CH 26

CHAPTER 26
Macroeconomic
Issues and Policy
Prepared by: Fernando

Quijano and Yvonn Quijano
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Macroeconomic Issues and Policy
Using the tools of macroeconomic analysis,

we take up five issues in this chapter:
1. The effects of the stock market in the economy;
2. The way the Federal Reserve (Fed) reacts to the
state of the economy;
3. The lags in the economys response to monetary
and fiscal policy changes;
4. The legislation concerned with the federal
government budget; and
5. The cyclical behavior since 1980 of the
economies of Japan and five European countries.
The Effects of the Stock Market
on the Economy
One of the main components of household

wealth is the value of stocks held by
households.
When stock prices rise, household wealth
increases, and when stock prices fall,
household wealth decreases.
Stock prices affect the economy by
affecting household wealth, which affects
household consumption.
The Stock Market Crash
of October 1987
The stock market crash of October 1987

represented a large drop in household
wealth.
In practice, after a $1.00 decrease in
wealth, consumption seems to be lower in
each future year by about four cents, or 4
percent of the decrease in wealth.
The $1 trillion decrease in wealth in 1987
implies a $40 billion lower level of
consumption in 1988, or 1 percent of GDP.
of October 1987
The life-cycle theory of consumption

predicts that households smooth their
consumption over time.
A decrease in wealth will not decrease
consumption in the current year by the full
amount of the decrease in wealth.
Instead, they cut consumption a little each
year.
of October 1987
The stock market crash of 1987 did not

result in a recession in 1988 because
households and business firms did not
lower their expectations drastically.
Because the initial decrease in wealth
turned out to be temporary, the negative
wealth effect was not nearly as large as it
otherwise would have been.
The Stock Market
Boom of 1995 2000
Highlights of the stock market boom of 1995
2000 include the following:
It was by far the largest stock market
boom in U.S. history.
It added roughly $14 trillion to household
wealth, about $2.5 trillion per year.
About 1.7 of the 4.5 percent increase in
the growth rate of real GDP was due to the
stock market boom.
The Federal Reserves Response to
the State of the Economy
The Fed is likely to increase the money supply
during times of low output and low inflation.
The opposite is also true: The Fed is likely to
decrease the money supply during times of
high output and high inflation.
Stagflation is a more difficult problem for the
Fed.
The Feds Response to
Low Output/Low Inflation
When the economy is
on the flat portion of
the AS curve, an
increase in the money
supply will lead to an
increase in output with
very little increase in
the price level.
The Feds Response to
High Output/High Inflation
When the economy is
on the relatively steep
portion of the AS
curve, the Fed is likely
to contract the money
supply. This will lead
to a decrease in the
price level, with little
decrease in output.
The Feds Response to Stagflation
Stagflation is a more difficult problem to solve.

