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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. 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. • It owns one-third of the land. • It occupies 2.6 billion sq. feet of office space. • It owns and operates 400,000 nonmilitary vehicles.

  4. 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.

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

  6. 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

  7. [*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.]

  8. [*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

  9. 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

  10. 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

  11. Here is an LFM question asked on the 2008 FRQ.

  12. 1.(a) Using a correctly labeled graph of the loanable funds market, show the impact of an increase in government spending on the real interest rate [RIR] in the economy. Answer to 1. (a) As can be seen on the LF graph, the RIR would increase as the government has to borrow more than previously, increasing demand in the LFM, which pushes up the RIR. D2 S D1 Borrowers Lenders 1.(b) How will the real interest rate change in part (d) affect the growth rate of the U.S. economy? Explain. rir=8% Real Interest Rate, (percent) E2 Answer to 1. (b): The increase in RIR will decrease real Ig, decreasing capital stock. This will decrease AD and decrease GDP or growth rate in the U.S. economy. rir=6% E1 $2.1 Tril. after $100 B increase $2 T $2 T T G F1 F2 Quantity of Loanable Funds Balanced Budget [G&T=$2 Tr.]

  13. Expansionary Fiscal Policy Loanable Funds Market D2 S [Incr G;Decr T] Real In. Rate D1 r=8% SRAS PL AD2 r=6% Start from a Balanced Budget G & T = $2 Trillion LRAS AD1 F1 F2 “Now, this is better.” $2.2 tril. “I can’t get a job.” PL2 $2 tril. $2 tril. 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

  14. Contractionary Fiscal Policy Loanable Funds Market D1 [Decr G; Incr T] Real In. Rate D2 S r=6% PL r=3% SRAS Start from a Balanced Budget G & T = $2 Trillion LRAS AD2 F2 F1 PL1 $2.2 Ttril. E1 $2 tril. $2 Ttril. $1.8tril.. 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

  15. Fiscal Policy During Recession Recessionary Gap SRAS LRAS AD2 AD1 YRY* Expansionary Fiscal Policy G T Keynes and Lydia Lopokova

  16. Fiscal Policy During Inflation Inflationary Gap SRAS LRAS AD2 AD1 Y*YI Contractionary Fiscal Policy G T

  17. 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

  18. 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”

  19. 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”

  20. Financing of Deficits [Is borrowingor “printing” the money more 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

  21. 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

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

  23. [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”. 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.”

  24. 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*

  25. 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

  26. 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]

  27. 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.

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

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

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

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

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

  33. Comparing the Laffer Curve to Robin Hood Arthur Laffer illustrated his supply-side views with a story relating to Robin Hood, who stole from the rich to give to the poor. Laffer likened people traveling through Sherwood Forest to taxpayers, whereas Robin Hood and his band of merry men were government. As taxpayers passed through the forest, Robin Hood and his men intercepted them and forced them to hand over all of their money. Laffer asked audiences, “Do you think that travelers continued to go through Sherwood Forest?” Robin Hood The “rich” Sherwood Forest His answer was, “No.”Taxpayers will avoid Sherwood Forest to the greatest extent possible. They will lower their taxable income by reducing work hours, retiring earlier, saving less, and engaging in tax avoidance and tax evasion activities. Robin Hood and his men may end up with less revenue than if they collected a relatively small “tax” from each traveler for passage through the forest.

  34. “I was on the Laffer curve.” Reaganomics [Ave. 23% cut] The core of the supply-side theory was that lower marginal tax rateswould cause people to “supply” more labor, working more and harder, which would increase growth – and the positive effect on growth would be so large that “G” tax revenue would actually increaserather than decrease in response to the tax cut.

  35. Reaganomics and Budget Deficits In honor of President Reagan’s 1st 4 years the democrats wanted this new $1 Trillion bill.

  36. 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 AS2 Was President Reagan a “closet Keynesian” with all the“G” & “T”? Perhaps he wasa “Keynesian in drag.” AS1 AD PL 10% 3% 10% 5%

  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. 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)

  39. 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)

  40. 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.

  41. LEGISLATIVE MANDATES Employment Act of 1946 Council of Economic Advisors (CEA) Joint Economic Committee (JEC)

  42. Legislative Mandates for Remedial Fiscal Measures 1. Employment Act of 1946 – a law promoting economic stability (by promoting “maximum employment, production, and purchasing power”) through monetary and fiscal policies. This act was a government commitmentto ensure prosperity after WWII. [not only“could”but“would” – no more laissez faire] This act gave the Keynesians economists the theoretical and legal justification to use fiscal policy to stabilize the economy. 2.Council of Economic Advisers (CEA) [for the President] – 3 distinguished economists (on leave from universities) who assist and advise the President on economic matters. Their staff is made up of 11 senior and 6 junior economists. They forecast and project the deficit, inflation, GDP growth, foreign exchange rates, immigration, &antitrust legislation. The President must submit an annual economic report describing the current economic state with recommendations. “The President’s intelligence armin the waragainst the business cycle.”

  43. JEC of Congress & Humphrey-Hawkins Act of 1978 3. Joint Economic Committee (JEC) of Congress – an advisory group or intelligence arm in the war against contractions in the business cycle. After gathering and analyzing economic data, they make forecasts and formulate programs to improve employment. 4. Humphrey-Hawkins Act of 1978 – requires government to establish five-year economic goals and formulateplans to achieve it. The goals are 4% unemployment and zero inflation. If you look at my “C” average college grades, the CEA can help me.

  44. 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

  45. 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)

  46. 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

  47. Fiscal Policy NS 1-8 1. With the Employment 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 a mixed[private & public)closed economy, taxes & (savings/government spending) are leakages, while Ig and (savings/government spending) areinjections. 5. In a mixedeconomy, the equilibrium GDP exists where (C+Ig/C+Ig+G+Xn)=GDP. 6. The balanced 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 that equilibrium GDP is $400 billion& the MPC is .80. Suppose the G collects new taxes of $50 bil. & spends the entire amount on our infrastructure. As a result equilibrium GDP will be ($400/$450/$500) billion. 8. Suppose a constitutional amendmentrequires that theG always balance its budget. If it desired to increase GDP by $40 billion, G should (increase/decrease) government spending & taxes by ($30/$40/$50) billion.

  48. 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”.

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