Lecture Essentials of Economics: Chapter 16 - Bradley R. Schiller, Cynthia Hill

Chapter  16
Theory and Reality

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Macroeconomics: 
Policy Tools
Policy tools for macroeconomics:
• Fiscal policy.
• Monetary policy.
• Supply-side policy.

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Table 16.1

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Fiscal Policy
• Fiscal policy is the use of government
taxes and spending to alter
macroeconomic outcomes, consisting
of:
– Automatic stabilizers.
– Discretionary policy.

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Automatic Stabilizers 
• Automatic stabilizers are federal
expenditure or revenue items that
automatically respond countercyclically to changes in national
income.
• Such stabilizers don’t require an
additional act of Congress.
‒ Examples include unemployment
benefits and income tax collections.

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Automatic Stabilizers 
• These actions “kick in” at the start of a
recession, and automatically:
– Reduce tax revenues.
– Increase government outlays.
– Widen budget deficits.

• They counteract the shifting of AD to
the left and help stabilize the economy.
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Discretionary Policy
• Discretionary policy refers to
deliberate changes in tax or spending
legislation.

– Additional spending and tax revenue
decreases can increase the federal
budget deficit.
– Reduced spending and tax revenue
increases can decrease the deficit.
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Monetary Policy 
• Monetary policy: the use of money
and credit controls to influence
macroeconomic activity.
• The tools of monetary policy include:
– Open-market operations.
– Discount rate changes.
– Reserve requirements.
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Monetary Policy 
• If the AS curve is horizontal, changes
in the money supply affect output only.
• If the AS curve is vertical, changes in
the money supply affect prices only.
• If the AS curve is upward-sloping,
changes in the money supply affect
both prices and output.
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Supply­Side Policy 
• Supply-side policy: the use of tax
rates, (de)regulation, and other
mechanisms to increase the ability and
willingness to produce goods and
services.
– The shape of the AS curve limits the
effectiveness of fiscal and monetary
policies.
– Supply-side policy concentrates on
shifting the AS, not the AD, curve.
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Supply­Side Policy 
• Supply-side policy wants to shift the AS
curve to the right.
• The supply-side tools are:
– Tax cuts to stimulate work effort, saving,
and investment.
– Deregulation to reduce production costs
and stimulate investment.
– Spending on education, training, and
research to expand the capacity to
produce.

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Case 1: Recession

• Output and employment fall far short of
the full-employment potential.
• Need to put people to work and
increase output.
• The GDP gap must be closed.

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Case 1: Recession – Keynesians
• Emphasize the need to stimulate AD
with fiscal policy by:
– Cutting taxes.
– Boosting government spending.
– Setting off a multiplier reaction to the
stimulus.

• AD will shift right, closing the GDP gap.
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Case 1: Recession – 
Monetarists
• See no point in discretionary policies.
– They assume the AS curve is vertical at
the natural rate of unemployment
– Changes in fiscal or monetary policy are
ineffective because increases in AD only
cause inflation.

• The appropriate response to a
recession is patience.
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Case 1: Recession – Supply­
Siders
• Believe that policy initiatives should
focus on changing the shape and
repositioning the AS curve to the right.
– Improve production incentives.
– Cut marginal tax rates on investment and
labor.
– Reduce government regulation.

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Case 2: Inflation – 
Keynesians
• Need to restrain AD by:
– Raising taxes.
– Cutting government spending.
– Relying on the multiplier to cool down the
economy.

• AD will shift left, closing the GDP gap.

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Case 2: Inflation – 
Monetarists
• Believe that inflation reflects excessive
money supply growth.
• Their response: Raise interest rates.
– Cut the money supply.
– Convince market participants that
cautious monetary policy will be
continued.

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Case 2: Inflation – Supply­
Siders
• Point out that inflation implies both too
much money and not enough goods.
– Expand productive capacity.
– Propose more incentives to save.
– Cut taxes and regulations, encourage
more immigration, and lower import
barriers.

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Case 3: Stagflation
• Stagflation is the simultaneous
occurrence of substantial

unemployment and inflation.
• There are no simple solutions for
stagflation.
– There is a need to balance the competing
threats of inflation and unemployment

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Case 3: Stagflation
• There are several possible contributors
to stagflation:
– High tax rates or costly regulation.
– An external shock (such as a natural
disaster) or an abrupt change in world
trade (such as higher oil prices).

• The result is a leftward shift of the AS
curve.
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Figure 16.2

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Why Things Don’t 
Always Work
• We can distinguish four obstacles to

policy success:
– Goal conflicts.
– Measurement problems.
– Design problems.
– Implementation problems.

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Politics versus 
Economics
• Tax hikes and budget cuts rarely win
votes.
• On the other hand, tax cuts and porkbarrel spending are always popular.
• Because of this, deficits will continue to
be with us, and the federal debt will
increase.
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Politics versus 
Economics
• Savvy politicians tend to stimulate the
economy before elections, then tighten
the fiscal restraints afterward.
• This creates a political business
cycle: a two-year pattern of short-run
stops and starts.

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