THE ART OF MACROECONOMIC POLICY
This chapter is a summary of the textbook. The textbook emphasized four broad policy lessons: (1)
models do not provide direct policy answers, (2) macroeconomic policy involves tradeoffs, (3) growth
requires getting institutions and incentives right, and (4) monetary and fiscal policy can help stabilize the
The textbook is organized into five different parts: (1) introduction to intermediate macroeconomics, (2)
growth in the long run, (3) short-term fluctuations in output, (4) the nuts and bolts of macroeconomic
policies, (5) and the art of macroeconomic policy.
Part I is covered in chapters 1 through 4. Chapter 1 introduces the terms and goals of macroeconomics
and briefly discusses models and their use. Chapter 2 presents the important terminology used throughout
the textbook. Chapter 3 covers the costs of unemployment and inflation. It looks at the occasional
tradeoff between the two, which policymakers sometimes face. Chapter 4 presents some macroeconomic
models. It introduces three important identities: aggregate quantity demanded equals aggregate quantity
supplied (AS=AD), aggregate output equals aggregate expenditures (Y=C+I+G+NX), and saving (which
includes private, foreign, and government saving) equals investment (Sp+Sf+Sg=I).
Part II is covered in chapters 5 through 7. Chapter 5 presents a brief history of growth and introduces the
Solow growth model. This model tells us that even if an economy saves and invests in order to grow, this
economy’s growth rate has a limit. The model predicts that countries with similar attributes will have
their economic growth rates converge in the future. The model also predicts that growth rates will
decrease, not increase, in the future. Chapter 6 discusses some of the problems with the Solow growth
model. The discussion in this chapter emphasizes the role of labor quality differentials and changing
institutions among countries as explanations for the divergence of growth rates between developed and
developing nations. The chapter introduces a new growth theory that focuses on endogenous technology
and increasing returns. Chapter 7 introduces the quantity theory of money as another long-term model.
This theory says that production is determined by the real variables and that the price level is governed by
the growth rate of money supply. The chapter also integrates the quantity theory of money into the
international economy by introducing exchange rates and the balance of payments.
Part III is covered in chapters 8 through 12. Chapter 8 derives the IS/LM model and the multiplier. The
IS/LM model explains short-term fluctuations in output. The chapter uses this model to explain the
impact of monetary and fiscal policies on the economy. Chapter 9 is a continuation of Chapter 8. It looks
at policy implications in more details using the IS/LM model. It also presents problems associated with
implementing short-term policies. Chapter 10 incorporates the international dimensions into the IS/LM
framework by introducing the balance of payments curve. It examines the impact of macroeconomic
policies on economies with fixed exchange rates and economies with flexible exchange rates. Chapter 11
presents the AS/AD model. This model shows the short-term and long-term effects of, say, a rise in
autonomous expenditures. It also explains how expectations and misperceptions by workers determine
the slope of the AS curve and, hence, the effectiveness of short-term policies. Chapter 12 presents the
microfoundations of consumption and investment. It shows how consumers and producers make their
decisions, and how that may determine the impact of short-term policies.
212 Chapter 15
Part IV is covered in chapters 13 and 14. Chapter 13 introduces the Federal Reserves System. It also
presents the debate about whether monetary policy should be conducted by rules or discretion. Chapter
14 looks at the nuts and bolts of fiscal policy. It shows fiscal policy is often determined by politics, not
by economics. The chapter also describes the process of the federal budget and the associated difficulties.
Part V is covered in this chapter. In a nutshell, this chapter looks at the different models derived
throughout the book, the difference between long-term growth and short-term fluctuations in output, and
macroeconomic policy challenges.
The goals of macroeconomic policy makers are high growth in the long run, low unemployment, low
inflation, reduced fluctuations on output in the short run, and some consistency between international and
domestic goals. The point learned from this book is that, even by applying sound economic models,
policymakers need combine to economic models with the art of macroeconomic policymaking to achieve
Some of the conventional wisdom (such as the tradeoff between inflation and unemployment) did not
hold very strong during the 1990s. The economy enjoyed a low rate of unemployment for a long time
without any inflationary pressures. Economists were able to explain the phenomenon. High productivity
of workers, large investments in plant and equipment, increased spending on research and development,
enhanced competition, and deregulation of a number of industries are factors that helped the economy to
grow at a very high rate without any inflationary threats.
I. FOUR BROAD POLICY LESSONS
- The textbook emphasized four broad policy lessons:
- Models do not provide direct policy answers.
- Macroeconomic policy involves tradeoffs.
- Right incentives and proper incentives are essential for economic growth.
- Monetary and fiscal policies can stabilize the economy in the short run.
