Principles of Macroeconomics

Twelfth Edition (1 of 2)

PART IV
FURTHER
MACROECONOMICS
ISSUES

Copyright
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Pearson
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Copyright

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PART IV FURTHER
MACROECONOMICS ISSUES
• In Part IV of the textbook, we will cover a number of
macroeconomic issues.
• Chapter 14: Financial crises, policy stabilization, and
deficits
• Chapter 15: Household and firm behavior in the
macroeconomy
• Chapter 16: Long-run growth
• Chapter 17: Alternative views in macroeconomics

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Principles of Macroeconomics
Twelfth Edition (2 of 2)

Chapter 14
Financial Crises,
Stabilization, and
Deficits

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Chapter Outline and Learning Objectives
14.1 The Stock Market, the Housing Market, and Financial
Crises
• Discuss the effects of historical fluctuations in stock and housing prices
on the economy.

14.2 Time Lags Regarding Monetary and Fiscal Policy

• Explain the purpose of stabilization policies and differentiate between
three types of time lags.

14.3 Government Deficit Issues

• Discuss the effects of government deficits and deficit targeting.

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Chapter 14 Financial Crises,
Stabilization, and Deficits
• What accounts for the large fluctuations in the
unemployment rate? Why can’t policy makers do a better
job of controlling the economy?
• This chapter tries to help answer these questions by first
considering the stock market and the housing market,
which affect the economy through a household wealth
effect.

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The Stock Market, the Housing Market,
and Financial Crises
Stocks and Bonds
• stock A certificate that certifies ownership of a certain
portion of a firm.
• A share of common stock is a certificate that represents
the ownership of a share of a business, almost always a
corporation.
• Shareholders are entitled to a share of the company’s
profit. When profits are paid directly to shareholders, the
payment is called a dividend.

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Stocks and Bonds
• capital gain An increase in the value of an asset.
• realized capital gain The gain that occurs when the
owner of an asset actually sells it for more than he or she
paid for it.
• The total return that an owner of a share of stock receives
is the sum of the dividends received and the capital gain or
loss.

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Determining the Price of a Stock
• The larger the expected future dividends, the larger the
current stock price, other things being equal.
• The price of a stock should equal the discounted value of
its expected future dividends, where the discount factors
depend on the interest rate and risk.
• Stock prices may also depend on what people expect
others to expect them to be in the future, bringing about
stock market “bubbles.”

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The Stock Market since 1948
• Dow Jones Industrial Average An index based on the
stock prices of 30 actively traded large companies. The
oldest and most widely followed index of stock market
performance.
• NASDAQ Composite An index based on the stock prices
of more than 5,000 companies traded on the NASDAQ
Stock Market. The NASDAQ market takes its name from
the National Association of Securities Dealers Automated
Quotation System.
• Standard & Poor’s 500 (S&P 500) An index based on the
stock prices of 500 of the largest firms by market value.

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FIGURE 14.1 The S&P 500 Stock Price Index, 1948 I–2014 IV

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FIGURE 14.2 Ratio of after-Tax Profits to GDP, 1948 I–2014 IV

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Housing Prices since 1952
• Housing prices grew roughly in line with the overall price
level until 2000.
• The increase between 2000 and 2006 was huge, followed
by an equivalent fall between 2006 and 2009.
• Between 2006 II and 2009 I, the fall in the value of housing
wealth was about $7 trillion.

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FIGURE 14.3 Ratio of a Housing Price Index to the GDP Deflator,
1952 I–2014 IV

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Household Wealth Effects on the
Economy
• Much of the fluctuation in household wealth in the recent
past has been due to fluctuations in stock prices and
housing prices.
• When housing and stock values rise, households feel
richer and spend more.
• An increase in stock prices may also increase investment.
The cost of an investment project in terms of shares of
stock is smaller the higher the price of the stock.

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Financial Crises and the 2008 Bailout
• In a financial crisis, macroeconomic problems caused by
the wealth effect of a falling stock market or housing
market are accentuated.
• Many people consider the fall in housing prices that began
in 2006 to have led to the financial crisis of 2008–2009.
• As a result of a bailout bill passed in October 2008, the
federal government bailed out most of the large financial
institutions experiencing financial trouble in the mortgage
market.
• The Federal Reserve also participated in the bailout by
buying huge amounts of mortgage-backed securities.
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ECONOMICS IN PRACTICE
Predicting Recessions

• Economists are not always very

good at predicting recessions,
meaning that the recognition lag
can be long.

• The 2008−2009 recession is a good

example. Why? Much of the
recession was driven by the fall in
housing and stock prices, which are
difficult to predict.

