MacroEcomonics principles, application, and tools 7th edition by sullivan chapter 17

New Methods to Measure the Long-Term Fiscal Imbalances for the United States Did the Federal Reserve cause the housing boom through excessively loose monetary policy?. C H A P T E R 17Ma

Macroeconomic Policy

Debates

P R E P A R E D B Y

Economists are often cautious and try to warn policymakers that

carrying out effective economic policy is difficult.

CHAPTER

17

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What are the long-term fiscal imbalances for the United States?

New Methods to Measure the Long-Term Fiscal Imbalances for the United States

Did the Federal Reserve cause the housing boom through excessively loose monetary policy?

Would a Policy Rule Have Prevented the Housing Boom?

Can the United States adopt a European-style value-added tax?

Is a VAT in Our Future?

3

C H A P T E R 17

Macroeconomic Policy

Debates 17.1 SHOULD WE BALANCE THE FEDERAL

BUDGET?

The Budget in Recent Decades

► FIGURE 17.1

Debt as a Percent of

GDP, 1791–2009

The nation’s debt/GDP

ratio tends to rise sharply

during wars because more

spending is needed to

finance them

However, the ratio also can

rise during peacetime, as it

did during the Reagan

presidency in the 1980s.

•Federal budget figures include revenue and expenditures from the Social Security

system Over the next decade, the Social Security portion of the budget is expected to run a surplus because of the huge number of baby boomers (those born between 1946 and 1964) currently paying taxes into the system

•That surplus won’t last forever, though Some economists argue that Social Security funds should not be included in federal budget figures because the money will be

needed to make future Social Security payments to these baby boomers

•Over the longer horizon, the surpluses in the Social Security account will disappear and turn to deficits

•As our society grows older, spending on both Social Security and Medicare will

increase

•That increase in spending is causing the CBO to predict emerging federal deficits and sharp increases in the debt/GDP ratio to levels comparable to those of World War II, unless taxes are raised and/or spending is cut significantly

C H A P T E R 17

Macroeconomic Policy

Debates

Five Debates About Deficits

DEBATE 1: DO DEFICITS LEAD TO INFLATION?

government deficit = new borrowing from the public + new money created

● monetizing the deficit

Purchases by a central bank of newly issued government bonds

Large, stable countries like the United Kingdom, the United States, and Japan

don’t monetize much of their debt because they are able to borrow from the

public In these countries, deficits do not lead inevitably to inflation

During the recent recession, the Fed purchased massive amounts of bonds,

but paid banks interest thus inducing them to hold additional reserves This

prevented a large increase in the money supply held by the public

BUDGET? (cont’d)

DEBATE 2: IS GOVERNMENT DEBT A BURDEN ON

FUTURE GENERATIONS?

● Ricardian equivalence The proposition that it does not matter whether government expenditure is financed by taxes or debt

P R I N C I P L E O F O P P O R T U N I T Y C O S T

The opportunity cost of something is what you sacrifice to get it.

The result of government deficits is that less savings are available

to firms for investment

Higher taxes will be imposed on future generations

C H A P T E R 17

Macroeconomic Policy

Debates

Five Debates About Deficits

DEBATE 2: IS GOVERNMENT DEBT A BURDEN ON

FUTURE GENERATIONS?

► FIGURE 17.2

International Comparisons of

Government Debt as

Percentage of GDP, 2009

Among developed countries,

the United States has a

relatively small percentage of

debt to GDP

Japan has the highest

percentage of debt of the

countries depicted.

BUDGET? (cont’d)

DEBATE 3: HOW DO DEFICITS AFFECT THE SIZE

OF GOVERNMENT?

Nobel Laureate James Buchanan has argued that people are less aware of

government deficits than of the taxes they’re forced to pay

Therefore, financing government expenditures through deficits, rather than through higher taxes, will inevitably lead to higher government spending and bigger

government

Although this argument may seem plausible, it presents two problems:

First, in recent U.S history, spending by state and local governments has grown much faster than federal spending However, state and local

governments face many more restrictions when it comes to borrowing money than the federal government faces

Second, if politicians trying to get reelected really prefer higher government spending and deficits to higher taxes and surpluses, why did the federal government run surpluses in the late 1990s?

C H A P T E R 17

Macroeconomic Policy

Debates

NEW METHODS TO MEASURE THE LONG-TERM FISCAL

IMBALANCES FOR THE UNITED STATES

APPLYING THE CONCEPTS #1: What are the long-term fiscal

imbalances for the United States?

•Even though federal budget-deficit projections have increased in recent years,

they still don’t accurately portray the long-run fiscal problems facing the U.S

•As the population ages, life expectancies increase, and health-care costs

continue to grow, expenditures on Social Security and Medicare are expected to

increase significantly, too

•Over time, there will be an escalating gap between revenues and expenditures,

which will have to be met by outright borrowing

•Economists Jagadeesh Gokhale of the Cato Institute and Kent Smetters of the

University of Pennsylvania have developed a method for estimating the present

value of the gap between the government’s revenues and expenditures and

adding it to the current national debt

•The “fiscal imbalance” is approximately $63 trillion, or five times GDP

A P P L I C A T I O N 1

DEBATE 4: CAN DEFICITS BE GOOD FOR AN

ECONOMY?