If the Fed expands the If the Fed contracts the
money supply, output will money supply, inflation
rise, but so will inflation. will fall, but so will output.
The Behavior of the Fed During the
1990 1991 Recession
After the Fed became convinced that a
recession was at hand, it responded by
engaging in open market operations to
lower interest rates.
Inflation was not a problem, so the Fed
could expand the economy without
worrying about inflationary pressures.
Data for Selected Variables for the
1989 2000 Period
Data for Selected Variables for the 1989 2000 Period
REAL GDP AAA FEDERAL
GROWTH UNEMPLOYMENT INFLATION THREE-MONTH BOND GOVERNMENT
QUARTER RATE (%) RATE (%) RATE (%) T-BILL RATE RATE SURPLUS SURPLUS/GDP
1989 I 5.0 5.2 4.3 8.5 9.7 108.8
108.8 0.020
II 2.2 5.2 4.0 8.4 9.5 127.3
127.3 0.023
III 1.9 5.3 2.9 7.9 9.0 140.6 0.025
IV 1.4 5.4 3.1 7.6 8.9 143.4 0.026
1990 I 5.1 5.3 4.5 7.8 9.2 172.1 0.030
II 0.9 5.3 4.7 7.8 9.4 171.2 0.030
III 0.7 5.7 3.9 7.5 9.4 164.6
164.6 0.028
IV 3.2 6.1 3.5 7.0 9.3 184.0 0.031
1991 I 2.0 6.6 4.7 6.1 8.9 160.1 0.027
II 2.3 6.8 2.9 5.6 8.9 213.4
213.4 0.036
III 1.0 6.9 2.5 5.4 8.8 234.7 0.039
IV 2.2 7.1 2.3 4.6 8.4 253.1
253.1 0.042
1992 I 3.8 7.4 3.1 3.9 8.3 288.3 0.047
II 3.8 7.6 2.2 3.7 8.3 291.8 0.046
III 3.1 7.6 1.3 3.1 8.0 316.5
316.5 0.050
IV 5.4 7.4 2.5 3.1 8.0 293.5 0.045
1993 I 0.1 7.2 3.4 3.0 7.7 300.9 0.046
II 2.5 7.1 2.2 3.0 7.4 267.3 0.041
III 1.8 6.8 1.8 3.0 6.9 275.5 0.041
IV 6.2 6.6 2.3 3.1 6.8 253.0 0.037
1994 I 3.4 6.6 2.0 3.3 7.2 237.5
237.5 0.034
II 5.7 6.2 1.8 4.0 7.9 190.6 0.027
III 2.2 6.0 2.4 4.5 8.2 211.8 0.030
IV 5.0 5.6 1.9 5.3 8.6 209.2 0.029
1989 2000 Period
1995 I 1.5 5.5 3.0 5.8 8.3 208.2
208.2 0.029
II 0.8 5.7 1.7 5.6 7.7 189.0
189.0 0.026
III 3.1 5.7 1.8 5.4 7.4 197.5 0.027
IV 3.2 5.6 2.0 5.3 7.0 173.1 0.023
1996 I 2.9 5.6 2.5 5.0 7.0 176.4 0.023
II 6.8 5.5 1.4 5.0 7.6 137.0 0.018
III 2.0 5.3 1.9 5.1 7.6 130.1
130.1 0.017
IV 4.6 5.3 1.6 5.0 7.2 103.9 0.013
1997 I 4.4 5.3 2.9 5.1 7.4 86.5 0.011
II 5.9 5.0 1.9 5.1 7.6 68.2
68.2 0.008
III 4.2 4.8 1.2 5.1 7.2 33.8 0.004
IV 2.8 4.7 1.4 5.1 6.9 25.0
25.0 0.003
1998 I 6.5 4.7 1.0 5.1 6.7 26.0 0.003
II 2.9 4.4 1.2 5.0 6.6 41.9 0.005
III 3.4 4.5 1.5 4.8 6.5 72.1 0.008
IV 5.6 4.4 1.1 4.3 6.3 56.4 0.006
1999 I 3.5 4.3 2.3 4.4 6.4 89.8 0.010
II 2.5 4.3 1.4 4.5 6.9 117.4 0.013
III 5.7 4.2 0.9 4.7 7.3 147.3 0.016
IV 8.3 4.1 1.3 5.0 7.5 143.4 0.015
2000 I 4.8 4.1 3.3 5.5 7.7 236.0 0.024
II 5.2 4.0 2.5 5.7 7.8 244.9 0.025
Note: The inflation rate is the percentage change in the GDP price index.
1989 2000 Period
1995 I 1.5 5.5 3.0 5.8 8.3 208.2
208.2 0.029
II 0.8 5.7 1.7 5.6 7.7 189.0
189.0 0.026
III 3.1 5.7 1.8 5.4 7.4 197.5 0.027
IV 3.2 5.6 2.0 5.3 7.0 173.1 0.023
1996 I 2.9 5.6 2.5 5.0 7.0 176.4 0.023
II 6.8 5.5 1.4 5.0 7.6 137.0 0.018
III 2.0 5.3 1.9 5.1 7.6 130.1
130.1 0.017
IV 4.6 5.3 1.6 5.0 7.2 103.9 0.013
1997 I 4.4 5.3 2.9 5.1 7.4 86.5 0.011
II 5.9 5.0 1.9 5.1 7.6 68.2
68.2 0.008
III 4.2 4.8 1.2 5.1 7.2 33.8 0.004
IV 2.8 4.7 1.4 5.1 6.9 25.0
25.0 0.003
1998 I 6.5 4.7 1.0 5.1 6.7 26.0 0.003
II 2.9 4.4 1.2 5.0 6.6 41.9 0.005
III 3.4 4.5 1.5 4.8 6.5 72.1 0.008
IV 5.6 4.4 1.1 4.3 6.3 56.4 0.006
1999 I 3.5 4.3 2.3 4.4 6.4 89.8 0.010
II 2.5 4.3 1.4 4.5 6.9 117.4 0.013
III 5.7 4.2 0.9 4.7 7.3 147.3 0.016
IV 8.3 4.1 1.3 5.0 7.5 143.4 0.015
2000 I 4.8 4.1 3.3 5.5 7.7 236.0 0.024
II 5.2 4.0 2.5 5.7 7.8 244.9 0.025
Note: The inflation rate is the percentage change in the GDP price index.
The Behavior of the Fed
in 1993 and 1994
During this period, inflation was not a
problem, so the Fed had room to stimulate
the economy and kept its expansionary
policy.
By the end of 1993 the Fed was worried
about inflation problems in the future, and
decided to begin slowing down the
economy.
in 1995 1997
Inflation did not become a problem after
1994, and the Fed lowered interest rates.
The three-month Treasury bill rate
remained at roughly 5.0 percent
throughout 1996 and 1997.
During this period, the economy
experienced good growth, low
unemployment, low inflation, and a
balanced government budget!
in 1998 2000
Based on concerns about the Asian
financial crisis, the Fed lowered the bill
rate to 4.3 percent in the fourth quarter of
1998.
The Asian crisis did not affect the U.S.
economy very much, and the Fed began
raising the bill rate on fears that the
economy might be overheating.
Lags in the Economys Response to
Monetary and Fiscal Policy
Stabilization policy describes both
monetary and fiscal policy, the goals of
which are to smooth out fluctuations in
output and employment and to keep prices
as stable as possible.
Time lags are delays in the economys
response to stabilization policies.
Two Time Paths for GDP
Path A is less stableit varies more over timethan

