CHAPTER 16 ACHIEVING ECONOMIC STABILITY

1. CHAPTER 16 ACHIEVING ECONOMIC STABILITY

2. I. THE COST OF ECONOMIC INSTABILITY • The “misery index” (the sum of inflation plus the unemployment rate) in the United States was below 8 percent at the end of the twentieth century, far lower than the 14 percent rate in Israel or the 22 percent rate in Spain.

3. A. THE ECONOMIC COSTS 1. The GDP gap measures the difference between actual GDP and the GDP that could have been achieved had all resources been fully employed. 2. The misery index is the sum of monthly inflation and unemployment rates. 3. Uncertainty increases when real GDP declines.

4. B. THE SOCIAL COSTS 1. Economic instability results in wasted labor, capital, and natural resources. 2. Economic instability can lead to political instability. 3. Economic instability is associated with increased crime, lower levels of police protection and municipal services, and less willingness by companies to hire disadvantaged people or provide on-the-job training.

5. II. MACROECONOMIC EQUILIBRIUM • In 1997, exports by the United States increased aggregate demand by $689 billion. Imports to the United States increased aggregate supply by $871 billion.

6. A. AGGREGATE SUPPLY 1. The aggregate supply curve shows the amount of real GDP that could be produced at various price levels. 2. When costs fall, the aggregate supply curve shifts to the right. 3. When costs rise, the aggregate supply curve shifts to the left.

7. B. AGGREGATE DEMAND 1. Aggregate demand shows the quantity of real GDP that would be purchased at various price levels. 2. A decrease in savings, expectations of a strong economy, an increase in transfer payments financed through deficit spending, or a reduction in taxes shifts the aggregate demand curve to the right. 3. An increase in savings, expectations of a weak economy, a decrease in transfer payments financed through deficit spending, or an increase in taxes shifts the aggregate demand curve to the left.

8. C. MACROECONOMIC EQUILIBRIUM 1. Macroeconomic equilibrium is achieved when aggregate supply equals aggregate demand. 2. Although aggregate supply and demand curves do not provide exact predictions about the economy, they are useful for analyzing macroeconomic trends.

9. III. STABILIZATION POLICIES • John Maynard Keynes (1883–1946) was one of the most influential economists of the twentieth century. In addition to revolutionizing economic thinking about fiscal policy, he played a central role in the Bretton Woods Conference of 1944, which created the International Monetary Fund and the World Bank.

10. A. DEMAND-SIDE POLICIES 1. The multiplier effect means that a change in investment spending will have a magnified effect on total spending. 2. When a change in investment is caused by a change in overall spending, a downward economic spiral may begin. This is known as the accelerator effect. 3. According to Keynes, only the government is large enough to offset changes in investment spending.

11. A. DEMAND-SIDE POLICIES continued 4. Unemployment insurance and federal entitlement programs work as automatic stabilizers, automatically increasing government spending whenever changes in the economy threaten people’s incomes. 5. In the long run, all attempts by the government to increase aggregate demand merely increase the price level without increasing real GDP.

12. B. SUPPLY-SIDE POLICIES 1. Hopes that reducing tax rates would actually increase tax collections failed to materialize in the 1980s. 2. Successful supply-side policies can shift aggregate supply, moving the economy into equilibrium. 3. Supply-side policies seek to promote economic growth rather than economic stability.

13. C. MONETARY POLICIES 1. Monetarists believe the money supply should be allowed to grow at a slow but steady rate in order to control inflation and permit economic growth. 2. Monetarists believe that expanding the money supply cannot permanently affect the rate of employment.

14. IV. ECONOMICS AND POLITICS • Martin Feldstein, former chair of the Council of Economic Advisers writes that people are frequently surprised to learn how small the Council actually is. They hear the word “council” and think of a dozen or more people sitting around a conference table when, in fact, the CEA has only a chairman and two additional members. Talking with senior economic officials from around the world, Feldstein also discovered that the institutionalized appointment of a professional economist to a country’s president or leader is rare. In other countries economists rarely have direct and regular access to the head of the government, nor are they able to participate as an equal in all cabinet-level discussions.

15. A. THE CHANGING NATURE OF ECONOMIC POLICY 1. For a variety of reasons, discretionary fiscal policy is used less today than it once was. 2. Passive fiscal policy, like automatic stabilizers and a progressive income tax, contribute to the stability of the American economy. 3. Structural fiscal policies are designed to strengthen the economy in the long run rather than deal with temporary problems, such as unemployment or inflation.

16. A. THE CHANGING NATURE OF ECONOMIC POLICY continued 4. Declining discretionary fiscal policy has increased the influence of monetary policy. 5. Though often the target of criticism, most members of Congress believe that the power to create money should remain with an independent agency, not elected officials.

17. B. WHY ECONOMISTS DIFFER 1. Economists choose policies that reflect their sense of which economic problems are most critical. 2. Economists are affected by the economic conditions prevailing in their lifetimes.

18. C. ECONOMIC POLITICS 1. The Council of Economic Advisers advises the president of the United States on economic policy. 2. Economists have contributed a great deal to the understanding of economic activity. They can help policy makers prevent another Great Depression, stimulate growth, or help disadvantaged groups. It is unlikely, however, that they can help a country avoid minor recessions.