II. A REVIEW
A. Introduction to Intermediate Macroeconomics (Part I)
- Chapter 1.
- Introduces terms and goals of macroeconomics.
- Discusses models and their use.
- Chapter 2.
- Present important terminology used throughout the textbook.
- Chapter 3.
- Looks at the cost of unemployment and inflation.
- Discusses the tradeoff between inflation and unemployment.
- Chapter 4.
- Presents three macroeconomic models:
- AS = AD
- Y = C+I+G+EX
- Sp+Sf+Sg, = I
B. Growth and the Long Run (Part II)
- Chapter 5.
- Shows the connection between markets and growth.
The Art of Macroeconomic Policy 213
- Introduces the basic Solow model.
- Equilibrium exists when the balanced growth investment line and the
investment function intersect.
- Each level of capital has its own steady-state equilibrium.
- Changing saving, investment, or population will take the economy to a
different steady-state equilibrium, but will not change growth in output
- The model predicts that countries with similar attributes will converge.
- The model predicts that the growth rate of output for all countries will
decline as they approach their steady-state.
- Chapter 6.
- Discusses the problems with the basic Solow model.
- Shows how differences in the quality of workers, institutions, explain divergence in
economic growth among countries.
- Introduces a new growth theory, which emphasizes the role of endogenous
technology and increasing returns as factors determining economic growth.
- Presents the views of many economists that growth is too complicated to understand
- Case studies and history are essential to understand the growth process.
- Chapter 7.
- Introduces another long-term model, which the quantity theory of money.
- According to this model, production is determined by real factors.
- Prices are determined by growth in money supply.
- It integrates the quantity theory of money with the international dimension of
- The purchasing power parity is used to explain the determinants of the real
C. Fluctuations and the Short run (Part III)
- Chapter 8.
- Presents the IS/LM model and explains the concept of the multiplier.
- The IS/LM model explains short-term fluctuations in output.
- An expansionary (contractionary) monetary policy shifts the LM curve to the right
(left), causing equilibrium output to increase (decrease) and the interest rate to
- An expansionary (contractionary) fiscal policy shifts the IS curve to the right (left),
causing equilibrium output to increase (decrease) and the interest rate to increase
- The chapter also explains the determinants of the slopes of the IS and LM curves.
- Chapter 9.
- This chapter is an extension to Chapter 8.
- It examines additional policy implications using the IS/LM model.
- It explains problems associated with implementing short-term policies.
- Chapter 10.
- It brings the international sector into the IS/LM model by adding the balance of
payments (BP) curve.
- Internal and external equilibrium occur when the IS, the LM, and the BP curves
214 Chapter 15
- In the case of flexible exchange rates, the BP curve will shift to intersect with the IS
and the LM curves.
- In the case of fixed exchange rates, internal and external equilibrium may differ. In
this case, the government can stimulate the BP curve using its policies, and shift
external equilibrium to internal equilibrium.
- These policies include buying or selling its currency, tariffs, and capital
- Chapter 11.
- It presents the AS/AD model.
- The AD curve, which is derived by the IS/LM model, shows all combinations of
price and income levels where the goods and services market and the money market
are in equilibrium.
- The AS curve shows how the price level behaves as a result of changes in the AD.
- Potential output is drawn as a vertical line in this model, and serves as a long run
anchor for real output.
- If equilibrium output differs from potential output, expectations about prices and
wages will change, causing the economy to adjust to its long-term equilibrium.
- Chapter 12.
- Presents the microfoundations of consumption and investment.
- It modifies the short-term model to include the intertemporal choices made by firms
- Consumption is a function of current disposable income, expected future income,
- Investment depends on interest rates and expected future profit.
D. The Nuts and Bolts of Macroeconomic Policy (Part IV)
- Chapter 13.
- Describes the Federal Reserve System.
- Introduces the debate about whether monetary policy should be conducted by rules
or by discretion.
- Short run models suggest that discretion must be used.
- Long run models suggest that rules must be used.
- In recent years, the Fed has reconciled both views into feedback rules.
- An example of the feedback rule is the Taylor rule.
- Chapter 14.
- Explains how fiscal policy works.
- Shows how fiscal policy is often guided and determined by politicians, not by
- Describes the process of the federal government’s budget and the difficulties
- Illustrates the three sources of financing the budget—taxes, borrowing, printing
E. Summary Tables of Long run and Shot-Run Models
- Tables 15-1 and 15-2 are very useful.
- They summarize the key assumptions, key predictions, and key policy implications of the 4
long run models and the 4 short run models discussed in the textbook.
