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Fiscal Policy Objectives

Fiscal Policy Objectives. 1. What is the difference between discretionary and nondiscretionary fiscal policy? 2. What is the cause-effect chain for expansionary and contractionary fiscal policy? 3. What are the automatic stabilizers ?

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Fiscal Policy Objectives

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  1. Fiscal Policy Objectives 1. What is the difference between discretionary and nondiscretionary fiscal policy? 2. What is the cause-effect chain for expansionary and contractionary fiscal policy? 3. What are the automatic stabilizers? 4. What period is considered the “Golden Age of Fiscal Policy”? 5. What is the “crowding-out” effect? 6. What is the “negative net export effect”? 7. What are the “lags” involved in fiscal policy? 8. What is “Supply-side” economists? 9. What is the Council of Economic Advisers and the Joint Economic Committee?

  2. Even if I have to dig a hole and cover it back up, I do have a job. John Maynard Keynes “Father of Fiscal Policy” Discretionary Fiscal Policy[“G” & “T”]can be used if further smoothing is required. Nondiscretionary Fiscal Policycan take 33% to 50% of thecurves out of the business cycle. [Automatic stabilizers, like welfare and unemploy. insur.] Peak Peak Contraction Peak Contraction Expansion Peak Contraction Expansion Contraction Trough Trough

  3. Introduction • 1. Can government spending and tax policies help ensure full employment? • 2. What policy actions will • help fight inflation? • 3. What are the roles of government intervention? • This chapter confronts the following questions:

  4. Taxes (“T”) and “G” Spending • Up until 1915, the federal government collected few taxes and spent little. • In 1902, it employed fewer than 350,000 people and spent $650 million. • Today, it employs nearly 5 millionpeopleand spends more than $3 trillion.

  5. Government Revenue • Government expansion started with the 16th Amendment to the U.S. Constitution (1913) which extended the taxing power to incomes. • Today, the federal government collects over $2.6trilliona year in tax revenues.

  6. Recession and Expansionary Fiscal Policy SRAS AD1 LRAS AD2 Recessions Decrease inAD Price Level PL1 $490 YR $510 YF Real GDP

  7. Expansionary Fiscal Policy [Increase “G” or “decrease “T” w. ME of 4] Full $20 Billion Increase in AD AD1 AD2 LRAS SRAS $5 Billion in additional G spending Price Level PL1 $490 YR Real GDP $510 YF

  8. What is the Loanable Funds Market? Is the “real” or “nominal” I.R. used with the LFM graph? “Real I.R.” will be used on the LFM [“r” & nominal I.R. on the money market [i].

  9. [*Use this graph if there is a chg in savings by consumers or chg in fiscal policy] [*Use theMoney Market graphwhen there is achange in MS] Loanable Funds Market D2 S Use the “real interest rate” with LFM, because it is long-term. Use “nominal interest rate” with money market, as it isshort-term. D1 Borrowers Lenders Starting from a balanced budget, if the G incr spending or decr T to get out of a recession, they would now be running a deficit and have to borrow, pushing up demand in the LFM and increasing the interest rate. r=8% Real Interest Rate, (percent) E2 r=6% E1 $2.2 T $2 T $2 T T G F1 F2 Quantity of Loanable Funds Balanced Budget [G&T=$2 Tr.]

  10. [*Use this graph if there is a chg in savings by consumers or chg in fiscal policy] [*Use theMoney Market graphwhen there is achange in MS] Loanable Funds Market S1 D1 S2 Borrowers Lenders Real Interest Rate, (percent) • The following would cause an • increase in supply in the LFM • and lower real interest rates: • Fed increases MS • HH save more • Business save more • Government saves more • Foreigners save more here r=6% E1 r=4% E2 F1 F2 Quantity of Loanable Funds

  11. Demand for Loanable Funds Market (b) (a) Demand for Loanable Funds at 3% [no G borrowing] Business firms demand for LoanableFundsat 3% [a lot of investment] DI Real Interest S Rate D1[noG] A A 3% 3% LFM 1.5 QID Low interest rates, so - a lot of investment Trillions of Dollars Trillions of Dollars