path B. Other things being equal, society prefers
path B to path A.
Stabilization: The Fool in the Shower
Attempts to stabilize the economy can prove

destabilizing because of time lags.
Milton Friedman likened these attempts to a
fool in the shower. The shower starts out
cold, so the fool turns up the hot water.
Nothing happens right away, so he turns up
the hot water further. Then, the hot water
comes on and scalds him. And the same
thing happens when he starts turning on the
cold water.
Stabilization: The Fool in the Shower
An expansionary policy that

should have begun to take
effect at point A does not
actually begin to have an
impact until point D, when the
economy is already on an
upswing. Hence, the policy
pushes the economy to points
F and G (instead of F and
G). Income varies more
widely than it would have if no
policy had been implemented.
Types of Lags
The recognition lag refers to the time it

takes for policy makers to recognize the
existence of a boom or a slump.
The implementation lag is the time it takes
to put the desired policy into effect once
economists and policy makers recognize
that the economy is in a boom or a slump.
The implementation lag for monetary policy
is generally much shorter than for fiscal
policy.
Types of Lags
The response lag is the time it takes for

the economy to adjust to the new conditions
after a new policy is implemented; the lag
that occurs because of the operation of the
economy itself.
There is a delay in the multiplier process
because neither individuals nor firms revise
their spending plans instantaneously.
Government Budget Policy
The Gramm-Rudman-
Hollings Bill, passed by
the U.S. Congress and
signed by President
Reagan in 1986, is a law
that set out to reduce the
federal deficit by $36 billion
per year, with a deficit of
zero slated for 1991.
In practice, these targets
never came close to being
achieved.
The Effects of Spending Cuts
on the Deficit
A cut in government
spending causes the
economy to contract.
Both the taxable
income of households
and the profits of firms
fall.
The deficit tends to
rise when GDP falls,
and tends to fall when
GDP rises.
The Effects of Spending Cuts
on the Deficit
The deficit response index (DRI) is the
amount by which the deficit changes with a
$1 change in GDP.
If the DRI equals .22, for example, the
deficit rises by $0.22 billion for each $1
billion decrease in GDP.
Spending cuts must be larger than the
deficit reduction we wish to achieve.
Economic Stability and
Deficit Reduction
Congress has two options:
1. Choose a target deficit and adjust
government spending and taxation to achieve
this target, or
2. Decide how much to spend and tax
regardless of the consequences on the deficit.
A negative demand shock is something
that causes a negative shift in
consumption or investment schedules or
that leads to a decrease in U.S. exports.
Deficit Reduction
Automatic stabilizers refer

