Mankiw.2003.Principles.of.Economics

CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 775

however, the economics profession would turn its attention to a different source of supply shock
shifts in the short-run Phillips curve: shocks to aggregate supply.
an event that directly alters
This time, the shift in focus came not from two American economics professors firms’ costs and prices, shifting
but from a group of Arab sheiks. In 1974, the Organization of Petroleum Exporting the economy’s aggregate-supply
Countries (OPEC) began to exert its market power as a cartel in the world oil mar- curve and thus the Phillips curve
ket in order to increase its members’ profits. The countries of OPEC, such as Saudi
Arabia, Kuwait, and Iraq, restricted the amount of crude oil they pumped and sold
on world markets. Within a few years, this reduction in supply caused the price of
oil to almost double.

A large increase in the world price of oil is an example of a supply shock.
A supply shock is an event that directly affects firms’ costs of production and thus
the prices they charge; it shifts the economy’s aggregate-supply curve and, as a re-
sult, the Phillips curve. For example, when an oil price increase raises the cost of
producing gasoline, heating oil, tires, and many other products, it reduces the
quantity of goods and services supplied at any given price level. As panel (a) of
Figure 33-8 shows, this reduction in supply is represented by the leftward shift in
the aggregate-supply curve from AS1 to AS2. The price level rises from P1 to P2, and
output falls from Y1 to Y2. The combination of rising prices and falling output is
sometimes called stagflation.

(a) The Model of Aggregate Demand and Aggregate Supply (b) The Phillips Curve

Price Inflation 4. . . . giving policymakers
Level a less favorable tradeoff
AS2 Aggregate Rate between unemployment
and inflation.
supply, AS1
B
3. . . . and P2 B 1. An adverse
raises P1 A shift in aggregate A
the price supply . . .
level . . . PC 2

Aggregate Phillips curve, PC 1
demand Unemployment
Rate
0 Y2 Y1 Quantity 0

of Output

2. . . . lowers output . . .

AN ADVERSE SHOCK TO AGGREGATE SUPPLY. Panel (a) shows the model of aggregate Figure 33-8
demand and aggregate supply. When the aggregate-supply curve shifts to the left from
AS1 to AS2, the equilibrium moves from point A to point B. Output falls from Y1 to Y2, and
the price level rises from P1 to P2. Panel (b) shows the short-run tradeoff between inflation
and unemployment. The adverse shift in aggregate supply moves the economy from a
point with lower unemployment and lower inflation (point A) to a point with higher
unemployment and higher inflation (point B). The short-run Phillips curve shifts to the
right from PC1 to PC2. Policymakers now face a worse tradeoff between inflation and
unemployment.

776 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS

This shift in aggregate supply is associated with a similar shift in the short-run
Phillips curve, shown in panel (b). Because firms need fewer workers to produce
the smaller output, employment falls and unemployment rises. Because the price
level is higher, the inflation rate—the percentage change in the price level from the
previous year—is also higher. Thus, the shift in aggregate supply leads to higher
unemployment and higher inflation. The short-run tradeoff between inflation and
unemployment shifts to the right from PC1 to PC2.

Confronted with an adverse shift in aggregate supply, policymakers face a dif-
ficult choice between fighting inflation and fighting unemployment. If they con-
tract aggregate demand to fight inflation, they will raise unemployment further. If
they expand aggregate demand to fight unemployment, they will raise inflation
further. In other words, policymakers face a less favorable tradeoff between infla-
tion and unemployment than they did before the shift in aggregate supply: They
have to live with a higher rate of inflation for a given rate of unemployment, a
higher rate of unemployment for a given rate of inflation, or some combination of
higher unemployment and higher inflation.

An important question is whether this adverse shift in the Phillips curve is
temporary or permanent. The answer depends on how people adjust their expec-
tations of inflation. If people view the rise in inflation due to the supply shock as a
temporary aberration, expected inflation does not change, and the Phillips curve
will soon revert to its former position. But if people believe the shock will lead to
a new era of higher inflation, then expected inflation rises, and the Phillips curve
remains at its new, less desirable position.

In the United States during the 1970s, expected inflation did rise substantially.
This rise in expected inflation is partly attributable to the decision of the Fed to

“Remember the good old days when all the economy needed was a little fine-tuning?”

CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 777

accommodate the supply shock with higher money growth. (As we saw in Chap-
ter 31, policymakers are said to accommodate an adverse supply shock when they
respond to it by increasing aggregate demand.) Because of this policy decision, the
recession that resulted from the supply shock was smaller than it otherwise might
have been, but the U.S. economy faced an unfavorable tradeoff between inflation
and unemployment for many years. The problem was compounded in 1979, when
OPEC once again started to exert its market power, more than doubling the price
of oil. Figure 33-9 shows inflation and unemployment in the U.S. economy during
this period.

In 1980, after two OPEC supply shocks, the U.S. economy had an inflation rate
of more than 9 percent and an unemployment rate of about 7 percent. This combi-
nation of inflation and unemployment was not at all near the tradeoff that seemed
possible in the 1960s. (In the 1960s, the Phillips curve suggested that an unem-
ployment rate of 7 percent would be associated with an inflation rate of only 1 per-
cent. Inflation of more than 9 percent was unthinkable.) With the misery index in
1980 near an historic high, the public was widely dissatisfied with the performance
of the economy. Largely because of this dissatisfaction, President Jimmy Carter lost
his bid for reelection in November 1980 and was replaced by Ronald Reagan.
Something had to be done, and soon it would be.

Q U I C K Q U I Z : Give an example of a favorable shock to aggregate supply.
Use the model of aggregate demand and aggregate supply to explain the
effects of such a shock. How does it affect the Phillips curve?

Inflation Rate 1980 1981 1975 Figure 33-9
(percent per year)
1974 1979 THE SUPPLY SHOCKS
10 1978 OF THE 1970S. This figure
shows annual data from 1972 to
8 1977 1976 1981 on the unemployment rate
and on the inflation rate (as
6 1973 measured by the GDP deflator).
In the periods 1973–1975 and
4 1972 1978–1981, increases in world
oil prices led to higher inflation
2 and higher unemployment.

SOURCE: U.S. Department of Labor;
U.S. Department of Commerce.

0 1 2 3 4 5 6 7 8 9 10 Unemployment
Rate (percent)

778 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS

THE COST OF REDUCING INFLATION

In October 1979, as OPEC was imposing adverse supply shocks on the world’s
economies for the second time in a decade, Fed Chairman Paul Volcker decided
that the time for action had come. Volcker had been appointed chairman by Presi-
dent Carter only two months earlier, and he had taken the job knowing that infla-
tion had reached unacceptable levels. As guardian of the nation’s monetary
system, he felt he had little choice but to pursue a policy of disinflation—a reduc-
tion in the rate of inflation. Volcker had no doubt that the Fed could reduce infla-
tion through its ability to control the quantity of money. But what would be the
short-run cost of disinflation? The answer to this question was much less certain.

WHEN PAUL VOLCKER BECAME THE SACRIFICE RATIO
FED CHAIRMAN, INFLATION WAS
To reduce the inflation rate, the Fed has to pursue contractionary monetary policy.
WIDELY VIEWED AS ONE OF THE Figure 33-10 shows some of the effects of such a decision. When the Fed slows the
rate at which the money supply is growing, it contracts aggregate demand. The fall
NATION’S FOREMOST PROBLEMS. in aggregate demand, in turn, reduces the quantity of goods and services that
firms produce, and this fall in production leads to a fall in employment. The econ-
omy begins at point A in the figure and moves along the short-run Phillips curve
to point B, which has lower inflation and higher unemployment. Over time, as
people come to understand that prices are rising more slowly, expected inflation

Figure 33-10 Inflation Long-run 1. Contractionary policy moves
Rate Phillips curve the economy down along the
DISINFLATIONARY MONETARY short-run Phillips curve . . .
POLICY IN THE SHORT RUN 0
AND LONG RUN. When the Fed A
pursues contractionary monetary
policy to reduce inflation, the Short-run Phillips curve
economy moves along a short- with high expected
run Phillips curve from point A to inflation
point B. Over time, expected
inflation falls, and the short-run CB
Phillips curve shifts downward.
When the economy reaches point Short-run Phillips curve
C, unemployment is back at its with low expected
natural rate. inflation

Natural rate of Unemployment
unemployment 2. . . . but in the long run, expected Rate
inflation falls, and the short-run
Phillips curve shifts to the left.

CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 779

falls, and the short-run Phillips curve shifts downward. The economy moves from sacrifice ratio
point B to point C. Inflation is lower, and unemployment is back at its natural rate.
the number of percentage points
Thus, if a nation wants to reduce inflation, it must endure a period of high un- of annual output lost in the
employment and low output. In Figure 33-10, this cost is represented by the move- process of reducing inflation
ment of the economy through point B as it travels from point A to point C. The size by 1 percentage point
of this cost depends on the slope of the Phillips curve and how quickly expecta-
tions of inflation adjust to the new monetary policy.

Many studies have examined the data on inflation and unemployment in or-
der to estimate the cost of reducing inflation. The findings of these studies are of-
ten summarized in a statistic called the sacrifice ratio. The sacrifice ratio is the
number of percentage points of annual output lost in the process of reducing in-
flation by 1 percentage point. A typical estimate of the sacrifice ratio is 5. That is,
for each percentage point that inflation is reduced, 5 percent of annual output
must be sacrificed in the transition.

Such estimates surely must have made Paul Volcker apprehensive as he con-
fronted the task of reducing inflation. Inflation was running at almost 10 percent
per year. To reach moderate inflation of, say, 4 percent per year would mean re-
ducing inflation by 6 percentage points. If each percentage point cost 5 percent of
the economy’s annual output, then reducing inflation by 6 percentage points
would require sacrificing 30 percent of annual output.

According to studies of the Phillips curve and the cost of disinflation, this sac-
rifice could be paid in various ways. An immediate reduction in inflation would
depress output by 30 percent for a single year, but that outcome was surely too
harsh even for an inflation hawk like Paul Volcker. It would be better, many ar-
gued, to spread out the cost over several years. If the reduction in inflation took
place over 5 years, for instance, then output would have to average only 6 percent
below trend during that period to add up to a sacrifice of 30 percent. An even more
gradual approach would be to reduce inflation slowly over a decade, so that out-
put would have to be only 3 percent below trend. Whatever path was chosen,
however, it seemed that reducing inflation would not be easy.

RATIONAL EXPECTATIONS AND THE POSSIBILITY OF
COSTLESS DISINFLATION

Just as Paul Volcker was pondering how costly reducing inflation might be, a rational expectations
group of economics professors was leading an intellectual revolution that would
challenge the conventional wisdom on the sacrifice ratio. This group included the theory according to which
such prominent economists as Robert Lucas, Thomas Sargent, and Robert Barro. people optimally use all the
Their revolution was based on a new approach to economic theory and policy information they have,
called rational expectations. According to the theory of rational expectations, peo- including information about
ple optimally use all the information they have, including information about gov- government policies, when
ernment policies, when forecasting the future. forecasting the future

This new approach has had profound implications for many areas of macro-
economics, but none is more important than its application to the tradeoff between
inflation and unemployment. As Friedman and Phelps had first emphasized, ex-
pected inflation is an important variable that explains why there is a tradeoff be-
tween inflation and unemployment in the short run but not in the long run. How
quickly the short-run tradeoff disappears depends on how quickly expectations
adjust. Proponents of rational expectations built on the Friedman–Phelps analysis

780 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS

to argue that when economic policies change, people adjust their expectations of
inflation accordingly. Studies of inflation and unemployment that tried to estimate
the sacrifice ratio had failed to take account of the direct effect of the policy regime
on expectations. As a result, estimates of the sacrifice ratio were, according to the
rational-expectations theorists, unreliable guides for policy.