The Art of Macroeconomic Policy 215
F. The Conflict Between the Long Run and the Short Run
- Short run goals often conflict with long run goals.
- Example is a country in a recession with low long run growth rate in output.
- The short run model suggests that policymakers encourage spending by lowering saving.
- The long run model suggests that policymakers encourage saving to stimulate investment
and capital accumulation.
III. THE GOALS OF POLICY
A. High Growth
- Macroeconomic theory highlights three policies to promote high growth:
- Maintain stable political, social and market environments.
- Promote saving and invest to build capital.
- Educate people to increase their productivity.
- Macroeconomic policies should also focus on developing markets and institutions to
B. Low Inflation
- The models show that to control inflation, the country must control the growth rate in its
- Many countries experience high inflation rate—a fact that suggests that policies cannot
always be implemented.
- The problem in these countries is an institutional one. They cannot rely on the tax system
nor on their financial system to fund their government budgets, so they print money.
C. Low Unemployment
- The art of macroeconomic policies should focus on solving two unemployment problems:
long run unemployment and short run unemployment.
- Modifying some of the institutional arrangements, such as welfare programs can reduce
long run unemployment (the natural rate).
- Eliminating short run unemployment (cyclical unemployment) also requires the art of
economic policies because the exact natural rate of unemployment is unknown.
D. Smooth Growth of Output
- Macroeconomic policies are expected to keep the output level around its potential.
- Most often, political realities, time lags, and changing expectation hinder macroeconomic
policies from achieving their sought objectives.
E. International Goals Consistent with Domestic Goals
- International goals often conflict with domestic goals.
- To achieve higher output level, for example, a country resorts to an expansionary
macroeconomic policy (fiscal or monetary). But using these policies will have an impact on
the country’s trade deficit and exchange rate.
- Flexible exchange rates help the economy in achieving domestic and international goals.
Fixed exchange rates do not.
- In small open economies, policymakers do not have control over the country's interest rate.
The country must accept the world's interest rate.
F. Conventional Wisdom
- Economists do not often agree about the course of economic policies when fighting a specific
problem in the economy.
- However, they do agree on many issues which the textbook calls "conventional wisdom".
216 Chapter 15
- Examples of "conventional wisdom" include the cause and cure of hyperinflation,
recessions, large trade deficits, and low growth (see Table 15-3)
IV. POLICY FOR THE NEW ECONOMY
- The US economy experienced high growth rate, low unemployment rate, and low inflation
rate during the 1990s.
- Most economists agree that such trends, which cannot be explained by short run models,
were the results of high productivity of workers, increase in investment and capital stock,
increase in spending on research and development, competition, and deregulation
- A good economists
- Knows the model
- Knows the assumptions of the model
- Uses his/her common sense to decide how to apply the model
Robert Parry, the President of the Federal Reserve Bank of San Francisco (FRBSF), presents a series of
lectures to civic and professional organizations in California. Economic Letters, which is published by
the FRBSF, publishes Parry's lectures. The most recent paper was published in July 2001. It is an
excellent continuation to the last parts of the chapter (Policy for the New Economy). The authors of the
book talked about the factors that caused the growth in output until late 1990s and 2000. Parry continues
the same discussion, but he looks at the factors causing the slowdown after that.
Combining what the authors discussed with what Parry added will help students learn more about the art
of macroeconomic policy and challenges facing policymakers.
Students can get a copy of the paper by going to:
TRIAL FINAL EXAM
1. What are the main determinants of potential output? What are the difficulties associated with
estimating potential output? Why is the location of potential output important to policy makers?
The main determinants of potential output are capital, labor and technology. It is difficult to measure
potential output because it is difficult to measure each of the inputs (capital, labor and technology). The
location of potential output is important because the inflation rate usually rises when output rises above
potential and falls when output falls below potential. Thus, policymakers try to keep the economy as
close to potential output as possible.
The Art of Macroeconomic Policy 217
2. Suppose the GDP deflator is 1.02 for 1997, 1.03 for 1998, 1.05 for 1999 and 1.07 for 2000 (all are
base year 1996).
a. Given the following, calculate real GDP for each year:
Year nominal GDP: (Billions of current dollars)
Real GDP equals nominal GDP divided by the GDP deflator.
Year Nominal GDP GDP Deflator Real GDP
1997 8318.4 1.02 8155.3
1998 8790.2 1.03 8534.2
1999 9299.2 1.05 8610.4
2000 9963.1 1.07 9311.3
b. Why calculate real GDP? In other words, what does it tell you that nominal GDP does not?
Real GDP measures the quantity of goods and services produced holding prices constant at a base year.