to revenue and expenditure
items in the federal budget
that automatically change with
the economy in such a way as
to stabilize GDP.
Deficit Reduction
Without deficit targeting, an increase in
the deficit caused by a negative demand
shock provides an automatic stabilizer
during contractions. Tax revenues
decrease, and transfer payments rise.
With deficit targeting, taxes could be
rising or government spending declining
while the economy is experiencing a
contraction. Deficit targeting measures
have undesirable macroeconomic
consequences.
Deficit Targeting as an
Automatic Stabilizer
Business Cycles in Other Countries
The overall performance of the Japanese

economy was good until 1992, when the
growth rate slowed considerably, and the
unemployment rate rose.
The Bank of Japan eased monetary policy.
By 1999, the short-term interest rate was
essentially zero, but this monetary-policy
stimulus was not sufficient to prevent the
slowdown from lasting a number of years.
Business Cycles in Other Countries
In the United Kingdom and other European

countries, a pattern of low or negative
growth in the early 1980s, and then again
in the early 1990s, has been accompanied
by a fairly high level of unemployment.
Some say that the prevalence of high
unemployment rates is caused by
generous social welfare benefits in Europe
especially unemployment benefits.
Data for Selected Variables
for Six Countries, 1980 1999
Data for Selected Variables for Six Countries, 1980 - 1999
GDP SHORT-TERM GDP SHORT-TERM
GROWTH INFLATION UNEMPLOYMENT INTEREST GROWTH INFLATION UNEMPLOYMENT INTEREST
RATE RATE RATE RATE RATE RATE RATE RATE
United Kingdom Spain