The government may deliberately run a deficit to pull the economy out

of a recession The deficit the government creates puts additional

income into the hands of the public

With more money, people don’t have to drastically cut their consumption

spending Because total spending in the economy does not fall as

much, the severity of the recession is lessened.

Deficits can also play a role in tax smoothing during periods of

unusually high government expenditures

By running deficits and only gradually raising taxes later to service the

debt, we avoid creating excess distortions in the economy.

C H A P T E R 17

Macroeconomic Policy

Debates

Five Debates About Deficits

DEBATE 5: WOULD A BALANCED-BUDGET

AMENDMENT REALLY WORK?

Proponents of the balanced-budget amendment say it will finally exert

discipline on the federal government, preventing large deficits in

peacetime, such as those that occurred in the 1980s.

Critics of a balanced-budget amendment point to many different

problems, such as the following:

• A balanced budget may not allow enough flexibility, or room, for the government to effectively deal with recessions

• The Constitution is not the right mechanism to try to enforce complicated budget rules.

• Congress could devise special budgets to get around the requirement.

• Congress could also find nonbudgetary ways to carry out the policies that it desires.

BUDGET? (cont’d)

DEBATE 1: SHOULD THE FED FOCUS ON ONLY INFLATION?

We have learned that in the long run, monetary policy can influence only the

level of prices, not the level of employment Proponents of inflation targeting

argue that the Fed should have only one primary goal: controlling inflation

Before he took over as chairman of the Federal Reserve in 2006, Ben Bernanke

was an advocate for inflation targeting Bernanke called inflation targeting a

policy of constrained discretion Under inflation targeting, the Fed could take

actions to offset shocks to real output or to the financial system, but it had to

keep its long-run inflation targets in clear view

However, many economists disagree with the idea of inflation targeting because

they strongly object to the Fed concentrating solely on controlling inflation

Economists also debate the level for an inflation target It is very difficult to

measure changes in prices accurately when there is a great deal of

technological change occurring in the economy

C H A P T E R 17

Macroeconomic Policy

Debates

WOULD A POLICY RULE HAVE PREVENTED THE

HOUSING BOOM?

APPLYING THE CONCEPTS #2: Did the Federal Reserve cause the housing boom through excessively loose monetary policy?

•John Taylor of Stanford argued that the Fed’s “easy money” policy

from mid-2001 through 2004 was responsible for the housing boom.

•The Fed lowered interest rates from 2 percent in 2001 to 1 percent

in 2004 Using the Taylor Principle, he found they should have raised

it to 4 percent.

•He showed that housing starts, which are very sensitive to interest

rates would have been much lower and the boom and bust would

have been avoided.

A P P L I C A T I O N 2

DEBATE 2: IF THERE WERE AN INFLATION TARGET, WHO

WOULD SET IT?

In the United Kingdom, which adopted targeting in 1992, the

elected government decides on the inflation target for the central

bank

In other countries, the central bank has more influence in setting

the inflation target.

Under current law, the Fed chairman reports regularly to

Congress, but the Fed has considerable power to use monetary

policy to stabilize output as well as to fight inflation as it pleases.

C H A P T E R 17

Macroeconomic Policy

Debates 17.3 SHOULD WE TAX CONSUMPTION

RATHER THAN INCOME?

● consumption taxes

Taxes based on the consumption, not the income, of individuals

Two Debates About Consumption Taxation

DEBATE 1: WILL CONSUMPTION TAXES LEAD

TO MORE SAVINGS?

There is no question that taxing consumption instead of savings

creates an incentive to save However, there’s no guarantee the

incentive will actually result in more money saved in the economy.

People will want to take advantage of this incentive and reduce

consumption and increase savings On the other hand, people will

also want to spend more because, with the tax cut, they are

wealthier.

DEBATE 2: ARE CONSUMPTION TAXES FAIR?

● capital gains

Profits investors earn when they sell stocks, bonds, real estate, or other assets

In practice, moving to a consumption-tax system could have a

major impact on the distribution of income in the economy.

Suppose we simply exempted the returns from savings from the

income tax

This exception would clearly favor wealthy and high-income

individuals who save the most and earn a lot of income in interest,

dividends, rents, and capital gains.

C H A P T E R 17

Macroeconomic Policy

Debates

Two Debates About Consumption Taxation

DEBATE 2: ARE CONSUMPTION TAXES FAIR?

RATHER THAN INCOME? (cont’d)

•Virtually all developed countries use a value-added tax; a VAT The United States is a prominent exception

•A VAT is essentially a sales tax added at each stage of production It is embedded and easy to collect, however it tends to be high; 17.5 percent in the United Kingdom

•A VAT would be regressive and might impinge on state taxing authority

C H A P T E R 17

Macroeconomic Policy

capital gains consumption taxes

monetizing the deficit Ricardian equivalence