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FISCAL POLICY CHAPTER TWELVE Fiscal Policy – Changing G & T LEGISLATIVE MANDATES Employment Act of 1946 It is the government’s responsibility to maintain economic stability through the use of monetary and fiscal policy. Fiscal Policy – Changing G & T LEGISLATIVE MANDATES Employment Act of 1946 Council of Economic Advisors (CEA) Fiscal Policy – Changing G & T LEGISLATIVE MANDATES Employment Act of 1946 Council of Economic Advisors (CEA) Presidential Advisors Joint Economic Committee (JEC) Committee of Congress Fiscal Policy – Changing G & T Discretionary Fiscal Policy Two Situations.... • Recession Fiscal Policy – Changing G & T Discretionary Fiscal Policy Two Situations.... • Recession • Demand-pull Inflation Discretionary – the deliberate manipulation of taxes and government spending by Congress to alter GDP. Fiscal Policy – Changing G & T Discretionary Fiscal Policy Two Situations.... • Recession • Demand-pull Inflation Expansionary Fiscal Policy Options.... Fiscal Policy – Changing G & T Discretionary Fiscal Policy Two Situations.... • Recession • Demand-pull Inflation Expansionary Fiscal Policy Options.... • Increase Government Spending Fiscal Policy – Changing G & T Discretionary Fiscal Policy Two Situations.... • Recession • Demand-pull Inflation Expansionary Fiscal Policy Options.... • Increase Government Spending • Reduce Taxes Fiscal Policy – Changing G & T Discretionary Fiscal Policy Two Situations.... • Recession • Demand-pull Inflation Expansionary Fiscal Policy Options.... • Increase Government Spending • Reduce Taxes • Some Combination of the Two Fiscal Policy – Changing G & T Expansionary Fiscal Policy P Price level $5 billion initial increase in spending P1 AD2 Real GDP (billions) Fiscal Policy – Changing G & T Q Expansionary Fiscal Policy P Price level $5 billion initial increase in spending P1 AD2 Real GDP (billions) Fiscal Policy – Changing G & T Q Expansionary Fiscal Policy the multiplier at work... P $5 billion initial increase in spending Price level Full $20 billion increase in aggregate demand P1 AD2 AD1 Real GDP (billions) Fiscal Policy – Changing G & T Q Expansionary Fiscal Policy the multiplier at work... P NOTES: $5 billion initial increase in spending Price level Increased government spending Full $20 billion The multiplier makes increase in aggregate GDP increase by a multiple of the original demand amount P1 AD2 AD1 Real GDP (billions) Fiscal Policy – Changing G & T Q Expansionary Fiscal Policy the multiplier at work... P NOTES: $5 billion initial Price level increase in spending P1 Tax reductions: The multiplier requiresFull $20 billion a tax decrease of more increase in aggregate than the desired GDP demand increase since the household sector only consumes part of its income (MPC). AD2 AD1 Real GDP (billions) Fiscal Policy – Changing G & T Q Contractionary Fiscal Policy P Price level $5 billion initial decrease in spending AD4 P1 Real GDP (billions) Fiscal Policy – Changing G & T Q Contractionary Fiscal Policy P Price level $5 billion initial decrease in spending AD4 P1 Real GDP (billions) Fiscal Policy – Changing G & T Q Contractionary Fiscal Policy P the multiplier at work... Price level $5 billion initial decrease in spending P1 Full $20 billion decrease in aggregate demand AD5 Real GDP (billions) Fiscal Policy – Changing G & T AD4 Q The Federal Budget! Total Revenues (Taxes) – Total Costs (Expenditures) + Budget Surplus 0 Balanced Budget - Budget Deficit Sum of all yearly 2005 Deficit: $319 Billion Fiscal Policy – Changing G & T deficits and surpluses is the National Debt of: 8.2 Trillion Dollars! $28,000 per citizen Financing Deficits and Disposing of Surpluses • Borrowing vs. New Money Fiscal Policy – Changing G & T Financing Deficits and Disposing of Surpluses • Borrowing vs. New Money • Borrowing Government enters the money market and borrows. Now it is competing with private business for borrowed $ Impact on Interest Rates?? UP! This is a concept called crowding out. It may reduce the Expansionary impact of deficit spending. Fiscal Policy – Changing G & T Financing Deficits and Disposing of