The reason we calculate it is so that we can compare the change in the real quantity of goods and services
c. Calculate the inflation rates for 1997-98, 1998-99, and 1999-2000.
Inflation is the percent change in the price level (which in this case is measured by the GDP deflator):
Year Inflation Rate
3. Explain why the CPI inflation rate is biased upwards. Explain why that matters for policy.
The CPI is biased upwards mainly because of the substitution bias. The substitution bias occurs because
the CPI is based on a fixed basket of goods and services. Over time, consumers substitute away from the
relatively more expensive items in the fixed basket of goods and towards the relatively less expensive
items in the market basket. As a result the true cost of living rises by less than the cost of living measured
by the CPI.
4. If you bought stock for $10,000 and paid a commission of $30, what would happen to GDP? (Be as
specific as possible.)
GDP would rise by $30. Only the brokerage commission is included because the stock purchase is a
resale but the brokerage fee is for a current period of service.
5. In a make-believe economy there are only two goods: widgets and wadgets. In 1990 the economy
produced 20 widgets at a price of $1.00 each and 20 wadgets at a price of $2 each. In 1991 it
produced 30 widgets at a price of $1.50 each and 10 wadgets at a price of $3 each. What is a
reasonable range of estimates of the change in the price level? Explain your reasoning.
Because both prices have risen by 50%, the best estimate of the change in the price level is 50%.
218 Chapter 15
6. Draw a typical Phillips curve. Explain the economic rationale behind its shape. Describe the
challenges that policymakers face when trying to use the Phillips curve to guide short run policy.
What is the sacrifice ratio? How is it related to the shape of the Phillips curve and why is it important
The accompanying diagram shows the typical
Phillips curve. The negative slope arises because
as the unemployment rate falls, the wage rate is bid
up and prices rise as well. Unfortunately, the actual
Phillips curve is not stable making it difficult for
policymakers to accurately predict the relationship
between inflation and unemployment resulting
from their policies.
The sacrifice ratio is the ratio of lost GDP growth
to the reduction in inflation. It is related to the
Phillips curve as follows. A reduction in the Phillips Curve
inflation rate typically leads to an increase in the
unemployment rate. As unemployment rises, GDP
growth falls (according to Okun’s rule of thumb). unemployment rate
Thus, a reduction in inflation is typically associated
with a loss of GDP growth. The flatter the Phillips curve, the greater the increase in unemployment for a
given reduction in inflation. Therefore, the flatter the Phillips curve, the greater the sacrifice ratio and the
steeper the Phillips curve the larger the sacrifice ratio. Policymakers care about the size of the sacrifice
ratio because it tells them the cost of reducing inflation in terms of lost output growth.
7. Use the Solow growth model to explain what happens to output per capita and per capita output
growth in the short run and the long run in each of the following cases:
a. A one-time increase in saving.
According to the Solow growth model, a one- y=f(k)
time increase in the saving rate will increase y1
income per person
the growth of output per person temporarily y0 nk
and increase output per capita. But eventually,
growth in per person output will return to zero.
The accompanying graph illustrates the effects v0y
of an increase in the saving rate. Output per
person is initially y0. The saving rate rises
from v0 to v1 causing output per person to rise
to y1. k0 k1 k
capital per person
b. A one-time decrease in population growth.
According to the Solow growth model, a one-time
decrease in the population growth rate will increase y=f(k)
the growth of output per person temporarily and y1
income per person
increase output per capita. But eventually, growth n0k
in per person output will return to zero. The y0
accompanying graph illustrates the effects of a
decrease in the population growth rate. Output per vy
person is initially y0. The population growth rate
falls from n0 to n1 causing output per person to rise
k0 k1 k
capital per person
The Art of Macroeconomic Policy 219
c. A one-time increase in technology.
According to the Solow growth model, a one- y=A1f(k)
time increase in the level of technology will y1 y=A0f(k)
increase the growth of output per person
imcome per person
temporarily and increase output per capita. But
eventually, growth in per person output will y0 nk
return to zero. The accompanying graph vA1f(k)
illustrates the effects of an increase in
technology. Output per person is initially y0. vA0f(k)
The state of technology rises from A0 to A1
causing output per person to rise to y1.
k0 k1 k
capital per person
d. According to the Solow growth model, what is the only possible source of long-term growth?
According to the Solow growth model the only way for output per capita to grow continuously is for
technology to grow continuously.
8. According to the Solow growth model, what causes growth? What policies does the Solow growth
theory recommend? According to new growth theory, what causes growth? What policies does new
growth theory recommend?
