5 Debates over macroeconomic policy

Principles of Macroeconomics: Ch. 22 Second Canadian Edition

Chapter 22

Five Debates Over Macroeconomic Policy

© 2002 by Nelson, a division of Thomson Canada Limited


OverviewMonetary and Fiscal Policy-makers

should try to Stabilize the Economy.Monetary Policy should be made by an

Independent Central Bank.The Central Bank should aim for Zero

Inflation.The Government should Balance its

Budget.The Tax Laws should be Reformed to

Encourage Saving.


Monetary and Fiscal Policy-makers should try to Stabilize the Economy: PRO

The economy is inherently unstable, and if left unchecked, the economy will go through long and frequent periods of recession and high unemployment.

With careful timing and proper actions, policy-makers can use monetary and fiscal stimulation to prevent recessions or at least minimize their severity.


Monetary and Fiscal Policy-makers should try to Stabilize the Economy: PRO

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

Monetary and fiscal policy can stabilize aggregate demand and, thereby, production and employment.


Monetary and Fiscal Policy-makers should try to Stabilize the Economy: CON

Discretionary 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 exert an influence of output and employment.

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


Monetary and Fiscal Policy-makers should try to Stabilize the Economy: CON

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

More often than not these policy initiatives will aggravate rather than reduce the ups and downs of the economy.


Quick Quiz!

Explain why monetary and fiscal policy work with a lag.

Why do these lags matter in the choice between active and passive policy?







Encourage Saving.


Monetary Policy Should Be Made By An Independent Central Bank: PRO

To the extent politicians influence monetary policy, economic fluctuations may come to reflect the electorial calendar - political business cycle.

There is a time inconsistency of policy - the discrepancy between announcements (which policy-makers say they are going to do) and actions (what they subsequently in fact do).


Monetary Policy Should Be Made By An Independent Central Bank: CON

Empowering central banks with complete independence in conducting monetary policy is a problem since it does not limit incompetence and abuse of power.

Since changes in aggregate demand translate into changes in employment and income, it is important that someone be accountable for monetary policy changes.


Monetary Policy Should Be Made By An Independent Central Bank: CON

Despite clear and forceful statements by the B of C, it is not obvious that enhancing the credibility of inflation targets has resulted in reducing the short-run cost of achieving lower inflation.

Elected policy-makers might find fiscal policy more useful than monetary policy when trying to influence votes.


Quick Quiz!

Should the Governor of the Bank of Canada be elected? Explain.







Encourage Saving.


The Central Bank Should Aim for Zero Inflation: PRO

Inflation confers no benefit to society, but it does impose several social costs.

Reducing inflation is a policy with temporary costs and permanent benefits. Once the disinflationary recession is over, the benefits of zero inflation would persist.


The Costs of Inflation

At least six costs of inflation are identified as:1 . Shoeleather costs2 . Menu Costs3 . Increased variability of relative prices4 . Tax liabilities5 . Confusion and inconvenience6 . Arbitrary redistribution of wealth


The Central Bank Should Aim for Zero Inflation: CON

Zero inflation is probably unattainable and getting there involves output and unemployment costs that are too high.

The stimulative effect of a little inflation is necessary to keep unemployment reasonably low.

The imperfections of measuring price levels result in uncertainty about measuring the successful attainment of zero inflation.


Quick Quiz!

Explain the costs and benefits of reducing inflation to zero.

Which are temporary and which are permanent?







Encourage Saving.


The Government Should Balance Its Budget: PRO

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.


The Government Should Balance Its Budget: PRO

By shifting the cost of current government benefits to future generations, there is a bias toward too large a public sector.

Deficits reduce national saving, thereby retarding capital formation, causing lower productivity, and limiting real growth.


The Government Should Balance Its Budget: CON

The deficit is only one small part of fiscal policy. The problem with the deficit is often exaggerated.

Intergenerational transfers may be justified and some government purchases produce benefits well into the future (i.e. reducing budget deficit by cutting spending on education).


The Government Should Balance Its Budget: CON

A balanced budget requirement would limit the policy options available to deal with emergencies and future economic crises.

The government debt can continue to rise. Population growth and technological progress increases the nation’s ability to pay the interest on the debt.

The budget deficit can be sustained annually, at 5 percent of the total government debt, or $28 billion.


Quick Quiz!Explain how a

budget deficit makes future generations worse off.

Explain how reducing the budget deficit might make future generations worse off.







Encourage Saving.


The Tax Laws Should Be Reformed To Encourage Saving

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


The Tax Laws Should Be Reformed To Encourage Saving: PRO

“A nation’s saving rate is a key determinate of its long-run economic prosperity.”

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



“Our society discourages saving in too many ways, such as by taxing the income from capital heavily and by reducing benefits for those who have accumulated wealth and capital.”

The consequences of high interest income tax policies are: reduced saving, reduced interest accumulation, lower labour productivity, and reduced economic growth.



An alternative to current tax policies, advocated by many economists is a consumption tax like the GST. – A person pays taxes only on the basis of

what they consume (spend) not on what they produce. Income that is saved is exempt from taxation until the saving is later withdrawn and spent on consumption goods.


The Tax Laws Should Be Reformed To Encourage Saving: CON

Most of the proposed changes in the tax policies to stimulate saving would benefit primarily the wealthy at the expense of lower income groups.

High-income households save a higher fraction of their income than low-income households. Any tax change that favors people who save will also tend to favor people with high income.


The Tax Laws Should Be Reformed To Encourage Saving: CON

Reforms would be either regressive or would further the inequality of income in our society.

Raising public saving by eliminating the government’s budget deficit would provide a more direct and equitable way to increase national saving.


Quick Quiz!

Give three examples of how our society discourages saving.

What are the drawbacks of eliminating these disincentives?







Encourage Saving.

5 Debates over macroeconomic policy

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