CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education,...

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 45

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

30PART VI FURTHER MACROECONOMICS ISSUES

Policy Timing, Deficit

Targeting, and Stock

Market Effects

Fernando & Yvonn Quijano

Prepared by:

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Time Lags Regarding Monetary and Fiscal PolicyStabilizationRecognition LagsImplementation LagsResponse Lags

Fiscal Policy: Deficit TargetingThe Effects of Spending Cuts on the DeficitEconomic Stability and Deficit ReductionSummary

The Stock Market and the EconomyStocks and BondsDetermining the price of a StockThe Stock Market Since 1948Stock Market Effects on the Economy

CHAPTER OUTLINE

Policy Timing, Deficit

Targeting, and Stock

Market Effects

30PART VI FURTHER MACROECONOMICS ISSUES

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Time Lags Regarding Monetary and Fiscal Policy

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

FIGURE 30.1 Two Possible Time Paths for GDP

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The main goal of stabilization policy is to:

a. Take economic measures that enhance the credibility of government institutions.

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.

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

c.c. Use monetary and fiscal policy to smooth out fluctuations in Use monetary and fiscal policy to smooth out fluctuations in output, employment, and prices.output, employment, and prices.

d. Use economic policy to solve social problems such as crime or child neglect.

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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.

FIGURE 30.2 Possible Stabilization Timing Problems

Stabilization

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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.

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.

b. Adam Smith.

c.c. Milton Friedman.Milton Friedman.

d. Jean-Paul Sartre.

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Recognition Lags

recognition lag The time it takes for policy makers to recognize the existence of a boom or a slump.

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.

Implementation Lags

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Response Lags

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?

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?

a. The recognition lag.

b. The implementation lag.

c.c. The response lag.The response lag.

d. All of the above refer to how the economy adjusts after a new policy is implemented.

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Response Lags

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.

Monetary policy works by changing interest rates, which then change planned investment.

The response of consumption and investment to interest rate changes takes time.

Response Lags for Monetary Policy

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Response Lags

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?

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?

a.a. An increase in government spending.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

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.

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.

FIGURE 30.3 Deficit Reduction Targets under Gramm-Rudman-Hollings

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deficit response index (DRI) The amount by which the deficit changes with a $1 change in GDP.

The Effects of Spending Cuts on the Deficit

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.

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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.

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.

a. exactly equal to

b.b. greater thangreater than

c. less than

d. exactly twice as large as

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The Effects of Spending Cuts on the Deficit

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:

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:

a.a. decrease the interest rate, but the amount of intervention decrease the interest rate, but the amount of intervention would have to be substantial.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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Economic Stability and Deficit Reduction

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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Economic Stability and Deficit Reduction

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.

FIGURE 30.4 Deficit Targeting as an Automatic Destabilizer

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In a world without deficit targeting, the deficit is:

a. An automatic stabilizer.

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.a. An automatic stabilizer.An automatic stabilizer.

b. An automatic destabilizer.

c. A negative demand shock.

d. Maximized.

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Summary

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

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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Determining the Price of a Stock

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 Since 1948

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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FIGURE 30.5 The S&P 500 Stock Price Index, 1948 I–2007 IV

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FIGURE 30.6 Ratio of After-Tax Profits to GDP, 1948 I–2007 IV

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Stock Market Effects on the Economy

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 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 Boom of 1995–2000

FIGURE 30.7 Personal Saving Rate, 1995 I–2002 III

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FIGURE 30.8 Investment-Output Ratio, 1995 I–2002 III

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FIGURE 30.9 Ratio of Federal Government Budget Surplus to GDP, 1995 I–2002 III

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FIGURE 30.10 Growth Rate of Real GDP, 1995 I–2002 III

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FIGURE 30.11 The Unemployment Rate, 1995 I–2002 III

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FIGURE 30.12 Inflation Rate, 1995 I–2002 III

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Fed Policy and the Stock Market

FIGURE 30.13 3-Month Treasury Bill Rate, 1995 I–2002 III

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The Post-Boom Economy

Both stock market wealth and housing wealth have important effects on the economy.

Bubbles or RationalInvestors?

Bernanke’s Bubble Laboratory: Princeton Protégés of Fed Chief Study the Economics of Manias

Wall Street Journal

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automatic destabilizers

automatic stabilizers

capital gain

deficit response index (DRI)

Dow Jones Industrial Average

Gramm-Rudman-Hollings Act

implementation lag

NASDAQ Composite

REVIEW TERMS AND CONCEPTS

negative demand shock

realized capital gain

recognition lag

response lag

stabilization policy

Standard and Poor’s 500 (S&P 500)

stock

time lags

CHAPTER 30 Policy Timing, Deficit Targeting, and Stock Market Effects © 2009 Pearson Education,...

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