  12. Demand for Loanable Funds Market (b) (a) Business firms demand for Loanable Funds at 5% [not as much investment] With “G” borrowing, the demand for LF goes to5% Government Demand for Funds Business Demand for Funds D2(G) DI Real S Interest Rate D1[noG] B B 5% 5% A 3% A 3% Higher interest rates, so not as much investment 1.0 1.5 LFM QID2 QID1 Trillions of Dollars Trillions of Dollars

  13. BalancedBudget [$2 Tril. “G” = $2 Tril. “T”] Recession Incr G to $2.2 or Decr T to $1.8 $2 Trillion $2 Trillion Deficit so higher I.R. Gonna have to borrow G T So expansionary fiscal policy leads to higher interest rates. Deficit Inflation Decr G to $1.8 or Incr T to $2.2 Surplus so Lower I.R. Wow! A surplus Budget So, contractionary fiscal policy leads to lower interest rates.

  14. Expansionary Fiscal Policy Loanable Funds Market D2 S [Incr G; Decr T] [But we get negative Xn] D1 r=8% SRAS Real In. Rate PL AD2 r=6% Start from a Balanced Budget G & T = $2 Trillion LRAS AD1 F1 F2 “Now, this is better.” $2.2 tr. “I can’t get a job.” PL2 $2 tr. $2 tr. PL1 E2 GT E1 YR YF Real GDP $2.2 $2.2 G G I.R. AD Y/Empl./PL; LFM $1.8 $1.8 T Y/Emp/PL; DI C AD T LFM IR

  15. Contractionary Fiscal Policy Loanable Funds Market D1 [Decr G; Incr T ] [Again, we get negative Xn] D2 S r=6% PL r=3% SRAS Real In. Rate Start from a Balanced Budget G & T = $2 Trillion LRAS AD2 F2 F1 PL1 $2.2 Ttril. E1 $2 tril. $2 Ttril. $1.8 tril.. PL2 GT AD1 E2 YI YF [like we have “money trees”] Real GDP $1.8 $1.8 G G I.R. AD Y/Empl./PL; LFM $2.2 $2.2 T Y/Emp/PL; DI C AD T LFM IR

  16. Discretionary Fiscal Policy Nondiscretionary Fiscal Policy Deliberate use of government spending and/or taxing. “G” and “T” Automatic Stabilizers 1.Welfare & food stamps 2. Unemploy. insurance 3. Social security 4. Corporate Dividends 5. Progressive Tax System Unempl. check Discretion of Congress

  17. Fiscal Policy [Automatic stabilizers] Suppose the economy is inrecession: Tax collections Real GDP Transfer payments AS AD1 G>T AD2 PL The deficit grows YRY* “Recession”

  18. Fiscal Policy [Automatic stabilizers] If the economy has aninflationary gap: Tax collections Real GDP Transfer payments AS AD2 PL AD1 G <T Y*YI The surplus grows “Inflationary Gap”

  19. Discretionary[“Active”]Fiscal Policy[“G” & “T”] [in a nutshell] • Contractionary Fiscal Policy • Decrease “G” • Increase “T” AS AD2 AD1 AD3 PL2 PL1 PL3 Peak Peak YF YR YI Peak Expansion Peak • Expansionary Fiscal Policy • Increase “G” • Decrease “T” Contraction Trough Trough [Takes about 1/3 to ½ out of the curves]

  20. Keynesian Policy “Balance the economy, not the budget.” Peak Peak Raise “T” Raise “T” AS AD2 AD1 AD3 PL2 Raise Taxes Deficit Spending Trough Deficit Spending PL1 “Balance the economy over the course of the Business Cycle” PL3 YF YR YI Bus. Cycle “Even if the jobs are digging holes and filling them up.” Recess – Lower T Deficits Inflat – Raise T Surpluses

