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  1. 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” FISCAL POLICY[“G” and “T”]

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

  3. Taxes (“T”)and“G”Spending • Up until 1915, the federal government collected few taxes and spent little. • In 1902, it employed fewer than 350,000people and spent$650 million. • Today, it employs nearly 4.3 millionpeopleand spends more than $3.4 trillion.

  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 $2.7trilliona year in tax revenues.

  5. Let’s say the German government decides to connect East Germany to West Germany by constructing a water bridgeover the Elbe River. They did this, spending 500 million euros. The next picture is a kilometer-long “concrete bathtub” water bridge near the town of Magdeburg.

  6. Loanable Funds Market [*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] 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 abalanced budget, if the G incr spendingordecr Tto get out of arecession, theywould now be running adeficitand have to borrow,pushing up demand in the LFM and increasing the interest rate. IR=10% Real Interest Rate, (percent) E2 IR=8% E1 $2 T$2 T T G F1 F2 Quantity of Loanable Funds Balanced Budget [G&T=$2 Tr.]

  7. 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

  8. 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 at5% Government Demand for Funds Business Demand for Funds D2(G) DI Real S Interest Rate D1[noG] B 5% 5% B A 3% A 3% Higher interest rates, so not as much investment LFM 1.0 1.5 QID2QID1 Trillions of Dollars Trillions of Dollars

  9. 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.

  10. Expansionary Fiscal Policy [Incr G;Decr T] PL SRAS AD2 LRAS Start from a Balanced Budget G & T = $2 Trillion AD1 “Now, this is better.” “I can’t get a job.” PL2 $2 T$2 T PL1 E2 GT E1 YR YF Real GDP G G I.R. AD Y/Empl./PL; LFM T Y/Emp/PL; DI C AD T LFM IR

  11. Contractionary Fiscal Policy [Decr G; Incr Tto close acontractionary gap] PL SRAS Start from a Balanced Budget G & T = $2 Trillion LRAS AD2 PL1 E1 $2T$2T PL2 GT AD1 E2 YI YF [like we have “money trees”] Real GDP G G I.R. AD Y/Empl./PL; LFM T Y/Emp/PL; DI C AD T LFM IR

  12. Everyone Wants To Go To HeavenBut No One Wants To Die. Everyone Wants Government Spending But No One Wants To Pay Taxes.

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

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

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

  16. BUILT-IN STABILITY More vertical [more progressive], the more stability for the economy. Taxes 12-31-65 Taxes Transfers More tax money More Transfers Surplus Government Expenditures, G, and Tax Revenues, T Gov. purchases by Fed, state and local governments Deficit Fewer Transfers Fewer Transfers Less Tax Money GDP1 GDP2 GDP3 Y* YI YR Real Domestic Output, GDP

  17. Keynesian Model Inflat. Gap Recess. Gap

  18. 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

  19. 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”

  20. 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”

  21. Discretionary Fiscal Policy • Contractionary Fiscal Policy • Decrease “G” • Increase “T” Discretionary • Expansionary Fis. Policy • Increase “G” • Decrease “T”

  22. The Kennedy/Johnson $10Billion Tax Cuts of 1964 The“Golden Age of Fiscal Policy”

  23. Fiscal Policy and Tax Cuts. When Kennedy came into office: 1. The top marginal tax rate was91% &drops to 52%[35%today] 2. The unemployment rate was 6.7%& dropsbelow 5%. 3. Arecessionbecomes a very goodlow unemployment - low inflation (2%)economy. 4. The expansion continued to 1969. Kennedy had been hesitant about a $10 billion tax cut but finally saw the Keynesian Light. 12/31-65

  24. Keynesian Policy: “Balance the Economy, not the Budget.” “Even if the jobs aredigging holes and filling them up.” Deficits Surpluses

  25. FINANCING OFDEFICITS [Isborrowingorprinting the moneymore expansionary?] • 1. Government borrows from the public • [results in higher interest rates • which crowds out investment] Higher I.R. MS1MS2 2. Just print the money [Money creation – lower interest rates so this would be more expansionary] 7% 4% Lower I.R. But the LR increase in MS results in an increase in inflation AS AD2 AD1 PL2 PL1 Y*Y

  26. How To Dispose of Surpluses [Should wehold the surplusorgive 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 PL Y*YI

