MacroeconomicPolicy Debates F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN...

Macroeconomic Policy Debates

FERNANDO QUIJANO, YVONN QUIJANO,

KYLE THIEL & APARNA SUBRAMANIAN

PREPARED BY:

© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez

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

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

2 What does the current chairman of the Federal Reserve think about inflation

targeting?

Bernanke on Inflation Targeting

3 What type of tax is the “flat tax”?

The Flat Tax Is a Tax on Consumption

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• government expendituresSpending on goods and services plus transfer payments.

• surplusThe amount by which governmentrevenues exceed governmentexpenditures in a given year.

SHOULD WE BALANCE THE FEDERAL BUDGET?17.1

• deficitThe amount by which governmentexpenditures exceed governmentrevenues in a given year.

• government debtThe total of all past governmentdeficits.

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The Budget in Recent Decades

► FIGURE 17.1Debt as a Percent of GDP, 1791–2005

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The Budget and Social Security

Five Debates About Deficits

DEBATE 1: DO DEFICITS LEAD TO INFLATION?

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

• monetizing the deficitPurchases by a central bank of newly issued government bonds.

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DEBATE 2: IS GOVERNMENT DEBT A BURDEN ON FUTURE GENERATIONS?

• Ricardian equivalenceThe proposition that it does not matter whether governmentexpenditure is financed by taxes or debt.

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DEBATE 2: IS GOVERNMENT DEBT A BURDEN ON FUTURE GENERATIONS?

► FIGURE 17.2International Comparisons of Government Debt as Percentage of GDP, 2005

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DEBATE 3: HOW DO DEFICITS AFFECT THE SIZE OF GOVERNMENT?

DEBATE 4: CAN DEFICITS BE GOOD FOR AN ECONOMY?

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NEW METHODS TO MEASURE THE LONG-TERM FISCAL IMBALANCES FOR THE UNITED STATES

APPLYING THE CONCEPTS #1: What are the long-term fiscal imbalances for the United States?

Even though federal budget-deficit projections have increased in recent years, they still don’t accurately portray the long-run fiscal problems facing the United States.

Over time, there will be an escalating gap between revenues and expenditures, which would have to be met by outright borrowing.

How can we measure the size of the gap?

• Economists have developed a more comprehensive measure of a nation’s indebtedness. The method includes estimating the present value of the gap between the government’s revenues and expenditures and adding it to the current national debt.

• The “fiscal imbalance” was calculated in 2003 to be approximately $44 trillion, or four times GDP.

• During World War II, government debt was only 1.2 times GDP.

Problem:

No one will lend the U.S. government that amount of money.

Economists estimate that about 80 percent of the fiscal imbalance will stem from Medicare.

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DEBATE 5: WOULD A BALANCED-BUDGET AMENDMENT REALLY WORK?

Critics of a balanced-budget amendment point to many different problems, such as the following:

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

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

• Congress could devise special budgets to get around the requirement, for example, by taking some types of spending “off budget,” which means simply not counting them as part of the official budget.

• Congress could also find non-budgetary ways to carry out the policies that it desires.

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SHOULD THE FED TARGET INFLATION?17.2

Two Debates About Inflation Targeting

DEBATE 1: SHOULD THE FED FOCUS ON ONLY INFLATION?

DEBATE 2: IF THERE WERE AN INFLATION TARGET, WHO WOULD SET IT?

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BERNANKE ON INFLATION TARGETING

APPLYING THE CONCEPTS #2: What does the current chairman of the Federal Reserve think about inflation targeting?

Before he took over as chairman of the Federal Reserve in 2006, Ben Bernanke was an advocate for inflation targeting.

• Inflation targeting increased the effectiveness of monetary policy because it provided a long-term anchor for inflation expectations.

• As long as the private sector understood that the Fed was holding firm to long-run inflation targets, it would have added flexibility to use aggressive monetary policy in the short run to offset adverse shocks to the economy—without upsetting long-run inflation expectations.