In a 1981 paper titled “The End of Four Big Inflations,” Thomas Sargent de-
scribed this new view as follows:

An alternative “rational expectations” view denies that there is any inherent
momentum to the present process of inflation. This view maintains that firms
and workers have now come to expect high rates of inflation in the future and
that they strike inflationary bargains in light of these expectations. However, it is
held that people expect high rates of inflation in the future precisely because the
government’s current and prospective monetary and fiscal policies warrant those
expectations. . . . An implication of this view is that inflation can be stopped
much more quickly than advocates of the “momentum” view have indicated and
that their estimates of the length of time and the costs of stopping inflation in
terms of foregone output are erroneous. . . . This is not to say that it would be
easy to eradicate inflation. On the contrary, it would require more than a few
temporary restrictive fiscal and monetary actions. It would require a change in
the policy regime. . . . How costly such a move would be in terms of foregone
output and how long it would be in taking effect would depend partly on how
resolute and evident the government’s commitment was.

According to Sargent, the sacrifice ratio could be much smaller than suggested by
previous estimates. Indeed, in the most extreme case, it could be zero. If the
government made a credible commitment to a policy of low inflation, people
would be rational enough to lower their expectations of inflation immediately. The
short-run Phillips curve would shift downward, and the economy would reach
low inflation quickly without the cost of temporarily high unemployment and low
output.

THE VOLCKER DISINFLATION

As we have seen, when Paul Volcker faced the prospect of reducing inflation from
its peak of about 10 percent, the economics profession offered two conflicting pre-
dictions. One group of economists offered estimates of the sacrifice ratio and con-
cluded that reducing inflation would have great cost in terms of lost output and
high unemployment. Another group offered the theory of rational expectations
and concluded that reducing inflation could be much less costly and, perhaps,
could even have no cost at all. Who was right?

Figure 33-11 shows inflation and unemployment from 1979 to 1987. As you
can see, Volcker did succeed at reducing inflation. Inflation came down from al-
most 10 percent in 1981 and 1982 to about 4 percent in 1983 and 1984. Credit for
this reduction in inflation goes completely to monetary policy. Fiscal policy at this
time was acting in the opposite direction: The increases in the budget deficit dur-
ing the Reagan administration were expanding aggregate demand, which tends to
raise inflation. The fall in inflation from 1981 to 1984 is attributable to the tough
anti-inflation policies of Fed Chairman Paul Volcker.

CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 781

Inflation Rate 1980 1981 Figure 33-11
(percent per year)
A THE VOLCKER DISINFLATION.
10 1979 This figure shows annual
data from 1979 to 1987 on
8 1982 the unemployment rate and
on the inflation rate (as
6 1984 B measured by the GDP deflator).
1983 The reduction in inflation during
4 1987 1985 this period came at the cost of
C very high unemployment in
2 1982 and 1983. Note that the
1986 points labeled A, B, and C in
this figure correspond roughly
to the points in Figure 33-10.

SOURCE: U.S. Department of Labor;
U.S. Department of Commerce.

0 1 2 3 4 5 6 7 8 9 10 Unemployment
Rate (percent)

The figure shows that the Volcker disinflation did come at the cost of high
unemployment. In 1982 and 1983, the unemployment rate was about 10 percent—
almost twice its level when Paul Volcker was appointed Fed chairman. At the same
time, the production of goods and services as measured by real GDP was well
below its trend level. (See Figure 31-1 in Chapter 31.) The Volcker disinflation
produced the deepest recession in the United States since the Great Depression of
the 1930s.

Does this experience refute the possibility of costless disinflation as suggested
by the rational-expectations theorists? Some economists have argued that the an-
swer to this question is a resounding yes. Indeed, the pattern of disinflation shown
in Figure 33-11 is very similar to the pattern predicted in Figure 33-10. To make the
transition from high inflation (point A in both figures) to low inflation (point C),
the economy had to experience a painful period of high unemployment (point B).

Yet there are two reasons not to reject the conclusions of the rational-
expectations theorists so quickly. First, even though the Volcker disinflation did
impose a cost of temporarily high unemployment, the cost was not as large as
many economists had predicted. Most estimates of the sacrifice ratio based on the
Volcker disinflation are smaller than estimates that had been obtained from previ-
ous data. Perhaps Volcker’s tough stand on inflation did have some direct effect on
expectations, as the rational-expectations theorists claimed.

Second, and more important, even though Volcker announced that he would
aim monetary policy to lower inflation, much of the public did not believe him.
Because few people thought Volcker would reduce inflation as quickly as he did,
expected inflation did not fall, and the short-run Phillips curve did not shift down
as quickly as it might have. Some evidence for this hypothesis comes from the

782 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS

forecasts made by commercial forecasting firms: Their forecasts of inflation fell
more slowly in the 1980s than did actual inflation. Thus, the Volcker disinflation
does not necessarily refute the rational-expectations view that credible disinflation
can be costless. It does show, however, that policymakers cannot count on people
immediately believing them when they announce a policy of disinflation.

THE GREENSPAN ERA

FED CHAIRMAN ALAN GREENSPAN Since the OPEC inflation of the 1970s and the Volcker disinflation of the 1980s, the
U.S. economy has experienced relatively mild fluctuations in inflation and unem-
HAS PRESIDED OVER A PERIOD OF LOW ployment. Figure 33-12 shows inflation and unemployment from 1984 to 1999.
This period is called the Greenspan era, after Alan Greenspan who in 1987 fol-
INFLATION AND RELATIVE TRANQUILLITY lowed Paul Volcker as chairman of the Federal Reserve.

IN THE ECONOMY. This period began with a favorable supply shock. In 1986, OPEC members
started arguing over production levels, and their long-standing agreement to re-
strict supply broke down. Oil prices fell by about half. As the figure shows, this fa-
vorable supply shock led to falling inflation and falling unemployment.

Since then, the Fed has been careful to avoid repeating the policy mistakes of
the 1960s, when excessive aggregate demand pushed unemployment below the
natural rate and raised inflation. When unemployment fell and inflation rose in
1989 and 1990, the Fed raised interest rates and contracted aggregate demand,
leading to a small recession in 1991. Unemployment then rose above most esti-
mates of the natural rate, and inflation fell once again.

Figure 33-12 Inflation Rate
(percent per year)
THE GREENSPAN ERA. This
figure shows annual data from 10
1984 to 1999 on the
unemployment rate and on 8
the inflation rate (as measured
by the GDP deflator). 6
During most of this period,
Alan Greenspan has been 4 1990 1991 1984
chairman of the Federal 1989
Reserve. Fluctuations in
inflation and unemployment 1988 1985
have been relatively small.
1987 1992
SOURCE: U.S. Department of Labor; 1995
U.S. Department of Commerce.
2 1997 1994 1986

1999 1996 1993

1998

0 1 2 3 4 5 6 7 8 9 10 Unemployment
Rate (percent)

CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 783

The rest of the 1990s witnessed a period of economic prosperity. Inflation
gradually drifted downward, approaching zero by the end of the decade. Unem-
ployment also drifted downward, leading many observers to believe that the nat-
ural rate of unemployment had fallen. Part of the credit for this good economic
performance goes to Alan Greenspan and his colleagues at the Federal Reserve, for
low inflation can be achieved only with prudent monetary policy. But as the fol-
lowing case study discusses, good luck in the form of favorable supply shocks is
also part of the story.

What does the future hold? Macroeconomists are notoriously bad at fore-
casting, but several lessons of the past are clear. First, as long as the Fed remains
vigilant in its control over the money supply and, thereby, aggregate demand,
there is no reason to allow inflation to heat up needlessly, as it did in the late 1960s.
Second, the possibility always exists for the economy to experience adverse shocks
to aggregate supply, as it did in the 1970s. If that unfortunate development occurs,
policymakers will have little choice but to confront a less desirable tradeoff
between inflation and unemployment.

C A S E S T U D Y WHY WERE INFLATION AND UNEMPLOYMENT
SO LOW AT THE END OF THE 1990S?

As the twentieth century drew to a close, the U.S. economy was experiencing
some of the lowest rates of inflation and unemployment in many years. In 1999,
for instance, unemployment had fallen to 4.2 percent, while inflation was
running a mere 1.3 percent per year. As measured by these two important
macroeconomic variables, the United States was enjoying a period of unusual
prosperity.

Some observers argued that this experience cast doubt on the theory of the
Phillips curve. Indeed, the combination of low inflation and low unemployment
might seem to suggest that there was no longer a tradeoff between these
two variables. Yet most economists took a less radical view of events. As we
have discussed throughout this chapter, the short-run tradeoff between infla-
tion and unemployment shifts over time. In the 1990s, this tradeoff shifted left-
ward, allowing the economy to enjoy low unemployment and low inflation
simultaneously.

What caused this favorable shift in the short-run Phillips curve? Part of the
answer lies in a fall in expected inflation. Under Paul Volcker and Alan
Greenspan, the Fed pursued a policy aimed at reducing inflation and keeping it
low. Over time, as this policy succeeded, the Fed gained credibility with the
public that it would continue to fight inflation as necessary. The increased cred-
ibility lowered inflation expectations, which shifted the short-run Phillips curve
to the left.

In addition to this shift from reduced expected inflation, many economists
believe that the U.S. economy experienced some favorable supply shocks
during this period. (Recall that a favorable supply shock shifts the short-run
aggregate-supply curve to the right, raising output and reducing prices. It
therefore reduces both unemployment and inflation and shifts the short-run
Phillips curve to the left.) Here are three events that may get credit for the
favorable shift to aggregate supply:

784 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS

N Declining Commodity Prices. In the late 1990s, the prices of many basic
commodities fell on world markets. This fall in commodity prices, in turn,
was partly due to a deep recession in Japan and other Asian economies,
which reduced the demand for these products. Because commodities are
an important input into production, the fall in their prices reduced
producers’ costs and acted as a favorable supply shock for the U.S.
economy.

N Labor-Market Changes. Some economists believe that the aging of the large
baby-boom generation born after World War II has caused fundamental
changes in the labor market. Because older workers are typically in more
stable jobs than younger workers, an increase in the average age of the
labor force may reduce the economy’s natural rate of unemployment.

N Technological Advance. Some economists think the U.S. economy has
entered a period of more rapid technological progress. Advances in
information technology, such as the Internet, have been profound and
have influenced many parts of the economy. Such technological advance
increases productivity and, therefore, is a type of favorable supply shock.

Economists debate which of these explanations of the shifting Phillips curve is
most plausible. In the end, the complete story may contain elements of each.

Keep in mind that none of these hypotheses denies the fundamental lesson
of the Phillips curve—that policymakers who control aggregate demand always
face a short-run tradeoff between inflation and unemployment. Yet the 1990s
remind us that this short-run tradeoff changes over time, sometimes in ways
that are hard to predict.

Q U I C K Q U I Z : What is the sacrifice ratio? How might the credibility of the
Fed’s commitment to reduce inflation affect the sacrifice ratio?

CONCLUSION

This chapter has examined how economists’ thinking about inflation and unem-
ployment has evolved over time. We have discussed the ideas of many of the best
economists of the twentieth century: from the Phillips curve of Phillips, Samuel-
son, and Solow, to the natural-rate hypothesis of Friedman and Phelps, to the
rational-expectations theory of Lucas, Sargent, and Barro. Four of this group have
already won Nobel prizes for their work in economics, and more are likely to be so
honored in the years to come.

Although the tradeoff between inflation and unemployment has generated
much intellectual turmoil over the past 40 years, certain principles have developed
that today command consensus. Here is how Milton Friedman expressed the rela-
tionship between inflation and unemployment in 1968:

There is always a temporary tradeoff between inflation and unemployment;
there is no permanent tradeoff. The temporary tradeoff comes not from inflation
per se, but from unanticipated inflation, which generally means, from a rising

CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 785

rate of inflation. The widespread belief that there is a permanent tradeoff is a
sophisticated version of the confusion between “high” and “rising” that we all
recognize in simpler forms. A rising rate of inflation may reduce unemployment,
a high rate will not.

But how long, you will say, is “temporary”? . . . I can at most venture a
personal judgment, based on some examination of the historical evidence, that
the initial effects of a higher and unanticipated rate of inflation last for something
like two to five years.

Today, more than 30 years later, this statement still summarizes the view of most
macroeconomists.

Summary

N The Phillips curve describes a negative relationship such as the increase in world oil prices during the 1970s,
between inflation and unemployment. By expanding gives policymakers a less favorable tradeoff between
aggregate demand, policymakers can choose a point on inflation and unemployment. That is, after an adverse
the Phillips curve with higher inflation and lower supply shock, policymakers have to accept a higher rate
unemployment. By contracting aggregate demand, of inflation for any given rate of unemployment, or a
policymakers can choose a point on the Phillips curve higher rate of unemployment for any given rate of
with lower inflation and higher unemployment. inflation.