  27. “CROWDING OUT” EFFECT [Incr G incr I.R.Decr Ig] AS G can finance a deficit by: 1. Borrowing - this raises interest rates in the LFM and “crowds out” investment. 2. MoneyCreation - no “crowding out” so is more expansionary than borrowing. 16 14 12 10 8 6 4 2 0 AD2 AD1 4% 2% G IG YR Y* Real interest rate (%) Crowding Out Effect DI Friedman Just follow the “monetary rule.” 5 10152025 30 35 40 Investment (billions of dollars)

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

  29. 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 -G -Ig -C SRAS LRAS +Xn +Ig +G +C -Xn YRY* Y*YI

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

  31. 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 hotwater 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]

  32. The G is like a “Fool in the Shower.” LRAS E4 SRAS1 AD1 SRAS2 AD2 E1 E2 E4 E3 YR YF YI E2

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

  34. Laffer Curve and Supply-Side Economics Was Reagan a “closet Keynesian” with all the “G” & “T”? Perhaps he was a “Keynesian in drag.”

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

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

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

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

  39. Ben Stein’s part in this movie as a boring econ prof was voted one of the 50 most famous scenes in American film. Ben Stein [from “Ferris Bueler’s Day Off”] graduated from Columbia University in 1966 with a degree in economics and from Yale Law School in 1970 as valedictorian. He was a speech writer for Nixon. He has written 16 books, including his latest humor book, “How To Ruin Your Life”.

  40. 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 hitting the top marginal tax rate of 90%. After 4, because he could only keep 10%, he would quit making movies until the next year. “Yes, I was on the Laffer cuve. I couldn’t shoot my way out” Maximum Tax Revenue m n l Tax revenue (dollars) Reagan The “Gipper” Bonzo m 100 0 Tax rate (percent) For rich people, there would be a disincentive to quitworkingwhen they hit the top marginal tax rate. For most workers, this was not the case.

  41. SUPPLY-SIDE FISCAL POLICY Emphasison Expansionary Tax Cuts [which shifts AD to the right, increasing Y & PL] Impact upon... • Saving and Investment • [Lower taxes increase DI& S; less business taxes will • increase investment. Our “national factory” will increase.] • Work Incentives • [Keeping more of our money makes us work harder and longer] • Risk Taking • [Lower tax rates promise a larger potential after-tax reward] • So, the AS Curve will shift right bringing prices down. We will have Economic Heaven.

  42. 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%

  43. MULTIPLIER WITH PRICE-LEVEL 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)=chg.Y/chg.E [80] [20] M(2)=chg.Y/chg. E [40] [20]

  44. 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 P1 $485 $505 Real GDP (billions)

  45. CONTRACTIONARY FISCAL POLICY [MPS=.25] the multiplier at work... AS AD1 AD2 P1 $5 billion initial direct decrease in spending P2 Price level Full $20 billion decrease in AD $515 Real GDP (billions)

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

  47. 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 commitment to 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.”

  48. Head of the CEA Greg Mankiwof Harvard has ridiculed supply-side tax cuts as“fad economics” conceived by“charlatans and cranks,” in his textbook. Edward Lazear PHD in Econ, Harvard Matt Slaughter of Dartmouth Ben Bernanke, Former Board Governor, succeeded Maniew. [scored 1590 on SAT] [Now Chairman of Fed] Katherine Baicker U.C.L.A.

  49. Joint Economic Committee of Congressand Humphrey-Hawkins Act of 1978 If you look at my “C” average college grades, the CEA can help me.

  50. AE & Fiscal Policy Questions on 2000 AP Exam If MPS incr from .10 to .20, the ME would decrease from 10 to 5. 1. (81%) The value of the spending multiplier(ME) decreases when a. tax rates are reduced d. government spending increases b. exports decline e. the marginal propensity to save increases c. imports decline 2. (75%) Which of the following policies would a Keynesian recommend during a period of high unemployment and low inflation? a. decreasing the MS to reduce AD b. decreasing taxes to stimulate AD c. decreasing government spending to stimulate AS d. balancing the budget to stimulate AS 3. (47%) Which of the following best explains why equilibrium income will increase by more than $100 in response to a $100 increase inG? a. Incomes will rise, resulting in a tax decrease. b. Incomes will rise, resulting in higher consumption. c. The increased spending raises the aggregate price level. d. The increased spending increases the money supply, lowering interest rates. e. The higher budget deficit reduces investment. 4. (56%) Unexpected increases in inventories usually precede a. increases in inflation b. increases in imports c. stagflation d. decreases in production e. decreases in unemployment The Multiplier ensures more C with each round.