• He called inflation targeting a policy of constrained discretion.

• Bernanke advocated that the Fed publish its inflation targets and make available its own forecasts of inflation for the next two years.

• To preserve credibility over the long term, inflation targeting provided a structure to policy that the private sector could understand.

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THE DEMOCRATS PLAYBOOK FOR BUSINESS

• Other hot button issues include guest worker programs for immigrants and trade issues that involve greater environment and labor protections.

• Big oil companies may not fare well with repeals of tax breaks likely and certain tax changes designed to repeal benefits targeting high income households while providing more breaks for the middle class.

• Sarbanes-Oxley reform and tort reform are also likely targets designed to make U.S. business more competitive.

• Other issues include deficit reduction and increased spending on education and alternative-energy research.

As you can see there are dozens of worthy projects that need governmental attention. Can they do it all? Time will tell how far Congress gets on this very aggressive agenda.

The election results are in and America voted for change and the Democratic majority has a full slate of macroeconomic issues to tackle. According to various prognosticators some of the more pressing issues we are likely to see addressed in 2007 are an increase in the minimum wage and some legislation giving Congress the ability to negotiate prescription drug prices with pharmaceutical companies.

Extra Application 5

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SHOULD WE TAX CONSUMPTIONRATHER THAN INCOME?17.3

Two Debates About Consumption Taxation

DEBATE 1: WILL CONSUMPTION TAXES LEAD TO MORE SAVINGS?

• consumption taxesTaxes based on the consumption, not the income, of individuals.

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FRENCH CONSUMER SPENDING DROPS SHARPLY

• The primary consumer goods taking the hit were textiles and leather goods, a category that fell by nearly 10 percent.

• While spending was down for the month, the quarterly data continue to support modest economic growth.

French consumers spent less money in September as consumer spending on manufactured goods fell by 2.7 percent over the previous month. The decline was the largest fall in nearly ten years and casts doubt on the recent supposed upswing in consumer spending. While many economists expected a correction from the strong 3.0 percent increase posted in August, most did not expect this magnitude.

Extra Application 4

Marginal Propensity to Consume (MPC)

Marginal Propensity to Save (MPS)

MPC + MPS = 1

Consumers either spend, or save, each dollar of income. The fraction of the next dollar (or Euro in this case) that is consumed or spent is known as the marginal propensity to consume or MPC. The fraction of the next Euro saved is known as the marginal propensity to save or MPS.

Consumer spending is one of the primary components of aggregate expenditures. Consumption, business investment, government spending and net exports all represent the major categories that drive the economy. If consumption falls and the other components do not increase by enough to offset the decline, then overall economic growth will fall as well.

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SHOULD WE TAX CONSUMPTIONRATHER THAN INCOME?17.3

DEBATE 2: ARE CONSUMPTION TAXES FAIR?

• capital gainsProfits investors earn when they sell stocks, bonds, real estate, or other assets.

Two Debates About Consumption Taxation

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THE FLAT TAX IS A TAX ON CONSUMPTION

APPLYING THE CONCEPTS #3: What type of tax is the “flat tax”?

The “flat tax” brings the personal income tax and corporate income tax into a single, unified tax system.

• One low, single tax rate applies to both businesses and individuals.

• Wage payments are deducted by businesses before they pay taxes.

• Would allow businesses to deduct any investment spending they make from their income before the tax is calculated.

• Can essentially be viewed as a type of consumption tax.

The flat tax has an important feature that ensures that wealthy individuals still pay taxes.

• Example: 14 million iPods were shipped in 2006.

• Profit for each iPod: $100

• Total profit: $1.4 billion

• Under this version of the flat tax, these extraordinary gains would be taxed in full.

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capital gains

consumption taxes

deficit

government debt

government expenditures

monetizing the deficit

Ricardian equivalence

surplus

MacroeconomicPolicy Debates F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN...

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