According to the Solow growth model, continuous growth in output per person is caused by continuous
growth in technology. The only policies the Solow model recommends are policies to encourage saving
and investment but increases in investment lead to only a temporary boost in growth. According to new
growth theory, technological growth is also responsible for growth but new growth theory has a model for
how technological progress happens. To encourage technological innovation, new growth theory
recommends policies to encourage industries with increasing returns, opening the economy to trade, and
creating a system of patent laws and a system of property rights.
9. In the long run, what causes inflation? Use the quantity theory of money to defend your answer. What
are the three key assumptions that lead to this prediction? Why does this prediction hold in the long
run but not the short run? What institutional features of an economy generally lead to inflation?
In the long run inflation is caused by growth in the money supply. The three key assumptions that lead to
this prediction are that the velocity of money is fairly stable or constant, the classical dichotomy holds and
causation runs from money to prices. In the short run the classical dichotomy does not hold and changes
in the money supply often affect real output as well as the price level. Economies that have weak central
banks and limited means of collecting tax revenues or issuing bonds often resort to printing money to
finance expenditures. As a result, they experience inflation.
10. Suppose the United States has a fixed exchange rate and a balance of payments surplus. Explain what
actions the Fed has to take to maintain the fixed exchange rate (are they buying or selling foreign
exchange?). Now suppose the Fed abandoned their fixed exchange rate target and let the exchange
rate float freely. Would the dollar appreciate, depreciate, or not change?
With a fixed exchange rate and balance of payments surplus the demand for dollars exceeds the supply of
dollars. There would be pressure for the dollar to appreciate so the Fed would have to sell dollars on the
foreign exchange market to prevent that from happening. If the Fed abandoned its fixed exchange rate the
dollar would appreciate.
220 Chapter 15
11. Suppose Congress and the President decide to cut taxes. Use the IS/LM diagram to explain what
would happen to the economy in each of the following cases:
a. The Fed accommodates fiscal policy.
If Congress and the President cut taxes the IS curve will r
shift from IS0 to IS1. If the Fed accommodates that policy LM1
the LM curve will shirt right from LM0 to LM1. Output LM0
rises from Y0 to Y1 and the interest rate remains
unchanged at r0.
Y0 Y1 Y
b. The Fed offsets fiscal policy.
If Congress and the President cut taxes the IS curve
will shift from IS0 to IS1. If the Fed offsets that
policy the LM curve will shirt left from LM0 to LM1. LM0
The interest rate rises from r0 to r1 and output remains
unchanged at y0.
Y0 real output Y
12. Suppose the economy is initially in equilibrium. Use the IS-LM diagram to show what would happen
to equilibrium income and the interest rate if the payments technology changed so that it was less
costly to transfer wealth from interest-bearing
financial assets to money.
If the payments technology changed to make it less
costly to transfer wealth from interest bearing
financial assets to money people would hold less
money. A decrease in the demand for money would LM1
shift the LM curve from LM0 to LM1. Output would
rise from Y0 to Y1 and the interest rate would fall
from r0 to r1. r1
Y0 Y1 real output Y
The Art of Macroeconomic Policy 221
13. You have been assigned to be the economic advisor to a country almost identical to the United
States; it is called Identicalland. The president asks you in and tells you he needs to know the
economy’s current structural deficit. You ask your research assistant for information and he tells you
the country’s actual surplus in the federal budget is $70 billion, its GDP is 600 billion, the
unemployment rate is 4.5 percent and that the natural rate of unemployment of 5.5 percent, its tax
rate is .1, and there are no spending programs determined by income. Tell the president what the
structural deficit is, giving a specific number and showing your calculations.
To calculate the structural deficit one must determine the economy’s potential income. Using Okun’s rule
of thumb I would estimate it to be $12 billion lower than actual income. Taxes would be 1.2 billion lower
if the economy were at potential income, so I estimate the structural surplus at $68.8 billion.
14. If the Fed buys bonds, what will likely happen to the short-term interest rate? Why?
The short-term interest rate will likely fall because people will adjust their portfolios in reaction to the
increased money supply by buying bonds, which will cause bond prices to rise (and therefore interest rate
15. One of the precocious students asks why when the Fed bought bonds the long-term corporate bond
rate rose while the Fed funds rate fell. What would be the most likely explanation?
The most likely explanation is that the Fed expansionary monetary policy generated inflationary
expectations, causing the yield curve to become steeper.
16. Why could the reported budget deficit or surplus be a misleading indicator of whether fiscal policy is
expansionary or contractionary?
