Chapter 36

Six Debates over Macroeconomic Policy

In this chapter,
look for the answers to these questions:
What are the arguments on both sides of each of the
following debates?
• Should policymakers try to stabilize the economy?
• Should fiscal policy fight recessions with spending hikes or tax
cuts?
• Should monetary policy be made by rule or discretion?
• Should the central bank aim for zero inflation?
• Should the government balance its budget?
• Should the tax laws be reformed to encourage saving?
Introduction
• This course has introduced you to the tools economists use to analyze
the behavior of the economy as a whole and the impact of policies on
the economy.
• This final chapter presents both sides in six classic debates over
macroeconomic policy.
1. Should Policymakers Try to Stabilize the
Economy?

Arguments for active stabilization:

• Left on their own, economies tend to fluctuate.
E.g., pessimism of households and firms causes a fall in
agg demand, which causes a recession.
• Policymakers can “lean against the wind,”
i.e. use monetary & fiscal policy to stabilize
agg demand, output, and employment.
• A more stable economy benefits everyone.
1. Should Policymakers Try to Stabilize the
Economy?

Arguments against active stabilization:

• Monetary & fiscal policy work with long lags,
so policy must act in advance of economic changes.
• But the shocks that cause fluctuations are unpredictable,
and forecasting is highly imprecise.
• If policy takes effect too late, it will worsen fluctuations.
• So, leave economy to its own devices.
ACTIVE LEARNING 1
Active stabilization policy
• Would you be more likely to support active
stabilization policy if wages, prices, and expectations
adjust quickly in response to economic changes, or if
they adjust slowly?
ACTIVE LEARNING 1
Answers
• If wages, prices, and expectations adjust slowly,
it will take longer for the economy to return to its
natural rates of output and employment.
• In that case, there’s a better chance that
expansionary policy will act in time to alleviate the
recession, rather than push the economy into an
inflationary boom.
2. Should the Government Fight
Recessions with Spending Hikes or Tax
Cuts?
Arguments for fighting recessions with spending:
• Each $ of govt spending adds directly to aggregate
demand, but only part of each $ of a tax cut does because
consumers save part of it.
• Since most states must keep balanced budgets, federal
spending given to states can prevent states from laying off
public workers, saving jobs.
2. Should the Government Fight
Recessions with Spending Hikes or Tax
Cuts?
Arguments for fighting recessions with tax cuts:
• Tax cuts increase households’ disposable income and
therefore increase consumption spending.
• Tax cuts can increase aggregate demand with incentives—
like the investment tax credit.
• Tax cuts can increase aggregate supply by increasing the
incentive to work and produce g&s.
• Rapid spending increases may be wasteful (“bridges to
nowhere”) and will require future tax increases.
3. Should Monetary Policy Be Made by Rule or
Discretion?
• The Federal Reserve has almost complete discretion
over monetary policy.
• Some argue that the Fed should be forced to follow a
rule, such as
• constant money growth rate
• inflation targeting:
• increase money growth rate
if inflation is below target
• decrease money growth rate
if inflation is above target
3. Should Monetary Policy Be Made by Rule or
Discretion?
Arguments against discretion:
• Allowing central bankers discretion could
do great harm if they are incompetent.
• Discretion allows the possibility of abuse.
• E.g., using monetary policy to affect election outcomes,
causing fluctuations called
“the political business cycle.”
• Central bankers who promise price stability
may renege if a recession occurs.
• Time-inconsistency: the discrepancy between actual
policy and announced policy
3. Should Monetary Policy Be Made by Rule or
Discretion?
Arguments for discretion:
• Discretion allows flexibility to react to unforeseen
events.
• Political business cycles and time-inconsistency are
theoretical possibilities but not that important in
practice.
• It is difficult to specify rules precisely and to determine
what the best rule would be.
4. Should the Central Bank Aim for
Zero Inflation?
• Recall two of the Ten Principles of Economics from
Chapter 1:
Prices rise when the govt prints too
much money.
Society faces a short-run tradeoff
between inflation and unemployment.
• How much inflation should the central bank accept? Is
zero the right target?
4. Should the Central Bank Aim for
Zero Inflation?
Arguments for a zero inflation target:
• The costs of inflation (shoeleather, menu, etc.)
can be substantial even for low inflation.
• Achieving zero inflation would have temporary costs
(higher unemployment) but permanent benefits.
• And these costs could be reduced if the commitment to
zero inflation is credible
(reduces the expected inflation rate).
4. Should the Central Bank Aim for
Zero Inflation?
Arguments against a zero inflation target:
• The benefits of moving from moderate to zero inflation
are small, but the costs are large:
• Estimates: must sacrifice 5% of a year’s GDP for each
1% reduction in inflation
• A disinflation would leave permanent scars:
• Investment falls, lowering the future capital stock
• Workers’ skills diminish while unemployed
• Some of inflation’s costs could be reduced through more
widespread indexation.
ACTIVE LEARNING 2
Another issue in the zero inflation debate
Suppose a structural change reduces the demand for
university administrators, lowering their equilibrium
real wage by 3%.
A. If the actual real wage paid to university administrators
remains constant, what would be the consequences?
B. Would it be easier to achieve the 3% real wage reduction if
the inflation rate is 0% or if it is 4%? Why?
ACTIVE LEARNING 2
Answers
A. If the actual real wage paid to university administrators
remains constant, what would be the consequences?
Whenever the actual real wage exceeds the
equilibrium real wage, there is a surplus of labor, which
represents wasted resources.
A fall in the wage would alleviate the surplus:
• it would encourage some administrators to switch to
university teaching or private sector employment
• it would increase the quantity of administrators
demanded
ACTIVE LEARNING 2
Answers
B. Would it be easier to achieve the 3% real wage
reduction if the inflation rate is 0% or if it is 4%? Why?
To restore labor market equilibrium under 0% inflation,
administrators would have to accept a 3% nominal
wage cut.
Under 4% inflation, they would have to accept a 1%
nominal wage increase.
The second scenario is more likely, as many people
suffer from “money illusion” and focus on nominal
variables rather than real ones.
5. Should the Government Balance
Its Budget?
Arguments for balancing the budget:
• Govt debt places a burden on future generations.
• Budget deficits crowd out investment, reducing growth
and future living standards.
• While deficits may be justified during recessions
or wars, the surging peacetime debt of recent decades is
unsustainable and detrimental.
5. Should the Government Balance
Its Budget?
Arguments against balancing the budget:
• The burden of the govt’s debt is exaggerated;
it’s only a tiny % of a person’s lifetime income.
• Cutting the deficit could do more harm than good:
• Cutting education would reduce human capital
accumulation and future living standards
• Raising taxes reduces incentives to work and save
• Focusing on the deficit diverts attention from other
programs that redistribute income across generations,
such as Social Security.
• Debt/income ratio more relevant than debt itself
6. Should the Tax Laws Be Reformed to
Encourage Saving?
Arguments for tax reform to encourage saving:
• One of the Ten Principles of Economics:
A nation’s standard of living depends
on its ability to produce g&s.
• Higher saving provides more funds for capital
accumulation, which increases productivity and living
standards.
6. Should the Tax Laws Be Reformed to
Encourage Saving?
Arguments for tax reform to encourage saving:
• Another of the Ten Principles of Economics:
People respond to incentives.
• The current U.S. tax system discourages saving:
• High marginal tax rates reduce return on saving
• Some saving is taxed twice (as corporate income and again
as personal income)
• High tax rates on bequests (up to 55%!!!)
• Better: replace income tax with a consumption tax to
increase the incentive to save
ACTIVE LEARNING 3
Switching to a consumption tax
• Suppose the income tax were replaced with a
consumption tax, and the tax rate was chosen
carefully to ensure that the average person’s tax
burden remains unchanged.
• Who would benefit? Who would be worse off?
ACTIVE LEARNING 3
Answers
• People with higher incomes save a bigger percentage
of their incomes, so would benefit most from this
change.
• People with low incomes use most or all of their
incomes for consumption and would be worse off.
(This is why most consumption tax proposals include
exemptions for necessities, like groceries, which
comprise a larger share of the budgets of low-income
persons.)
6. Should the Tax Laws Be Reformed to
Encourage Saving?
Arguments against tax reform to encourage saving:
• Such tax reform would mainly benefit the wealthy,
who need tax relief the least.
• Estimates of interest-rate elasticity of saving are low, so tax
incentives may not increase saving much.
• Reducing taxes on capital income may increase the govt’s
budget deficit, negating the benefits of higher private saving.
• Better: increase national saving directly by reducing the
budget deficit.
CONCLUSION
• Economics teaches us “there’s no such thing as a free lunch.” There are
few easy answers and many unresolved questions.
• Crafting the best policy requires knowing the pros and cons of every
alternative.
• Being an informed voter requires the ability to evaluate the candidates’
policy proposals.
• Knowing the principles of economics helps in these endeavors.
SUMMARY

