Six Debates over Macroeconomic Policy

1. Should Policymakers Try to Stabilize the Economy?

• Arguments for active stabilization:

 Left on their own, economies tend to fluctuate
• Pessimism of households and firms causes a fall in AD, which causes a
recession
 Policymakers can “lean against the wind”
 Use monetary & fiscal policy to stabilize AD, output, and employment
 A more stable economy benefits everyone
 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.

2. Should the Government Fight Recessions with Spending Hikes or Tax Cuts?

• Arguments for fighting recessions with spending:

 Each $ of government spending adds directly to aggregate demand
• But only part of each $ of a tax cut does because consumers save part of it.
 Most states must keep balanced budgets,
• Federal spending given to states can prevent states from laying off public
workers, saving jobs.
• 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 goods and services
 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
• Arguments against discretion:
 Allowing central bankers discretion could
do great harm if they are incompetent.
 Discretion allows the possibility of abuse.
• 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
p
• 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?

• Prices rise when the government 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?
• 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).
• 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.

5. Should the Government Balance Its Budget?

• Arguments for balancing the budget:

 Government debt places a burden on future generations.
 Budget deficits crowd out investment, reducing growth and future living
standards.
• Crowding out of investment less savings for investment which increases
the interest rate
 While deficits may be justified during recessions or wars, the surging
peacetime debt
of recent decades is unsustainable and detrimental.
• Arguments against balancing the budget:
 Burden of the government’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
 Divert attention from other programs that redistribute income across
generations
 Debt/income ratio more relevant than debt itself. (= debt/GDP)
• Examples high debt ratio: Greece, Italy, Japan
6. Should the Tax Laws Be Reformed to Encourage Saving?

• Arguments for tax reform to encourage saving:

 One of the Ten Principles: A nation’s standard of living depends on its
ability to
produce goods and services.
 Higher saving provides more funds for capital accumulation, which
increases
productivity and living standards