  21. FINANCING OFDEFICITS [Isborrowingorprinting the moneymore expansionary?] • 1. Government borrows from the public • [results in higher interest rates • which crowds out investment] Higher I.R. MS1 MS2 2.Just print the money [Money creation – lower interest rates so this would be more expansionary] 7% 4% Lower I.R. AS But the LR increase in MS results in an increase in inflation AD2 AD1 PL2 PL1 Y*Y

  22. How To dispose of Surpluses [Should we hold the surplus or give it back] 1. Debt Retirement [Give the surplus back during recessions to get lower interest rates and expand the economy] 2. Impound The Surplus [Keep the surplus during inflations and give it back during recessions] AS AD2 AD1 PL2 PL1 Y* YI

  23. What is the "Crowding-out" Effect?

  24. [Incr G incr I.R. Decr Ig] "Crowding-out" Effect DI 10% 8% 6% 4% 2% Loanable Funds Market PL s D2 AS Real I.R. D1 AD2 AD1 4% 2% G 10% Realinterest rate Crowding Out Effect 6% IG YR Y* F2 F1 5 10 1520 25 15 0 Quantity of LF Investment (billions of dollars) In this case, it would be 100% “crowding out”. [The higher RIR could also cause crowding-out of Xn.] G can finance a deficit by: 1. Borrowing - this raises interest ratesin the LFM and “crowds out” investment. 2. Money Creation - no “crowding out” so is more expansionary than borrowing. Friedman Just follow the “monetary rule.”

  25. Negative Net Export Effect of Fiscal Policy “Negative Xn” Expansionary Fiscal Policy Due to higher interest rates, dollar appreciates LRAS SRAS AD AD +Ig +G +C AD -Xn YRY*

  26. Negative Net Export Effect of Fiscal Policy “Negative Xn”of “Negative Xn”of Expansionary Fiscal Policy Contractionary Fiscal Policy Due to lower interest rates, dollar depreciates Due to higher interest rates, dollar appreciates LRAS SRAS AD AD SRAS LRAS -G -C -Ig AD +Xn +Ig +G +C -Xn YRY* Y*YI

  27. Liberal (“G”)orConservative (“G”) Liberals Recession: Increase “G”;Inflation: Increase “T” G Conservatives Recession: Decrease “T”; Inflation: Decrease “G” G

  28. Fiscal Policy Lags “The shower starts out too cold, because the pipes have not yet warmed up. So the fool turns up the hot water. Nothing happens, so he turns up the hot water further. The hot water comes on and scalds him. He turns up the cold water. Nothing happens right away, so he turns up the cold further. When the cold finally starts to come up, he finds the shower too cold, and so it goes.” • Fiscal Policy lags • Data (recognition) lag • “Wait-and-see” lag – short run • Legislative lag (political) • Effect lag [takes months]

  29. The G is like a “Fool in the Shower.” Discretionary fiscal policies intended to fight a recession often end up feeding a boom and vice versa. LRAS E4 SRAS1 AD1 SRAS2 AD2 E1 E2 E4 E3 YF YR YI E2 All too often, policy makers can inadvertently exacerbate rather than mitigate the magnitude of economic fluctuations.

  30. Traditional Fiscal Policy [“G” & “T”]will not work withStagflation AD2 SRAS2 AD1 LRAS 15% 10% AD3 4% 10% YR 5% 15% Stagflation YR YF

