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Five Debates Over Macroeconomic Policy + Revision

Mankiw and Taylor, Chapter 39 In discussing these debates the aim is to review and revise existing material, not introduce new material

Five (+2) Debates over Macroeconomic Policy

1. If only we knew what we know!

2. Are structural deficits real or not?

3. Should the government balance its budget?

4. Do we need macro-prudential policy?

5. How did economists get it so wrong?

Other ongoing debates, which again are useful revision are:

1. Should monetary and fiscal policymakers try to stabilise the economy?

2. Should the tax laws be reformed to encourage saving?

There is no “right” answer

• Individual opinions

• Political considerations

• Power and rent-seeking involved

1. If only we knew what we know! • Pro: Information Helps Make Accurate Decisions

• Con: Economic Forecasting is Nothing More than a Con-Trick

– Black Swan events mean we never know for sure what is going to happen

– Most economists missed the financial crisis in 2007

– Need to use data and forecasts acknowledging their uncertainties

2. Are structural deficits real or not?

• Cyclical versus structural deficits

– Deficits rise in a recession. Structural deficits are when there is a deficit irrespective of the business cycle

• Pro: Policy makers need to eradicate structural deficits

– So that when countries enter a recession their debt levels are manageable

• Con: Structural deficits are a myth

– We cannot measure the ‘output gap’ reliably

3. Should the government balance its budget?

Revision. An aside on the loanable funds model: investment tax credits affect the demand curve

Pro: The government should balance its budget

• Budget deficits impose an unjustifiable burden on future generations by raising their taxes and lowering their incomes

• When the debts and accumulated interest come due, future taxpayers will face a difficult choice:

– They can pay higher taxes, enjoy less government spending, or both

Pro: The government should balance its budget

• By shifting the cost of current government benefits to future generations, there is a bias against future taxpayers

• Deficits reduce national saving, leading to a smaller stock of capital, which reduces productivity and growth

Con: The government should not balance its budget

• The problem with the deficit is often exaggerated

• The transfer of debt to the future may be justified because some government purchases produce benefits well into the future

– e.g. spending on education today, even if it means running a deficit, may pay off in the future with higher GDP growth

– It’s an investment

Con: The government should not balance its budget

• Government debt can continue to rise because population growth and technological progress increase the nation’s ability to pay the interest on the debt

• That is, we need to look not at debt, but at debt to GDP ratios

– And as long as Debt ↑ no more quickly than nominal GDP then Debt/GDP is stable

4. Do we need macro-prudential policy?

• Pro: Financial crisis was down to leverage and excessive risk taking by many banks

– Macro-prudential policy would monitor banks’ capital ratios and seek to minimise their risk taking, especially when they’re “too big to fail”

• Con: Impossible to detect excessive risk-taking (and financial bubbles) in “real-time”

– Banks will find ways round the rules in any case, even if countries can agree on common rules

5. How did economists get it so wrong?

• Belief in efficient markets; and

• Distrust of government intervention

The efficient markets hypothesis

– Asset prices reflect all publicly available information

about the value of an asset

→ Price = Value. Prices move only as info changes

– Each company listed on a major stock exchange is

followed closely by many money managers

• and they buy shares whose price < value and sell

those whose price > value • ‘If an economist had a formula that could reliably forecast prices a

week in advance, say, then that formula would become part of

generally available information and prices would fall a week earlier’

• Equilibrium of supply and demand sets the

market price, so all shares are fairly valued

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EMH

• Stock markets

– Exhibit informational efficiency

• Informational efficiency

– Asset prices reflect all available information

• At a given point in time, the market price is the best

guess of the stock’s value

• Prices only change as new information (news) arrives.

