Economic Theory and Reality
This is one of the most important units of the course. This unit
compares the major economic policy tools and discusses some
of the obstacles to their success.
Why don’t things work the way they are supposed to work?
Fiscal policy tools or levers are economic policies that affect the
Fiscal policy tools are initiated and approved by Congress and
Some fiscal policy tools are automatic stabilizers
unemployment benefits and tax revenues are examples. These
automatic stabilizers are triggered by changing economic
conditions and do not require legislative action.
The basic fiscal policy tools that our government can use to
change economic conditions are:
Government spending increases/decreases
Increase/decrease transfer payments
Fiscal policy tools concentrate on increasing or decreasing
Monetary policy tools are designed to change the supply of
money. Monetary policy is controlled by the Federal Reserve
and not by the Congress or the President.
Monetary Policy tools consist of:
Changing discount rates (raise/lower)
Open Market Operations (buy/sell bonds)
Changing the reserve requirement (increase/decrease)
side theory involves incentives to work, invest, and
side policy is affected by the federal budgetary
process and also by legislation concerning regulations.
Key components of supply
side theory are:
Consumer and Business tax incentives
Human capital investment
Congress and the President both make policy and spending
decisions that affect the supply
During a recessionary GDP gap, which economic policy lever is
the most effective to use?
Keynes, who concentrated on fiscal policy would suggest
cutting taxes and/or increasing government spending to shift
AD to the right. The multiplier effect helps boost initial
spending increases and tax cuts.
Keynes (Modern), a more modern adaptation of Keynesian
theory, in addition to above, would propose monetary policy
changes (interest rates cuts) which can increase the supply of
money and help reduce recessionary effects.
Monetarists, in regards to the recessionary GDP gap believe
that federal budgetary changes in the form of taxes or spending
only alter the mix of output, not the demand.
Since the velocity of money is constant, recessionary problems
are only temporary.
Monetarists believe that you should wait for the recession to
end by itself
eventually when sales decline enough, interest
rates will drop and new investment will occur.
side theory would eliminate a recessionary GDP gap by
providing business with greater incentives to produce (tax
incentives to invest in new capital, accelerated depreciation
rates, etc.), cutting the marginal tax rates for investment and
labor, and by reducing government regulation.
Increased government spending on infrastructure as well as
increased spending by companies and the federal government
on human capital investment are also key components of
An economy experiencing inflation is faced
with swiftly rising prices. The economy is
deemed to be “overheated” and needs to be
An inflationary GDP gap occurs where
current equilibrium GDP is greater than full
Aggregate demand needs to be reduced
the curve needs to shift to the left.
To eliminate the inflationary GDP gap, Keynesians would
concentrate on either raising taxes or decreasing government
Increasing interest rates, like the discount rate are also an
The intent is to reduce the amount of money consumers have
to spend, thereby reducing demand.
Politically, raising taxes and or decreasing government
spending is not likely.
Confronted with an inflationary GDP gap, Monetarists would
concentrate their efforts on reducing the money supply.
To reduce the supply of money, monetarists would have the
Federal Reserve sell bonds or raise the reserve requirement.
Monetarists believe that discount rate changes are not
effective. Monetarists believe in a long
run vertical supply
curve and that changes in the money supply will affect prices,
siders when faced with an inflationary GDP gap, believe
that inflation is caused by a lack of output to satisfy demand
and greater expansion in output is needed.
Government needs to provide more incentives to save and
invest in capital. Taxes should be reduced, government
regulation should also be reduced and import barriers lowered.
Notice that supply
side theory does not believe that excessive
demand exists, only that insufficient supply exists.
occurs when significant unemployment and
inflation both exist.
Stagflation can be caused by many factors:
Rising prices and unemployment due to structural problems.
Excessively high tax rates.
Costly government regulation.
Solving stagflation usually requires a combination of policy
side policy which reduces tax rates, regulation, and
encourages human capital investment will help.
Government spending on infrastructure improvements will help.