N The tradeoff between inflation and unemployment N When the Fed contracts growth in the money supply to
described by the Phillips curve holds only in the short reduce inflation, it moves the economy along the short-
run. In the long run, expected inflation adjusts to run Phillips curve, which results in temporarily high
changes in actual inflation, and the short-run Phillips unemployment. The cost of disinflation depends on
curve shifts. As a result, the long-run Phillips curve is how quickly expectations of inflation fall. Some
vertical at the natural rate of unemployment. economists argue that a credible commitment to low
inflation can reduce the cost of disinflation by inducing
N The short-run Phillips curve also shifts because of a quick adjustment of expectations.
shocks to aggregate supply. An adverse supply shock,

Phillips curve, p. 763 Key Concepts rational expectations, p. 779
natural-rate hypothesis, p. 772
supply shock, p. 775
sacrifice ratio, p. 779

Questions for Review

1. Draw the short-run tradeoff between inflation and 4. Suppose a drought destroys farm crops and drives up
unemployment. How might the Fed move the economy the price of food. What is the effect on the short-run
from one point on this curve to another? tradeoff between inflation and unemployment?

2. Draw the long-run tradeoff between inflation and 5. The Fed decides to reduce inflation. Use the Phillips
unemployment. Explain how the short-run and long- curve to show the short-run and long-run effects
run tradeoffs are related. of this policy. How might the short-run costs be
reduced?
3. What’s so natural about the natural rate of
unemployment? Why might the natural rate
of unemployment differ across countries?

786 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS

Problems and Applications

1. Suppose the natural rate of unemployment is 6 percent. economy to its original inflation rate and original
On one graph, draw two Phillips curves that can be unemployment rate? If the Fed undertakes
used to describe the four situations listed below. Label contractionary monetary policy, can it return the
the point that shows the position of the economy in each economy to its original inflation rate and original
case: unemployment rate? Explain why this situation
a. Actual inflation is 5 percent and expected inflation differs from that in part (b).
is 3 percent.
b. Actual inflation is 3 percent and expected inflation 5. Suppose the Federal Reserve believed that the natural
is 5 percent. rate of unemployment was 6 percent when the actual
c. Actual inflation is 5 percent and expected inflation natural rate was 5.5 percent. If the Fed based its policy
is 5 percent. decisions on its belief, what would happen to the
d. Actual inflation is 3 percent and expected inflation economy?
is 3 percent.
6. The price of oil fell sharply in 1986 and again in 1998.
2. Illustrate the effects of the following developments on a. Show the impact of such a change in both the
both the short-run and long-run Phillips curves. Give aggregate-demand/aggregate-supply diagram and
the economic reasoning underlying your answers. in the Phillips-curve diagram. What happens to
a. a rise in the natural rate of unemployment inflation and unemployment in the short run?
b. a decline in the price of imported oil b. Do the effects of this event mean there is no short-
c. a rise in government spending run tradeoff between inflation and unemployment?
d. a decline in expected inflation Why or why not?

3. Suppose that a fall in consumer spending causes a 7. Suppose the Federal Reserve announced that it would
recession. pursue contractionary monetary policy in order to
a. Illustrate the changes in the economy using both an reduce the inflation rate. Would the following
aggregate-supply/aggregate-demand diagram and conditions make the ensuing recession more or less
a Phillips-curve diagram. What happens to inflation severe? Explain.
and unemployment in the short run? a. Wage contracts have short durations.
b. Now suppose that over time expected inflation b. There is little confidence in the Fed’s determination
changes in the same direction that actual inflation to reduce inflation.
changes. What happens to the position of the short- c. Expectations of inflation adjust quickly to actual
run Phillips curve? After the recession is over, does inflation.
the economy face a better or worse set of inflation–
unemployment combinations? 8. Some economists believe that the short-run Phillips
curve is relatively steep and shifts quickly in response to
4. Suppose the economy is in a long-run equilibrium. changes in the economy. Would these economists be
a. Draw the economy’s short-run and long-run more or less likely to favor contractionary policy in
Phillips curves. order to reduce inflation than economists who had the
b. Suppose a wave of business pessimism reduces opposite views?
aggregate demand. Show the effect of this shock on
your diagram from part (a). If the Fed undertakes 9. Imagine an economy in which all wages are set in three-
expansionary monetary policy, can it return the year contracts. In this world, the Fed announces a
economy to its original inflation rate and original disinflationary change in monetary policy to begin
unemployment rate? immediately. Everyone in the economy believes the
c. Now suppose the economy is back in long-run Fed’s announcement. Would this disinflation be
equilibrium, and then the price of imported oil costless? Why or why not? What might the Fed do to
rises. Show the effect of this shock with a new reduce the cost of disinflation?
diagram like that in part (a). If the Fed undertakes
expansionary monetary policy, can it return the 10. Given the unpopularity of inflation, why don’t elected
leaders always support efforts to reduce inflation?
Economists believe that countries can reduce the cost

CHAPTER 33 THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT 787

of disinflation by letting their central banks make to its natural rate. Unfortunately, because the natural
decisions about monetary policy without interference rate of unemployment can change over time, they aren’t
from politicians. Why might this be so? certain about the value of the natural rate. What
macroeconomic variables do you think they should look
11. Suppose Federal Reserve policymakers accept the at when conducting monetary policy?
theory of the short-run Phillips curve and the natural-
rate hypothesis and want to keep unemployment close



IN THIS CHAPTER
YOU WILL . . .

Consider whether
policymakers should

try to stabilize
the economy

Consider whether
monetary policy
should be made by
rule rather than

by discretion

FIVE DEBATES OVER Consider whether the
central bank should
MACROECONOMIC POLICY aim for zero inflation

It is hard to open up the newspaper without finding some politician or editorial Consider whether
writer advocating a change in economic policy. The president should use the bud- fiscal policymakers
get surplus to reduce government debt, or he should use it to increase government should reduce the
spending. The Federal Reserve should cut interest rates to stimulate a flagging
economy, or it should avoid such moves in order not to risk higher inflation. Con- government debt
gress should reform the tax system to promote faster economic growth, or it
should reform the tax system to achieve a more equal distribution of income. Eco- Consider whether
nomic issues are central to the continuing political debate in the United States and the tax laws should
other countries around the world. It is no surprise that when Bill Clinton first ran
for president in 1992, his chief strategist posted a sign to remind the staff of the be reformed to
central campaign issue: “The economy, stupid.” encourage saving

The previous dozen chapters have developed the tools that economists use
when analyzing the behavior of the economy as a whole and the impact of policies

791

792 PART THIRTEEN FINAL THOUGHTS

on the economy. This final chapter presents both sides in five leading debates over
macroeconomic policy. The knowledge you have accumulated in this course pro-
vides the background with which we can discuss these important, unsettled is-
sues. It should help you choose a side in these debates or, at least, help you see
why choosing a side is so difficult.

SHOULD MONETARY AND FISCAL POLICYMAKERS
TRY TO STABILIZE THE ECONOMY?

In Chapters 31, 32, and 33, we saw how changes in aggregate demand and aggre-
gate supply can lead to short-run fluctuations in production and employment. We
also saw how monetary and fiscal policy can shift aggregate demand and, thereby,
influence these fluctuations. But even if policymakers can influence short-run eco-
nomic fluctuations, does that mean they should? Our first debate concerns whether
monetary and fiscal policymakers should use the tools at their disposal in an at-
tempt to smooth the ups and downs of the business cycle.

PRO: POLICYMAKERS SHOULD TRY
TO STABILIZE THE ECONOMY

Left on their own, economies tend to fluctuate. When households and firms be-
come pessimistic, for instance, they cut back on spending, and this reduces the ag-
gregate demand for goods and services. The fall in aggregate demand, in turn,
reduces the production of goods and services. Firms lay off workers, and the un-
employment rate rises. Real GDP and other measures of income fall. Rising unem-
ployment and falling income help confirm the pessimism that initially generated
the economic downturn.

Such a recession has no benefit for society—it represents a sheer waste of re-
sources. Workers who become unemployed because of inadequate aggregate de-
mand would rather be working. Business owners whose factories are left idle
during a recession would rather be producing valuable goods and services and
selling them at a profit.

There is no reason for society to suffer through the booms and busts of the
business cycle. The development of macroeconomic theory has shown policy-
makers how to reduce the severity of economic fluctuations. By “leaning against
the wind” of economic change, monetary and fiscal policy can stabilize aggregate
demand and, thereby, production and employment. When aggregate demand is
inadequate to ensure full employment, policymakers should boost government
spending, cut taxes, and expand the money supply. When aggregate demand
is excessive, risking higher inflation, policymakers should cut government
spending, raise taxes, and reduce the money supply. Such policy actions put
macroeconomic theory to its best use by leading to a more stable economy, which
benefits everyone.

CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 793

CON: POLICYMAKERS SHOULD NOT TRY
TO STABILIZE THE ECONOMY

Although monetary and fiscal policy can be used to stabilize the economy in the-
ory, there are substantial obstacles to the use of such policies in practice.

One problem is that monetary and fiscal policy do not affect the economy im-
mediately but instead work with a long lag. Monetary policy affects aggregate de-
mand by changing interest rates, which in turn affect spending, especially
residential and business investment. But many households and firms set their
spending plans in advance. As a result, it takes time for changes in interest rates to
alter the aggregate demand for goods and services. Many studies indicate that
changes in monetary policy have little effect on aggregate demand until about six
months after the change is made.

Fiscal policy works with a lag because of the long political process that gov-
erns changes in spending and taxes. To make any change in fiscal policy, a bill
must go through congressional committees, pass both the House and the Senate,
and be signed by the president. It can take years to propose, pass, and implement
a major change in fiscal policy.

Because of these long lags, policymakers who want to stabilize the economy
need to look ahead to economic conditions that are likely to prevail when their ac-
tions will take effect. Unfortunately, economic forecasting is highly imprecise, in
part because macroeconomics is such a primitive science and in part because the
shocks that cause economic fluctuations are intrinsically unpredictable. Thus,
when policymakers change monetary or fiscal policy, they must rely on educated
guesses about future economic conditions.

All too often, policymakers trying to stabilize the economy do just the oppo-
site. Economic conditions can easily change between the time when a policy action
begins and when it takes effect. Because of this, policymakers can inadvertently

794 PART THIRTEEN FINAL THOUGHTS

exacerbate rather than mitigate the magnitude of economic fluctuations. Some
economists have claimed that many of the major economic fluctuations in history,
including the Great Depression of the 1930s, can be traced to destabilizing policy
actions.

One of the first rules taught to physicians is “do no harm.” The human body
has natural restorative powers. Confronted with a sick patient and an uncertain
diagnosis, often a doctor should do nothing but leave the patient’s body to its own
devices. Intervening in the absence of reliable knowledge merely risks making
matters worse.

The same can be said about treating an ailing economy. It might be desirable if
policymakers could eliminate all economic fluctuations, but that is not a realistic
goal given the limits of macroeconomic knowledge and the inherent un-
predictability of world events. Economic policymakers should refrain from inter-
vening often with monetary and fiscal policy and be content if they do no harm.

Q U I C K Q U I Z : Explain why monetary and fiscal policy work with a lag.
Why do these lags matter in the choice between active and passive policy?

SHOULD MONETARY POLICY BE MADE BY RULE
RATHER THAN BY DISCRETION?

As we first discussed in Chapter 27, the Federal Open Market Committee sets
monetary policy in the United States. The committee meets about every six
weeks to evaluate the state of the economy. Based on this evaluation and fore-
casts of future economic conditions, it chooses whether to raise, lower, or leave un-
changed the level of short-term interest rates. The Fed then adjusts the money
supply to reach that interest-rate target until the next meeting, when the target is
reevaluated.

The Federal Open Market Committee operates with almost complete discre-
tion over how to conduct monetary policy. The laws that created the Fed give the
institution only vague recommendations about what goals it should pursue. And
they do not tell the Fed how to pursue whatever goals it might choose. Once mem-
bers are appointed to the Federal Open Market Committee, they have little man-
date but to “do the right thing.”

