examples of time inconsistency §2. To reduce expected inflation, the central bank announces it will tighten monetary policy. § But faced with high unemployment, the central bank may be tempted to cut interest rates. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Examples of time inconsistency §3. Aid is given to poor countries contingent on fiscal reforms. § The reforms do not occur, but aid is given anyway, because the donor countries do not want the poor countries’ citizens to starve. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Monetary policy rules §a. Constant money supply growth rate §Advocated by monetarists. §Stabilizes aggregate demand only if velocity is stable. The preceding slides gave some arguments against discretionary policy. This and the following slides describe the alternative: policy by rule. In particular, rules for monetary policy. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Monetary policy rules §b. Target growth rate of nominal GDP §Automatically increase money growth whenever nominal GDP grows slower than targeted; decrease money growth when nominal GDP growth exceeds target. a. Constant money supply growth rate cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Monetary policy rules §c. Target the inflation rate §Automatically reduce money growth whenever inflation rises above the target rate. §Many countries’ central banks now practice inflation targeting, but allow themselves a little discretion. a. Constant money supply growth rate b. Target growth rate of nominal GDP cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Monetary policy rules d. The Taylor rule: Target the federal funds rate based on §inflation rate §gap between actual & full-employment GDP §c. Target the inflation rate a. Constant money supply growth rate b. Target growth rate of nominal GDP cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The Taylor Rule §iff = p + 2 + 0.5 (p – 2) – 0.5 (GDP gap) §where § iff = nominal federal funds rate target § GDP gap = 100 x §= percent by which real GDP is below its natural rate The equation here appears on p.422. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The Taylor Rule §iff = p + 2 + 0.5 (p – 2) – 0.5 (GDP gap) §If p = 2 and output is at its natural rate, then fed funds rate targeted at 4 percent. §For each one-point increase in p, mon. policy is automatically tightened to raise fed funds rate by 1.5. §For each one percentage point that GDP falls below its natural rate, mon. policy automatically eases to reduce the fed funds rate by 0.5. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The federal funds rate: Actual and suggested 0 2 4 6 8 10 12 1987 1990 1993 1996 1999 2002 2005 Taylor’s Rule Actual Figure 14-3, p. 422. The Fed never announced that it follows the Taylor Rule. But if you compare the actual fed funds rate to rate suggested by the Taylor Rule, it appears that the Fed’s behavior is roughly consistent with the Taylor Rule, whether intentionally or not. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Central bank independence §A policy rule announced by central bank will work only if the announcement is credible. §Credibility depends in part on degree of independence of central bank. > We have seen this issue in Chapter 13: If the Fed credibly announces a new commitment to bring inflation down, then expected inflation will fall, reducing the sacrifice ratio. If the Fed’s announcement is not credible, then expected inflation will not fall, and a painful recession will be required to bring inflation down. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Inflation and central bank independence Mankiw6e_FIG index of central bank independence This figure shows a measure of the independence of various countries’ central banks (higher numbers = greater independence). One would expect higher average inflation in countries whose central banks are less independent, as monetary policy could be used for political purposes (e.g., lowering unemployment prior to elections). And the graph shows that this is the case. This graph appears on p.424 of the text as Figure 14-4 , and was originally in Alesina and Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit, and Banking, May 1993. Chapter Summary §1. Advocates of active policy believe: §frequent shocks lead to unnecessary fluctuations in output and employment §fiscal and monetary policy can stabilize the economy §2. Advocates of passive policy believe: §the long & variable lags associated with monetary and fiscal policy render them ineffective and possibly destabilizing §inept policy increases volatility in output, employment CHAPTER 14 Stabilization Policy slide 35 cover R3,C1 > Chapter Summary §3. Advocates of discretionary policy believe: §discretion gives more