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© 2015 Pearson
Can fiscal stimulus end a recession?
Did the Fed save us from another Great Depression?
Can fiscal stimulus
end a recession?
© 2015 Pearson
Did the Fed save us from
another Great Depression?
20
Fiscal Policy and
Monetary Policy
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Describe the federal budget process and explain the
effects of fiscal policy.
2 Describe the Federal Reserve’s monetary policy process
and explain the effects of monetary policy.
© 2015 Pearson
20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Fiscal policy is the use of the federal budget to achieve
the macroeconomic objectives of high and sustained
economic growth and full employment.
The Federal Budget
The federal budget is an annual statement of tax
revenues, outlays, and surplus or deficit of the
government of the United States.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Budget Time Line
The President and the
Congress make the
budget and develop
fiscal policy on a fixed
annual time line.
Fiscal year is a year
that begins on
October 1 and ends on
September 30 of the
next year.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Budget Balance, Surplus, or Deficit
Budget balance = Tax revenues – Outlays
The government has a balanced budget when tax
revenues equal outlays (budget balance is zero).
The government has a budget surplus when tax
revenues exceed outlays (budget balance is positive).
The government has a budget deficit when outlays
exceed tax revenues (budget balance is negative).
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20.1 THE FEDERAL BUDGET
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Surplus, Deficit, and Debt
The government borrows to finance a budget deficit and
repays its debt when it has a budget surplus.
The amount of debt outstanding that arises from past
budget deficits is called national debt.
Debt at end of 2015 = Debt at end of 2014 + Budget
deficit in 2015.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
On the tax revenues side of the budget:
The largest item is personal income taxes―taxes that
people pay on wages and salaries and on interest.
The second largest item is Social Security taxes―taxes
paid by workers and employers to fund Social Security
benefits.
Corporate income taxes, which are the taxes paid by
corporations on their profits, are much smaller.
Indirect taxes, the smallest revenue source, are sales
taxes and customs and excise taxes.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
On the outlays side of the budget:
The largest item is transfer payments.
Transfer payments are Social Security benefits,
Medicare and Medicaid benefits, unemployment
benefits, and other cash benefits paid to individuals and
firms.
Expenditure on goods and services includes the
government’s defense and homeland security budgets.
Debt interest is the interest on the national debt.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Types of Fiscal Policy
Fiscal policy actions can be
• Discretionary fiscal policy
• Automatic fiscal policy
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Discretionary Fiscal Policy
Discretionary fiscal policy is a fiscal policy action
that is initiated by an act of Congress.
For example, an increase in defense spending or a cut
in the income tax rate.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Automatic Fiscal Policy
Automatic fiscal policy is a fiscal policy action that
is triggered by the state of the economy.
For example, an increase in unemployment induces an
increase in payments to the unemployed or in a
recession tax receipts decrease as incomes fall.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
 Discretionary Fiscal Policy: Demand-Side
Effects
Discretionary fiscal policy can take the form of a change
in government outlays or a change in tax revenues.
Other things remaining the same, a change in any of
the items in the government budget changes aggregate
demand and …
has a multiplier effect—aggregate demand changes by
a greater amount than the initial change in the item in
the government budget.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
The Government Expenditure Multiplier
The government expenditure multiplier is the
effect of a change in government expenditure on goods
and services on aggregate demand.
An increase in aggregate expenditure increases
aggregate demand, which increases real GDP.
The increase in real GDP induces an increase in
consumption expenditure, which further increases
aggregate demand.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
The Tax Multiplier
The tax multiplier is the effect of a change in taxes on
aggregate demand.
A decrease in taxes increases disposable income.
The increase in disposable income increases
consumption expenditure and aggregate demand.
With increased aggregate demand, employment and
real GDP increase and consumption expenditure
increases yet further.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
So a decrease in taxes works like an increase in
government expenditure.
Both actions increase aggregate demand and have a
multiplier effect.
The magnitude of the tax multiplier is smaller than the
government expenditure multiplier.
The reason: A $1 tax cut increases aggregate
expenditure by less than $1 whereas a $1 increase in
government expenditure increases aggregate
expenditure by $1.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
The Transfer Payments Multiplier
The transfer payments multiplier is the effect of a
change in transfer payments on aggregate demand.
This multiplier works like the tax multiplier but in the
opposite direction.
An increase in transfer payments increases disposable
income, which increases consumption expenditure.
With increased consumption expenditure, employment
and real GDP increase and consumption expenditure
increases yet further.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
The Balanced Budget Multiplier
The balanced budget multiplier is the effect on
aggregate demand of a simultaneous change in
government expenditure and taxes that leaves the
budget balance unchanged.
