Download Highlights of Chapter #11 Fiscal Policy

CAN GOVERNMENT CURE A SICK
ECONOMY
WITH FISCAL POLICY?????
Government Shutdown
Averted- What’s the big Deal??
What is Fiscal Policy Anyway?
Usually Countercyclical in nature
Deliberate changes in
government spending or taxing to
Achieve full employment
Control inflation
Encourage economic growth
Fiscal Policy
What tools can the federal government use
to alter macroeconomic outcomes?
Taxing and spending in a variety of
combinations.
Can Taxing and spending alterations ensure
full-employment?
What policy actions will help fight inflation/
deflation?
What are possible risks of government
intervention?
Where does the power to tax original
from?
Article I, Section 8, U.S.
Constitution
1789- “to lay and collect taxes, duties,
imposts, and excises, to pay the
debts and provide for the common
defense and general welfare of the
United States.”
1913- 16th Amendment allowed the
federal government to collect from
individuals…
Terms to Know
Automatic fiscal policy
a change in fiscal policy caused by the
state of the economy. (unemployed- pay
fewer taxes.)
Discretionary fiscal policy
a policy action initiated by an Act of
Congress
Expansionary fiscal policy
government should either increase its
purchases of g&s or cut its taxes. (causes
govt to borrow.)
Discretionary Decision by
Congress (discretionary spending)
Government can alter aggregate
demand by:
Give examples……………….
 Purchasing more or fewer goods and
services
 Raising or lowering taxes
 Changing the level of income
transfers
Government gets serious about Aggregates in 40’s
Employment Act of 1946
After WWII…the unemployment issues
needed to be addressed.
“Employment Act of 1946 passed- commits
the Federal government to use all
practicable means, consistent with
the market system, to create
economic conditions under which there
will be…. employment opportunities,
including self-employment for those able,
willing, and seeking work, and to promote
maximum employment production, and
purchasing power.”
The Employment Act:
Commits Federal government to take
action through monetary and fiscal
policy to maintain economic
stability.
Humphrey-Hawkins Full
Employment Act
 This Act passed in 1978 and set up
specific policy requirements for the
Fed.
 Created the dual mandate for Fedunemployment and inflation guages
 This charge has specifically been
assigned to the Federal Reserve (sans
the fiscal part)…
The Executive branch responsible for
fulfilling the PURPOSE of the ACT.
Advisory groups to President:
CEA (Council of Economic Advisors)
JEC (Joint Economic Committee of
Congress)
 Purpose is to Shift Aggregate
Demand either right or left…
depending on needs for stability.
Expansionary and Contractionary
Fiscal Policy: Changes in
Government Spending
If there is a recessionary gap
in panel (a), fiscal policy can
presumably increase
aggregate demand
Expansionary and Contractionary
Fiscal Policy: Changes in
Government Spending
If there is an inflationary gap,
fiscal policy can presumably
decrease aggregate demand
The Tax Cut Multiplier
Tax Cut
First round of spending:
Second round of spending:
More consumption
= MPC X tax cut
More saving
= MPS X tax cut
More income
More saving
More consumption
More income
Third round of spending:
More saving
More consumption
Cumulative change in
saving: = tax cut
This is a simple explanation of how we
can jumpstart an economy….
Potentially!!!
What do we normally like to do if we win
the lottery
Multiplier Effect
The Multiplier
 The Multiplier:
-- The multiple by which an
initial change in spending will
alter total expenditure after an
infinite number of spending
cycles;
n
n
An increase in spending by one party
increases the income of others. Thus, an
increase in spending can expand output by
a much larger amount.
The multiplier is the number by which the
initial change in spending is multiplied to
obtain the total amplified increase in
income.
n
The size of the multiplier increases with
the
marginal propensity to consume (MPC).
The Multiplier
 In evaluating the
importance of the
multiplier, one should
remember:
n
n
n
taxes and spending on imports will
dampen the size of the multiplier;
it takes time for the multiplier to work;
and,
the amplified effect on real output will
be valid only when the additional
spending brings idle resources into
production without price changes.
Multiplier Formula
Multiplier is
______1_____
1 – MPC
When money is spent by someone, it
becomes someone else’s income.
When someone spends a dollar,
perhaps someone who received that
dollar would spend 80 cents..next
person would spend 64 cents…If you
add up the spending created by that
one dollar, it will add up to four or
five times that dollar… hence “the
multiplier”
The multiplier principle applies in
reverse also. (decrease, yields
reduction) (money in shoe box)
Marginal Propensity to Consume is the
key
*Income increases- we spend some
on “more stuff” In turn
consumption expenditures on
“stuff” will generate additional
income for others who will spend
part of their income on “stuff”
also.
