USC ECON 205 - Should Policymakers try to stabilize the economy?

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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 economistsCurrent Lecture1. 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 everyoneCon:- 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 fluctuations2. 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 increasesTax 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 increases3. 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 policyDiscretion:- 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 be4. 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 benefitsAgainst 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 wages5. 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 recessionsNo:- 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 itself6. 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 bequestsNo:- 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 deficitPolicy in Recent Recession- Stimulus packages increased G by $800 billion- TARP: troubled asset relief program- Recapitalize banking systemdecreased Fed Funds rate to just about

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