BUSI 101 - Chapter 18

(a)1 What is the purpose of Chapter 18’s five macroeconomic-policy debates, and why can reasonable economists reach different conclusions even when they agree on the underlying economic theory?

(a)2 In the argument for economic stabilization, trace how pessimism by households and firms can become partly self-fulfilling and generate a recession.

(a)3 Why do supporters of active stabilization view a recession caused by inadequate aggregate demand as a waste of resources rather than a necessary economic benefit?

(a)4 What does it mean for policymakers to “lean against the wind,” and how should monetary and fiscal policy respond differently to deficient versus excessive aggregate demand?

(a)5 What is the central argument against actively trying to stabilize every economic fluctuation?

(a)1 The chapter applies earlier macroeconomic theory to five unsettled policy questions. Economists can agree about mechanisms yet disagree about empirical magnitudes, political constraints, distributional effects, risks, and the relative importance of competing objectives.

(a)2 Pessimism causes households and firms to reduce spending → aggregate demand falls → production falls → firms lay off workers → unemployment rises and income falls → weaker income and employment reinforce the original pessimism.

(a)3 Workers who want jobs remain unemployed and productive factories sit idle. The economy is producing less than it could because spending is inadequate, so valuable resources are being wasted.

(a)4 Policymakers counteract the direction of the shock. When aggregate demand is too weak, they can raise government purchases, cut taxes, or expand the money supply. When aggregate demand is excessive and inflationary, they can do the opposite.

(a)5 Even if stabilization works in theory, long policy lags, poor forecasts, and unpredictable shocks mean intervention may arrive at the wrong time and destabilize rather than stabilize the economy.

(b)1 Why do both monetary and fiscal stabilization policies operate with lags, and what is the main source of the lag for each?

(b)2 How can a policy designed to stabilize the economy actually make economic fluctuations larger if it takes effect too late?

(b)3 Why does imperfect economic forecasting strengthen the argument against discretionary stabilization policy?

(b)4 Suppose aggregate demand is currently weak, but policymakers expect the economy to recover strongly before a proposed fiscal stimulus can take effect. Why might implementing the stimulus be counterproductive?

(b)5 What is the fundamental tradeoff in the debate over active stabilization policy?

(b)1 Monetary policy works with a lag because interest-rate changes take time to alter household and firm spending plans. Fiscal policy has an additional political and legislative lag because changes in taxes and government spending must be proposed, approved, and implemented.

(b)2 A stimulus aimed at a recession may begin affecting demand after the economy has already recovered, causing excessive aggregate demand and inflation. A contraction can similarly arrive after a downturn has begun.

(b)3 Policymakers must decide today based on conditions expected when the policy eventually takes effect. If those future conditions cannot be forecast accurately, the chance of applying the wrong policy increases.

(b)4 By the time the stimulus takes effect, private aggregate demand may already have recovered. The additional government stimulus could then push demand above sustainable output and intensify the boom.

(b)5 Active stabilization may reduce severe recessions and booms, but policy mistakes caused by lags and uncertainty may make fluctuations worse.

(c)1 What is meant by central-bank independence, and what potential economic advantage does the chapter associate with keeping monetary policy relatively insulated from elected politicians?

(c)2 What is a political business cycle, and how could political control over monetary policy theoretically create one?

(c)3 What is the time inconsistency of policy?

(c)4 Why can time-inconsistent monetary policy lead the public to expect more inflation and thereby worsen the short-run inflation–unemployment tradeoff?

(c)5 How can an independent central bank make a low-inflation commitment more credible?

(c)1 Independence means monetary-policy decisions are made with substantial freedom from day-to-day political control. The proposed advantage is that policymakers have less incentive to manipulate monetary conditions for electoral gain and may therefore achieve greater price stability.

(c)2 It is a pattern in which economic fluctuations follow the electoral calendar. Politicians might stimulate output and employment before an election and leave the resulting inflation or contraction until afterward.

(c)3 It occurs when policymakers announce one policy but later have an incentive to deviate from it after people have formed expectations based on the announcement.