THINKING PRACTICALLY

1. Why might it have been hard to predict the boom in the U.S. economy in the last half of
the 1990s?

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Time Lags Regarding Monetary and
Fiscal Policy (1 of 3)
• stabilization policy Describes both monetary and fiscal
policy, the goals of which are to smooth out fluctuations in
output and employment and to keep prices as stable as
possible.
• time lags Delays in the economy’s response to
stabilization policies.

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FIGURE 14.4 Two Possible Time Paths for GDP

• Path A is less stable—it varies more over time—than path B.

• Other things being equal, society prefers path B to path A.

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FIGURE 14.5 Possible Stabilization Timing Problems

• Attempts to stabilize the economy can prove destabilizing because of time lags.

• An expansionary policy that should have begun to take effect at point A does not
actually begin to have an impact until point D, when the economy is already on an
upswing.

• Hence, the policy pushes the economy to points E and F (instead of points E
and F).

• Income varies more widely than it would have if no policy had been implemented.

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Time Lags Regarding Monetary and
Fiscal Policy (2 of 3)

Recognition Lags
• recognition lag The time it takes for policy makers to
recognize the existence of a boom or a slump.

Implementation Lags
• implementation lag The time it takes to put the desired
policy into effect once economists and policy makers
recognize that the economy is in a boom or a slump.

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Time Lags Regarding Monetary and
Fiscal Policy (3 of 3)
Response Lags
• response lag The time it takes for the economy to adjust
to the new conditions after a new policy is implemented;
the lag that occurs because of the operation of the
economy itself.

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Response Lags (1 of 2)
Response Lags for Fiscal Policy
• Because it takes time for the government spending
multiplier to reach its full value, there is a lag between the
time a fiscal policy action is initiated and the time the full
change in GDP is realized.
• In practice, it takes about a year for a change in taxes or
in government spending to have its full effect on the
economy.

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Response Lags (2 of 2)
Response Lags for Monetary Policy
• The response lags are even longer for monetary policy.
• When interest rates change, the sales of firms do not
change until households change their consumption
spending and/or firms change their investment spending.

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Summary
• It takes time for policy makers to recognize the existence
of a problem and to implement a solution, and it takes time
for firms and households to respond to the stabilization
policies taken.
• Monetary policy can be adjusted more quickly and easily
than fiscal policy, making it a useful instrument in
stabilizing the economy.
• Because the response lag is probably shorter for fiscal
policy, tax and spending changes may also play a useful
role in macroeconomic management.

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Government Deficit Issues
• A government trying to stimulate the economy through tax
cuts or spending increases will increase the government
deficit.
• Deficits in recessions (cyclical deficits) are temporary and
do not impose any long-run problems.
• Deficits at full employment (structural deficits) can have
negative long-run consequences.
• The large deficits beginning in 2008 led to a large rise in
the ratio of the federal government debt to GDP. Without
significant new measures, the debt/GDP ratio is projected
to continue to rise.
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Deficit Targeting (1 of 2)
• Gramm-Rudman-Hollings Act Passed by the U.S.
Congress and signed by President Reagan in 1986, this
law set out to reduce the federal deficit by $36 billion per
year, with a deficit of zero slated for 1991.
• automatic stabilizers Revenue and expenditure items in
the federal budget that automatically change with the
economy in such a way as to stabilize GDP.
• automatic destabilizers Revenue and expenditure items
in the federal budget that automatically change with the
economy in such a way as to destabilize GDP.

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FIGURE 14.6 Deficit Reduction Targets under Gramm-Rudman-
Hollings

• The GRH legislation, passed in 1986, set out to lower the federal deficit by $36 billion
per year.

• If the plan had worked, a zero deficit would have been achieved by 1991.

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FIGURE 14.7 Deficit Targeting as an Automatic Destabilizer

• Deficit targeting changes the way the economy responds to negative

demand shocks because it does not allow the deficit to increase.

• The result is a smaller deficit but a larger decline in income than would
have otherwise occurred.

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Deficit Targeting (2 of 2)
• Deficit targeting has undesirable macroeconomic
consequences.
• It requires cuts in spending or increases in taxes at times
when the economy is already experiencing problems.
• Locking in spending cuts or tax increases during periods of
negative demand shocks is not a good way to manage the
economy.
• Moving forward, policy makers around the globe will have
to devise other methods to control growing structural
deficits.

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REVIEW TERMS AND CONCEPTS
• automatic destabilizers • response lag

• automatic stabilizers • stabilization policy

• capital gain • Standard & Poor’s 500 (S&P 500)

• Dow Jones Industrial Average • stock

• Gramm-Rudman-Hollings Act • time lags

• implementation lag

• NASDAQ Composite

• realized capital gain

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