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ECN 111 Chapter 16 Lecture Notes 16.1 The Federal Budget and Fiscal Policy Fiscal policy is the use of the federal budget to smooth the business cycle and encourage economic growth. A. The Federal Budget The federal budget is an annual statement of the expenditures, tax revenues, and surplus or deficit of the government of the United States. The government has a budget surplus if tax receipts exceed expenditures, a budget deficit if expenditures exceed tax receipts, and a balanced budget if tax receipts equal expenditures. 1. Budget Time Line a. The President proposes a budget, which is debated and amended by the Congress and then approved by the President. 2. The Employment Act of 1946 The Employment Act of 1946 is an act of Congress that recognized a role for government actions to keep unemployment low, the economy expanding, and inflation in check. 3. The Council of Economic Advisers and the National Economic Council The President’s Council of Economic Advisers writes an annual Economic Report of the President. The National Economic Council coordinates economic policy and attempts to ensure that the President’s economic policy agenda is implemented. 4. Types of Fiscal Policy a. Discretionary Fiscal Policy Discretionary fiscal policy is a fiscal policy action that is initiated by an act of Congress. b. Automatic Fiscal Policy Automatic fiscal policy is a fiscal policy action that is triggered by the state of the economy such as an increase in payments to the unemployed and a decrease in tax receipts triggered by recession. B. Discretionary Fiscal Policy: Demand-Side Effects 1. The Government Purchases Multiplier The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on aggregate demand. 2. The Tax Multiplier The tax multiplier is the magnification effect of a change in taxes on aggregate demand. The magnitude of the tax multiplier is less than the magnitude of the government purchases multiplier. 3. The Balanced Budget Multiplier The balanced budget multiplier is the magnification effect on aggregate demand of a simultaneous change in government purchases and taxes that leaves the budget balance unchanged. 4. Discretionary Fiscal Stabilization a. A deflationary gap can be offset by an increase in government purchases or a decrease in taxes because both increase aggregate demand. b. An inflationary gap can be offset by a decrease in government purchases or an increase in taxes because both decrease aggregate demand. C. Discretionary Fiscal Policy: Supply-Side Effects 1. Supply-Side Effects of Government Purchases Some government purchases provide services that increase the nation’s production possibilities. The interstate highway system and education are examples. So an increase in these purchases increases potential GDP and increases aggregate supply. 2. Supply-Side Effects of Taxes Taxes create disincentives to work, save, and provide entrepreneurial services. So an increase in taxes decreases potential GDP and decreases aggregate supply. 3. Balanced Budget Supply-Side Effects A simultaneous increase in government purchases and increase in taxes creates offsetting effects on potential GDP. The productive nature of some government purchases increases potential GDP and aggregate supply and the disincentive effects of taxes decreases potential GDP and aggregate supply. Economists do no agree on which effect is larger. 4. Supply-Side Effects on the AS Curve An increase in government purchases of productive services and capital or a decrease in taxes increases aggregate supply and the AS curve shifts rightward. 5. Combined Demand and Supply Effects a. An increase in government purchases or a decrease in taxes increases both aggregate demand and aggregate supply. b. The conventional view is that the increase in aggregate demand exceeds the increase in aggregate supply so that real GDP increases and the price level rises. c. The supply-side view is that the increase in aggregate supply exceeds the increase in aggregate demand so that real GDP increases and the price level falls. D. Limitations of Discretionary Fiscal Policy 1. Law-Making Time Lags. It takes time for Congress to act when the economy needs stimulation. This time lag can be important because often by the time the action is taken, the economy might need an entirely different fiscal medicine. 2. Estimating Potential GDP. It is not easy to tell whether real GDP is below, above, or at potential GDP. 3. Economic Forecasting. 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. E. Automatic Fiscal Policy Automatic stabilizers are features of fiscal policy that stabilize real GDP without explicit action by the government. 1. Induced Taxes Induced taxes are taxes that vary with real GDP. When real GDP increases in an expansion, induced taxes rise and when real GDP decreases in a recession, induced taxes fall. 2. Needs-Tested Spending 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 changes in autonomous expenditure so they moderate both expansions and recessions and make real GDP more stable. 16.2. The Federal Reserve and Monetary Policy A. The Monetary Policy Process 1. Monitoring Economic Conditions The Beige Book is a report that summarizes current economic conditions in each Federal Reserve district and each sector of the economy. It serves as a background document for the members of the Federal Open Market Committee. 2. Meetings of the Federal Open Market Committee (FOMC) The FOMC meets eight times a year and makes the monetary policy decisions. 3. 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. B. Influencing the Interest Rate 1. In the Long Run In the long run, saving supply and investment demand determine the real interest rate in global financial markets. In the long run, the Fed influences the nominal interest rate by the effects of its policies on the inflation rate. But it does not directly control the nominal interest rate and it has no control over the real interest rate. 2. In the Short Run In the short run, the Fed can influence the nominal interest rate and the real interest rate. 3. The Fed Raises the Interest Rate The FOMC instructs the New York Fed to sell securities in the open market. This action decreases bank reserves. Some banks are short of reserves and seek to borrow reserves from other banks. The federal funds interest rate rises. 4. The Fed Lowers the Interest Rate The FOMC instructs the New York Fed to buy securities in the open market. This action increases bank reserves. Flush with reserves, banks now seek to lend reserves to other banks. The federal funds interest rate falls. C. The Ripple Effects of the Fed’s Actions 1. Investment and Consumption Expenditure When the Fed increases the nominal interest rate, the real interest rate rises temporarily and investment and expenditure on consumer durables decrease. 2. The Dollar and Net Exports A rise in the interest rate, other things remaining the same, means that the U.S. interest rate rises relative to the interest rate in other countries. Foreigners are attracted to the higher interest rate they can now earn on U.S. bank deposits and bonds, which increases the demand for U.S. dollars. With more dollars demanded, the price of the dollar rises on the foreign exchange market. Foreigners must now pay more for U.S.-made goods and services, so U.S. exports decrease. 3. The Multiplier Process A rise in the interest rate leads to a decrease in aggregate expenditure. The multiplier effect then brings a larger decrease in aggregate demand. D. Monetary Stabilization in the AS-AD Model 1. The Fed Tightens to Fight Inflation If the Fed conducts an open market operation that increases the interest rate, there is a decrease in aggregate demand, which produces a decrease in real GDP and a fall in the price level. 2. The Fed Eases to Fight Recession If the Fed conducts an open market operation that decreases the interest rate, there is an increase in aggregate demand, which produces an increase in real GDP and a rise in the price level. 3. The Size of the Multiplier Effect The size of the multiplier effect of monetary policy depends on the sensitivity of expenditure plans to the interest rate. E. Limitations of Monetary Stabilization Policy 1. Monetary policy does not suffer from the law-making time lags. 2. Monetary policy still has the problems of estimating potential GDP and forecasting economic activity in the future. 3. Monetary policy suffers an additional limitation because its effects are indirect and depend on how private decisions respond to a change in the interest rate.