(c)4 If people expect policymakers to abandon low-inflation promises to obtain temporarily lower unemployment, they build higher inflation into wages and contracts. Higher expected inflation shifts the short-run Phillips curve upward.

(c)5 An independent central banker has less electoral incentive to exploit temporary increases in output or decreases in unemployment, making promises of low inflation more believable.

(d)1 What is the strongest argument against giving an independent central bank broad discretion over monetary policy?

(d)2 Why does the chapter question whether greater central-bank credibility necessarily reduces the real economic cost of disinflation?

(d)3 How could rational expectations weaken politicians’ ability to benefit from creating a political business cycle?

(d)4 Why might fiscal policy be easier than monetary policy for politicians to direct toward specific groups of voters?

(d)5 What democratic tradeoff lies at the centre of the debate over central-bank independence?

(d)1 Accountability. Monetary policy can substantially affect employment, income, and inflation, yet highly independent central bankers are not directly answerable to voters for those decisions.

(d)2 The chapter notes that credible anti-inflation announcements did not obviously eliminate the high unemployment and output losses associated with actual disinflation episodes.

(d)3 If voters understand that pre-election monetary stimulus creates only temporary employment gains and later costs, they may not reward politicians for attempting the manipulation.

(d)4 Spending programs and tax changes can be directed toward particular industries, regions, or groups, whereas interest-rate and inflation changes tend to affect broad categories of borrowers, lenders, and asset holders.

(d)5 Independence may improve credibility and limit political manipulation, but democratic accountability argues that major decisions affecting employment, income, and inflation should ultimately be responsive to citizens.

(e)1 What major economic costs of inflation are used to support the argument for a zero-inflation target?

(e)2 Why do supporters of zero inflation characterize disinflation as imposing temporary costs in exchange for permanent benefits?

(e)3 How could a credible commitment to zero inflation reduce the output and unemployment costs of disinflation?

(e)4 Why do supporters argue that zero has an advantage as an inflation target compared with an arbitrary positive number?

(e)5 Explain why there is no permanent long-run reduction in unemployment from accepting permanently higher inflation according to the chapter’s argument.

(e)1 Shoeleather costs, menu costs, greater relative-price variability, tax distortions caused by imperfect indexation, confusion from a changing unit of account, and arbitrary redistribution between debtors and creditors.

(e)2 Lowering inflation may temporarily produce recession and unemployment, but once expectations adjust, output returns to its natural level while the reduced costs of inflation continue indefinitely.

(e)3 If people believe the commitment, expected inflation falls more quickly. Wage and price setting then adjusts sooner, reducing how much unemployment is required to lower actual inflation.

(e)4 Zero represents literal price stability. Supporters argue that a positive target can appear arbitrary and might be raised again when inflation exceeds it.

(e)5 Expected inflation eventually adjusts. Once it does, the short-run Phillips curve shifts, leaving unemployment at its natural rate regardless of the permanent inflation rate.

(f)1 Suppose reducing inflation by 1 percentage point costs 3.5 percent of one year’s output. If policymakers reduce inflation from 4 percent to zero, what output loss does the sacrifice-ratio calculation imply, and why is this relevant to the argument against zero inflation?

(f)2 Why may the social burden of a disinflationary recession be larger than the aggregate loss of GDP alone suggests?

(f)3 How can a recession created to reduce inflation leave permanent effects on future productive capacity even after output recovers?

(f)4 What does it mean to say that moderate inflation can “grease the wheels” of the labour market?

(f)5 Why can moderate positive inflation give monetary policymakers more ability to stimulate an economy than zero inflation?

(f)1 4×3.5%=14%4\times3.5\%=14\% of one year’s output. The calculation illustrates that eliminating moderate inflation can require a very large temporary sacrifice in production and employment.

(f)2 Recession losses are concentrated rather than evenly distributed. Workers who become unemployed—often workers with fewer skills or less experience—bear much larger losses than people who remain employed.

(f)3 Firms reduce investment, leaving a smaller future capital stock, while prolonged unemployment can erode workers’ skills. Productivity and income can therefore remain below the path they otherwise would have followed.

