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expenditure lags between fiscal actions and their effects supply. But, since then, the focus has clearly returned
on aggregate demand are probably fairly short. By con- to interest rates.


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Part 3
296 Fiscal and Monetary Policy



10. When the aggregate supply curve is very flat, changes 13. When the lags in the operation of fiscal and monetary
in aggregate demand will have large effects on the na- policy are long and unpredictable, attempts to stabilize
tion™s real output but small effects on the price level. economic activity may actually destabilize it.
Under those circumstances, stabilization policy works 14. Some economists believe that our imperfect knowledge of
well as an antirecession device, but it has little power to the channels through which stabilization policy works, the
combat inflation. long lags involved, and the inaccuracy of forecasts make it
11. When the aggregate supply curve is steep, changes in unlikely that discretionary stabilization policy can succeed.
aggregate demand have small effects on real output but 15. Other economists recognize these difficulties but do not
large effects on the price level. In such a case, stabiliza- believe they are quite as serious. They also place much
tion policy can do much to fight inflation but is not a less faith in the economy™s ability to cure recessions and
very effective way to cure unemployment. inflations on its own. They therefore think that discre-
12. The aggregate supply curve is likely to be relatively flat tionary policy is not only advisable, but essential.
in the short run but relatively steep in the long run. 16. Stabilizing the economy by fiscal policy need not imply
Hence, stabilization policy affects mainly output in the a tendency toward “big government.”
short run but mainly prices in the long run.


| KEY TERMS |
Velocity 278 Monetarism 281 Controlling M versus
controlling r 284
Equation of exchange 278 Effect of fiscal policy on
interest rates 281 Rules versus discretionary
Quantity theory of money 279
policy 291
Lags in stabilization policy 283
Effect of interest rate on
velocity 280


| TEST YOURSELF |
1. How much money by the M1 definition (cash plus b. New statistical methods are found that improve the
checking account balances) do you typically have at any accuracy of economic forecasts.
particular moment? Divide this amount into your total c. A Republican president is elected when there is an
income over the past 12 months to obtain your own per- overwhelmingly Democratic Congress. Congress and
sonal velocity. Are you typical of the nation as a whole? the president differ sharply on what should be done
2. The following table provides data on nominal gross do- about the national economy.
mestic product and the money supply (M1 definition) in 5. (More difficult) The money supply (M) is the sum of
recent selected years. Compute velocity in each year. bank deposits (D) plus currency in the hands of the pub-
Can you see any trend? How does it compare with the lic (call that C). Suppose the required reserve ratio is
trend that prevailed from 1975 to 1995? 20 percent and the Fed provides $50 billion in bank re-
serves (R 5 $50 billion).
End-of-Year a. First assume that people hold no currency (C 5 0).
Money Supply How large will the money supply (M) be? If the Fed
Year (M1) Nominal GDP increases bank reserves to R 5 $60 billion, how large
2004 $1,376 $11,686 will M be then?
2005 1,375 12,434
b. Next, assume that people hold 20 cents worth of cur-
2006 1,367 13,195
rency for each dollar of bank deposits, that is,
2007 1,364 13,841
C 5 0.2D. Define the monetary base (B) as the sum of
NOTE: Amounts are in billions.
reserves (R) plus currency (C): B 5 R 1 C. If the Fed
3. Use a supply-and-demand diagram similar to Figure 2 now creates $50 billion worth of monetary base, how
to show the choices open to the Fed following an unex- large will M be? (Hint: You will need a little bit of
pected decline in the demand for money. If the Fed is fol- algebra to figure this out. Remember that the
lowing a monetarist policy, what will happen to the rate $50 billion monetary base is divided between two
of interest? purposes: bank reserves and currency.) Now, if the
Fed increases the monetary base to B 5 $60 billion,
4. Which of the following events would strengthen the ar-
how large will M be?
gument for the use of discretionary policy, and which
would strengthen the argument for rules? c. What do you notice about the relationship between
M and B?
a. Structural changes make the economy™s self-correcting
mechanism work more quickly and reliably than before.