Surpluses • Borrowing vs. New Money • Borrowing • Money Creation Increasing the money supply will avoid crowding out but now what will be the primary concern??? Inflation! Fiscal Policy – Changing G & T Financing Deficits and Disposing of Surpluses • Borrowing vs. New Money • Borrowing • Money Creation • Debt Retirement vs. Idle Surplus What to do with surpluses?? Fiscal Policy – Changing G & T Financing Deficits and Disposing of Surpluses • Borrowing vs. New Money • Borrowing • Money Creation • Debt Retirement vs. Idle Surplus • Debt Reduction If the government decides to pay off some of its debt, it now “floods” the money market. Lower interest rate may spur new investment and spending - Inflation Fiscal Policy – Changing G & T Financing Deficits and Disposing of Surpluses • Borrowing vs. New Money • Borrowing • Money Creation • Debt Retirement vs. Idle Surplus • Debt Reduction in a “Lock Box” no • Impounding Hold Inflationary risk! Fiscal Policy – Changing G & T Financing Deficits and Disposing of Surpluses • Borrowing vs. New Money • Borrowing • Money Creation • Debt Retirement vs. Idle Surplus • Debt Reduction • Impounding Which Policy Option? T or G? Fiscal Policy – Changing G & T It depends on your political affiliation! Expenditures & Revenues (trillions) 3.5 3.0 Taxes Surplus T>G 2.5 Gov Spending 2.0 1.5 Deficit G>T 9 10 11 12 13 Real domestic product, GDP (trillions of dollars) Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Automatic -Built-In Stabilizers These are intended to speed the economy or slow the economy when needed automatically. Two Points.... Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Two Points.... Net tax revenues vary directly The higher the GDP the higher the tax with GDP revenues. Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Two Points.... Net tax revenues vary directly with GDP Transfer payments behave the opposite way as tax collections The higher the GDP the lower the transfer payments. Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers Currently existing policies – progressive tax system, welfare, unemployment compensation, agricultural subsidies Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity You want higher taxes (surpluses) in expansionary times as a check against inflation. Opposite for times of recession. Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Progressive Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Progressive • Proportional Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Progressive • Proportional • Regressive The more progressive the tax system, the greater the built in stability The built in stability provided by the tax system has reduced fluctuations, but other policies may be needed during more severe recessions or inflationary times. Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Actual Budget The mere fact that the government operates has an effect on the economy. Complications arise when the impact of the business cycle impacts the budget. It is difficult to tell what effect discretionary policies have versus the built in stabilizers. Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Actual Budget • Cyclical Budget Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Actual Budget • Cyclical Budget • Cyclical Deficit Fiscal Policy – Changing G & T Expenditures & Revenues (trillions) 3.5 3.0 Taxes 2.5 2.0 1.5 A A B C B 9 10 Gov Spending 11 12 13 Real domestic product, GDP (trillions of dollars) If Full Employment GDP is at 10 Trillion, AB is a planned “Structural Deficit” If a Recession occurs and GDP falls to $9 Trillion, the Deficit is AC the sum of AB (Structural Deficit) and BC (Cyclical Deficit). Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Actual Budget • Cyclical Budget • Cyclical Deficit • Full-Employment Budget Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Actual Budget • Cyclical Budget • Cyclical Deficit • Full-Employment Budget Structural Budget & Deficit Fiscal Policy – Changing G & T Expenditures & Revenues (trillions) 3.5 3.0 Taxes 2.5 2.0 1.5 A A B C B 9 10 Gov Spending 11 12 13 Real domestic product, GDP (trillions of dollars) If Full Employment GDP is at 10 Trillion, AB is a planned “Structural Deficit” If a Recession occurs and GDP falls to $9 Trillion, the Deficit is AC the sum of AB (Structural Deficit) and BC (Cyclical Deficit). Fiscal Policy – Changing G & T Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Actual Budget • Cyclical Budget • Cyclical Deficit • Full-Employment Budget Structural Budget & Deficit Proposed Balanced-Budget Requirement Fiscal Policy – Changing G & T GLOBAL PERSPECTIVE BUDGET DEFICIT AS A PERCENT OF GDP - 1996 0 Greece Italy Britain Japan France Germany Sweden Canada United States Fiscal Policy – Changing G & T 2 4 6 8 GLOBAL PERSPECTIVE BUDGET DEFICIT AS A PERCENT OF GDP - 1996 0 Greece Italy Britain Japan France Germany Sweden Canada United States Fiscal Policy – Changing G & T 2 4 6 8 GLOBAL PERSPECTIVE BUDGET DEFICITS OR SURPLUSES AS A PERCENTAGE OF GDP, 1999 -8 -6 -4 -2 0 2 4 Denmark Canada Sweden United Kingdom United States Germany Italy France Czech Republic Hungary Japan Source: Organization for Economic Development and Cooperation Fiscal Policy – Changing G & T Problems, Criticisms, and Complications Fiscal Policy – Changing G & T Problems, Criticisms, and Complications • Problems of Timing • Recognition Lag • Administrative Lag • Operational Lag Fiscal Policy – Changing G & T Problems, Criticisms, and Complications • Problems of Timing • Recognition Lag • Administrative Lag • Operational Lag • Political Problems • Other Goals • State & Local Finance • Expansionary Bias • A Political Business Cycle? Fiscal Policy – Changing G & T Problems, Criticisms, and Complications • Problems of Timing • Recognition Lag • Administrative Lag • Operational Lag • Political Problems • Other Goals • State & Local Finance • Expansionary Bias • A Political Business Cycle? • Crowding-Out Effect Fiscal Policy – Changing G & T Problems, Criticisms, and Complications • Problems of Timing • Recognition Lag • Administrative Lag • Operational Lag • Political Problems • Other Goals • State & Local Finance • Expansionary Bias • A Political Business Cycle? • Crowding-Out Effect Debate as to its impact. Fiscal Policy – Changing G & T Aggregate Supply and Inflation AS Price level P Fiscal Policy: Pure & Simple P1 AD1 Q1 Q2 Real GDP (billions) Fiscal Policy – Changing G & T AD2 Q Aggregate Supply and Inflation AS Price level P P1 Fiscal Policy: Pure & Simple Demonstrating the crowdingout effect.... Q1 AD AD 1 2 Q2 Real GDP (billions) Fiscal Policy – Changing G & T Q Aggregate Supply and Inflation AS P Price level Fiscal Policy: AD does not reach potential due to crowding out effect by government P1 AD1 AD’2 AD2 Q1 Q2 Real GDP (billions) Fiscal Policy – Changing G & T Q Aggregate Supply and Inflation (the same graph) AS P Price level Fiscal Policy: AD does not reach potential due to the net export effect Demonstrating the effect of inflation.... P1 AD1 AD’2 AD2 Q1 Q2 Real GDP (billions) Fiscal Policy – Changing G & T Q Aggregate Supply and Inflation AS Price level P P1 AD1 Q1 Q2 Real GDP (billions) Fiscal Policy – Changing G & T Q Aggregate Supply and Inflation AS P Price level A more realistic AS curve in the intermediate range P2 P1 AD1 Q1 Q2 Real GDP (billions) Fiscal Policy – Changing G & T AD2 Q Fiscal Policy in the Open Economy Shocks Originating from Abroad AD shocks which alter the effect of fiscal policy Fiscal Policy – Changing G & T Fiscal Policy in the Open Economy Shocks Originating from Abroad Net Export Effect Fiscal Policy – Changing G & T Aggregate Supply and Inflation AS P Price level Fiscal Policy: AD does not reach potential due to crowding out effect by government Demonstrating the net export effect.... P1 AD1 AD’2 AD2 Q1 Q2 Real GDP (billions) Fiscal Policy – Changing G & T Q Aggregate Supply and Inflation (the same graph) AS P Price level Fiscal Policy: AD does not reach potential due to the net export effect P1 AD1 AD’2 AD2 Q1 Q2 Real GDP (billions) Fiscal Policy – Changing G & T Q Problems in Macro It’s all BS??? Fiscal Policy – Changing G & T Not all problems are demand side problems! Errors in timing and interpretation! Supply-Side Fiscal Policy Fiscal Policy – Changing G & T Supply-Side Fiscal Policy