Some economists are critical of this institutional design. Our second debate
over macroeconomic policy, therefore, focuses on whether the Federal Reserve
should have its discretionary powers reduced and, instead, be committed to fol-
lowing a rule for how it conducts monetary policy.

PRO: MONETARY POLICY SHOULD BE MADE BY RULE

Discretion in the conduct of monetary policy has two problems. The first is that it
does not limit incompetence and abuse of power. When the government sends

CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 795

police into a community to maintain civic order, it gives them strict guidelines
about how to carry out their job. Because police have great power, allowing them
to exercise that power in whatever way they want would be dangerous. Yet when
the government gives central bankers the authority to maintain economic order,
it gives them no guidelines. Monetary policymakers are allowed undisciplined
discretion.

As an example of abuse of power, central bankers are sometimes tempted to
use monetary policy to affect the outcome of elections. Suppose that the vote for
the incumbent president is based on economic conditions at the time he is up for
reelection. A central banker sympathetic to the incumbent might be tempted to
pursue expansionary policies just before the election to stimulate production and
employment, knowing that the resulting inflation will not show up until after the
election. Thus, to the extent that central bankers ally themselves with politicians,
discretionary policy can lead to economic fluctuations that reflect the electoral cal-
endar. Economists call such fluctuations the political business cycle.

The second, more subtle, problem with discretionary monetary policy is that
it might lead to more inflation than is desirable. Central bankers, knowing that
there is no long-run tradeoff between inflation and unemployment, often an-
nounce that their goal is zero inflation. Yet they rarely achieve price stability.
Why? Perhaps it is because, once the public forms expectations of inflation,
policymakers face a short-run tradeoff between inflation and unemployment.
They are tempted to renege on their announcement of price stability in order to
achieve lower unemployment. This discrepancy between announcements (what
policymakers say they are going to do) and actions (what they subsequently in
fact do) is called the time inconsistency of policy. Because policymakers are so often
time inconsistent, people are skeptical when central bankers announce their in-
tentions to reduce the rate of inflation. As a result, people always expect more
inflation than monetary policymakers claim they are trying to achieve. Higher ex-
pectations of inflation, in turn, shift the short-run Phillips curve upward, making
the short-run tradeoff between inflation and unemployment less favorable than it
otherwise might be.

One way to avoid these two problems with discretionary policy is to commit
the central bank to a policy rule. For example, suppose that Congress passed a law
requiring the Fed to increase the money supply by exactly 3 percent per year. (Why
3 percent? Because real GDP grows on average about 3 percent per year and be-
cause money demand grows with real GDP, 3 percent growth in the money supply
is roughly the rate necessary to produce long-run price stability.) Such a law would
eliminate incompetence and abuse of power on the part of the Fed, and it would
make the political business cycle impossible. In addition, policy could no longer be
time inconsistent. People would now believe the Fed’s announcement of low in-
flation because the Fed would be legally required to pursue a low-inflation mone-
tary policy. With low expected inflation, the economy would face a more favorable
short-run tradeoff between inflation and unemployment.

Other rules for monetary policy are also possible. A more active rule might al-
low some feedback from the state of the economy to changes in monetary policy.
For example, a more active rule might require the Fed to increase monetary growth
by 1 percentage point for every percentage point that unemployment rises above
its natural rate. Regardless of the precise form of the rule, committing the Fed to
some rule would yield advantages by limiting incompetence, abuse of power, and
time inconsistency in the conduct of monetary policy.

796 PART THIRTEEN FINAL THOUGHTS

IN THE NEWS In an interview, Mr. Fraga said the micromanage than if it is trying to target
Inflation Targeting Central Bank is in the process of work- the level of interest rates or the cur-
ing out the details of an “inflation target- rency,” says Morgan Stanley Dean Wit-
DURING THE 1990S, MANY CENTRAL BANKS ing” regime for managing interest rates ter & Co. economist Ernest W. Brown.
around the world adopted inflation and the economy. Inflation targeting— The downside of setting explicit targets
targeting as a rule—or at least as a a system used by other countries with is that a hard-to-predict economy without
rough guide—for setting monetary free-floating currencies such as Britain, price controls like Brazil’s is apt to miss
policy. Brazil is a recent example. Canada, and New Zealand—is fairly sim- its inflation targets from time to time, and
ple: If prices are rising faster than expec- miss them publicly.
Brazil to Use Inflation Data for tations, interest rates are lifted to cool
Managing Interest Rates off the economy. If prices are falling or That causes some to worry about
steady, rates are cut. . . . the Brazilian Central Bank’s lack of inde-
BY PETER FRITSCH pendence. Brazil’s Central Bank reports
RIO DE JANEIRO—Brazil’s Central Bank Once in place, Brazil’s new policy to the Finance Ministry, and thus to the
will adopt in late June a formal process will look like the Bank of England’s. president. What if missing—or hitting—
for managing interest rates based on Britain’s central bank hitched interest- an inflation target clashes with other ad-
predefined inflation targets for the fol- rate policy to a more visible price anchor ministration goals, such as reducing
lowing 30 months, according to the after the inflationary shock of the unemployment? “Inflation targeting goes
bank’s president, Arminio Fraga. pound’s severe weakening in 1992. To- in the right direction of trying to insulate
day, the United Kingdom targets annual the Central Bank from politics,” says
inflation at 2.5% over a two-year horizon J. P. Morgan & Co. economist Marcelo
and adjusts short-term interest rates Carvalho. “Still, introducing inflation tar-
when its price forecasts wander from geting without proper formal Central
that goal by more than a percentage Bank independence risks just pouring
point. old wine into new bottles.”

In general, outside observers like SOURCE: The Wall Street Journal, May 22, 1999,
the simplicity of this policy. “The ad- p. A8.
vantage of targeting inflation is that
the Central Bank is less likely to

CON: MONETARY POLICY SHOULD NOT BE MADE BY RULE

Although there may be pitfalls with discretionary monetary policy, there is also an
important advantage to it: flexibility. The Fed has to confront various circum-
stances, not all of which can be foreseen. In the 1930s banks failed in record num-
bers. In the 1970s the price of oil skyrocketed around the world. In October 1987
the stock market fell by 22 percent in a single day. The Fed must decide how to re-
spond to these shocks to the economy. A designer of a policy rule could not possi-
bly consider all the contingencies and specify in advance the right policy response.
It is better to appoint good people to conduct monetary policy and then give them
the freedom to do the best they can.

Moreover, the alleged problems with discretion are largely hypothetical. The
practical importance of the political business cycle, for instance, is far from clear.
In some cases, just the opposite seems to occur. For example, President Jimmy
Carter appointed Paul Volcker to head the Federal Reserve in 1979. Nonetheless, in

CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 797

October of that year Volcker moved to contract monetary policy to combat the
high rate of inflation that he had inherited from his predecessor. The predictable
result of Volcker’s decision was a recession, and the predictable result of the reces-
sion was a decline in Carter’s popularity. Rather than using monetary policy to
help the president who had appointed him, Volcker helped to ensure Carter’s de-
feat by Ronald Reagan in the November 1980 election.

The practical importance of time inconsistency is also far from clear. Although
most people are skeptical of central-bank announcements, central bankers can
achieve credibility over time by backing up their words with actions. In the 1990s,
the Fed achieved and maintained a low rate of inflation, despite the ever present
temptation to take advantage of the short-run tradeoff between inflation and un-
employment. This experience shows that low inflation does not require that the
Fed be committed to a policy rule.

Any attempt to replace discretion with a rule must confront the difficult task
of specifying a precise rule. Despite much research examining the costs and bene-
fits of alternative rules, economists have not reached a consensus about what a
good rule would be. Until there is a consensus, society has little choice but to give
central bankers discretion to conduct monetary policy as they see fit.

Q U I C K Q U I Z : Give an example of a monetary policy rule. Why might
your rule be better than discretionary policy? Why might it be worse?

SHOULD THE CENTRAL BANK
AIM FOR ZERO INFLATION?

One of the Ten Principles of Economics discussed in Chapter 1, and developed more
fully in Chapter 28, is that prices rise when the government prints too much
money. Another of the Ten Principles of Economics discussed in Chapter 1, and de-
veloped more fully in Chapter 33, is that society faces a short-run tradeoff between
inflation and unemployment. Put together, these two principles raise a question
for policymakers: How much inflation should the central bank be willing to toler-
ate? Our third debate is whether zero is the right target for the inflation rate.

PRO: THE CENTRAL BANK SHOULD
AIM FOR ZERO INFLATION

Inflation confers no benefit on society, but it imposes several real costs. As we dis-
cussed in Chapter 28, economists have identified six costs of inflation:

N Shoeleather costs associated with reduced money holdings
N Menu costs associated with more frequent adjustment of prices
N Increased variability of relative prices
N Unintended changes in tax liabilities due to nonindexation of the tax code

798 PART THIRTEEN FINAL THOUGHTS

N Confusion and inconvenience resulting from a changing unit of account

N Arbitrary redistributions of wealth associated with dollar-denominated debts

Some economists argue that these costs are small, at least for moderate rates of in-
flation, such as the 3 percent inflation experienced in the United States during the
1990s. But other economists claim these costs can be substantial, even for moder-
ate inflation. Moreover, there is no doubt that the public dislikes inflation. When
inflation heats up, opinion polls identify inflation as one of the nation’s leading
problems.

Of course, the benefits of zero inflation have to be weighed against the costs of
achieving it. Reducing inflation usually requires a period of high unemployment
and low output, as illustrated by the short-run Phillips curve. But this disinfla-
tionary recession is only temporary. Once people come to understand that policy-
makers are aiming for zero inflation, expectations of inflation will fall, and the
short-run tradeoff will improve. Because expectations adjust, there is no tradeoff
between inflation and unemployment in the long run.

Reducing inflation is, therefore, a policy with temporary costs and permanent
benefits. That is, once the disinflationary recession is over, the benefits of zero in-
flation would persist into the future. If policymakers are farsighted, they should be
willing to incur the temporary costs for the permanent benefits. This is precisely
the calculation made by Paul Volcker in the early 1980s, when he tightened mone-
tary policy and reduced inflation from about 10 percent in 1980 to about 4 percent
in 1983. Although in 1982 unemployment reached its highest level since the Great
Depression, the economy eventually recovered from the recession, leaving a legacy
of low inflation. Today Volcker is considered a hero among central bankers.

Moreover, the costs of reducing inflation need not be as large as some econo-
mists claim. If the Fed announces a credible commitment to zero inflation, it can
directly influence expectations of inflation. Such a change in expectations can im-
prove the short-run tradeoff between inflation and unemployment, allowing the
economy to reach lower inflation at a reduced cost. The key to this strategy is cred-
ibility: People must believe that the Fed is actually going to carry through on its
announced policy. Congress could help in this regard by passing legislation that
made price stability the Fed’s primary goal. Such a law would make it less costly
to achieve zero inflation without reducing any of the resulting benefits.

One advantage of a zero-inflation target is that zero provides a more natural
focal point for policymakers than any other number. Suppose, for instance, that the
Fed were to announce that it would keep inflation at 3 percent—the rate experi-
enced during the 1990s. Would the Fed really stick to that 3 percent target? If
events inadvertently pushed inflation up to 4 or 5 percent, why wouldn’t they just
raise the target? There is, after all, nothing special about the number 3. By contrast,
zero is the only number for the inflation rate at which the Fed can claim that it
achieved price stability and fully eliminated the costs of inflation.

CON: THE CENTRAL BANK SHOULD NOT
AIM FOR ZERO INFLATION

Although price stability may be desirable, the benefits of zero inflation compared
to moderate inflation are small, whereas the costs of reaching zero inflation are

CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 799

large. Estimates of the sacrifice ratio suggest that reducing inflation by 1 percent-
age point requires giving up about 5 percent of one year’s output. Reducing infla-
tion from, say, 4 percent to zero requires a loss of 20 percent of a year’s output. At
the current level of gross domestic product of about $9 trillion, this cost translates
into $1.8 trillion of lost output, which is about $6,500 per person. Although people
might dislike inflation, it is not at all clear that they would (or should) be willing
to pay this much to get rid of it.