But this news arrives randomly…

• Implication of efficient markets hypothesis

– Stock prices should follow a random walk

• Future changes in stock prices are impossible to predict

from currently available information 15

Implications of the EMH

• If prices do reflect all available information

and are correctly valued, then no stock is

a better buy than any other

• The best you can do is buy a diversified

portfolio (an index fund) like a mutual fund

which buys all the stocks in an index – to

minimise idiosyncratic risk

– Can’t beat the market on a risk-adjusted basis

– There is no means of picking winners and losers

16

Economics got it wrong

• There was too much trust in the ideas that people behave rationally and that the market is the best way to allocate resources

• But (new) Keynesians believe that while in the long-run wages and prices may adjust to restore output at its natural rate, there can be significant short-run deviations with unemployment higher than its natural rate

– Does this imply a role for governments to stimulate the economy, given deficient demand?

Efficient markets still have some currency

• Efficient markets mean precisely that it is impossible to predict the future (and impossible to predict crises like the one in 2007/8)

• Markets may get it wrong (experience bubbles) but they remain preferable to government intervention

Other Debates, and a chance to review

some of the main models in this course

1. Should monetary and fiscal policymakers try to stabilise the economy?

Pro: Policymakers should try to stabilise the economy

• The economy is inherently unstable, and left on its own will fluctuate

• Policy can manage aggregate demand in order to offset this inherent instability and reduce the severity of economic fluctuations

Pro: Policymakers should try to stabilise the economy

• There is no reason for society to suffer through the booms and busts of the business cycle

• Monetary and fiscal policy can stabilise aggregate demand and, thereby, production and employment

Con: Policymakers should not try to stabilise the economy

• Monetary policy affects the economy with long and unpredictable lags between the need to act and the time that it takes for these policies to work

• Many studies indicate that changes in monetary policy have little effect on aggregate demand until about six months after the change is made

Con: Policymakers should not try to stabilise the economy

• Fiscal policy works with a lag because of the long political process that governs changes in spending and taxes

• It can take years to propose, pass, and implement a major change in fiscal policy

Con: Policymakers should not try to stabilise the economy

• All too often policymakers can inadvertently exacerbate rather than mitigate the magnitude of economic fluctuations

• It might be desirable if policy makers could eliminate all economic fluctuations, but this is not a realistic goal

Causes of Economic Fluctuations

• Shift in aggregate demand

– Wave of pessimism (credit crunch) –

Aggregate demand shifts left

– Short-run fluctuations: the business cycle • Output falls

• Price level falls

– Long-run • Short-run aggregate supply curve shifts right

• Output reverts to it natural rate (so does this mean

there’s no need for government to intervene?)

• Price level falls (to offset shift in AD) 25

Exhibit 8

26

A Contraction in Aggregate Demand

Price

Level

Quantity of Output

A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve

from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1

to Y2, and the price level falls from P1 to P2. Over time, as the expected price level adjusts, the

short-run aggregate-supply curve shifts to the right from AS1 to AS2, and the economy reaches

point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve.

In the long run, the price level falls to P3, and output returns to its natural rate, Y1.

Long-run

aggregate supply

Y1

Short-run aggregate

supply, AS1

Aggregate demand, AD1

P1 A

AD2

P2

B

Y2

AS2

P3

C

1. A decrease in aggregate

demand . . .

2. . . . causes output to fall in the short run . . .

3. . . . but over time, the

short-run aggregate-supply

curve shifts . . .

4. . . . and output returns to its

natural rate.

AD-SRAS/LRAS model

• Model of long run: Vertical long-run AS curve

• Model of short run: Upward sloping short-run AS curve

– 3 explanations for why this SRAS is upward sloping

• Sticky wages

• Sticky prices

• Misperceptions

SRAS Curve: in summary

• All three theories imply that:

Quantity of output supplied =

= Natural rate of output +

+ a(Actual price level – Expected price level)

• where a determines how much output

responds to unexpected changes in the price

level

• But in the long run, actual prices = expected

prices and SRAS = LRAS = vertical

28

29

The Long-Run Equilibrium

Price

Level

Quantity of Output

The long-run equilibrium of the economy is found where the aggregate-demand

curve crosses the long-run aggregate-supply curve (point A). When the economy

reaches this long-run equilibrium, the expected price level will have adjusted to equal

the actual price level. As a result, the short-run aggregate-supply curve crosses this

point as well.