The balanced budget multiplier is not zero—it is
positive—because the government expenditure
multiplier is larger than the tax multiplier.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
A Successful Fiscal Stimulus
Fiscal stimulus is an increase in
government outlays or a decrease in
tax revenue designed to boost real
GDP and create or save jobs.
Cash for Clunkers
was a fiscal stimulus.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Figure 20.2 illustrates a fiscal
stimulus.
Potential GDP is $16 trillion,
real GDP is $15 trillion, and
1. There is a $1 trillion
recessionary gap.
2. An increase in government
expenditure or a tax cut
increases expenditure by ∆E.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
3. The multiplier increases
induced expenditure. The
AD curve shifts rightward to
AD1.
The price level rises to 105,
real GDP increases to $16
trillion, and the recessionary
gap is eliminated.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Discretionary Fiscal Policy: Supply-Side Effects
Fiscal policy has supply-side effects because it influences
potential GDP and the growth rate of potential GDP.
These influences on potential GDP arise because
• The government provides public goods and services
that increase labor productivity and
• Taxes change the incentives the people face.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Supply-Side Effects of Government Expenditure
Government provides services such as law and order,
public education, and public health that increase
production possibilities.
Government also provides social infrastructure capital
such as highways, bridges, and dams that increase our
production possibilities.
An increase in government expenditure that increases
the quantities of productive resources increases
potential GDP and increases aggregate supply.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Supply-Side Effects of Taxes
To pay for its outlays, the government collects taxes.
All taxes create disincentives to work, save, and provide
entrepreneurial services.
An increase in taxes decreases the supply of labor, capital,
and entrepreneurial services; decreases potential GDP; and
decreases aggregate supply.
A tax cut strengthens the incentives to work, save, and
provide entrepreneurial services. So a tax cut increases
potential GDP and increases aggregate supply.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Supply-Side Effects on Potential GDP
A tax cut strengthens the incentive to work, which
increases the supply of labor and increases the
equilibrium level of employment at full employment.
Figure 20.3 (on the next slide) illustrates the effects of a
tax cut on potential GDP.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Initially, the full employment
quantity of labor is 200 billion
hours and potential GDP is
$16 trillion.
1. A tax cut strengthens the
incentive to work and
employment increases.
The tax cut also strengthens
the incentive to save and
invest, which increases the
quantity of capital.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
2. With more capital per
worker, labor productivity
increases and the
production function shifts
upward.
3. The combined effect is an
increase in potential GDP.
An increase in potential GDP
increases aggregate supply,
which also increases actual
real GDP.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Law-Making Time Lag
The amount of time it takes Congress to pass the laws
needed to change taxes or spending.
This process takes time because each member of
Congress has a different idea about what is the best tax
or spending program to change, so long debates and
committee meetings are needed to reconcile conflicting
views.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Shrinking Area of Law-Maker Discretion
Expenditure on the military and on homeland security and
very large expansion in expenditure on entitlement
programs such as Medicare has increased.
The result is that around 80 percent of the federal budget
is effectively off limits for discretionary fiscal policy action.
The 20 percent that is available for discretionary change
include items such as education and the space program,
which are hard to cut.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Estimating Potential GDP
It is not easy to tell whether real GDP is below, above,
or at potential GDP.
So a discretionary fiscal action might move real GDP
away from potential GDP instead of toward it.
This problem is a serious one because too much fiscal
stimulation brings inflation and too little might bring
recession.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Economic Forecasting
Fiscal policy changes take a long time to enact in
Congress and yet more time to become effective.
So fiscal policy must target forecasts of where the
economy will be in the future.
Economic forecasting has improved enormously in
recent years, but it remains inexact and subject to error.
So for a second reason, discretionary fiscal action might
move real GDP away from potential GDP and create
the very problems it seeks to correct.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Automatic Fiscal Policy
A consequence of tax revenues and outlays that
fluctuate with real GDP.
Automatic stabilizers are features of fiscal policy
that stabilize real GDP without explicit action by the
government.
Induced taxes are taxes that vary with real GDP.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Needs-tested spending is spending on programs that
entitle suitably qualified people and businesses to
receive benefits—benefits that vary with need and with
the state of the economy.
Induced taxes and needs-tested spending decrease the
multiplier effects of change in autonomous expenditure
and moderate both expansions and recessions and
make real GDP more stable.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Because government tax revenues fall and outlays
increase in a recession, the budget provides automatic
stimulus that helps to shrink the recessionary gap.
Similarly, because tax revenues rise and outlays
decrease in a boom, the budget provides automatic
restraint to shrink an inflationary gap.
