Section 6 Review Video
Some of the fluctuations in the budget balance are due to the effects of the business cycle. In order to separate the effects of the business cycle from the effects of discretionary fiscal policy, governments estimate the cyclically adjusted budget balance, an estimate of the budget balance if the economy were at potential output.
U.S. government budget accounting is calculated on the basis of fiscal years that run from October 1 to September 30. Annual budget deficits, minus budget surpluses, accumulate into government debt. Persistent budget deficits have long-
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A widely used measure of fiscal health is the debt–
The Federal Reserve can use monetary policy to change the interest rate. In practice, this involves setting a target federal funds rate. Expansionary monetary policy reduces the interest rate by increasing the money supply. This increases investment spending and consumer spending, which in turn increases aggregate demand and real GDP in the short run. Contractionary monetary policy raises the interest rate by reducing the money supply. This reduces investment spending and consumer spending, which in turn reduces aggregate demand and real GDP in the short run.
The Federal Reserve and other central banks try to stabilize their economies, limiting fluctuations of actual output to around potential output, while also keeping inflation low but positive. Under the Taylor rule for monetary policy, the target interest rate rises when there is inflation, or a positive output gap, or both; the target interest rate falls when inflation is low or negative, or when the output gap is negative, or both. Some central banks engage in inflation targeting, which is a forward-
In the long run, changes in the money supply affect the aggregate price level but not real GDP or the interest rate. Data show that the concept of monetary neutrality holds: changes in the money supply have no real effect on the economy in the long run.
In analyzing high inflation, economists use the classical model of the price level, which says that changes in the money supply lead to proportional changes in the aggregate price level even in the short run.
Governments sometimes print money in order to finance budget deficits. When they do, they impose an inflation tax, generating tax revenue equal to the inflation rate times the money supply, on those who hold money. Revenue from the real inflation tax, the inflation rate times the real money supply, is the real value of resources captured by the government. In order to avoid paying the inflation tax, people reduce their real money holdings and force the government to increase inflation to capture the same amount of real inflation tax revenue. In some cases, this leads to a vicious circle of a shrinking real money supply and a rising rate of inflation, leading to hyperinflation and a fiscal crisis.
Countries that don’t need to print money to cover government deficits can still stumble into moderate inflation. When an increase in the price of a key input such as oil decreases aggregate supply, the result is cost-
A positive output gap is associated with lower-
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At a given point in time, there is a downward-
Once inflation has become embedded in expectations, getting inflation back down can be difficult because disinflation can be very costly, requiring the sacrifice of large amounts of aggregate output and imposing high levels of unemployment. However, policy makers in the United States and other wealthy countries were willing to pay that price of bringing down the high inflation of the 1970s.
Deflation poses several problems. It can lead to debt deflation, in which a rising real burden of outstanding debt intensifies an economic downturn. Also, interest rates are more likely to run up against the zero bound in an economy experiencing deflation. When this happens, the economy enters a liquidity trap, rendering conventional monetary policy ineffective.
Classical macroeconomics asserted that monetary policy affected only the aggregate price level, not aggregate output, and that the short run was unimportant. By the 1930s, measurement of business cycles was a well-
Keynesian economics attributed the business cycle to shifts of the aggregate demand curve, often the result of changes in business confidence. Keynesian economics also offered a rationale for macroeconomic policy activism.
In the decades that followed Keynes’s work, economists came to agree that monetary policy as well as fiscal policy is effective under certain conditions. Monetarism is a doctrine that called for a monetary policy rule as opposed to discretionary monetary policy. On the basis of the Quantity Theory of Money and a belief that the velocity of money was stable, monetarists argued that GDP would grow steadily if the money supply grew steadily. This idea was influential for a time but was eventually rejected by many macroeconomists.
The natural rate hypothesis became almost universally accepted, limiting the role of macroeconomic policy to stabilizing the economy rather than seeking a permanently low unemployment rate. Fears of a political business cycle concocted to advance the careers of the politicians in power led to a consensus that monetary policy should be insulated from politics.
Rational expectations suggests that even in the short run there might not be a trade-
New Keynesian economics argues that market imperfections can lead to price stickiness, so that changes in aggregate demand have effects on aggregate output after all.
The modern consensus is that monetary and fiscal policy are both effective in the short run but that neither can reduce the unemployment rate in the long run. Discretionary fiscal policy is considered generally unadvisable, except in special circumstances.
There are continuing debates about the appropriate role of monetary policy. Some economists advocate the explicit use of an inflation target, but others oppose it. There’s also a debate about what kind of unconventional monetary policy, if any, should be adopted to address a liquidity trap.