The social costs of disinflation are even larger than this $6,500 figure suggests,
for the lost income is not spread equitably over the population. When the econ-
omy goes into recession, all incomes do not fall proportionately. Instead, the
fall in aggregate income is concentrated on those workers who lose their jobs.
The vulnerable workers are often those with the least skills and experience.
Hence, much of the cost of reducing inflation is borne by those who can least af-
ford to pay it.

Although economists can list several costs of inflation, there is no professional
consensus that these costs are substantial. The shoeleather costs, menu costs, and
others that economists have identified do not seem great, at least for moderate
rates of inflation. It is true that the public dislikes inflation, but the public may be
misled into believing the inflation fallacy—the view that inflation erodes living
standards. Economists understand that living standards depend on productivity,
not monetary policy. Because inflation in nominal incomes goes hand in hand with
inflation in prices, reducing inflation would not cause real incomes to rise more
rapidly.

Moreover, policymakers can reduce many of the costs of inflation without ac-
tually reducing inflation. They can eliminate the problems associated with the
nonindexed tax system by rewriting the tax laws to take account of the effects of
inflation. They can also reduce the arbitrary redistributions of wealth between
creditors and debtors caused by unexpected inflation by issuing indexed govern-
ment bonds, as in fact the Clinton administration did in 1997. Such an act insulates
holders of government debt from inflation. In addition, by setting an example, it
might encourage private borrowers and lenders to write debt contracts indexed for
inflation.

Reducing inflation might be desirable if it could be done at no cost, as some
economists argue is possible. Yet this trick seems hard to carry out in practice.
When economies reduce their rate of inflation, they almost always experience a pe-
riod of high unemployment and low output. It is risky to believe that the central
bank could achieve credibility so quickly as to make disinflation painless.

Indeed, a disinflationary recession can potentially leave permanent scars on
the economy. Firms in all industries reduce their spending on new plants and
equipment substantially during recessions, making investment the most volatile
component of GDP. Even after the recession is over, the smaller stock of capital re-
duces productivity, incomes, and living standards below the levels they otherwise
would have achieved. In addition, when workers become unemployed in reces-
sions, they lose valuable job skills. Even after the economy has recovered, their
value as workers is diminished. Some economists have argued that the high un-
employment in many European economies during the past decade is the aftermath
of the disinflations of the 1980s.

Why should policymakers put the economy through a costly, inequitable dis-
inflationary recession to achieve zero inflation, which may have only modest ben-
efits? Economist Alan Blinder, whom Bill Clinton appointed to be vice chairman of

800 PART THIRTEEN FINAL THOUGHTS

the Federal Reserve, argued forcefully in his book Hard Heads, Soft Hearts that
policymakers should not make this choice:

The costs that attend the low and moderate inflation rates experienced in the
United States and in other industrial countries appear to be quite modest—more
like a bad cold than a cancer on society. . . . As rational individuals, we do not
volunteer for a lobotomy to cure a head cold. Yet, as a collectivity, we routinely
prescribe the economic equivalent of lobotomy (high unemployment) as a cure
for the inflationary cold.

Blinder concludes that it is better to learn to live with moderate inflation.

Q U I C K Q U I Z : Explain the costs and benefits of reducing inflation to zero.
Which are temporary and which are permanent?

SHOULD FISCAL POLICYMAKERS
REDUCE THE GOVERNMENT DEBT?

Perhaps the most persistent macroeconomic debate in recent years has been over
the finances of the federal government. Throughout most of the 1980s and 1990s,
the U.S. federal government spent more than it collected in tax revenue and fi-
nanced this budget deficit by issuing government debt. When we studied financial
markets in Chapter 25, we saw how budget deficits affect saving, investment, and
interest rates.

This situation reversed itself in the late 1990s, when a combination of tax hikes,
spending cuts, and strong economic growth eliminated the government’s budget
deficit and even produced a small budget surplus. Our fourth debate concerns
whether fiscal policymakers should use this budget surplus to reduce the govern-
ment debt. The alternative is to eliminate the budget surplus by cutting taxes or
increasing spending.

“MY SHARE OF THE GOVERNMENT DEBT PRO: POLICYMAKERS SHOULD
IS $14,000.” REDUCE THE GOVERNMENT DEBT

The U.S. federal government is far more indebted today than it was two decades
ago. In 1980, the federal debt was $710 billion; in 1999, it was $3.7 trillion. If we di-
vide today’s debt by the size of the population, we learn that each person’s share
of the government debt is about $14,000.

The most direct effect of the government debt is to place a burden on future
generations of taxpayers. When these debts and accumulated interest come due,
future taxpayers will face a difficult choice. They can pay higher taxes, enjoy less
government spending, or both, in order to make resources available to pay off the
debt and accumulated interest. Or they can delay the day of reckoning and put the
government into even deeper debt by borrowing once again to pay off the old debt
and interest. In essence, when the government runs a budget deficit and issues
government debt, it allows current taxpayers to pass the bill for some of their

CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 801

government spending on to future taxpayers. Inheriting such a large debt cannot
help but lower the living standard of future generations.

In addition to this direct effect, budget deficits also have various macroeco-
nomic effects. Because budget deficits represent negative public saving, they lower
national saving (the sum of private and public saving). Reduced national saving
causes real interest rates to rise and investment to fall. Reduced investment leads
over time to a smaller stock of capital. A lower capital stock reduces labor produc-
tivity, real wages, and the economy’s production of goods and services. Thus,
when the government increases its debt, future generations are born into an econ-
omy with lower incomes as well as higher taxes.

There are, nevertheless, situations in which running a budget deficit is justifi-
able. Throughout history, the most common cause of increased government debt is
war. When a military conflict raises government spending temporarily, it is rea-
sonable to finance this extra spending by borrowing. Otherwise, taxes during
wartime would have to rise precipitously. Such high tax rates would greatly dis-
tort the incentives faced by those who are taxed, leading to large deadweight
losses. In addition, such high tax rates would be unfair to current generations of
taxpayers, who already have to make the sacrifice of fighting the war.

Similarly, it is reasonable to allow a rise in government debt during a tempo-
rary downturn in economic activity. When the economy goes into a recession, tax
revenue falls automatically, because the income tax and the payroll tax are levied
on measures of income. If the government tried to balance its budget during a re-
cession, it would have to raise taxes or cut spending at a time of high unemploy-
ment. Such a policy would tend to depress aggregate demand at precisely the time
it needed to be stimulated and, therefore, would tend to increase the magnitude of
economic fluctuations.

The rise in government debt during the 1980s and 1990s, however, cannot be
justified by appealing to war or recession. During this period, the United States
avoided major military conflict and major economic downturn. Nonetheless, the
government consistently ran a budget deficit, largely because the president and
Congress found it easier to increase government spending than to increase taxes.
As a result, government debt as a percentage of annual gross domestic product in-
creased from 26 percent in 1980 to 50 percent in 1995, before falling back a bit to
44 percent in 1999. It is hard to see any rationale for this rise in government debt.
If the U.S. government had been operating with a balanced budget since 1980,
today’s college graduates would be entering an economy that promised them
greater economic prosperity.

It’s now time to reverse the effects of this policy mistake. A combination of
fiscal prudence and good luck left the U.S. government with a budget surplus in
the late 1990s and projected surpluses for subsequent years. We should use these
surpluses to repay some of the debt that the government has accumulated. Com-
pared to the alternative of cutting taxes or increasing spending, repaying the debt
would mean greater national saving, investment, and economic growth.

CON: POLICYMAKERS SHOULD NOT
REDUCE THE GOVERNMENT DEBT

The problem of government debt is often exaggerated. Although the government
debt does represent a tax burden on younger generations, it is not large compared
to the average person’s lifetime income. The debt of the U.S. federal government is

802 PART THIRTEEN FINAL THOUGHTS

about $14,000 per person. A person who works 40 years for $25,000 a year will earn
$1 million over his lifetime. His share of the government debt represents less than
2 percent of his lifetime resources.

Moreover, it is misleading to view the effects of government debt in isolation.
The government debt is just one piece of a large picture of how the government
chooses to raise and spend money. In making these decisions over fiscal policy,
policymakers affect different generations of taxpayers in many ways. The govern-
ment’s budget deficit or surplus should be considered together with these other
policies.

For example, suppose the government uses the budget surplus to pay off the
government debt instead of using it to pay for increased spending on education.
Does this policy make young generations better off? The government debt will be
smaller when they enter the labor force, which means a smaller tax burden. Yet if
they are less well educated than they could be, their productivity and incomes will
be lower. Many estimates of the return to schooling (the increase in a worker’s
wage that results from an additional year in school) find that it is quite large. Re-
ducing the government debt rather than funding more education spending could,
all things considered, make future generations worse off.

Single-minded concern about the government debt is also dangerous because
it draws attention away from various other policies that redistribute income across
generations. For example, in the 1960s and 1970s, the U.S. federal government
raised Social Security benefits for the elderly. It financed this higher spending by
increasing the payroll tax on the working-age population. This policy redistributed
income away from younger generations toward older generations, even though
it did not affect the government debt. Thus, government debt is only a small
piece of the larger issue of how government policy affects the welfare of different
generations.

To some extent, the adverse effects of government debt can be reversed by
forward-looking parents. Suppose a parent is worried about the impact of the
government debt on his children. The parent can offset the impact simply by sav-
ing and leaving a larger bequest. The bequest would enhance the children’s ability
to bear the burden of future taxes. Some economists claim that people do in fact
behave this way. If this were true, higher private saving by parents would offset
the public dissaving of budget deficits, and deficits would not affect the economy.
Most economists doubt that parents are so farsighted, but some people probably
do act this way, and anyone could. Deficits give people the opportunity to con-
sume at the expense of their children, but deficits do not require them to do so. If
the government debt actually represented a great problem facing future genera-
tions, some parents would help to solve it.

Critics of budget deficits sometimes assert that the government debt cannot
continue to rise forever, but in fact it can. Just as a bank officer evaluating a loan
application would compare a person’s debts to his income, we should judge the
burden of the government debt relative to the size of the nation’s income. Popula-
tion growth and technological progress cause the total income of the U.S. economy
to grow over time. As a result, the nation’s ability to pay the interest on the gov-
ernment debt grows over time as well. As long as the government debt grows
more slowly than the nation’s income, there is nothing to prevent the government
debt from growing forever.

Some numbers can put this into perspective. The real output of the U.S. econ-
omy grows on average about 3 percent per year. If the inflation rate is 2 percent per

CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 803

IN THE NEWS How big should government be? percent of the 1,007 respondents opted
The Budget Surplus Do Americans prefer to pay less in for spending on social programs such as
taxes or have government do more? education or a prescription-drug benefit
WHEN POLICYMAKERS FACE GOVERNMENT How much should younger workers sac- for Medicare recipients, 22 percent
budget surpluses, they have three op- rifice to support baby-boomer parents picked paying down the federal debt, and
tions: cutting taxes, increasing spend- and grandparents in retirement, and how only 20 percent picked tax cuts. (The
ing, or reducing the government debt. much should baby-boomers set aside in rest picked defense or didn’t make a
Choosing is not easy. advance? How much should government choice.)
interfere with the workings of the market
Lawmakers Discover to spread the benefits of today’s pros- “We are not in a period like the
That Surpluses perity? Is paying off debt incurred in the late 1970s when people really despised
1980s and 1990s more or less important government,” says Republican pollster
Can Be as Vexing as Deficits than raising spending on education and Robert Teeter, who conducted the poll
health or lowering taxes? with Democrat Peter Hart. “The elec-
BY DAVID WESSEL AND GREG HITT torate is saying there are serious le-
WASHINGTON—It took politicians 15 con- With something less than unanimity, gitimate issues that the government
tentious years to eliminate the biggest Republicans make the case for bigger should address, and they are willing to
federal budget deficits since World tax cuts and smaller government. “Re- use some of their money to do it,” Mr.
War II. Now, they are having nearly as publicans believe it’s a matter of principle Teeter adds. . . .
much difficulty deciding what to do with to return excess tax money in Wash-
the roughly $3 trillion in surpluses pro- ington to the families and workers who Fed Chairman Greenspan continues
jected over the next 10 years. sent it here,” House Ways and Means to preach the virtues of debt reduction.
Chairman Bill Archer, a Texas Republi- Although he doesn’t admit to as much,
The sudden emergence of a budget can, said on the floor of the House of he sees virtue in gridlock. If Congress
windfall larger than anticipated just six Representatives during last week’s tax- and Mr. Clinton can get appropriations
months ago is forcing into fast-forward cut debate. “Republicans believe that bills enacted this year, but agree on
a longstanding debate over fiscal policy Americans have the right to keep more nothing else, then the surplus will auto-
and the role of government. of what they earn.” matically go to reducing the government
debt.
On the surface, lawmakers face a Where Republicans see an over-
simple multiple-choice question: Should taxed populace, however, liberal Democ- SOURCE: The Wall Street Journal, July 29, 1999,
the surplus be saved, spent, or devoted rats in Congress see “unmet needs.” p. A1.
to tax cuts? But at its core, the debate
is about profound issues that were “The question,” says Rep. Barney
long suppressed by the deficit-reduction Frank, a Massachusetts Democrat, “is
imperative: not whether the surplus should be spent
according to people’s wishes. Of course
it should. The question is whether it
should be spent on private goods or
public goods.” . . .

