Fiscal Policy

2. Fiscal Policy When the government deliberately changes its taxation or spending policies in order to influence the level of activity in the national economy.

3. Fiscal Policy History • John Maynard Keynes • “General Theory” published 1936 • Keynesian Policy (Theory) • FDR – New Deal • 1933 Fix problems of Great Depression • Full Employment Act of 1946 • Post World War II • Fear of a return to the Great Depression • Congress set goals for management of national economy

4. Fiscal Policy – Basic Theory • Capitalism (Market Economies) • are not stable. • Economy can get stuck in recession/depression • Consumer expectations “animal spirits” are important • Government needs to be significant part of economy. (GDP = C + Ig + G) • Current GDP $15.2 trillion • Federal Budget $3.7 trillion

5. Fiscal Policy – Basic Theory • Multiplier Effect magnifies government actions. Who Spend Taxes Gov’t Inject $1000 Amy $ 900 $100 Bob $ 800 $100 Cathy $ 700 $100 Dennis $ 600 $100 Elaine $ 500 $100 Frank $ 400 $100 Gigi $ 300 $100 Hank $ 200 $100 Irene $ 100 $100 Joe $ 0 $100 Total $5,500 $1,000 Real World multiplier is roughly 2.

6. Fiscal Policy Actions • Performed by Congress & President • Federal Budget Process • During Contractions (Unemployment) • Increase government spending • Decrease taxes • Deficit spending is OK

7. Fiscal Policy Actions • During Expansions (Inflation) • Decrease government spending • Increase taxes • Surplus budget • Long run balanced budget

8. Fiscal Policy Limitations • Cyclical Asymmetry • Congress • Easy to cut taxes and/or increase spending • Hard to raise taxes and/or decrease spending • Time Lags • Recognition • Policy discussion • Implementation • Monetary Policy • 2nd method to control the economy

9. Fiscal Policy • Automatic Fiscal Policy • Solves problems of time lags • During contractions • Unemployment Insurance • Welfare Programs • Progressive Income Tax

11. Fiscal Policy • Discretionary Fiscal Policy • Used when automatic stabilizers are not enough. • G.W. Bush’s Tax Rebate checks (2x) • Bailouts of Financial & Auto Industry • Obama’s stimulus package • Obama & Republican’s compromise on taxes.

13. AD – AS Model Aggregate Demand -- Aggregate Supply Price Level (Inflation) AS Potential GDP Output (GDP)

14. AD – AS Model Current GDP is less than Potential GDP Economy is in Recession Fiscal Policy should attempt to increase GDP by increasing AD Price Level (Inflation) AS AD Potential GDP Output (GDP) Current GDP

15. AD – AS Model Current GDP is maximized Inflation is increasing Fiscal policy should attempt to reduce inflation by decreasing AD Price Level (Inflation) AD AS Accelerating Inflation Potential GDP Output (GDP)

22. 5 Stagflation: Traditional Keynesian Policy can’t fix this!

23. Discretionary or Automatic?Expansionary or Contractionary ? • Recession raises amount of unemployment compensation. • Automatic - Expansionary • The Government cuts personal income-tax rates. • Discretionary - Expansionary • The government eliminates favorable tax treatment on long-term capital gains. • Discretionary - Contractionary

24. Discretionary or Automatic?Expansionary or Contractionary ? • Incomes rise; as a result, people pay a larger fraction of their income in taxes. • Automatic - Contractionary • As a result of a recession, more families qualify for food stamps and welfare benefits • Automatic - Expansionary • The government eliminates the deductibility of interest expense for tax purposes • Discretionary - Contractionary

25. Discretionary or Automatic?Expansionary or Contractionary ? • The government launches a major new space program to explore Mars. • Discretionary - Expansionary • The government raises Social Security taxes. • Discretionary - Contractionary • Corporate profits increase; as a result, government collects more corporate income taxes • Automatic - Contractionary

26. Discretionary or Automatic?Expansionary or Contractionary ? • The government raises corporate income tax rates. • Discretionary - Contractionary • The government gives all its employees a large pay raise. • Discretionary - Expansionary • President Obama proposes to continue the FICA (Social Security) tax cut into 2012. • Discretionary - Expansionary

27. Keynes Rap • PBS debate / rap on Keynes • Keynes vs. Hayek: Late Economists' Hip-Hop Legacy | PBS NewsHour | Dec. 16, 2009 | PBS • Round 2

28. Economist Magazine online dictionary

29. Animal spiritshttp://www.economist.com/research/economics/alphabetic.cfm?letter=A • The colourful name that Keynes gave to one of the essential ingredients of economic prosperity: confidence. According to Keynes, animal spirits are a particular sort of confidence, "naive optimism". He meant this in the sense that, for entrepreneurs in particular, "the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death". Where these animal spirits come from is something of a mystery. Certainly, attempts by politicians and others to talk up confidence by making optimistic noises about economic prospects have rarely done much good

30. Liquidity trap • When MONETARY POLICY becomes impotent. Cutting the rate of INTEREST is supposed to be the escape route from economic RECESSION: boosting the MONEYSUPPLY, increasing DEMAND and thus reducing UNEMPLOYMENT. But KEYNES argued that sometimes cutting the rate of interest, even to zero, would not help. People, BANKS and FIRMS could become so RISKAVERSE that they preferred the LIQUIDITY of cash to offering CREDIT or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policymakers. • KEYNESIANs reckon that in the 1930s the economies of both the United States and the UK were caught in a liquidity trap. In the late 1990s, the Japanese economy suffered a similar fate. But MONETARISM has no place for liquidity traps. Monetarists pin the blame for the Great DEPRESSION and Japan’s more recent troubles on other factors and reckon that ways could have been found to make monetary policy work.