ECON 205 1st Edition Lecture 21 Outline of Last Lecture II How does interest rate effect help explain slope of AD III How can central bank use monetary policy to shift the AD curve IV In what way does fiscal policy affect AD V What are arguments for and against using policy to smooth out cycles Outline of Current Lecture Pros and cons to common questions asked by economists Current Lecture 1 Should Policymakers try to stabilize the economy Pro Left on their own economies tend to fluctuate pessimism and optimism of households and firms decrease of AD Policymakers can lean against the wind use monetary and fiscal policy o stabilize AD output and employment More stable economy benefits everyone Con Monetary and fiscal policy work with long lags so policy must act in advance of economic changes Shocks that cause fluctuations are unpredictable and forecasting is highly imprecise If policy takes effect too late it will worsen fluctuations 2 Should the government fight recessions with spending hikes or tax cuts Spending Each dollar of government spending adds directly to aggregate demand but only part of each dollar of a tax cut does because consumers save part of it Bigger bang for the buck from spending increases Tax cuts Increase households disposable income increase in consumption spending Tax cuts can increase AD with incentives Tax cuts increase AS by increasing incentives to work and produce goods and services Rapid spending increases may be wasteful and will require future tax increases 3 Should monetary policy be made by Rule or Discretion Rule Central banker discretion could do great harm if incompetent Discretion allows possibility of abuse The political business cycle Central bankers may renege price stability promises if recession occurs Time consistency discretionary between actual policy and announced policy Discretion allows flexibility to react to unforeseen events Political business cycles and time inconsistency are theoretical possibilities but not that important in practice Difficult to specify rules precisely and to determine what best rule would be 4 How much inflation should the central bank accept Is zero the right target For Zero Costs of inflation i e menu costs can be substantial even for low inflation Achieving zero inflation may have temporary costs higher unemployment but permanent benefits Against Zero Benefits of getting to zero are small compared to large costs Estimates must sacrifice 5 of a year s GDP for each 1 decrease in inflation Disinflation leaves permanent scars investment falls decrease future capital stock workers skills diminish while unemployed Inflation may grease the wheels of the labor market Gives an opportunity to change sticky wages by not changing nominal wage and having inflation to decrease real wages 5 Should the government balance the budget Yes gov debt places burden on future generations deficits crowd out investment decrease growth and future living standards maybe deficits are justified during wars and recessions No burden of debt is exaggerated only a tiny percentage of a person s lifetime income cutting deficit could do more harm than good cutting education decreases human capital increase in taxes decreases incentives to work and save focusing on the deficit diverts attention from other programs that redistribute income across generations such as Social Security Debt income ratio more relevant than the debt itself 6 Should tax laws be reformed to encourage saving Yes People respond to incentives Current system discourages saving high marginal tax rates decrease return on saving some saving is taxed twice as corporate income and again as personal income high tax rates on bequests No tax reform mainly benefits wealthy who need relief the least tax incentives may not increase savings much decrease taxes on capital income may increase government s budget deficit negating benefits of higher private saving Can increase national saving directly by decreasing the budget deficit Policy in Recent Recession Stimulus packages increased G by 800 billion TARP troubled asset relief program Recapitalize banking system decreased Fed Funds rate to just about zero