The public is split, but a new Wall
Street Journal/NBC News poll suggests
that the GOP is having trouble selling
its call for tax cuts. . . . Asked to pick
just one option for using the surplus, 46

804 PART THIRTEEN FINAL THOUGHTS

year, then nominal income grows at a rate of 5 percent per year. The government
debt, therefore, can rise by 5 percent per year without increasing the ratio of debt
to income. In 1999 the federal government debt was $3.7 trillion; 5 percent of this
figure is $165 billion. As long as the federal budget deficit is smaller than $165 bil-
lion, the policy is sustainable. There will never be any day of reckoning that forces
the budget deficits to end or the economy to collapse.

If moderate budget deficits are sustainable, there is no need for the govern-
ment to maintain budget surpluses. Let’s put this excess of revenue over spending
to better use. The government could use these funds to pay for valuable govern-
ment programs, such as increased funding for education. Or it could use them to
finance a tax cut. In the late 1990s taxes reached an historic high as a percentage of
GDP, so there is every reason to suppose that the deadweight losses of taxation
reached an historic high as well. If all these taxes aren’t needed for current spend-
ing, the government should return the money to the people who earned it.

Q U I C K Q U I Z : Explain how reducing the government debt makes future
generations better off. What fiscal policy might improve the lives of future
generations more than reducing the government debt?

SHOULD THE TAX LAWS BE REFORMED TO
ENCOURAGE SAVING?

A nation’s standard of living depends on its ability to produce goods and services.
This was one of the Ten Principles of Economics in Chapter 1. As we saw in Chapter
24, a nation’s productive capability, in turn, is determined largely by how much it
saves and invests for the future. Our fifth debate is whether policymakers should
reform the tax laws to encourage greater saving and investment.

PRO: THE TAX LAWS SHOULD BE
REFORMED TO ENCOURAGE SAVING

A nation’s saving rate is a key determinant of its long-run economic prosperity.
When the saving rate is higher, more resources are available for investment in new
plant and equipment. A larger stock of plant and equipment, in turn, raises labor
productivity, wages, and incomes. It is, therefore, no surprise that international
data show a strong correlation between national saving rates and measures of eco-
nomic well-being.

Another of the Ten Principles of Economics presented in Chapter 1 is that people
respond to incentives. This lesson should apply to people’s decisions about how
much to save. If a nation’s laws make saving attractive, people will save a higher
fraction of their incomes, and this higher saving will lead to a more prosperous
future.

Unfortunately, the U.S. tax system discourages saving by taxing the return to
saving quite heavily. For example, consider a 25-year-old worker who saves $1,000

CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 805

of her income to have a more comfortable retirement at the age of 70. If she buys a
bond that pays an interest rate of 10 percent, the $1,000 will accumulate at the end
of 45 years to $72,900 in the absence of taxes on interest. But suppose she faces a
marginal tax rate on interest income of 40 percent, which is typical of many work-
ers once federal and state income taxes are added together. In this case, her after-
tax interest rate is only 6 percent, and the $1,000 will accumulate at the end of 45
years to only $13,800. That is, accumulated over this long span of time, the tax rate
on interest income reduces the benefit of saving $1,000 from $72,900 to $13,800—
or by about 80 percent.

The tax code further discourages saving by taxing some forms of capital in-
come twice. Suppose a person uses some of his saving to buy stock in a corpora-
tion. When the corporation earns a profit from its capital investments, it first pays
tax on this profit in the form of the corporate income tax. If the corporation pays
out the rest of the profit to the stockholder in the form of dividends, the stock-
holder pays tax on this income a second time in the form of the individual income
tax. This double taxation substantially reduces the return to the stockholder,
thereby reducing the incentive to save.

The tax laws again discourage saving if a person wants to leave his accumu-
lated wealth to his children (or anyone else) rather than consuming it during his
lifetime. Parents can bequeath some money to their children without tax, but if the
bequest becomes large, the inheritance tax rate can be as high as 55 percent. To a
large extent, concern about national saving is motivated by a desire to ensure eco-
nomic prosperity for future generations. It is odd, therefore, that the tax laws dis-
courage the most direct way in which one generation can help the next.

In addition to the tax code, many other policies and institutions in our society
reduce the incentive for households to save. Some government benefits, such as
welfare and Medicaid, are means-tested; that is, the benefits are reduced for those
who in the past have been prudent enough to save some of their income. Colleges
and universities grant financial aid as a function of the wealth of the students and
their parents. Such a policy is like a tax on wealth and, as such, discourages stu-
dents and parents from saving.

There are various ways in which the tax code could provide an incentive to
save, or at least reduce the disincentive that households now face. Already the tax
laws give preferential treatment to some types of retirement saving. When a tax-
payer puts income into an Individual Retirement Account (IRA), for instance, that
income and the interest it earns are not taxed until the funds are withdrawn at re-
tirement. The tax code gives a similar tax advantage to retirement accounts that go
by other names, such as 401(k), 403(b), Keogh, and profit-sharing plans. There are,
however, limits to who is eligible to use these plans and, for those who are eligible,
limits on the amount that can be put in them. Moreover, because there are penal-
ties for withdrawal before retirement age, these retirement plans provide little in-
centive for other types of saving, such as saving to buy a house or pay for college.
A small step to encourage greater saving would be to expand the ability of house-
holds to use such tax-advantaged savings accounts.

A more comprehensive approach would be to reconsider the entire basis by
which the government collects revenue. The centerpiece of the U.S. tax system is
the income tax. A dollar earned is taxed the same whether it is spent or saved.
An alternative advocated by many economists is a consumption tax. Under a
consumption tax, a household pays taxes only on the basis of what it spends.
Income that is saved is exempt from taxation until the saving is later withdrawn

806 PART THIRTEEN FINAL THOUGHTS

and spent on consumption goods. In essence, a consumption tax puts all sav-
ing automatically into a tax-advantaged savings account, much like an IRA. A
switch from income to consumption taxation would greatly increase the incentive
to save.

CON: THE TAX LAWS SHOULD
NOT BE REFORMED TO ENCOURAGE SAVING

Increasing saving may be desirable, but it is not the only goal of tax policy. Policy-
makers also must be sure to distribute the tax burden fairly. The problem with pro-
posals to increase the incentive to save is that they increase the tax burden on those
who can least afford it.

It is an undeniable fact that high-income households save a greater fraction of
their income than low-income households. As a result, any tax change that favors
people who save will also tend to favor people with high income. Policies such
as tax-advantaged retirement accounts may seem appealing, but they lead to a
less egalitarian society. By reducing the tax burden on the wealthy who can take
advantage of these accounts, they force the government to raise the tax burden on
the poor.

Moreover, tax policies designed to encourage saving may not be effective at
achieving that goal. Many studies have found that saving is relatively inelastic—
that is, the amount of saving is not very sensitive to the rate of return on saving.
If this is indeed the case, then tax provisions that raise the effective return by
reducing the taxation of capital income will further enrich the wealthy without
inducing them to save more than they otherwise would.

Economic theory does not give a clear prediction about whether a higher
rate of return would increase saving. The outcome depends on the relative size
of two conflicting effects, called the substitution effect and the income effect. On
the one hand, a higher rate of return raises the benefit of saving: Each dollar
saved today produces more consumption in the future. This substitution effect
tends to raise saving. On the other hand, a higher rate of return lowers the need
for saving: A household has to save less to achieve any target level of consumption
in the future. This income effect tends to reduce saving. If the substitution and
income effects approximately cancel each other, as some studies suggest, then
saving will not change when lower taxation of capital income raises the rate of
return.

There are other ways to raise national saving than by giving tax breaks to the
rich. National saving is the sum of private and public saving. Instead of trying to
alter the tax code to encourage greater private saving, policymakers can simply
raise public saving by increasing the budget surplus, perhaps by raising taxes on
the wealthy. This offers a direct way of raising national saving and increasing pros-
perity for future generations.

Indeed, once public saving is taken into account, tax provisions to encourage
saving might backfire. Tax changes that reduce the taxation of capital income
reduce government revenue and, thereby, lead to a budget deficit. To increase na-
tional saving, such a change in the tax code must stimulate private saving by more
than it reduces public saving. If this is not the case, so-called saving incentives can
potentially make matters worse.

CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 807

Q U I C K Q U I Z : Give three examples of how our society discourages saving.
What are the drawbacks of eliminating these disincentives?

CONCLUSION

This chapter has considered five debates over macroeconomic policy. For each, it
began with a controversial proposition and then offered the arguments pro and
con. If you find it hard to choose a side in these debates, you may find some com-
fort in the fact that you are not alone. The study of economics does not always
make it easy to choose among alternative policies. Indeed, by clarifying the in-
evitable tradeoffs that policymakers face, it can make the choice more difficult.

Difficult choices, however, have no right to seem easy. When you hear politi-
cians or commentators proposing something that sounds too good to be true, it
probably is. If they sound like they are offering you a free lunch, you should look
for the hidden price tag. Few if any policies come with benefits but no costs. By
helping you see through the fog of rhetoric so common in political discourse, the
study of economics should make you a better participant in our national debates.

Summary

N Advocates of active monetary and fiscal policy view the N Advocates of reducing the government debt argue that
economy as inherently unstable and believe that policy the debt imposes a burden on future generations by
can manage aggregate demand to offset the inherent raising their taxes and lowering their incomes. Critics of
instability. Critics of active monetary and fiscal policy reducing the government debt argue that the debt is
emphasize that policy affects the economy with a lag only one small piece of fiscal policy. Single-minded
and that our ability to forecast future economic concern about the debt can obscure the many ways in
conditions is poor. As a result, attempts to stabilize the which the government’s tax and spending decisions
economy can end up being destabilizing. affect different generations.

N Advocates of rules for monetary policy argue that N Advocates of tax incentives for saving point out that our
discretionary policy can suffer from incompetence, society discourages saving in many ways, such as by
abuse of power, and time inconsistency. Critics of rules heavily taxing the income from capital and by reducing
for monetary policy argue that discretionary policy is benefits for those who have accumulated wealth. They
more flexible in responding to changing economic endorse reforming the tax laws to encourage saving,
circumstances. perhaps by switching from an income tax to a
consumption tax. Critics of tax incentives for saving
N Advocates of a zero-inflation target emphasize that argue that many proposed changes to stimulate saving
inflation has many costs and few if any benefits. would primarily benefit the wealthy, who do not need a
Moreover, the cost of eliminating inflation—depressed tax break. They also argue that such changes might have
output and employment—is only temporary. Even this only a small effect on private saving. Raising public
cost can be reduced if the central bank announces a saving by increasing the government’s budget surplus
credible plan to reduce inflation, thereby directly would provide a more direct and equitable way to
lowering expectations of inflation. Critics of a zero- increase national saving.
inflation target claim that moderate inflation imposes
only small costs on society, whereas the recession
necessary to reduce inflation is quite costly.