The reported budget balance is potentially a misleading indicator of the stance of fiscal policy because it
is influenced by the state of the economy. If the economy is booming the budget balance will rise
because tax revenues will increase and expenditures will decrease automatically. If the economy slows
the budget balance will fall because tax revenues will decrease and expenditures will increase
automatically. Thus, a decrease in the budget balance could indicate a slowdown or it could indicate
expansionary fiscal policy. Similarly, an increase in the budget balance could indicate a boom or it could
indicate contractionary fiscal policy.
17. Why does an increase in the money supply lead to an increase in aggregate output?
An increase in the money supply causes the interest rate to fall, which causes investment expenditures to
rise, which causes equilibrium output to rise.
18. What is crowding out? Why does it occur?
Crowding out is where an increase in government spending or a decrease in taxes leads to a decrease in
private investment expenditures. The reason crowding out occurs is because an increase in government
spending makes income rise which causes the demand for money to rise. Holding the money supply
constant, an increase in the demand for money will cause the interest rate to rise. An increase in the
interest rate causes investment and output to fall.
222 Chapter 15
19. Congratulations! You’ve been appointed Chairperson of the Council of Economic Advisors for
Strangeland. Luckily, you're assigned a research assistant who tells you the following:
* The marginal propensity to consume is relatively small.
* The marginal propensity to import is large.
* Interest has no effect on investment.
* The interest demand for money is highly elastic.
* The economy is below the target rate of income.
* The trade balance is zero.
* The price level is fixed.
The president meets you and lets you know that he wants to both increase income significantly and
decrease interest rates. Carefully draw the relevant IS/LM curves and show graphically what policy
you would recommend. Explain why you would recommend that policy.
Because interest has no effect on investment the IS curve is perfectly inelastic, meaning that to increase
income I must use fiscal policy. The LM curve is elastic. Thus my recommendation is to run
expansionary monetary and fiscal policy as shown on the following graph:
20. Congratulations! You have just been appointed chairperson of the Council of Economic Advisors for
the Country of Funlandia. You are assigned a research assistant who provides you with the following
The marginal propensity to save is .3
The government has a tax rate of 10 percent
The marginal propensity to import is .1
Actual income is $800 billion below the government's targeted income
The country has a trade deficit of $20 billion
The budget deficit is $30 billion.
The government wants to change the level of exogenous taxes to achieve its targeted income. What
change in taxes would you recommend? Show your work.
The multiplier is 1/(1-mpc(1-t)+m) =2.13 which means that I need to change autonomous expenditures by
376. To do that I must cut taxes by 376x2.13=800.
21. What are two reasons why the AD curve is downward sloping?
The interest rate effect and the international effect.
22. How does an upward sloping aggregate supply curve modify the results of standard IS/LM analysis?
The upward sloping AS curve reduces the effect on expansionary monetary and fiscal policy on real
output. The expansion in output is split between a price increase and an increase in real output.
The Art of Macroeconomic Policy 223
23. Use the IS/LM model along with the balance of payments line (assuming perfect capital mobility in a
small open economy) and words to describe the impact of expansionary fiscal policy in each of the
a. Fixed exchange rates.
By assuming perfect capital mobility the balance of
payments line becomes a horizontal line. LM0
Expansionary fiscal policy shifts the IS curve to the
right from IS0 to IS1. The increases in interest rates
will cause the currency to appreciate. To prevent rw BP
that from happening and to keep the exchange rate
fixed the Fed must expand the money supply
shifting the LM curve from LM0 to LM1. The end IS 1
result is an increase in equilibrium output from Y0 IS 0
to Y1. Y Y 0 1 real income
b. Flexible exchange rates.
Now assume that the exchange rate is flexible.
Expansionary fiscal policy shifts the IS curve to the LM
right from IS0 to IS1. The increases in interest rates will
cause the currency to appreciate. As the currency
appreciates, the current account falls. A decline in the rw BP
current account causes the IS curve to shift back until it
returns to its original position at income Y0. IS 1
Y0 Y1 real income
24. Why do economies experience business cycles? What policies are available to minimize the size of
business cycles? Have these policies been successful?
Economies experience business cycles because of coordination failures. Changes in demand in the short
run cause fluctuations in real output because markets are not able to coordinate economic activity quickly
enough to accommodate those changes. For example, if consumer become pessimistic about the economy
and cut back on consumption expenditures businesses will see a drop in the demand for their products.
Most likely inventories will rise well before the price of output is reduced and unemployment will rise
well before wages start to fall. The fact that prices and wages are sticky is another form of coordination
failure. The goods and labor market do not react to the decline in demand by dropping prices and wages
but instead by causing inventories and unemployment to rise.
Fiscal and monetary policies have traditionally been used to minimize these fluctuations. These policies
have been somewhat successful in reducing the size of economic fluctuations in the post World War II
period. However, the evidence is controversial, some believe that the size of fluctuations is roughly the
same as it was prior to the Great Depression.