(f)4 Workers often resist nominal wage cuts. With modest inflation, firms can reduce real wages by allowing nominal wages to rise more slowly than prices rather than cutting the nominal wage itself.

(f)5 With positive inflation, a near-zero nominal interest rate can imply a negative real interest rate. Zero inflation prevents real rates from becoming negative when nominal rates reach their lower bound.

(g)1 What is the fundamental difference between inflation targeting and price-level targeting?

(g)2 Under price-level targeting, what must the central bank do after the price level grows more slowly than its target path?

(g)3 Why does price-level targeting reduce long-run uncertainty about the price level while increasing short-run variability in inflation?

(g)4 How could price-level targeting give the central bank more flexibility to respond to a housing or credit boom?

(g)5 What communication problem could make price-level targeting difficult to implement successfully?

(g)1 Inflation targeting aims at a desired rate of change in prices each period. Price-level targeting aims to keep the actual price level on a predetermined long-run path.

(g)2 It must temporarily allow inflation to run faster so the price level catches back up to the target path.

(g)3 Past misses are corrected under a price-level target, making the long-run price level more predictable. Those corrections require inflation to vary from year to year.

(g)4 The Bank could temporarily tighten monetary policy to restrain borrowing even if inflation fell below normal, provided it later allowed higher inflation to return the price level to its target path.

(g)5 Households and firms must understand that deviations in inflation are deliberate and temporary and that the central bank remains committed to returning the price level to its long-run path.

(h)1 Why do supporters of balanced budgets argue that persistent government deficits impose costs on future generations?

(h)2 Trace the chapter’s argument from a budget deficit to lower national saving, higher borrowing costs or exchange-rate effects, lower investment, and lower future living standards.

(h)3 Why does the argument for fiscal discipline still allow government borrowing for wars, infrastructure, and temporary recessions?

(h)4 What does it mean to argue that the government budget should be balanced over the business cycle rather than balanced every year?

(h)5 Why could forcing the government to balance its budget during a recession actually deepen the downturn?

(h)1 Borrowing allows current taxpayers to receive government services without fully paying for them. Future taxpayers inherit debt servicing obligations that may require higher taxes or lower government services.

(h)2 Deficit → lower public and national saving → less financing available for investment and/or greater dependence on foreign capital → possible higher interest rates and currency appreciation → lower investment and net exports → slower capital accumulation and lower future productivity and income.

(h)3 War involves unusually large temporary costs, infrastructure benefits future generations as well as current taxpayers, and recessions automatically reduce tax revenue and increase support spending. Borrowing can spread these temporary costs across time.

(h)4 Governments may appropriately run deficits during recessions but should offset them with surpluses during expansions so debt does not continually accumulate.

(h)5 Recession already reduces private demand. Raising taxes or cutting government spending merely to preserve budget balance would reduce aggregate demand further and amplify the recession.

(i)1 Why do opponents of strict balanced-budget policies argue that government debt should be judged relative to the economy’s ability to pay rather than simply by its dollar amount?

(i)2 Why might using a budget surplus to reduce government debt make future generations worse off if the alternative was productive spending on education or infrastructure?

(i)3 Why is government debt only one part of the broader issue of intergenerational redistribution?

(i)4 How could forward-looking parents theoretically offset some of the burden that government debt places on their children?

(i)5 If nominal GDP grows by 5 percent per year while government debt grows by only 3 percent per year, what happens to the debt-to-GDP ratio, and what does this illustrate about debt sustainability?

(i)1 A growing economy has a greater tax base and greater ability to service debt. The same dollar amount of debt is therefore much easier to manage in a larger, higher-income economy.

(i)2 Future generations might inherit less debt but also less human or physical capital. If productive government spending has a high return, eliminating it merely to repay debt may reduce future incomes by more than the debt reduction benefits them.

(i)3 Taxes, pensions, education spending, health programs, infrastructure, and many other policies transfer resources across generations even if they do not appear in government debt statistics.

(i)4 Parents benefiting from low current taxes could save more and leave larger bequests to children, helping those children pay the future taxes associated with the debt.

(i)5 The ratio falls because the denominator grows faster than the numerator. It illustrates that debt can continue rising in dollars while becoming less burdensome relative to national income.