808 PART THIRTEEN FINAL THOUGHTS

Questions for Review

1. What causes the lags in the effect of monetary and fiscal 6. What are two situations in which most economists view
policy on aggregate demand? What are the implications a budget deficit as justifiable?
of these lags for the debate over active versus passive
policy? 7. Give an example of how the government might hurt
young generations, even while reducing the
2. What might motivate a central banker to cause a government debt they inherit.
political business cycle? What does the political business
cycle imply for the debate over policy rules? 8. Some economists say that the government can continue
running a budget deficit forever. How is that possible?
3. Explain how credibility might affect the cost of reducing
inflation. 9. Some income from capital is taxed twice. Explain.

4. Why are some economists against a target of zero 10. Give an example, other than tax policy, of how our
inflation? society discourages saving.

5. Explain two ways in which a government budget deficit 11. What adverse effect might be caused by tax incentives
hurts a future worker. to raise saving?

Problems and Applications

1. The chapter suggests that the economy, like the human the money supply by 3 percent per year plus
body, has “natural restorative powers.” 1 percentage point for every percentage point
a. Illustrate the short-run effect of a fall in aggregate that unemployment rises above its normal level?
demand using an aggregate-demand/aggregate- Illustrate your answer.
supply diagram. What happens to total output, c. Which of the foregoing rules better stabilizes
income, and employment? the economy? Would it help to allow the Fed to
b. If the government does not use stabilization policy, respond to predicted unemployment instead of
what happens to the economy over time? Illustrate current unemployment? Explain.
on your diagram. Does this adjustment generally
occur in a matter of months or a matter of years? 4. Some economists have proposed that the Fed use the
c. Do you think the “natural restorative powers” of following rule for choosing its target for the federal
the economy mean that policymakers should be funds interest rate (r):
passive in response to the business cycle?
r ϭ 2% ϩ π ϩ 1/2 (y Ϫ y*)/y* ϩ 1/2 (π Ϫ π*),
2. Policymakers who want to stabilize the economy must
decide how much to change the money supply, where π is the average of the inflation rate over the
government spending, or taxes. Why is it difficult for past year, y is real GDP as recently measured, y* is an
policymakers to choose the appropriate strength of their estimate of the natural rate of output, and π* is the Fed’s
actions? goal for inflation.
a. Explain the logic that might lie behind this rule for
3. Suppose that people suddenly wanted to hold more
money balances. setting interest rates. Would you support the Fed’s
a. What would be the effect of this change on the use of this rule?
economy if the Federal Reserve followed a rule of b. Some economists advocate such a rule for monetary
increasing the money supply by 3 percent per year? policy but believe π and y should be the forecasts of
Illustrate your answer with a money-market future values of inflation and output. What are the
diagram and an aggregate-demand/aggregate- advantages of using forecasts instead of actual
supply diagram. values? What are the disadvantages?
b. What would be the effect of this change on the
economy if the Fed followed a rule of increasing 5. The problem of time inconsistency applies to fiscal
policy as well as to monetary policy. Suppose the

CHAPTER 34 FIVE DEBATES OVER MACROECONOMIC POLICY 809

government announced a reduction in taxes on income children’s taxes in the future? Can you do something
from capital investments, like new factories. today to offset this future effect?
a. If investors believed that capital taxes would
9. Explain how each of the following policies redistributes
remain low, how would the government’s action income across generations. Is the redistribution from
affect the level of investment? young to old, or from old to young?
b. After investors have responded to the announced a. an increase in the budget deficit
tax reduction, does the government have an b. more generous subsidies for education loans
incentive to renege on its policy? Explain. c. greater investments in highways and bridges
c. Given your answer to part (b), would investors d. indexation of Social Security benefits to inflation
believe the government’s announcement? What
can the government do to increase the credibility 10. Surveys suggest that most people are opposed to budget
of announced policy changes? deficits, but these same people elected representatives
d. Explain why this situation is similar to the time who in the 1980s and 1990s passed budgets with
inconsistency problem faced by monetary significant deficits. Why might the opposition to budget
policymakers. deficits be stronger in principle than in practice?

6. Chapter 2 explains the difference between positive 11. The chapter says that budget deficits reduce the income
analysis and normative analysis. In the debate about of future generations, but can boost output and income
whether the central bank should aim for zero inflation, during a recession. Explain how both of these
which areas of disagreement involve positive statements statements can be true.
and which involve normative judgments?
12. What is the fundamental tradeoff that society faces if it
7. Why are the benefits of reducing inflation permanent chooses to save more?
and the costs temporary? Why are the costs of
increasing inflation permanent and the benefits 13. Suppose the government reduced the tax rate on income
temporary? Use Phillips-curve diagrams in your from savings.
answer. a. Who would benefit from this tax reduction most
directly?
8. Suppose the federal government cuts taxes and b. What would happen to the capital stock over time?
increases spending, raising the budget deficit to What would happen to the capital available to each
12 percent of GDP. If nominal GDP is rising 7 percent worker? What would happen to productivity?
per year, are such budget deficits sustainable forever? What would happen to wages?
Explain. If budget deficits of this size are maintained for c. In light of your answer to part (b), who might
20 years, what is likely to happen to your taxes and your benefit from this tax reduction in the long run?



GLOSSARY

ability-to-pay principle—the idea that capital flight—a large and sudden complements—two goods for which
taxes should be levied on a person reduction in the demand for assets an increase in the price of one leads
according to how well that person located in a country to a decrease in the demand for the
can shoulder the burden other
cartel—a group of firms acting in
absolute advantage—the comparison unison constant returns to scale—the prop-
among producers of a good accord- erty whereby long-run average total
ing to their productivity catch-up effect—the property whereby cost stays the same as the quantity
countries that start off poor tend to of output changes
accounting profit—total revenue mi- grow more rapidly than countries
nus total explicit cost that start off rich consumer price index (CPI)—a mea-
sure of the overall cost of the goods
aggregate-demand curve—a curve that central bank—an institution designed and services bought by a typical
shows the quantity of goods and to oversee the banking system and consumer
services that households, firms, and regulate the quantity of money in
the government want to buy at each the economy consumer surplus—a buyer’s willing-
price level ness to pay minus the amount the
ceteris paribus—a Latin phrase, trans- buyer actually pays
aggregate-supply curve—a curve that lated as “other things being equal,”
shows the quantity of goods and used as a reminder that all variables consumption—spending by house-
services that firms choose to pro- other than the ones being studied holds on goods and services, with
duce and sell at each price level are assumed to be constant the exception of purchases of new
housing
appreciation—an increase in the value circular-flow diagram—a visual model
of a currency as measured by the of the economy that shows how dol- cost—the value of everything a seller
amount of foreign currency it can lars flow through markets among must give up to produce a good
buy households and firms
cost-benefit analysis—a study that
automatic stabilizers—changes in fis- classical dichotomy—the theoretical compares the costs and benefits to
cal policy that stimulate aggregate separation of nominal and real society of providing a public good
demand when the economy goes variables
into a recession without policymak- cross-price elasticity of demand—a
ers having to take any deliberate closed economy—an economy that measure of how much the quantity
action does not interact with other demanded of one good responds to
economies in the world a change in the price of another
average fixed cost—fixed costs good, computed as the percentage
divided by the quantity of output Coase theorem—the proposition that if change in quantity demanded of the
private parties can bargain without first good divided by the percentage
average revenue—total revenue cost over the allocation of resources, change in the price
divided by the quantity sold they can solve the problem of exter-
nalities on their own crowding out—a decrease in invest-
average tax rate—total taxes paid ment that results from government
divided by total income collective bargaining—the process by borrowing
which unions and firms agree on
average total cost—total cost divided the terms of employment crowding-out effect—the offset in ag-
by the quantity of output gregate demand that results when
collusion—an agreement among firms expansionary fiscal policy raises the
average variable cost—variable costs in a market about quantities to pro- interest rate and thereby reduces in-
divided by the quantity of output duce or prices to charge vestment spending

balanced trade—a situation in which commodity money—money that takes currency—the paper bills and coins in
exports equal imports the form of a commodity with in- the hands of the public
trinsic value
benefits principle—the idea that peo- cyclical unemployment—the devia-
ple should pay taxes based on the common resources—goods that are tion of unemployment from its
benefits they receive from govern- rival but not excludable natural rate
ment services
comparable worth—a doctrine accord- deadweight loss—the fall in total
bond—a certificate of indebtedness ing to which jobs deemed compara- surplus that results from a market
budget constraint—the limit on the ble should be paid the same wage distortion, such as a tax

consumption bundles that a con- comparative advantage—the compari- demand curve—a graph of the rela-
sumer can afford son among producers of a good ac- tionship between the price of a good
budget deficit—a shortfall of tax rev- cording to their opportunity cost and the quantity demanded
enue from government spending
budget surplus—an excess of govern- compensating differential—a differ- demand deposits—balances in bank
ment receipts over government ence in wages that arises to offset accounts that depositors can access
spending the nonmonetary characteristics of on demand by writing a check
different jobs
capital—the equipment and structures demand schedule—a table that shows
used to produce goods and services competitive market—a market with the relationship between the price
many buyers and sellers trading of a good and the quantity
identical products so that each demanded
buyer and seller is a price taker

811

812 GLOSSARY

depreciation—a decrease in the value equilibrium quantity—the quantity game theory—the study of how people
of a currency as measured by the supplied and the quantity de- behave in strategic situations
amount of foreign currency it can manded when the price has ad-
buy justed to balance supply and GDP deflator—a measure of the
demand price level calculated as the ratio
depression—a severe recession of nominal GDP to real GDP times
diminishing marginal product—the equity—the property of distributing 100
economic prosperity fairly among
property whereby the marginal the members of society Giffen good—a good for which an
product of an input declines as the increase in the price raises the
quantity of the input increases excludability—the property of a good quantity demanded
diminishing returns—the property whereby a person can be prevented
whereby the benefit from an extra from using it government purchases—spending on
unit of an input declines as the goods and services by local, state,
quantity of the input increases explicit costs—input costs that re- and federal governments
discount rate—the interest rate on the quire an outlay of money by the
loans that the Fed makes to banks firm gross domestic product (GDP)—the
discouraged workers—individuals market value of all final goods and
who would like to work but have exports—goods and services that are services produced within a country
given up looking for a job produced domestically and sold in a given period of time
discrimination—the offering of differ- abroad
ent opportunities to similar individ- horizontal equity—the idea that tax-
uals who differ only by race, ethnic externality—the impact of one per- payers with similar abilities to pay
group, sex, age, or other personal son’s actions on the well-being of a taxes should pay the same amount
characteristics bystander
diseconomies of scale—the property human capital—the accumulation of
whereby long-run average total factors of production—the inputs used investments in people, such as edu-
cost rises as the quantity of output to produce goods and services cation and on-the-job training
increases
dominant strategy—a strategy that is Federal Reserve (Fed)—the central implicit costs—input costs that do not
best for a player in a game regard- bank of the United States require an outlay of money by the
less of the strategies chosen by the firm
other players fiat money—money without intrinsic
value that is used as money because import quota—a limit on the quantity
economic profit—total revenue minus of government decree of a good that can be produced
total cost, including both explicit abroad and sold domestically
and implicit costs financial intermediaries—financial
institutions through which savers imports—goods and services that
economics—the study of how society can indirectly provide funds to are produced abroad and sold
manages its scarce resources borrowers domestically

economies of scale—the property financial markets—financial institu- in-kind transfers—transfers to the
whereby long-run average total tions through which savers can di- poor given in the form of goods and
cost falls as the quantity of output rectly provide funds to borrowers services rather than cash
increases
financial system—the group of institu- income effect—the change in con-
efficiency—the property of society tions in the economy that help to sumption that results when a price
getting the most it can from its match one person’s saving with change moves the consumer to a
scarce resources another person’s investment higher or lower indifference curve

efficiency wages—above-equilibrium Fisher effect—the one-for-one adjust- income elasticity of demand—a mea-
wages paid by firms in order to in- ment of the nominal interest rate to sure of how much the quantity de-
crease worker productivity the inflation rate manded of a good responds to a
change in consumers’ income, com-
efficient scale—the quantity of output fixed costs—costs that do not vary puted as the percentage change in
that minimizes average total cost with the quantity of output quantity demanded divided by the
produced percentage change in income
elasticity—a measure of the respon-
siveness of quantity demanded fractional-reserve banking—a bank- indexation—the automatic correction
or quantity supplied to one of its ing system in which banks hold of a dollar amount for the effects of
determinants only a fraction of deposits as inflation by law or contract
reserves
equilibrium—a situation in which indifference curve—a curve that
supply and demand have been free rider—a person who receives the shows consumption bundles that
brought into balance benefit of a good but avoids paying give the consumer the same level of
for it satisfaction
equilibrium price—the price that bal-
ances supply and demand frictional unemployment—unemploy- inferior good—a good for which, other
ment that results because it takes things equal, an increase in income
time for workers to search for the leads to a decrease in demand
jobs that best suit their tastes and
skills