Fluctuations in the government budget balance over the
business cycle create a need to distinguish between the
budget’s cyclical balance and structural balance.
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20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Cyclical and Structural Budget Balances
A structural surplus or deficit is the budget
balance that would occur if the economy were at full
employment.
A cyclical surplus or deficit is the budget balance
that arises because tax revenues and outlays are not at
their full-employment levels.
The actual budget balance is the sum of the structural
balance and the cyclical balance.
© 2015 Pearson
In February 2009, in the depths of the 2008–2009
recession, Congress passed the American Recovery and
Reinvestment Act, a $787 billion fiscal stimulus package.
This Act of Congress is an example of discretionary fiscal
policy.
Did this action by Congress contribute to ending the 2008–
2009 recession and making the recession less severe than
it might have been?
The Obama Administration economists are confident that
the stimulus package made a significant contribution to
easing and ending the recession.
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But many, and perhaps most, economists don’t agree.
They think that the stimulus package played a small role
and that the truly big story is not discretionary fiscal policy
but the role played by automatic stabilizers.
What were the fiscal policy actions and their likely effects?
Discretionary Fiscal Policy
President Obama promised that fiscal stimulus would save
or create 650,000 jobs by the end of the 2009 summer.
In October 2009, the Administration economists declared
that the fiscal stimulus had saved or created the promised
650,000 jobs.
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This claim of success might be correct, but it isn’t startling
and it isn’t a huge claim. Why?
How much GDP would 650,000 people produce?
In 2009, each employed person produced $100,000 of real
GDP on average. So 650,000 people would produce $65
billion of GDP.
But only 20 percent of the $787 billion stimulus package
had been spent (or taken in tax breaks), so the stimulus
was only about $160 billion.
If government outlays of $160 billion created $65 billion of
GDP, the multiplier was 0.4 (65/160 = 0.4).
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This multiplier is much smaller than the 1.6 that the Obama
economists say will eventually occur.
They believe, like Keynes, that the multiplier starts out small
and gets larger over time as spending plans respond to
rising incomes.
An initial increase in expenditure increases aggregate
expenditure.
But the increase in aggregate expenditure generates higher
incomes, which in turn induces greater consumption
expenditure.
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Automatic Fiscal Policy
Government revenue is sensitive to the state of the
economy.
When personal incomes and corporate profits fall, income
tax revenues fall too.
When unemployment increases, outlays on unemployment
benefits and other social welfare benefits increase.
These fiscal policy changes are automatic. They occur with
speed and without help from Congress.
© 2015 Pearson
In 2009, real GDP fell to 6 percent below potential GDP—a
recessionary gap of $800 billion. Tax revenues crashed and
transfer payments skyrocketed.
The figure shows that the automatic stabilizers were much
larger than the discretionary actions.
Automatic action played the major role in limiting job losses.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
Monetary policy is the adjustment of interest rates and
the quantity of money to achieve the dual objective of
price stability and full employment.
The Board of Governors of the Federal Reserve System
conducts monetary policy independently of the
government but under the terms of the Federal Reserve
Act of 1913 and its subsequent amendments.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
Monetary Policy Process
The Fed makes monetary policy in a process that has
three main elements:
• Monitoring economic conditions
• Meetings of the Federal Open Market Committee
(FOMC)
• Monetary Policy Report to Congress
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20.2 FEDERAL RESERVE AND MONETARY POLICY
Monitoring Economic Conditions
The Fed constantly gathers information and brings the
results together in the Beige Book, which is published
eight times a year.
The Beige Book summarizes current economic
conditions in each Federal Reserve district and each
sector of the economy.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
Decisions of the Federal Open Market Committee
(FOMC)
The FOMC, which meets eight times a year, makes the
monetary policy decisions.
After each meeting, the FOMC announces its decisions
and describes its view of the likelihood that its goals of
price stability and full employment will be achieved.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
Monetary Policy Report to Congress
Twice a year, in February and July, the Fed prepares a
Monetary Policy Report to Congress, and the Fed
chairman testifies before the House of Representatives
Committee on Financial Services.
The report and the chairman’s testimony review the
monetary policy and economic developments of the
past year and the economic outlook for the coming
year.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
The Federal Funds Rate Target
Following the FOMC meeting, the Fed announces its
monetary policy decisions as a target for the federal
funds rate.
The figure on the next slide shows the federal funds
rate since 2000.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
Figure 20.4 shows the
federal funds rate
since 2000.
The Fed sets a target
for the federal
funds rate and then
takes actions to
keep the rate close to
target.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
When the Fed wants
to slow inflation,
it raises the federal
funds rate target.