If an external “shock” occurred, many of these policy tools may
be ineffective until sufficient time has passed.
is the process of making small adjustments in
tuning enables the economy to stay on course
unemployment and low inflation.
tuning consists of fiscal or monetary stimulus when
unemployment is increasing.
If inflation might be a problem, then monetary restraint or mild
fiscal restraint can help. A mild reduction in government
spending or an increase in interest rates are both examples of
tuning to avoid inflation.
The Economic Record
Over the past 50+ years our economy has experienced periods
of high unemployment, high inflation, and high growth.
We have also experienced slow growth, low unemployment,
and low inflation.
The long term growth trend has been at 3% growth in real
GDP. Periods of growth less than 3% are called
Why Don’t Things Work???
In general there are four
obstacles to policy success:
The most frequent source of
are the policy
decisions revolving around inflation and unemployment.
Policies designed to reduce unemployment can cause inflation
Policies designed to reduce inflation can cause unemployment
If balancing the budget is a policy goal, then any increase in
government spending will require an increase in government
occur when politicians make promises in order
to get elected to office.
Often upon election, the conflicts become apparent.
Choices will be made by evaluating the opportunity cost of each
Those choices which produce the least opportunity cost are
likely to be chosen.
Economic data is produced weekly, monthly, quarterly,
When data is produced there is often a time lag from the period
being measured to the period when the data is produced.
For example, data which can provide information about
unemployment, CPI, PPI, inflation, business investment,
consumer spending, consumer confidence are often delayed by
a month or more. This can cause
When evaluating economic data, trends are very important.
Therefore a one period reduction or increase may not indicate a
It may take 6 or more months before a trend is noticed and
action is desired.
Economic forecasts are based upon assumptions that may
External shocks to the economy can significantly alter future
refer to the actual response to an economic
condition. Our response may be based upon sound economic
theory and policy.
Consumers, businesses may not respond like the theories
For example, if the government cuts taxes by 20%, consumers
are expected to spend most of the tax cut (MPC = .90). If they
don’t, then we have a design problem.
Tax cuts and changes in government spending require the
approval of Congress and the President.
Policy changes can occur as legislation moves through the
House and Senate.
Politics often gets in the way of good policy.
The resulting economic package may be weaker than originally
proposed or contain provisions which reduce its effectiveness.
One of the most serious implementation problems is associated
. Many economic policy changes require
congressional and presidential approval.
By the time the policy is adopted and implemented into the
budget, economic conditions could be worse (or better).
Additional changes may be needed because of the time lag
but you will have to wait until the data is published that
indicates the effectiveness of existing policy, then propose
changes, then get legislative and presidential approval and
then…now you understand the problem!!!
Federal Reserve policy changes can help.
Fed policy changes do not require congressional or presidential
Fed changes can be implemented quickly
It may take some time to measure the effect, but Fed policy
changes can offer a temporary or permanent solution to minor
economic disturbances. Most economists, especially
Monetarists, believe that Fed policy changes are more effective
Maintaining the Economy
Policy makers argue whether the economy
should be subject to frequent fine
Pressure to make economic adjustments is
high during major elections
regardless of the
term consequences. Politicians are eager
to please voters with massive spending
programs and/or tax cuts.
Some economists believe that the government
should provide a stable economic environment
and then “stay out of the way”.
Maintaining the Economy
theory is a hypothesis that people’s
spending decisions are based on all available information,
anticipated or future effects
of government policy
People will spend based upon their perceptions of economic
conditions, income level, and expectations of the future. Often
the media shapes consumer perceptions of current and future
economic conditions. Do you get all of your economic news
from one TV station or a single newspaper? If so, you may not
receive a balanced viewpoint on the economy.
Do you think your spending decisions are based upon your
perceptions of the current and future economic conditions?
Think about it…
Policy levers, policy types.
Sources of fiscal, monetary, and supply
Economic conditions and policy responses.
Past history of economic goals and reality.
Goal conflicts and measurement problems, design problems
and implementation problems.
Federal budgetary process and timetable.