GLOSSARY 813

inflation—an increase in the overall macroeconomics—the study of econ- model of aggregate demand and
level of prices in the economy omy-wide phenomena, including aggregate supply—the model that
inflation, unemployment, and eco- most economists use to explain
inflation rate—the percentage change nomic growth short-run fluctuations in economic
in the price index from the preced- activity around its long-run trend
ing period marginal changes—small incremental
adjustments to a plan of action monetary neutrality—the proposition
inflation tax—the revenue the govern- that changes in the money supply
ment raises by creating money marginal cost—the increase in total do not affect real variables
cost that arises from an extra unit of
internalizing an externality—altering production monetary policy—the setting of the
incentives so that people take ac- money supply by policymakers in
count of the external effects of their marginal product—the increase in out- the central bank
actions put that arises from an additional
unit of input money—the set of assets in an econ-
investment—spending on capital omy that people regularly use to
equipment, inventories, and struc- marginal product of labor—the in- buy goods and services from other
tures, including household pur- crease in the amount of output from people
chases of new housing an additional unit of labor
money multiplier—the amount of
job search—the process by which marginal rate of substitution—the rate money the banking system gener-
workers find appropriate jobs given at which a consumer is willing to ates with each dollar of reserves
their tastes and skills trade one good for another
money supply—the quantity of money
labor force—the total number of work- marginal revenue—the change in total available in the economy
ers, including both the employed revenue from an additional unit
and the unemployed sold monopolistic competition—a market
structure in which many firms sell
labor-force participation rate—the marginal tax rate—the extra taxes products that are similar but not
percentage of the adult population paid on an additional dollar of identical
that is in the labor force income
monopoly—a firm that is the sole
law of demand—the claim that, other market—a group of buyers and sellers seller of a product without close
things equal, the quantity de- of a particular good or service substitutes
manded of a good falls when the
price of the good rises market economy—an economy that multiplier effect—the additional shifts
allocates resources through the in aggregate demand that result
law of supply—the claim that, other decentralized decisions of many when expansionary fiscal policy
things equal, the quantity supplied firms and households as they in- increases income and thereby in-
of a good rises when the price of the teract in markets for goods and creases consumer spending
good rises services
mutual fund—an institution that sells
law of supply and demand—the claim market failure—a situation in which a shares to the public and uses the
that the price of any good adjusts to market left on its own fails to allo- proceeds to buy a portfolio of stocks
bring the supply and demand for cate resources efficiently and bonds
that good into balance
market for loanable funds—the mar- Nash equilibrium—a situation in
liberalism—the political philosophy ket in which those who want to which economic actors interacting
according to which the government save supply funds and those who with one another each choose their
should choose policies deemed want to borrow to invest demand best strategy given the strategies
to be just, as evaluated by an impar- funds that all the other actors have chosen
tial observer behind a “veil of
ignorance” market power—the ability of a single national saving (saving)—the total in-
economic actor (or small group of come in the economy that remains
libertarianism—the political philoso- actors) to have a substantial influ- after paying for consumption and
phy according to which the govern- ence on market prices government purchases
ment should punish crimes and
enforce voluntary agreements but maximin criterion—the claim that the natural monopoly—a monopoly that
not redistribute income government should aim to maxi- arises because a single firm can sup-
mize the well-being of the worst-off ply a good or service to an entire
life cycle—the regular pattern of person in society market at a smaller cost than could
income variation over a person’s two or more firms
life medium of exchange—an item that
buyers give to sellers when they natural-rate hypothesis—the claim
liquidity—the ease with which an want to purchase goods and that unemployment eventually re-
asset can be converted into the services turns to its normal, or natural, rate,
economy’s medium of exchange regardless of the rate of inflation
menu costs—the costs of changing
lump-sum tax—a tax that is the same prices natural rate of unemployment—the
amount for every person normal rate of unemployment
microeconomics—the study of how around which the unemployment
households and firms make deci- rate fluctuates
sions and how they interact in
markets

814 GLOSSARY

natural resources—the inputs into the Pigovian tax—a tax enacted to correct factors of production and the avail-
production of goods and services the effects of a negative externality able production technology
that are provided by nature, such as productivity—the amount of goods
land, rivers, and mineral deposits positive statements—claims that at- and services produced from each
tempt to describe the world as it is hour of a worker’s time
negative income tax—a tax system profit—total revenue minus total cost
that collects revenue from high- poverty line—an absolute level of in- progressive tax—a tax for which
income households and gives trans- come set by the federal government high-income taxpayers pay a larger
fers to low-income households for each family size below which a fraction of their income than do
family is deemed to be in poverty low-income taxpayers
net exports—the value of a nation’s ex- proportional tax—a tax for which
ports minus the value of its imports, poverty rate—the percentage of the high-income and low-income tax-
also called the trade balance population whose family income payers pay the same fraction of
falls below an absolute level called income
net foreign investment—the purchase the poverty line public goods—goods that are neither
of foreign assets by domestic resi- excludable nor rival
dents minus the purchase of domes- price ceiling—a legal maximum on the public saving—the tax revenue that
tic assets by foreigners price at which a good can be sold the government has left after paying
for its spending
nominal exchange rate—the rate price discrimination—the business purchasing-power parity—a theory of
at which a person can trade the practice of selling the same good exchange rates whereby a unit of
currency of one country for the cur- at different prices to different any given currency should be able
rency of another customers to buy the same quantity of goods
in all countries
nominal GDP—the production of price elasticity of demand—a mea-
goods and services valued at cur- sure of how much the quantity quantity demanded—the amount of a
rent prices demanded of a good responds to good that buyers are willing and
a change in the price of that good, able to purchase
nominal interest rate—the interest rate computed as the percentage change
as usually reported without a cor- in quantity demanded divided by quantity equation—the equation M ϫ
rection for the effects of inflation the percentage change in price V ϭ P ϫ Y, which relates the quan-
tity of money, the velocity of money,
nominal variables—variables mea- price elasticity of supply—a measure and the dollar value of the econ-
sured in monetary units of how much the quantity supplied omy’s output of goods and services
of a good responds to a change in
normal good—a good for which, other the price of that good, computed as quantity supplied—the amount of a
things equal, an increase in income the percentage change in quantity good that sellers are willing and
leads to an increase in demand supplied divided by the percentage able to sell
change in price
normative statements—claims that at- quantity theory of money—a theory
tempt to prescribe how the world price floor—a legal minimum on the asserting that the quantity of money
should be price at which a good can be sold available determines the price level
and that the growth rate in the
oligopoly—a market structure in prisoners’ dilemma—a particular quantity of money available deter-
which only a few sellers offer simi- “game” between two captured pris- mines the inflation rate
lar or identical products oners that illustrates why coopera-
tion is difficult to maintain even rational expectations—the theory ac-
open economy—an economy that in- when it is mutually beneficial cording to which people optimally
teracts freely with other economies use all the information they have,
around the world private goods—goods that are both including information about gov-
excludable and rival ernment policies, when forecasting
open-market operations—the pur- the future
chase and sale of U.S. government private saving—the income that
bonds by the Fed households have left after paying real exchange rate—the rate at which a
for taxes and consumption person can trade the goods and
opportunity cost—whatever must be services of one country for the
given up to obtain some item producer price index—a measure of goods and services of another
the cost of a basket of goods and
perfect complements—two goods services bought by firms real GDP—the production of goods
with right-angle indifference curves and services valued at constant
producer surplus—the amount a seller prices
perfect substitutes—two goods with is paid for a good minus the seller’s
straight-line indifference curves cost real interest rate—the interest rate
corrected for the effects of inflation
permanent income—a person’s nor- production function—the relationship
mal income between quantity of inputs used to
make a good and the quantity of
Phillips curve—a curve that shows the output of that good
short-run tradeoff between inflation
and unemployment production possibilities frontier—a
graph that shows the combinations
physical capital—the stock of equip- of output that the economy can pos-
ment and structures that are used to sibly produce given the available
produce goods and services

GLOSSARY 815

real variables—variables measured in price change moves the consumer resources get used more than is
physical units along a given indifference curve to desirable from the standpoint of
a point with a new marginal rate of society as a whole
recession—a period of declining real substitution transaction costs—the costs that par-
incomes and rising unemployment sunk cost—a cost that has already been ties incur in the process of agreeing
committed and cannot be recovered and following through on a bargain
regressive tax—a tax for which high- supply curve—a graph of the relation-
income taxpayers pay a smaller ship between the price of a good unemployment insurance—a govern-
fraction of their income than do and the quantity supplied ment program that partially pro-
low-income taxpayers supply schedule—a table that shows tects workers’ incomes when they
the relationship between the become unemployed
reserve ratio—the fraction of deposits price of a good and the quantity
that banks hold as reserves supplied unemployment rate—the percent-
supply shock—an event that directly age of the labor force that is
reserve requirements—regulations alters firms’ costs and prices, shift- unemployed
on the minimum amount of re- ing the economy’s aggregate-supply
serves that banks must hold against curve and thus the Phillips curve union—a worker association that bar-
deposits surplus—a situation in which quantity gains with employers over wages
supplied is greater than quantity and working conditions
reserves—deposits that banks have demanded
received but have not loaned out unit of account—the yardstick people
tariff—a tax on goods produced use to post prices and record debts
rivalry—the property of a good abroad and sold domestically
whereby one person’s use dimin- utilitarianism—the political philoso-
ishes other people’s use tax incidence—the study of who bears phy according to which the govern-
the burden of taxation ment should choose policies to
sacrifice ratio—the number of percent- maximize the total utility of every-
age points of annual output lost in technological knowledge—society’s one in society
the process of reducing inflation by understanding of the best ways to
1 percentage point produce goods and services utility—a measure of happiness or
satisfaction
scarcity—the limited nature of soci- theory of liquidity preference—
ety’s resources Keynes’s theory that the interest value of the marginal product—the
rate adjusts to bring money supply marginal product of an input times
shoeleather costs—the resources and money demand into balance the price of the output
wasted when inflation encourages
people to reduce their money total cost—the market value of the variable costs—costs that do vary with
holdings inputs a firm uses in production the quantity of output produced

shortage—a situation in which quan- total revenue (for a firm)—the amount velocity of money—the rate at which
tity demanded is greater than a firm receives for the sale of its money changes hands
quantity supplied output
vertical equity—the idea that tax-
stagflation—a period of falling output total revenue (in a market)—the payers with a greater ability to
and rising prices amount paid by buyers and re- pay taxes should pay larger
ceived by sellers of a good, com- amounts
stock—a claim to partial ownership in puted as the price of the good times
a firm the quantity sold welfare—government programs that
supplement the incomes of the
store of value—an item that people trade balance—the value of a nation’s needy
can use to transfer purchasing exports minus the value of its im-
power from the present to the ports, also called net exports welfare economics—the study of how
future the allocation of resources affects
trade deficit—an excess of imports economic well-being
strike—the organized withdrawal of over exports
labor from a firm by a union willingness to pay—the maximum
trade policy—a government policy amount that a buyer will pay for
structural unemployment—unem- that directly influences the quantity a good
ployment that results because the of goods and services that a country
number of jobs available in some imports or exports world price—the price of a good that
labor markets is insufficient to pro- prevails in the world market for
vide a job for everyone who wants trade surplus—an excess of exports that good
one over imports

substitutes—two goods for which an Tragedy of the Commons—a parable
increase in the price of one leads to that illustrates why common
an increase in the demand for the
other

substitution effect—the change in
consumption that results when a