When the inflation rate
is below target
and the Fed wants to
avoid recession,
it lowers the federal
funds rate.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
When the Fed changes the federal funds rate, events
ripple through the economy and lead to the ultimate
policy goals.
The Ripple Effects of the Fed’s Actions
Figure 20.5 summarizes the ripple effects.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
1. The first effect of a
monetary policy decision
by the FOMC is a change
in the federal funds rate.
2. Other interest rates then
change quickly and
relatively predictably.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
The Exchange Rate Changes
The exchange rate responds to changes in the interest
rate in the United States relative to the interest rates in
other countries—the U.S. interest rate differential.
When the Fed raises the federal funds rate, the U.S.
interest rate differential rises and, other things remaining
the same, the U.S. dollar appreciates.
And when the Fed lowers the federal funds rate, the U.S.
interest rate differential falls and, other things remaining
the same, the U.S. dollar depreciates.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
The Quantity of Money and
Bank Loans
3. To change the federal
funds rate, the Fed must
change the quantity of
bank reserves, which in
turn changes the quantity
of deposits and loans that
the banking system can
create.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
The Long-Term Real
Interest Rate
4. Changes in the federal
funds rate change the
supply of bank loans,
which changes the supply
of loanable funds and
changes the real interest
rate in the loanable funds
market.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
Expenditure Plans
5. A change in the real
interest rate changes
consumption expenditure,
investment, and net
exports.
Aggregate Demand
6. A change consumption
expenditure, investment,
and net exports changes
aggregate demand.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
7. About a year after the
change in the federal
funds rate occurs, real
GDP growth changes.
8. About two year after the
change in the federal
funds rate occurs, the
inflation rate change.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
 Monetary Stabilization in the AS-AD Model
The Fed Eases to Fight Recession
If real GDP is above potential GDP, an inflationary gap
exists.
If the Fed fears inflation rising, it takes action to lower
the inflation rate and restore price stability.
Figure 20.6 on the next slide illustrates.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
1. The FOMC lowers the
federal funds rate target
from 5 percent to 4
percent a year.
Investment and other
interest-sensitive
components of
expenditure increase.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
2. Expenditure increases by
the change in investment.
3. The multiplier induces an
additional increase in
expenditure.
Aggregate demand increases.
Real GDP increases to
potential GDP and recession is
avoided.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
The Fed Tightens to Fight Inflation
If real GDP is above potential GDP, an inflationary gap
exists.
If the Fed fears inflation rising, it takes action to lower
the inflation rate and restore price stability.
Figure 20.7 on the next slide illustrates.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
1. The FOMC raises the
federal funds rate target
from 5 percent to 6
percent a year.
Investment and other
interest-sensitive
components of
expenditure decrease.
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20.2 FEDERAL RESERVE AND MONETARY POLICY
2. Expenditure decreases by
the change in investment.
3. The multiplier induces an
additional decrease in
expenditure.
Aggregate demand decreases.
Real GDP decreases to
potential GDP and inflation is
avoided.
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An increase in financial risk drove
the banks to increase their holdings
of reserves and everyone else to
lower their bank deposits and hold
more currency.
Between 1929 and 1933, the
banks’ desired reserve ratio
increased from 8 percent to 12
percent and …
the currency drain ratio increased
from 9 percent to 19 percent.
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The money multiplier fell from
6.5 to 3.8.
The quantity of money crashed
by 35 percent.
This massive contraction in the
quantity of money was
accompanied by a similar
contraction of bank loans.
A large number of banks failed.
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Friedman and Schwartz say that
this contraction of money and bank
loans and the failure of banks could
(and should) have been avoided by
a more alert and wise Fed.
The Fed could have accommodate
the banks’ increased desired
reserve ratio and …
offset the rise in currency holdings
as people switched out of bank
deposits.
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Bernanke did what Friedman and
Schwartz said the Fed needed to
do.
At the end of 2008, the Fed flooded
the banks with the reserves that
they wanted.
The money multiplier fell from 9.1
in 2008 to 2.5 in 2015—much more
than it had fallen from 1929 to 1933.
The quantity of money did not
contract as it did in 1933.
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The quantity of M2 increased by
37.5 percent in the 5 years to
August 2015, a 6.6 percent
annual rate.
We can’t be sure that the Fed
averted a Great Depression in
2009.
But we can be confident that the
Fed’s actions helped to limit the
depth and duration of the
2008–2009 recession.
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In 2015, the “dual mandate” put
the Fed in a dilemma.
The recovery was slow and
unemployment was not falling
quickly enough.
The Fed’s dilemma was when to
stop fighting the slow recovery
and start worrying about
unleashing inflation.
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