Chapter 18 in Principles of Macroeconomics Version 11 - By: Case, Fair, Oster Pr

Question

Chapter 18 in Principles of Macroeconomics Version 11 - By: Case, Fair, Oster

Problem #7.            

When Bill Clinton took office in January 1993, he faced two major economic problems: a large federal budget deficit and high unemployment resulting from a very slow recovery from the recession of 1990 to 1991. In his first State of the Union message, the president called for spending cuts and substantial tax increases to reduce the deficit, Most of these proposed spending cuts were in the defense budget. The following day Alan Greenspan, chair of the Federal Reserve Board of Governors Signaled his support for the president’s plan. Many elements of the president’s original plan were later incorporated into the deficit reduction bill passes in 1993.

a. Some said at the time that without the Fed’s support, the Clinton Plan would be a disaster. Explain this argument.

b. Supply-side economists and monetarists were very worried about the plan and the support it received from the Fed. What specific problems might a monetarists and a supply side economist worry about?

c. Suppose you were hired by the Federal Reserve Bank of St. Louis to report in the events of 1995 and 1996. What specific evidence would you look for to see whether the Clinton plan was effective or whether the critics were right to be skeptical?

Explanation / Answer

a)      Ceteris paribus, a cut in government spending would be expected to have a negative impact on aggregate demand. We would expect a fall in AD. This would lead to lower economic growth and lower inflation. If other components, such as consumer spending were rising – then a cut in government spending may just reduce the growth of AD. If the government cut spending when the economy is already in difficulties, then we will get a significant fall in real GDP. Combined with low growth, export growth is slow and there is fear that a small cut in government spending could reduce consumer/business confidence and push the economy back into recession. It also depends on monetary policy. If the government cut spending, but at the same time, we can have a loosening of monetary policy – cutting interest rates – then in this case AD could continue to rise. If monetary policy can’t be loosened (e.g. interest rates already zero, then cutting spending will have a bigger negative impact. And if a cut in government spending does cause a further economic downturn the improvement in finances will be limited. This is because if spending cuts cause lower growth, it will lead to lower tax revenues and higher spending on benefits.

b)      Supply side economics or Reaganomics is an economics theory built around the idea that by giving the rich enough money, tax breaks and deregulation, they will be freed from the constraints that allegedly prevent them from expanding their businesses and hiring more people. In turn, by expanding their businesses and employee pools, they will expand and fortify the nation's economic strength.

Thus here when taxes are too high, people refuse to engage in economic activity. If taxed activity drops too low, then there are fewer transactions to collect tax from. For supply siders, this mechanism constitutes the primary determinant of economic growth. They assume that lower taxes can actually increase government revenues in the long run, because the surplus income from an expanding economy is supposed to make up for the immediate effects of tax cuts. Similarly the monetarists believe that a proper monetary policy is the most effective method to smooth out the business cycle—superior, in fact, to the fiscal policies.

c) Large and persistent deficits push up interest rates, reduce investment, and create a burden of indebtedness that is difficult for governments and taxpayers to bear. Further, deficits interfere with the effective functioning of markets at home and abroad. Most important, they compromise the living standards of current and future generations. Governments of industrial countries have entered into a costly covenant with their citizens by offering generous assistance to the poor, unemployed, disabled, and elderly, and the increased spending has sent debt ratios soaring throughout the industrial world for the past two decades. As population’s age and productivity grows slowly, these debts are forcing decisions upon national governments.

Measures to reduce government spending are imperative, particularly through restructuring entitlement programs that have grown beyond sustainable limits. The choices are difficult, but must be addressed soon to buy time for changes to be made gradually, reducing the harm done to those dependent on government transfers and allowing all to adjust to possible new taxes and to the prospect of lower benefits. Further skirting of the deficit issue is irresponsible.

I would hence agree to the effectiveness of the plan.

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