25. How does the impact of a permanent tax cut differ from the impact of a temporary tax cut? Why do
these policies have different effects on the economy?
A permanent tax cut will boost consumption expenditures by more than a temporary tax cut. The reason is
that people base their consumption on permanent or lifetime income. A permanent tax cut increases
lifetime income by more than a temporary tax cut.
224 Chapter 15
26. What is the present value of $1,000 to be received 10 years from now if the interest rate is 12
percent? How would that present value change if the interest rate rose? How would it change if the
payment date were moved closer to the present?
The present value of $1000 to be received 10 years from now is $321.97. This number is found by
solving for PV = 1000/(1+.12)10. The present value would decline if the interest rate rose and it would
increase if the payment date were moved closer.
27. If the interest rate in the economy rises from 4 percent to 5 percent, what would you expect would
happen to the price of:
a. a one year $1000 bond with a coupon rate of 4%?
The present value of the bond initially would be $1000 since the interest rate in the economy equals the
coupon rate. The present value would fall to PV=1,100/1.05=$990.48.
b. a perpetuity bond (a bond that lasts forever) with a face value of $1000 and coupon rate of 5
The present value of the bond initially would be $1000 since the interest rate in the economy equals the
coupon rate. The present value would fall to PV=40/.05 =$800 with the rise in the interest rate.
28. Why is present value an important concept in the microeconomic foundations of macroeconomics?
Present value is an important concept in the microeconomic foundations of macroeconomics because
micro choices in macroeconomic contexts are often choices over time. Examples are choices about how
much to consume now versus how much to consume in the future and how much to invest now versus
how much to invest in the future. These calculations all involve present values.
29. Describe the institutional structure of the Federal Reserve.
The Federal Reserve System consists of 12 regional Federal Reserve banks and a board of governors in
Washington D.C. There are 7 members of the board of governors. Each member is appointed by the
President and confirmed by the Senate. Board members serve 14-year terms. The chair of the Fed is
appointed to a 4-year term. The important monetary policy committee of the Federal Reserve is the
Federal Open Market (FOMC) committee. The FOMC is comprised of the seven board members and 5
regional bank presidents. Membership rotates among the regional bank presidents except for the
president of the New York Fed who is always a voting member of the FOMC.
The Fed was established by an act of Congress is 1913 and began operations in 1918. It was designed to
provide liquidity to the banking sector in times of financial crisis. It is institutionally separate from
Congress and the President. The Fed does not have to accommodate increases in government spending or
decreases in taxes. This independence is an important feature of the Fed. It allows it to take a long-term
view of the economy, which is generally consistent with low inflation.
30. At an FMOC meeting a decision has been made to increase income in the economy by $600 million.
You are assigned to write the directive for what open market operation to undertake. Your research
assistant tells you that the cash to deposit ratio is .4, the reserve requirement is .1, and banks hold no
excess reserves. Your research assistant tells you that for each increase in the money supply of $100
million interest rates fall by a percentage point (e.g. from 6 percent to 5 percent.) and that for each
percentage-point fall in the interest rate, investment rises by $200 million. He also tells you that the
marginal propensity to consume is .7, the marginal propensity to import is .1 and the marginal tax
rate is .2. Draft the relevant directive for the open market operation, being as specific as you can be.
First I calculate the money multiplier: (1+c)/(r+c) = 2.8. Then I calculate the income multiplier: 1/(1-
mpc(1-t) +b) = 1.85. Then I divide 600/1.85 = 324 which is how much I have to increase autonomous
investment. That will require a fall of interest rates of 1.62 percentages points. That would require an
increase in the money supply of 162 million. Given the money multiplier of 2.8 that requires an increase
in reserves by 162/2.8 or 58. So the directive I would give is to the open market committee is to buy 58
million of government securities.
The Art of Macroeconomic Policy 225
31. What are the advantages and disadvantages of conducting monetary policy with a rule versus with
discretion? Which type of policy does the Fed currently use?
The advantage of conducting monetary policy with a rule is that it is transparent—everyone knows how
the Fed will react to a particular situation and it avoids the time inconsistency problem. The time
inconsistency problem occurs when the Fed conducts monetary policy with discretion. The Fed has an
incentive to announce that it will keep the inflation rate low. However, once inflation is low and people
have adjusted their expectations to the low inflation the Fed’s incentive is to surprise everyone with an
increase in the inflation rate so that the unemployment rate falls. Over time, of course, people will begin
to incorporate the higher inflation in to their expectations and the output gain from the surprise inflation
will disappear. In the end, discretion yields higher inflation but no gain in output or reduction in the
unemployment rate. The disadvantage of a rule is that it cannot possibly take account of every possible
contingency. Some economic problem may arise that the Fed would be unable to deal with because they
are bound by a rule.