(j)1 Why can nominal government debt increase while the real economic burden of the debt falls?

(j)2 How can inflation, population growth, and GDP growth each change the interpretation of whether government debt is becoming more or less burdensome?

(j)3 Why is the debt-to-GDP ratio often more informative than the nominal dollar amount of government debt?

(j)4 Suppose government debt rises from $500 billion to $550 billion while nominal GDP rises from $1 trillion to $1.25 trillion. What happens to the debt-to-GDP ratio, and how could someone reach the wrong conclusion by looking only at the dollar value of debt?

(j)5 What is the central policy disagreement between those who prioritize balanced budgets and those who tolerate moderate deficits?

(j)1 Inflation reduces the purchasing power of the dollars in which the debt is denominated, while economic and population growth can increase the resources available to support it.

(j)2 Inflation reduces its real value; population growth spreads the burden across more taxpayers; and GDP growth raises the economy’s income and tax-paying capacity.

(j)3 It compares debt with the economy’s income-generating capacity and therefore provides information about how manageable the debt burden is.

(j)4 Initially, debt/GDP is 500/1000=50%500/1000=50\%. Later it is 550/1250=44%550/1250=44\%. Nominal debt increased, but its burden relative to GDP fell. Looking only at $500 billion versus $550 billion would miss this improvement.

(j)5 Supporters of balance emphasize national saving, future tax burdens, and intergenerational fairness. Opponents argue that moderate deficits can be sustainable and that the use of borrowed resources may matter more than achieving balance itself.

(k)1 Trace the argument from a higher national saving rate to higher future productivity, wages, and living standards.

(k)2 Why does taxing interest and other returns to saving reduce the incentive to save, especially when returns compound over many years?

(k)3 How can corporate profits distributed to shareholders effectively face taxation at two different stages, and why might this discourage saving?

(k)4 How do TFSAs and RRSPs attempt to increase the incentive to save through different tax treatments?

(k)5 Why does shifting taxation from income toward consumption generally increase the incentive to save?

(k)1 Higher saving makes more resources available for investment → the capital stock grows → workers have more productive capital → labour productivity rises → real wages and incomes rise.

(k)2 Taxation reduces the after-tax rate of return. Over long periods, even a modest reduction in the return produces a very large reduction in accumulated wealth because compound growth occurs on a smaller base each year.

(k)3 Corporate profits can first be taxed through the corporate income tax and then taxed again when distributed to shareholders as dividends, lowering the ultimate after-tax return to ownership.

(k)4 TFSA investment earnings are sheltered from tax. RRSP contributions receive an immediate tax deduction and investment income accumulates tax-deferred until withdrawal.

(k)5 An income tax applies to income whether it is consumed or saved. A consumption tax postpones taxation of saved income until that money is eventually spent, increasing the relative reward to saving.

(l)1 Why do critics of saving incentives argue that policies favouring saving can make the tax system less equitable?

(l)2 Why might reducing taxes on capital income fail to produce much additional saving even though it raises the after-tax return?

(l)3 Explain the opposing substitution and income effects of a higher return on saving.

(l)4 Why could increasing public saving through a larger government budget surplus be an alternative to trying to increase private saving through tax incentives?

(l)5 Under what condition could a tax break intended to encourage private saving actually reduce national saving?

(l)1 Higher-income households generally save more and can therefore receive a disproportionate share of benefits from tax-favoured saving vehicles, potentially shifting more of the overall tax burden toward lower-income households.

(l)2 Saving may be relatively insensitive to the rate of return. Taxpayers could receive a larger after-tax return on saving they would have undertaken anyway without substantially changing the amount saved.

(l)3 The substitution effect raises saving because future consumption becomes cheaper relative to current consumption. The income effect lowers saving because a higher return means less saving is needed to reach a desired future level of wealth.

(l)4 National saving equals private plus public saving. Governments can directly increase public saving by running larger surpluses instead of relying on uncertain household responses to saving incentives.

(l)5 If the tax break reduces government revenue and public saving by more than it increases private saving, total national saving falls rather than rises.