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Chapter 14 297
The Debate over Monetary and Fiscal Policy



| DISCUSSION QUESTIONS |
1. Use the concept of opportunity cost to explain why ve- 6. Explain why lags make it possible that policy actions
locity is higher at higher interest rates. intended to stabilize the economy will actually desta-
bilize it.
2. How does monetarism differ from the quantity theory of
money? 7. Many observers think that the Federal Reserve suc-
ceeded in using deft applications of monetary policy to
3. Given the behavior of velocity shown in Figure 1, would
“fine-tune” the U.S. economy into the full-employment
it make more sense for the Federal Reserve to formulate
zone in the 1990s without worsening inflation. Use the
targets for M1 or M2?
data on money supply, interest rates, real GDP, unem-
4. Distinguish between the expenditure lag and the pol-
ployment, and the price level given on the inside back
icy lag in stabilization policy. Does monetary or fiscal
cover of this book to evaluate this claim.
policy have the shorter expenditure lag? What about
8. During the year 2007, U.S. economic performance dete-
the policy lag?
riorated sharply. Can this decline be blamed on inferior
5. Explain why their contrasting views on the shape of the
monetary or fiscal policy? (You may want to ask your in-
aggregate supply curve lead some economists to argue
structor about this question.)
much more strongly for stabilization policies to fight un-
employment and other economists to argue much more
strongly for stabilization policies to fight inflation.




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Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:




Budget Deficits in the Short
and Long Run
Blessed are the young, for they shall inherit the national debt.
HERBERT HO OVER



M onetary policy and fiscal policy are typically thought of as tools for short-run
economic stabilization”that is, as ways to combat either inflation or unemploy-
ment. Debates over the Federal Reserve™s next interest-rate decision, or over this year™s
federal budget, are normally dominated by short-run considerations such as: Does the
economy need to be stimulated or restrained right now?
But the monetary and fiscal choices the government makes today also have
profound effects on our economy™s ability to produce goods and services in the future.
We began Part 2 by emphasizing long-run growth, and especially the role of capital
formation (see Chapters 6 and 7). But for most of Part 3, we have been preoccupied
with the shorter-run issues of inflation, unemployment, and recession. This chapter
integrates the two perspectives by considering both the long-run and short-run impli-
cations of fiscal and monetary policy decisions. What differences does it make if we
stimulate (or restrain) the economy with fiscal or monetary policy? Should we strive
to balance the budget? What are the economic virtues and vices of large budget
deficits, both now and in the future?




CONTENTS
INTERPRETING THE BUDGET DEFICIT DEBT, INTEREST RATES, AND
ISSUE: IS THE FEDERAL GOVERNMENT BUDGET
DEFICIT TOO LARGE? OR SURPLUS CROWDING OUT
The Structural Deficit or Surplus The Bottom Line
SHOULD THE BUDGET BE BALANCED?
On-Budget versus Off-Budget Surpluses
THE SHORT RUN THE MAIN BURDEN OF THE NATIONAL
Conclusion: What Happened after 1981?
The Importance of the Policy Mix DEBT: SLOWER GROWTH
WHY IS THE NATIONAL DEBT CONSIDERED ISSUE REVISITED: IS THE BUDGET DEFICIT
SURPLUSES AND DEFICITS: THE LONG RUN
A BURDEN? TOO LARGE?
DEFICITS AND DEBT: TERMINOLOGY
BUDGET DEFICITS AND INFLATION THE ECONOMICS AND POLITICS OF THE
AND FACTS
The Monetization Issue U.S. BUDGET DEFICIT
Some Facts about the National Debt




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Part 3
300 Fiscal and Monetary Policy