1980 1.6 18.8 NA 15.2 2.2 13.4 NA 15.7
1981 1.3 11.4 NA 13.0 0.1 12.6 NA 15.8
1982 1.5 7.8 10.3 11.5 1.5 13.9 14.9 15.7
1983 3.6 5.3 11.1 9.6 2.2 11.8 17.5 19.8
1984 2.5 4.4 11.2 9.3 1.5 11.6 20.3 13.4
1985 3.5 5.9 11.5 11.6 1.7 7.7 21.7 10.9
1986 4.4 3.2 11.6 10.4 3.2 11.1 21.2 8.6
1987 4.8 5.0 10.6 9.3 5.6 5.8 20.6 8.0
1988 5.0 6.1 8.7 9.8 5.2 5.7 19.5 10.8
1989 2.1 7.4 7.3 13.1 4.7 7.1 17.2 13.6
1990 0.6 7.6 7.1 14.1 3.7 7.3 16.2 14.2
1991 1.5 6.7 8.9 11.0 2.3 7.1 16.4 12.5
1992 0.1 4.0 10.0 8.9 0.7 6.9 18.4 12.4
1993 2.3 2.8 10.5 5.2 1.2 4.3 22.7 10.5
1994 4.4 1.5 9.6 5.2 2.3 4.0 24.1 8.1
1995 2.8 2.5 8.7 6.3 2.7 4.8 22.9 9.8
1996 2.6 3.3 8.2 5.8 2.3 3.4 22.2 7.2
1997 3.5 2.9 7.0 6.5 3.8 2.1 20.8 5.0
1998 2.2 3.2 6.3 6.8 4.0 2.3 18.8 3.8
1999 1.7 1.6 6.1 5.0 3.7 2.5 15.9 3.0
France Italy
1980 1.3 11.7 NA 11.9 3.5 20.9 NA 15.9
1981 0.6 12.0 NA 15.3 0.5 19.1 NA 19.7
1982 2.2 12.1 7.7 14.9 0.5 17.0 6.4 19.4
1983 0.8 9.6 8.1 12.5 1.2 15.1 7.5 17.9
1984 1.3 7.5 9.7 11.7 2.6 11.6 8.0 15.4
1985 1.8 5.8 10.1 9.9 2.8 9.0 8.3 13.7
1986 2.4 5.3 10.2 7.7 2.8 7.8 9.0 11.4
1987 2.2 3.0 10.4 8.0 3.1 6.1 9.8 10.7
1988 4.2 3.1 9.8 7.5 3.9 6.8 9.8 11.1
1989 4.1 3.2 9.3 9.1 4.9 6.5 9.8 12.6
1990 2.6 2.9 9.0 9.9 2.0 8.2 9.0 12.4
1991 1.0 3.0 9.5 9.5 1.4 7.6 8.6 12.5
1992 1.5 2.0 10.4 10.4 0.8 4.5 8.8 14.3
1993 1.0 2.4 11.7 8.8 0.9 3.9 10.3 10.6
1994 2.0 1.8 12.3 5.7 2.2 3.5 11.2 9.2
1995 1.7 1.7 11.7 6.4 2.9 5.0 11.6 10.9
1996 1.1 1.4 12.4 3.7 0.9 5.2 11.7 8.5
1997 2.0 1.4 12.3 3.2 1.5 2.6 12.0 6.3
1998 3.3 0.8 11.8 3.4 1.3 2.8 11.9 4.6
1999 2.4 0.6 11.3 2.7 1.0 1.7 11.3 2.9
Germany Japan
1980 1.0 5.0 2.6 7.9 2.8 5.4 2.0 10.9
1981 0.1 4.2 4.0 10.4 3.2 4.1 2.2 7.4
1982 0.9 4.4 5.7 8.3 3.1 1.8 2.4 6.9
1983 1.8 3.2 6.9 5.6 2.3 1.8 2.7 6.4
1984 2.8 2.1 7.1 5.9 3.9 2.6 2.7 6.1
1985 2.0 2.1 7.2 5.0 4.4 2.1 2.6 6.5
1986 2.3 3.2 6.5 3.9 2.9 1.7 2.8 4.8
1987 1.5 1.9 6.3 3.3 4.2 0.1 2.8 3.5
1988 3.7 1.5 6.2 3.6 6.2 0.7 2.5 3.6
1989 3.6 2.4 5.6 6.3 4.8 2.0 2.3 4.9
1990 5.7 3.2 4.8 8.1 5.1 2.3 2.1 7.2
1991 5.1 3.9 4.2 8.3 3.8 2.7 2.1 7.5
1992 2.2 5.0 4.5 8.3 1.0 1.7 2.2 4.6
1993 1.1 3.7 7.9 6.2 0.3 0.6 2.5 3.1
1994 1.2 3.7 8.4 5.1 0.6 0.2 2.9 2.2
1995 2.9 0.8 8.2 4.4 1.5 0.6 3.1 1.2
1996 0.8 1.0 8.9 3.4 5.0 1.4 3.4 0.5
1997 1.5 0.8 9.9 3.3 1.4 0.1 3.4 0.5
1998 2.2 1.0 9.4 3.4 2.8 0.3 4.1 0.4
1999 1.3 0.6 8.7 2.9 1.4 0.0 4.7 0.1
Source: Organization for Economic Cooperation and Development (OECD) and IMF.

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CHAPTER 26

Prepared by: Fernando

Using the tools of macroeconomic analysis,

One of the main components of household

The stock market crash of October 1987

The life-cycle theory of consumption

The stock market crash of 1987 did not

Stagflation is a more difficult problem to solve.

Path A is less stableit varies more over timethan

Attempts to stabilize the economy can prove

An expansionary policy that

The recognition lag refers to the time it

The response lag is the time it takes for

Automatic stabilizers refer

The overall performance of the Japanese

In the United Kingdom and other European

United Kingdom Spain

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