• Advocates of active policy argue that the economy is

inherently unstable and believe that policy can
manage aggregate demand to help stabilize output
and employment. Critics of active policy note that
policies act with long lags and can end up
destabilizing the economy rather than helping it.
• Advocates of monetary policy rules argue that
discretionary policy can suffer from incompetence,
abuse, and time-inconsistency. Critics of rules argue
that the flexibility of discretion is important for
responding to changing economic circumstances.
SUMMARY

• Advocates of fighting recessions with spending hikes

rather than tax cuts argue that spending has a larger
effect on aggregate demand, since households may not
spend all of a tax cut. Advocates of fighting recessions
with tax cuts argue that hastily implemented spending
increases may be wasteful, and that tax cuts have
beneficial incentive effects on both demand and supply.
SUMMARY

• Advocates of zero inflation argue that inflation has

many costs and no benefits. The costs of achieving
zero inflation are temporary, while the benefits are
permanent. Critics claim that the costs of low
inflation are small, whereas the recession necessary
to reduce inflation is quite costly.
• Advocates of balancing the budget note that deficits
burden future generations by raising their taxes and
lowering their incomes. Critics argue that the deficit
is only one part of fiscal policy and should be
considered in a broader context.
SUMMARY

• Advocates of reforming the tax laws to encourage

saving note that current tax laws discourage saving.
Higher saving would increase investment, productivity
growth, and future living standards.
Critics argue that such reforms would mainly benefit the
wealthy, and that such changes may have only a small
effect on saving. They feel that reducing the budget
deficit would be a more effective and more equitable
way to increase national saving.