  31. THE LAFFER CURVE 100 Tax rate (percent) l 0 Tax revenue (dollars)

  32. THE LAFFER CURVE 100 Tax rate (%) m l 0 Tax revenue (dollars)

  33. THE LAFFER CURVE 100 n Tax rate (percent) m l 0 Tax revenue (dollars)

  34. THE LAFFER CURVE 100 n m m Maximum Tax Revenue Tax rate (%) l 0 Tax revenue (dollars)

  35. Supply-Side Economics [Voodoo Economics?] Shift the AS curve back to the right 1. Reduce corporate taxes from 50% to 35% [they have more money and increase investment, so more jobs] 2. Accelerated depreciation of capital investment from 10 years to 3 years [businesses save taxes enabling them to invest more] 3. Reduce personal incometaxesby $250 billion[keeping more of our money makes us work harder & longer; also, we buy more, so more jobs and in addition, we save more, which lowers interest rates, which increases Ig] 4. Tax Credits for R&D [businesses have more money, so more Ig and more jobs] Motto:Get the government off our [ regulations] backs & watch the AS curve shift. StagFlation Was President Reagan a “closet Keynesian” with all the“G” & “T”? Perhaps he wasa “Keynesian in drag.” AS2 AS1 AD PL 10% 3% 10% 5%

  36. The Laffer Curve President Reagan said he was on the Laffer curve. He said that after WWII, when he started making big money, that he could do 4 movies before making $200,000 and hitting the top marginal tax rate of 91%. After four, because he could only keep 9%, he would quit making movies until the next year. “Yes, I was on the Laffer cuve. I couldn’t shoot my way out” b Maximum Tax Revenue c a Tax revenue (dollars) Reagan The “Gipper” Bonzo b 100 0 Tax rate (percent) For rich people, this was a disincentive to keep working, so they would quit when they hit the top marginal tax rate. For most workers, this was not the case.

  37. SUPPLY-SIDE FISCAL POLICY Can sustain a much greater increase in AD if the AS curve is also shifting to the right. AD2 AD1 AS1 AS2 PL2 Price level PL1 10% PL3 0 Q1 Q2 Q3 Real GDP 10%

  38. MULTIPLIER WITH PL CHANGES Inflation and the Multiplier [4] AS Full Multiplier Effect Reduced Multiplier Effect Due to Inflation AD3 AD2 AD1 +20 +20 Price Level P2 P1 + 40 bil. + 80 bil. GDP1 GDP2 GDP3 M(4) = Y/ E [80] [20] M(2) = Y/ E [40] [20]

  39. EXPANSIONARY FISCAL POLICY [MPS=.25] the multiplier at work... $5 billion initial direct increase in spending AS AD2 AD1 Full $20 billion increase in AD +5 Price level PL $485 $505 Real GDP (billions)

  40. CONTRACTIONARY FISCAL POLICY [MPS=.25] the multiplier at work... AS AD1 AD2 PL1 $5 billion initial direct decrease in spending PL2 Price level Full $20 billion decrease in AD $515 Real GDP (billions)

  41. Built-In Stability 50% More vertical [more progressive], the more stability for the economy. Taxes Even more Tax money 12-31-65 Taxes 35% Transfers More tax money More Transfers Surplus Government Expenditures, G, and Tax Revenues, T Deficit Gov. purchases Fewer Transfers Fewer Transfers Less Tax Money 10% But larger deficits GDP1 GDP2 GDP3 5% Y* YI YR Real Domestic Output, GDP

  42. Nondiscretionary [“Passive”] Fiscal Policy (Automatic stabilizers) 1. Transfer Payments D. Corporate dividends • A. Welfare checks E. Social Security • B. Food Stamps F. Veteran’s benefits • C. Unemployment checks • 2. Progressive Income Taxes AS AD2 AD1 AD3 Automatic stabilizers take 33-50% out. Stabilizersare like a thermostat maintaining temperature. They are shock absorbers. 33%-50% YR Y*YI YR ; T ; AD2 YI ; T ; AD3 Taxes reduce the drop in DI during recessionsandreduces the jump in DI during expansions. Automatic Stabilizers The automatic stabilizers may be called theautomatic pilotof our economy, not very well suited for takeoffs and landings, but fine for the smooth part of the the flight. But when thegoing getsrough, the economymust use manual controls. [discretionary G&T] Apilot may take a stroll thruand let theco-pilot cruise. If there isturbulence, thepilot will rush to the cockpit[President & Congress]and use manual controlstocorrect turbulence. Discretionary fiscal policy is our manual control system.