ISSUE: IS THE FEDERAL GOVERNMENT BUDGET DEFICIT TOO LARGE?
Several of these questions were brought into sharp relief by the partisan
debate over the budget deficit during the 2008 presidential campaign.
During the primary season, virtually all the Democratic candidates
railed against the large budget deficits of the Bush years. Most”including
both Hillary Clinton and Barack Obama”proposed to repeal parts of the
tax cuts enacted in 2001 and 2003, especially those that benefited upper-
income groups, in order to shrink the budget deficit”which, they said, was a dan-
ger to the nation™s economic health.
By contrast, virtually all the Republican candidates, including John McCain,
vowed to maintain the Bush tax cuts, arguing that repealing them would harm
the economy. While these candidates also objected to large budget deficits, they
stoutly defended most of the Bush administration™s spending initiatives as well.
Since you cannot reduce the budget deficit without either raising taxes or cutting
spending, they were implicitly saying that reducing the budget deficit was not a
high priority.
Which side was right? Is it important to shrink the budget deficit? Or is it more
advisable to maintain both the tax cuts and the spending? Politics aside, by the end of
the chapter, you will be in an excellent position to make an informed judgment on this
important policy issue for yourself.



SHOULD THE BUDGET ALWAYS BE BALANCED? THE SHORT RUN
Americans have long been attracted by the idea of balancing the government budget year
after year”so much so that a constitutional amendment to require a balanced budget has
been proposed and debated many times. Let us begin our examination of the virtues and
vices of a balanced budget by reviewing the basic principles of fiscal policy that we have
learned so far (especially in Chapter 11).
These principles certainly do not imply that we should always maintain a balanced
budget, much as that notion may appeal to our intuitive sense of prudent financial man-
agement. Rather, they instruct fiscal policy makers to focus on balancing aggregate supply
and aggregate demand. They therefore point to the desirability of budget deficits when pri-
vate demand, C 1 I 1 (X 2 IM), is weak and of budget surpluses when private demand is
strong. The budget should be balanced, according to these principles, only when C 1 I 1
G 1 (X 2 IM) under a balanced-budget policy approximately equals potential GDP. This
situation may sometimes prevail, but it will not necessarily be the norm.
The reason why a balanced budget is not always advisable should be clear from our
earlier discussion of stabilization policy. Consider the fiscal policy that the federal govern-
ment would follow if its goal were to maintain a balanced budget every year, as most of
the 50 states do. Suppose the budget was initially balanced and private spending sagged
for some reason, as it did in 2007“2008. The multiplier would pull GDP down. Because
personal and corporate tax receipts fall sharply when GDP declines, the budget would
automatically swing into the red. To restore budget balance, the government would then
have to cut spending or raise taxes”exactly the opposite of the appropriate fiscal policy
response to a recessionary gap, and exactly the opposite of what the federal government
actually did. Thus:
Attempts to balance the budget during recessions”as was done, say, during the Great
Depression”will prolong and deepen slumps.
This is precisely what many observers feel happened to Japan when it raised taxes in a
weak economy in 1997. In fact, Ryutaro Hashimoto, Japan™s prime minister from 1996 to
1998, was disparagingly called the “Herbert Hoover of Japan” because he sought to




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Licensed to:

Chapter 15 301
Budget Deficits in the Short and Long Run



reduce the budget deficit despite Japan™s sinking economy. State and local governments
in the United States also often raise taxes or cut spending during recessions because they
have balanced-budget requirements.
This problem arises in both directions. Budget balancing also can lead to inappropriate
fiscal policy under boom conditions. If rising tax receipts induce a budget-balancing gov-
ernment to spend more or to cut taxes, then fiscal policy will “boom the boom””with
unfortunate inflationary consequences.


The Importance of the Policy Mix
Actually, the issue is even more complicated than we have indicated so far. As we know,
fiscal policy is not the only way for the government to affect aggregate demand. It also can
influence aggregate demand through its monetary policy. For this reason,
The appropriate fiscal policy depends, among other things, on the current stance of
monetary policy. Although a balanced budget may be appropriate under one monetary
policy, a deficit or a surplus may be appropriate under another monetary policy.
An example will illustrate the point. Suppose Congress and the president believe that the
aggregate supply and demand curves will intersect approximately at full employment if the
budget is balanced. Then a balanced budget would seem to be the appropriate fiscal policy.
Now suppose monetary policy turns contractionary, pulling the aggregate demand curve
F I GU R E 1
inward to the left, as shown by the brick-colored arrow in Figure 1, and thereby creating a
The Interaction of

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