Long-run

aggregate

supply

Natural rate

of output

Short-run

aggregate

supply

Aggregate

demand

Equilibrium

price

A

Shifts to the SRAS curve

• The short-run AS curve might shift because of:

– Changes in labour, capital, natural resources, or

technological knowledge

• i.e. all those factors that explained movements in the

LRAS curve (since they shift SRAS and LRAS), but also

– Expected price level increases and the SRAS curve

shifts to the left (up) – i.e. SRAS curve depends on sticky wages, sticky prices and

misperceptions. Since these are all set based on expectations of

prices, when price expectations change the SRAS shifts

– In the short run expectations are fixed and economy is at the

intersection of the AD and SRAS curves

– But we will see that, in the long run, expectations shift to ensure

intersection of the AD and LRAS curves 30

Table 2

31

The Short-Run Aggregate-Supply Curve: Summary

Table 2

32

The Short-Run Aggregate-Supply Curve: Summary

2. Should the tax laws be reformed to encourage saving?

Pro: Tax laws should be reformed to encourage saving

• A nation’s saving rate is a key determinant of its long-run economic prosperity

• A nation’s productive capability is determined largely by how much it saves and invests for the future

• When the saving rate is higher, more resources are available for investment in new plant and equipment

• Raise future productivity

– Invest more current resources in the

production of capital

– Trade-off

• This involves devoting fewer resources to produce

goods and services for current consumption

• To invest more in capital, a society must consume

less and save more of its current income

• Financial markets coordinate S and I in market

economies. Governments can also affect S and I,

and therefore economic growth

Saving and Investment

35

Diminishing Returns

• Higher savings rate

– Fewer resources are need to make

consumption goods

– So there are more resources to make capital

goods

– Capital stock increases

– Rising productivity

– More rapid growth in GDP

• But there can be difficulties in inferring causation from

correlation (in principle, GDP could be causing

Investment, not the other way round)

36

Diminishing Returns

• Diminishing returns

– Benefit from an extra unit of an input

declines as the quantity of the input

increases

• In the long run, higher savings rate →

– Higher level of productivity

– Higher level of income but not higher

growth in productivity or income

– But the long-run can be a long time

coming 37

Figure

38

Illustrating the Production Function

Output

per Worker

Capital per Worker

This figure shows how the amount of capital per worker influences the amount of

output per worker. Other determinants of output, including human capital, natural

resources, and technology, are held constant. The curve becomes flatter as the

amount of capital increases because of diminishing returns to capital.

1

1

1. When the economy has a low level of

capital, an extra unit of capital leads to a

large increase in output.

2. When the economy has a

high level of capital, an extra

unit of capital leads to a small

increase in output.

Productivity

• Productivity

– Quantity of goods and services produced

from each unit of labour input

• Why productivity is so important

– Key determinant of living standards

– Growth in productivity is the key

determinant of growth in living standards

– An economy’s income is the economy’s

output

39

Pro: Tax laws should be reformed to encourage saving

• The tax system discourages saving in many ways, such as by heavily taxing the income from capital and by reducing benefits for those who have accumulated wealth

Pro: Tax laws should be reformed to encourage saving

• The consequences of high capital income tax policies are reduced saving, reduced capital accumulation, lower labor productivity, and reduced economic growth

Pro: Tax laws should be reformed to encourage saving

• An alternative to current tax policies advocated by many economists is a consumption tax

• With a consumption tax, a household pays taxes based on what it spends not on what it earns

– Income that is saved is exempt from taxation until the saving is later withdrawn and spent on consumption goods

Con: Tax laws should not be reformed to encourage saving

• Many of the changes in tax laws to stimulate saving would primarily benefit the wealthy

– High-income households save a higher fraction of their income than low-income households

– Any tax change that favours people who save will also tend to favour people with high incomes