The Fed currently operates with discretion. The advantage of this is that they have the flexibility to react
to unforeseen economic shocks but the disadvantage is that there is a possible time inconsistency
problem, which will yield higher inflation than under a rule.
32. Describe the evolution of fiscal policy since the Great Depression. Are Congress and the President
now more or less likely to use fiscal policy to try to steer the economy compared to the 1960s? Why?
Beginning in the Great Depression the Federal government began playing a larger role in the economy.
Spending on programs such as Social Security, welfare, Medicare and Medicaid, farm support programs
as well as a whole host of other programs. Growth in these programs reflects the growth of the welfare
state. In addition to a growing welfare state the federal government also played an increasing role in fine-
tuning the economy by adjusting taxes and spending to smooth out the business cycle. Efforts to fine-
tune the economy proved to be disappointing. The lag between recognizing an economic problem and
formulating and passing legislation to deal with that problem is so long that often the economic problem
disappeared on its own before the fiscal policy could be implemented. As a result, Congress and the
President are much less likely to use fiscal policy to steer the economy (unless faced with a prolonged and
severe downturn). In addition to the difficulty with implementing fiscal policy to steer the economy, the
fact that the deficit was growing so large during the 1980s and early 1990s also made the Federal
government reluctant to use fiscal policy to stimulate the economy. The focus of spending and taxing
policy in the 1980s and 1990s was on reducing the budget deficit.
33. What are the three options that governments face to finance their expenditures? Describe the
economic impact of each financing method.
The government has three sources of financing expenditures: tax revenues, new bonds and new money.
The main source of revenue for the United States is tax revenues. But during times of large spending
increases (during a war, for example) the government may be unable to raise enough revenue by
increasing taxes so they issue bonds. This is called tax smoothing—it allows taxes to stay roughly the
same and spreads the burden of paying for large expenditures over time. In other words, by issuing
bonds, future generations help pay for the war when they pay the interest and the principle on the bonds.
Using taxes to finance expenditures can cause disincentive effects, which can harm long-term growth.
High marginal tax rates discourage people from working and firms from investing leading to lower
But too much debt can be harmful for the economy. Issuing bonds to increase expenditures can lead to
crowding out of private investment and lower output per person in the future. It is also important to look
at what the government is buying when evaluating whether a large amount of debt is harmful for the
economy. If government spending is primarily on consumption and has no long lasting effects on
potential output, a large and growing debt can be a problem. However, if government spending is on
investment (an interstate highway system) then a large and growing debt may not be a problem.
226 Chapter 15
The final source of government revenue is printing new money. The U.S. relies very little on
“seignorage” but other developing countries rely on it more. Printing new money to finance expenditures
usually only occurs if the other sources of revenue are not available.
34. If the real deficit is 200, the nominal deficit is 500, the real interest rate is 10 percent, and the
inflation rate is 12 percent, what is the total government debt?
The real deficit equals the actual deficit minus the inflation rate times the government debt:
200 = 500 - .12 (X). 300/.12=X so X = 2500.
35. Someone has just suggested that the answer to the Social Security problem is to increase the Social
Security trust fund by increasing taxes now. Give a short one or two-sentence response.
I would say that it does not solve the real problem, which is that regardless of what happens with the trust
fund or taxes now. The real problem is that the quantity of aggregate demand will be higher than potential
income in the future and any real solution must bring these into equilibrium.
36. Describe the rhetorical tools politicians and economists use to describe the impact of fiscal policy.
What incentive does each have to overstate the impact of policies they support?
Politicians use various forms of rhetoric to make economic policies appear economically more important
than they really are. One way to inflate the importance of a policy is to state tax cuts or spending
increases in levels or dollar amounts. $40 billion might sound like a lot to the average person but it really
is small compared to the size of the economy. Another way to inflate the importance of a policy is to
front load the spending increases and back load the tax increases. This was a common technique used
during the 1980s and early 1990s when Congress and the President were trying to reduce the budget
deficit. They would propose a multi year spending and tax plan where the spending increases would
come first and the tax increases to pay for the plan would be instituted later.
Another common political technique is to take credit for anything good that happens to the economy and
blame others for anything bad that happens to the economy.
Economists also use rhetoric to make their policies look good. Often times that rhetoric is hidden behind
economic forecasts. But economic forecasts are partly based on judgment. So economists can use their
judgment to influence the outcome of policy by changing their forecasts to achieve the policy they want.