There is a direct correlation between
expenditure multiplier and MPC.
The Multiplier Process
3. Income reduced by $100 billion
4. Consumption reduced by $75 billion
Households
7. Income reduced by
$75 billion more
8. Consumption reduced
by $56.25 billion more
Factor
markets
Product
markets
6. Further cutbacks in
employment or wages
2. Cutbacks in employment or wages
9. And so on
Business
firms
5. Sales fall $75 billion
1. $100 billion in unsold goods appear
The Multiplier Principle
Expenditure
Stage
Additional
Income
Additional
Consumption
(Dollars)
(Dollars)
Marginal
Propensity
To Consume
Round 1
Round 2
Round 3
Round 4
Round 5
Round 6
Round 7
Round 8
Round 9
Round 10
All Others
1,000,000
750,000
562,500
421,875
316,406
237,305
177,979
133,484
100,113
75,085
225,253
750,000
562,500
421,875
316,406
237,305
177,979
133,484
100,113
75,085
56,314
168,939
3/4
3/4
3/4
3/4
3/4
3/4
3/4
3/4
3/4
3/4
3/4
Total
4,000,000
3,000,000
3/4
For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.
• The multiplier concept is fundamentally based upon the
proportion of additional income that households choose to spend
on consumption: the marginal propensity to consume (here
assumed to be 75%  3/4).
Government Going Into Debt!
If government year after year engages
in deficit spending… (more spending
less revenue)… then the national
debt will mount.
DUH!!! That’s the big controversy right
now… Will we spend ourselves into a
3rd world nation.
Public Debt on Daily Report
 http://www.public
debt.treas.gov/
Government expenditures rise- taxes
remain the same- what has to give?
1.
2.
3.
4.
Government borrow the
difference.
Has to offer higher
interest rates to attract
takers
This is the interest rate
effect of expansionary
fiscal policy
When interest rates go
up, businesses less apt
to invest, consumers
less apt to purchase
interest sensitive g & s
How does government pull this off?
 Borrowing from the public..
This is done by selling interest-bearing
bonds.*most likely will drive up interest rates and
“crowd out private investments. (*note this is
where foreign money is so important to
the U.S. government and can put us in
considerable peril if overdone)
**also note any decline in private
spending will weaken or reduce the
expansionary effect of deficit spending.
Possible Offsets to Fiscal Policy
 Crowding-Out Effect
 The tendency of expansionary fiscal
policy to cause a decrease in planned
investment or planned consumption in
the private sector; this decrease
normally results from the rise of interest
rates.
Remember Crowding Out
Government comes in and makes
financial investments so attractive
that it crowds out the private
sector…
The big-time investor will want to
seek the best rate of return, and
anytime government wants, they
can make that be the scenario.
Second way for government to overspend
 Money Creation
 The Central Bank creates new money and
private spending is not affected by
expansionary efforts of the fiscal aspects.
 **** this means that… Federal spending can
continue without disrupting private spending or
investment….Referred to monetizing the
debt.(more $$ in circulation – debt goes “poof.”)
 Print money to pay the bill!

**** Problem is it is very inflationary… (Too
many $$$ chasing too few goods)
What is the relationship between tax
receipts and GDP???
 Increased Taxes reduce consumer
spending… and aggregate demand…
 These reductions would be favored if
moving toward inflation… but
increases in spending would be
favored if economy is slumping.
 So… we have inflation
Unemployment ?
 What % of GDP does consumption
take up?
So… answer this question!!
What is the limit for Congress to spend
in any given year?
Where does the limit come from?
Is it stationary or floating?
Is this a question that our current
government is faced with?????
3 Questions to Ask About Economic
Stability
1. Can government spending and
taxing ensure full employment?
2. What fiscal policy actions will help
fight inflation
3. What are the risks of government
intervention
What happens if the Fed pulls back and
decides to balance the budget?
Will a tax cut hurt or help the budget?
Does it matter who gets the tax cut?
How would the multiplier work here?
Who Decides?
Which is the better way to eliminate
recession and inflation? (government
spending or taxes)
The answer here is whether you want
big government or “smaller”
government.
Possible Offsets to Fiscal Policy
 Supply-Side Economics
 The suggestion that creating incentives
for individuals and firms to increase
productivity will cause the aggregate
supply curve to shift outward
Possible Offsets to Fiscal Policy
 Question
 Would a tax increase cause you to work
more or less or about the same?