  43. o 45 ADDING THE PUBLIC SECTOR [“G”] $20 Billion Government Spending & Impact on Equilibrium Y Government Spending of $20 Billion C +Ig+Xn +G C + Ig + Xn $20 bil. on National Defense $550 Consumption $470 Increases Y by $80 [$20 x 4 = $80] Private-public - ROW $390 Mixed - Open AE (billions) o RGDP 550 390 470

  44. o 45 ADDING THE PUBLIC SECTOR [“G”] Incr. T by $20 billion [MT = 3] Equilibrium GDP[-60] C +Ig + Xn+G Ca+ Ig + Xn+G $550 $20 bil. incr in T $490 Mixed-Open -20 x 3 = -$60 o RGDP $550 $490 Real domestic product, GDP (billions of dollars)

  45. Balanced Budget Multiplier [$20 billion] [“T”affects AD indirectly thru “C”;“G” affects AD directly] GDP=$80 The increase in “G” flows directly into the economy. +$20 Net Change in GDP = The increase in “T” means we would have consumed $15 and kept $5 in our pockets. GDP= -$60 G $20 Sa= -$5 T $20 Ca= -$15 ME = 1/MPS ME = 1/.25 = 4 So, 4 x $20 = $80 MT = MPC/MPS=.75/.25=3 So, 3 x -$20 = -$60 AS AD2 AD1 PL $470 billion $490 billion

  46. Fiscal Policy NS 1-8 1. With theEmployment Act of 1946, the federal government committed itself to accept (total/some) degree of responsibility for employment/prices. 2.Fiscal policyis carried out primarily by the(local/state/federal) government. 3.Discretionary fiscal policy[G & T] (does/does not) require congressional action. 4. In amixed[private & public)closed economy, taxes & (savings/government spending) areleakages, while Ig and (savings/government spending) areinjections. 5. In amixedeconomy, the equilibrium GDP exists where (C+Ig/C+Ig+G+Xn)=GDP. 6. Thebalanced budget multiplierindicates that equal increases in G&T tend to (decrease/increase/not change) the equilibrium GDP. [MBB is “1”] 7. Assume in a private economy thatequilibrium GDP is $400 billion& the MPC is .80. Suppose theG collects new taxes of $50 bil. & spends the entire amounton our infrastructure. As a result equilibrium GDP will be ($400/$450/$500) billion. 8. Suppose aconstitutional amendmentrequires that theG always balance its budget.If it desired toincrease GDP by $40 billion, G should (increase/decrease) government spending & taxes by ($30/$40/$50) billion.

  47. 9. In asevere recession, Keynesians would favor a(n) (increase/decrease) in taxes. AE2 PL AE1 YR Y* 800 ? 10. If the government tries toeliminate a budget deficit during a depression, these efforts will (help/hurt) the depression. 11. Aconservative economistwho advocates an active fiscal policy would recommend tax (increases/decreases) during arecessionand (increases/decreases) ingovernment spendingduringinflation. AE PL O C YI YR A 12. If theF.E. GDP is OC, then it would be appropriate fiscal policy for government to (increase/decrease) “G” and (increase/decrease) “T”. 13. If theF.E. GDP is OA, then it would be appropriate fiscal policy for government to (increase/decrease) “G” and (increase/decrease) “T”.

  48. 14. If G increases its spending during a recession to assist the economy, the funds must come from some source. (Additional taxes/Borrowing from the public/Creating new money) would tend to be the most expansionary. 15. The following fiscal actions, (incurring a budget surplus and allowing it to accumulate as idle Treasury balances/ incurring a budget surplus which is used to retire debt held by the public) is likely to be most effective incurbing inflation. 16. The greatest anti-inflationary impact of a budget surplus will occur when the G (impounds/uses) the surplus funds & lets them (stand idle/pay off the debt). 17. In describing the built-in stabilizers, we can say that personal & corporate income tax collections automatically (incr/decr) as GDP increases & transfers and subsidies (incr/decr) as GDP increases. Should I give it back?

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