Emphasis on spending restraint and expansionary tax cuts Three primary tools – taxes, regulation, interest rates This will shift AS to the right. Fiscal Policy – Changing G & T Supply-Side Fiscal Policy Emphasis on spending restraint and expansionary tax cuts Impact upon.... • Saving and Investment Fiscal Policy – Changing G & T Supply-Side Fiscal Policy Emphasis on spending restraint and expansionary tax cuts Impact upon.... • Saving and Investment • Work Incentives Fiscal Policy – Changing G & T Supply-Side Fiscal Policy Emphasis on spending restraint and expansionary tax cuts Impact upon.... • Saving and Investment • Work Incentives • Risk Taking Fiscal Policy – Changing G & T Problems, Criticisms, and Complications Or “It’s all BS!” • Incentive argument isn’t very strong •AS movements take longer than AD Fiscal Policy – Changing G & T Forecasting the Future The leading indicators.... Fiscal Policy – Changing G & T Forecasting the Future The leading indicators.... • Average Workweek Fiscal Policy – Changing G & T Forecasting the Future The leading indicators.... • Average Workweek • Initial Claims for Unemployment Insurance Fiscal Policy – Changing G & T Forecasting the Future The leading indicators.... • Average Workweek • Initial Claims for Unemployment Insurance • New Orders for Consumer Goods Fiscal Policy – Changing G & T Forecasting the Future The leading indicators.... • Average Workweek • Initial Claims for Unemployment Insurance • New Orders for Consumer Goods • Vendor Performance Fiscal Policy – Changing G & T Forecasting the Future The leading indicators.... • Average Workweek • Initial Claims for Unemployment Insurance • New Orders for Consumer Goods • Vendor Performance • New Orders for Capital Goods Fiscal Policy – Changing G & T Forecasting the Future The leading indicators.... • Average Workweek • Initial Claims for Unemployment Insurance • New Orders for Consumer Goods • Vendor Performance • New Orders for Capital Goods • Building Permits for Houses Fiscal Policy – Changing G & T Forecasting the Future The leading indicators.... • Average Workweek • Initial Claims for Unemployment Insurance • New Orders for Consumer Goods • Vendor Performance • New Orders for Capital Goods • Building Permits for Houses • Stock Prices Fiscal Policy – Changing G & T Forecasting the Future The leading indicators.... • Average Workweek • Initial Claims for Unemployment Insurance • New Orders for Consumer Goods • Vendor Performance • New Orders for Capital Goods • Building Permits for Houses • Stock Prices • Money Supply Fiscal Policy – Changing G & T Forecasting the Future The leading indicators.... • Average Workweek • Initial Claims for Unemployment Insurance • New Orders for Consumer Goods • Vendor Performance • New Orders for Capital Goods • Building Permits for Houses • Stock Prices • Money Supply • Interest-Rate Spread Fiscal Policy – Changing G & T Forecasting the Future The leading indicators.... • Average Workweek • Initial Claims for Unemployment Insurance • New Orders for Consumer Goods • Vendor Performance • New Orders for Capital Goods • Building Permits for Houses • Stock Prices January 2006 grew .1% • Money Supply • Interest-Rate Spread • Consumer Confidence Fiscal Policy – Changing G & T Forecasting the Future The leading indicators.... • Average Workweek • Initial Claims for Unemployment Insurance • New Orders for Consumer Goods • Vendor Performance • New Orders for Capital Goods • Building Permits for Houses • Stock Prices • Money Supply • Interest-Rate Spread • Consumer Confidence Fiscal Policy – Changing G & T Employment Act of 1946 Council of Economic Advisers discretionary fiscal policy expansionary fiscal policy budget deficit contractionary fiscal policy budget surplus built-in stabilizer Fiscal Policy – Changing G & T progressive tax system proportional tax system regressive tax system actual budget cyclical budget full-employment budget structural budget political business cycle crowding-out effect net export effect supply-side fiscal policy Chapter 13 Money and Banking Next... Fiscal Policy – Changing G & T
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