Figure 13-5 Laffer Curve
Tax rates and
tax revenues
rise together
Tax revenues
are at a maximum
Tax rates and tax
revenues fall
together
Automatic Stabilizers
 Automatic or Built-In Stabilizers (
should these be changed today???)
 Changes in government spending and
taxation that occur automatically without
deliberate action of Congress
 The tax system
 Unemployment compensation
 Welfare spending
Automatic Stabilizers
The automatic changes
tend to drive the economy
back toward its fullemployment output level
Discretionary Fiscal Policy in Practice:
Coping with Time Lags - Fiscal results
 Long – a policy designed to correct a
recession may not produce results until
the economy is experiencing inflation. (912 months)
 Variable in length – they can be from 1-3
years, and the timing of the desired effect
cannot be predicted. (unemployment)
 Because fiscal policy time lags tend to
be variable, policymakers have a
difficult time fine-tuning the economy.
3 Kinds of Taxes
 Progressive tax- = tax rate/GDP rises with
GDP.
 Proportional tax = average tax rate
remains constant as GDP rises.
 Regressive tax system = average tax rate
falls as GDP rises.
 The progressive tax system is greater
built-in stabilizer… BUT….proportional tax
will ultimately bring in more revenue
remember Laffer curve).
Axiom to remember….. Always!
Increased taxes reduce spending
and Aggregate Demand
Reductions in spending are
desirable when economy is
moving toward inflation
Or Increases in spending are
desirable when economy is
moving toward a slump.
Timing!!!!!
Often times the move either way for
Congress and/or Admin is slow to realize
Administrative lag….. Takes time to digest
all the fiscal data and decide what to
suggest.
Operational Lag…usually a 9 to 12 month
period before any fiscal move can actually
take affect in the real world… work
projects, money into economy… Congress
passing the Bill and lots of pork added.
Remember… Porkbarrelling!!!
Leading Indicators
1.
2.
3.
4.
5.
6.
7.
8.
9.
Average workweek
Initial claims for unemployment insurance.
New orders for consumer goods
Vendor preferences (delivery status)
New orders for capital goods
Building permits for houses
Stock prices
Money supply
Interest-rate spread(smaller difference between
short term and long term rates usually spells
decline of GDP)
10. Consumer expectations
If government reduces taxes and increases
spending… created budget deficit…*this is where
we are now
Deficit spending = use of borrowed
funds to finance government
expenditures that exceed tax
revenues
Budget Deficit= amt which govt
spending exceeds govt revenues
(specific time period)
Surplus= ………..
Discretionary and automatic spending.
Each year… Pres/Congress put together
budget blueprint for next fiscal year.
OMB and CBO…
Fiscal year for federal government = October
1
Cyclical Deficits = portion of budget deficit
attributable to unemployment or inflation
Structural Deficit = whatever does not fall
into cyclical falls into structural (created
deficits by works of Congress)
Let’s Talk about DEBT
Accumulation of Debt:
When Treasury borrows funds it
issues treasury bonds. Treasury
bonds = promissory notes (IOUs)
issued by the U.S. Treasury.
Total stock of all outstanding bonds
represent national debt.
Who owns the Debt?
National Debt represents a liability as
well as an asset in the form of
bonds.
Liability – obligation to make future
payment : debt
Asset = anything having exchange
value in the marketplace is wealth
*National debt creates as much wealth
(for bond holders as liabilities for the
U.S. Treasury).
Actual Ownership of the Debt
 Federal Agencies hold roughly 43% of outstanding
Treasury Bonds
 Federal Reserve acquires Treasury bonds in its
conduct of monetary policy
 SS Trust Fund is the largest owner of U.S. Debt
 State and local governments hold 7%
 All debt held by U.S. households, institutions and
governments is called internal debt and equals
approximately 88% of the total
 External debt- U.S. govt debt (Treasury bonds) held
by foreign households and institutions. ** this is
increasing
FED now owns most of debt.
Debt Service
 This is the interest required to be paid
each year on outstanding debt.
 Paying interest on the debt restricts
government’s ability to balance the
budget or fund other public sectors
 Most debt servicing is a redistribution of
income from taxpayers to bondholders.
 Opportunity cost or burden of debt is the
OC of the activities financed by the debt
(what they could do with the money…in
the alternative)
WHAT CAN YOU DO?
Be cognizant of economic events
Don’t be an ostrich
VOTE FOR BEST CANDIDATE
Then appear the Elephants in
the Living Room
SOCIAL SECURITY
MEDICARE