flexibility to policymakers in responding to the unexpected §4. Advocates of policy rules believe: §the political process cannot be trusted: Politicians make policy mistakes or use policy for their own interests §commitment to a fixed policy is necessary to avoid time inconsistency and maintain credibility CHAPTER 14 Stabilization Policy slide 36 cover R3,C1 > MACROECONOMICS cover art ROW 1 (90) C H A P T E R © 2008 Worth Publishers, all rights reserved SIXTH EDITION PowerPoint® Slides by Ron Cronovich N. GREGORY MANKIW Government Debt 15 Chapter 15 is short but fun. Lots of policy & real-world relevance, little theory (a nice breather after the analytically challenging chapters 10-13). This presentation includes a lot of data that complements the material in the chapter: To support the case study “the troubling outlook for fiscal policy,” I have included data on the proportion of the population 65+ years old, spending on Social Security and Medicare as a share of GDP, and CBO projections of the government’s debt over the next 50 years. To support the textbook’s discussion of the cyclically-adjusted budget deficit, I include a graph of CBO’s estimate of the cyclical component of the deficit, which is used to “correct” the deficit for the gap between actual and potential GDP. And finally, to support the textbook’s case study on inflation-indexed Treasury bonds, I include data on the yields on indexed and non-indexed 10-year T-bonds. The difference between these yields is a measure of expected inflation, which I also include on the graph. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy In this chapter, you will learn… §about the size of the U.S. government’s debt, and how it compares to that of other countries §problems measuring the budget deficit §the traditional and Ricardian views of the government debt §other perspectives on the debt > Indebtedness of the world’s governments Country Gov Debt (% of GDP) Country Gov Debt (% of GDP) Japan 159 U.S.A. 64 Italy 125 Sweden 62 Greece 108 Finland 53 Belgium 99 Norway 52 France 77 Denmark 50 Portugal 77 Spain 49 Germany 70 U.K. 47 Austria 69 Ireland 30 Canada 69 Korea 20 Netherlands 64 Australia 15 An abbreviated version of Table 15-1 on p.432 Source: OECD Economic Outlook. Despite all the alarms sounded by politicians and some economists, the U.S. debt-to-GDP ratio is moderate when compared to other countries. (Of course, the U.S. has the largest GDP, so in absolute terms U.S. debt is a whopper when compared to other countries’ government debts.) cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Ratio of U.S. govt debt to GDP 0 0.2 0.4 0.6 0.8 1 1.2 1791 1815 1839 1863 1887 1911 1935 1959 1983 2007 Revolutionary War Civil War WW1 WW2 Iraq War Figure 15-1, p.433. The historical pattern: the debt-GDP ratio rises during wars and falls during peace-time. The exception is the substantial rise that occurred beginning in the early 1980s. This graph suggests that the recent (1981-1994) increase in the debt is not so horrible when viewed in the larger context of history. Nonetheless, the debt ratio was higher in the early 1990s than during any previous time, except for WW2. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The U.S. experience in recent years §Early 1980s through early 1990s §debt-GDP ratio: 25.5% in 1980, 48.9% in 1993 §due to Reagan tax cuts, increases in defense spending & entitlements §Early 1990s through 2000 §$290b deficit in 1992, $236b surplus in 2000 §debt-GDP ratio fell to 32.5% in 2000 §due to rapid growth, stock market boom, tax hikes §Since 2001 §the return of huge deficits, due to Bush tax cuts, 2001 recession, Iraq war > The stock market boom of the latter 1990s created huge capital gains, which helped bring down the budget deficit by increasing revenues. Even if the government budget had been balanced, rapid economic growth from 1995-2000 would still have brought down the debt-GDP ratio. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The troubling fiscal outlook §The U.S. population is aging. §Health care costs are rising. §Spending on entitlements like Social Security and Medicare is growing. §Deficits and the debt are projected to significantly increase… US Capitol Bldg(60) > This and the next few slides correspond to the case study on pp.434-435, which has been updated and expanded for the 6^th edition. If you prefer, “hide” or omit this slide from your presentation, and instead give the information verbally to students as you display the following slides. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Percent of U.S. population age 65+ Percent of pop. 5 8 11 14 17 20 23 actual projected Source: U.S. Census Bureau, 2004, "U.S. Interim Projections by Age, Sex, Race, and Hispanic Origin," Table 2a. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy U.S. government spending on Medicare and Social Security Percent of GDP 0 2 4 6 8 Source: Table 15.4--TOTAL GOVERNMENT EXPENDITURES BY MAJOR CATEGORY OF EXPENDITURE: 1948-2005, page 314 of “Historical Tables, Budget of the United States Government, Fiscal Year 2007” From the Budget of the U.S., FY 2007 Online via GPO Access [wais.access.gpo.gov] cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy CBO projected U.S. federal govt debt in two scenarios 0 50 100 150 200 250 300 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 optimistic scenario pessimistic scenario Even in the optimistic scenario, the debt ratio more than doubles over the next 40 years. In the pessimistic scenario, the debt ratio increases from 40% today to over 250% in just 45 years! Source: “A CBO Study: The Long-Term Budget Outlook.” December 2005. Available at www.cbo.gov The CBO actually did projections for 6 scenarios, which differ in their assumptions regarding government spending and revenues. The report cited above explains the assumptions behind all six scenarios. I read the report and studied the six scenarios, and then picked two that I thought were reasonable for this graph. The “pessimistic scenario” on this graph is Scenario 2 in the CBO report. The “optimistic scenario” on this graph is Scenario 5 in the CBO report. For details of the CBO’s projections in the other scenarios, please see the report. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Problems measuring the deficit §1. Inflation §2. Capital assets §3. Uncounted liabilities §4. The business cycle Before we assess whether the debt is a problem, we first consider whether the standard measures of the debt & deficit are accurate. It turns out they are not, for these four reasons. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy MEASUREMENT PROBLEM 1: Inflation §Suppose the real debt is constant, which implies a zero real deficit. §In this case, the nominal debt D grows at the rate of inflation: § DD/D = p or DD = p D §The reported deficit (nominal) is p D even though the real deficit is zero. §Hence, should subtract p D from the reported deficit to correct for inflation. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy MEASUREMENT PROBLEM 1: Inflation §Correcting the deficit for inflation can make a huge difference, especially when inflation is high. §Example: In 1979, § nominal deficit = $28 billion § inflation = 8.6% § debt = $495 billion § p D = 0.086 ´ $495b = $43b § real deficit = $28b - $43b = $15b surplus > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy MEASUREMENT PROBLEM 2: Capital Assets §Currently, deficit = change in debt §Better, capital budgeting: deficit = (change in debt) - (change in assets) §EX: Suppose govt sells an office building and uses the proceeds to pay down the debt. §under current system, deficit would fall §under capital budgeting, deficit unchanged, because fall in debt is offset by a fall in assets. §Problem w/ cap budgeting: Determining which govt expenditures count as capital expenditures. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy MEASUREMENT PROBLEM 3: Uncounted liabilities §Current measure of deficit omits important liabilities of the government: §future pension payments owed to current govt workers. §future Social Security payments §contingent liabilities, e.g., covering federally insured deposits when banks fail § (Hard to attach a dollar value to contingent liabilities, due to inherent uncertainty.) > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy MEASUREMENT PROBLEM 4: The business cycle §The deficit varies over the business cycle due to automatic stabilizers (unemployment insurance, the income tax system). §These are not measurement errors, but do make it harder to judge fiscal policy stance. §E.g., is an observed increase in deficit due to a downturn or an expansionary shift in fiscal policy? > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy MEASUREMENT PROBLEM 4: The business cycle §Solution: cyclically adjusted budget deficit (aka “full-employment deficit”) – based on estimates of what govt spending & revenues would be if economy were at the natural rates of output & unemployment. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The cyclical contribution to the U.S. Federal budget -120 -80 -40 0 40 80 120 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: CBO. Obtained from: http://www.cbo.gov/Spreadsheets.shtml http://www.cbo.gov/ftpdocs/70xx/doc7060/03-07-CycMeas.pdf CBO includes this note: “The cyclical contribution to revenues is negative when actual GDP is less than potential GDP. The cyclical contribution to mandatory spending is positive when the unemployment rate is higher than the nonaccelerating inflation rate of unemployment. The cyclical contribution to the budget surplus or deficit equals the cyclical contribution to revenues minus the cyclical contribution to mandatory spending.” In essence, the graph on this slide shows the size of the correction to the measured budget deficit due to the business cycle. The data are in billions of current dollars. The increasing magnitude of the cyclical contribution is due to inflation and economic growth, both of which increase nominal magnitudes of most macroeconomic variables. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The bottom line We must exercise care when interpreting the reported deficit figures. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Is the govt debt really a problem? §Consider a tax cut with corresponding increase in the government debt. §Two viewpoints: §1. Traditional view §2. Ricardian view > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The traditional view §Short run: Y, u §Long run: §Y and u back at their natural rates §closed economy: r, I §open economy: e, NX (or higher trade deficit) §Very long run: §slower growth until economy reaches new steady state with lower income per capita > The traditional view is just the viewpoint embodied in the models that students learned in chapters 3 through 13 of this textbook. This viewpoint is accepted by most mainstream economists. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The Ricardian view §due to David Ricardo (1820), more recently advanced by Robert Barro §According to Ricardian equivalence, a debt-financed tax cut has no effect on consumption, national saving, the real interest rate, investment, net exports, or real GDP, even in the short run. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy The logic of Ricardian Equivalence §Consumers are forward-looking, know that a debt-financed tax cut today implies an increase in future taxes that is equal – in present value – to the tax cut. §The tax cut does not make consumers better off, so they do not increase consumption spending. § Instead, they save the full tax cut in order to repay the future tax liability. §Result: Private saving rises by the amount public saving falls, leaving national saving unchanged. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Problems with Ricardian Equivalence §Myopia: Not all consumers think so far ahead, some see the tax cut as a windfall. §Borrowing constraints: Some consumers cannot borrow enough to achieve their optimal consumption, so they spend a tax cut. §Future generations: If consumers expect that the burden of repaying a tax cut will fall on future generations, then a tax cut now makes them feel better off, so they increase spending. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Evidence against Ricardian Equivalence? §Early 1980s: Reagan tax cuts increased deficit. National saving fell, real interest rate rose, exchange rate appreciated, and NX fell. §1992: Income tax withholding reduced to stimulate economy. §This delayed taxes but didn’t make consumers better off. §Almost half of consumers increased consumption. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy Evidence against Ricardian Equivalence? §Proponents of R.E. argue that the Reagan tax cuts did not provide a fair test of R.E. §Consumers may have expected the debt to be repaid with future spending cuts instead of future tax hikes. §Private saving may have fallen for reasons other than the tax cut, such as optimism about the economy. §Because the data is subject to different interpretations, both views of govt debt survive. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy OTHER PERSPECTIVES: Balanced budgets vs. optimal fiscal policy §Some politicians have proposed amending the U.S. Constitution to require balanced federal govt budget every year. §Many economists reject this proposal, arguing that deficit should be used to §stabilize output & employment §smooth taxes in the face of fluctuating income §redistribute income across generations when appropriate > The material on this slide is related to the material on the slide after the following one, entitled Other Perspectives: Debt and Politics. If you wish to save time, you can combine the two. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy OTHER PERSPECTIVES: Fiscal effects on monetary policy §Govt deficits may be financed by printing money §A high govt debt may be an incentive for policymakers to create inflation (to reduce real value of debt at expense of bond holders) §Fortunately: §little evidence that the link between fiscal and monetary policy is important §most governments know the folly of creating inflation §most central banks have (at least some) political independence from fiscal policymakers > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy OTHER PERSPECTIVES: Debt and politics §“Fiscal policy is not made by angels…” – N. Gregory Mankiw, p.449 §Some do not trust policymakers with deficit spending. They argue that §policymakers do not worry about true costs of their spending, since burden falls on future taxpayers §since future taxpayers cannot participate in the decision process, their interests may not be taken into account §This is another reason for the proposals for a balanced budget amendment (discussed above). > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy OTHER PERSPECTIVES: International dimensions §Govt budget deficits can lead to trade deficits, which must be financed by borrowing from abroad. §Large govt debt may increase the risk of capital flight, as foreign investors may perceive a greater risk of default. §Large debt may reduce a country’s political clout in international affairs. > cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy CASE STUDY: Inflation-indexed Treasury bonds §Starting in 1997, the U.S. Treasury issued bonds with returns indexed to the CPI. §Benefits: §Removes inflation risk, the risk that inflation – and hence real interest rate – will turn out different than expected. §May encourage private sector to issue inflation-adjusted bonds. §Provides a way to infer the expected rate of inflation… > This slide and the next correspond to the case study “the Benefits of Indexed Bonds” that closes Chapter 15 (see pp.451-452). It might be worth taking a moment to help your students understand why inflation risk is an undesirable thing. It’s also a good idea to help your students understand why we can infer the expected inflation rate from the difference between the yields on standard and inflation-indexed bonds of the same maturity. A simple example might help: Suppose the inflation-indexed Treasury bond pays 3 percent after inflation, while a standard Treasury bond with the same maturity pays 5 percent. We can infer that the market expects 2 percent inflation during the term of the bond. If people expected less than two percent inflation, then the non-indexed bond would have a higher real return than the indexed bond, so everyone would try to buy the non-indexed bond. But this would drive up its price, and drive down its return, until the difference between the returns on the two bonds just equals expected inflation. cover R1,C4 slide ‹#› CHAPTER 14 Stabilization Policy CHAPTER 14 Stabilization Policy CASE STUDY: Inflation-indexed Treasury bonds 0 1 2 3 4 5 6 2003- 01-03 2003- 07-04 2004- 01-02 2004- 07-02 2004- 12-31 2005- 07-01 2005- 12-30 2006- 06-30 2006- 12-29 2007- 06-29 rate on non-indexed bond implied expected inflation rate rate on indexed bond This graph presents the yields on 10-year constant maturity non-indexed and inflation-indexed U.S. Treasury bonds. The implied expected rate of inflation is simply the difference between the non-indexed (i.e. nominal) and indexed (i.e. real) bond yields. Expected inflation was 1.51% at the beginning of 2003. It was as high as 2.7% (nearly double the 1/2003 figure) in March 2005 and again in May 2006. Source: Board of Governors of the Federal Reserve Obtained from: http://research.stlouisfed.org/fred2/ Chapter Summary §1. Relative to GDP, the U.S. government’s debt is moderate compared to other countries §2. Standard figures on the deficit are imperfect measures of fiscal policy because they §are not corrected for inflation §do not account for changes in govt assets §omit some liabilities (e.g., future pension payments to current workers) §do not account for effects of business cycles CHAPTER 15 Government Debt slide 68 cover R3,C1 > Chapter Summary §3. In the traditional view, a debt-financed tax cut increases consumption and reduces national saving. In a closed economy, this leads to higher interest rates, lower investment, and a lower long-run standard of living. In an open economy, it causes an exchange rate appreciation, a fall in net exports (or increase in the trade deficit). §4. The Ricardian view holds that debt-financed tax cuts do not affect consumption or national saving, and therefore do not affect interest rates, investment, or net exports. CHAPTER 15 Government Debt slide 69 cover R3,C1 > Chapter Summary §5. Most economists oppose a strict balanced budget rule, as it would hinder the use of fiscal policy to stabilize output, smooth taxes, or redistribute the tax burden across generations. §6. Government debt can have other effects: §may lead to inflation §politicians can shift burden of taxes from current to future generations §may reduce country’s political clout in international affairs or scare foreign investors into pulling their capital out of the country CHAPTER 15 Government Debt slide 70 cover R3,C1 >