Download Fiscal and Monetary Policy Effects

Fiscal and Monetary Policy Effects
Outline:
1. What is fiscal and monetary policy and how
do they work?
2. The Federal Budget
3. Principles of taxation
4. The automatic stabilizers
16
Federal, State & Local Government Spending
as a Percent of GDP
www.economagic.com
14
12
10
8
6
4
2
50
55
60
65
70
75
State and Local
80
85
Federal
90
95
00
Fiscal Policy
Fiscal policy is the use of the federal budget to
smooth the business cycle and encourage economic
growth.
The Employment Act of
1946 establishes a
responsibility for the
Federal government to
“promote maximum
employment, production,
and purchasing power.
The Federal Budget
The Federal budget is an annual statement of
expenditures, tax receipts, and surplus or deficit
of the government of the U.S.
Let:
•G denote federal spending for goods and services
in a fiscal year (Oct. 1 thru Sept. 30).
•TX is federal tax receipts.
•TR is federal transfer payments.
•T is federal net taxes (TX - TR)
If G exceeds T in a fiscal year,
then we have a federal deficit.
If, however, T exceeds G,
then we have
a federal surplus.
Federal Outlays and Tax Receipts,
1978-2002 (in millions of dollars)
2500000
www.economagic.com
2000000
1500000
1000000
500000
0
78
80
82
84
86
88
OUTLAYS
90
92
94
96
98
RECEIPT S
00
02
How Fiscal Policy Works
AE
AE2
AE1
Y
1

G (1  MPC  MPI  MTR)
G
Full
employment
GDP
0
Y1
YFE
Real GDP
The preceding slide
illustrates the type of
expansionary fiscal policy
that Keynesians
recommend for
recession. We will now
use the AS-AD
framework to illustrate
contractionary fiscal
policy.
Modeling Expansionary Fiscal Policy
Price Level
Potential
GDP
AS
AD2
AD1
0
Y1
Real GDP
Question: How is Fed policy
“transmitted” to macroeconomic
variables such as real GDP,
employment, and the general price
level?
Fed Open Market Purchase of Securities
Increase in the Money Supply
Decrease in the interest rate
Increase in components of spending that are
sensitive to interest rates—specifically,
investment and consumer durable goods
Multiplier Effect
Real GDP
Nominal Interest Rate (%)
Diagrammatic explanation of
the transmission mechanism
MS1 MS2
6%
AE
AE2
AE1
C  I
4%
Md
0
Money
450
0
Y1
1
Y 
(C  I )
(1  MPC  MPI  MTR )
Y2 Real
GDP
The Fed pulled on the
string big time
beginning in 1979—it
was an anti-inflation
strategy under
Chairman Paul Volcker
Modeling Contractionary Monetary Policy
Price Level
Potential
GDP
AS
AD2
AD1
0
Y1
Real GDP
20
Recessions are shaded
18
16
14
12
10
8
79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01
Federal Funds
20
Recessions are shaded
Conventional 30 year
18
16
14
12
10
8
6
80
82
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84
86
88
Mortgage Interest Rates
90
92
Monthly payments on a $110,000
30 year mortgage note
Mortgage rate
Monthly
Payment1
8%
$807.14
10%
$965.33
12%
$1,131.47
14%
$1,303.36
16%
$1,479.23
1 Does
not include prorated insurance or
property taxes.
2400
Recessions are shaded
Data in thousands of units
2000
1600
1200
800
400
80
www.economagic.gov
82
84
86
88
Monthly Housing Starts
90
92
More recently, the
Fed raised the
federal funds rate six
times between May
99 and May 2000—
from 4.75% to 6.5
%.
The Fed reversed course
at the beginning of 2001
and reduced the federal
funds rate 11 times
that year!
Principles of Taxation
•Horizontal equity: Tax code should be written so that
those in the same economic circumstances pay the same
amount in taxes.
•Vertical equity: Tax code should be written so that
those in different economic circumstances should pay an
unequal amount in taxes.
•Benefits received principle: Those who derive more
benefits from government programs should pay more
taxes.
•Taxable income: Gross income - income exempt
from taxes. Example: For single filers who use the
1040EZ:
Gross Income:
$35,000
Minus:
Standard deduction
7,050
Equals:
Taxable income
$27,950
•Average tax rate (ATR): Tax payments as a
percent of taxable income.
•Marginal tax rate (MTR): The tax rate applied to
the last dollar of taxable income.
•Progressive tax: The proportion of taxable
income taken in taxes increases as taxable
income increases.
•Regressive tax: The proportion of taxable
income taken in taxes decreases as taxable
income increases.
•Proportional tax: The proportion of
taxable income taken in taxes remains
constant as taxable income increases.
Needy
By making the tax
structure “progressive,”
governments can make
the after-tax distribution
of income more
equitable (or even).
Affluent
Federal personal Income Tax rates Under the
1993 Tax Reform Act
(Married couple filing jointly)
Total Taxable
Income
Marginal Tax
Rate (%)
$0
0%
0-36,900
36,901-89,150
15
28
89,151-140,000
31
140,001-250,000
36
250,000 and up
39.6
Average and Marginal Tax Rates under the Tax
Reform Act of 1993 (for a couple with 2 children)
Income
$10,000
20,000
30,000
50,000
75,000
150,000
250,000
400,000
Tax
$0
272
1,766
4,766
10,315
32,140
66,802
128,710
Ave. Tax Rate Marginal Tax Rate
0%
0%
1.4
15
5.9
15
9.5
15
13.8
28
21.4
31
26.7
36
32.2
39.6
Tax Brackets for 2003 under the 2001 Tax
Reform Act
2003 Taxable Income
Marginal Tax Rate
$0-$12,000
10.0%
$12,000-$47,500
15.0
$47,500-$114,650
27.0
$114,650-$174,700
30.0
$174,700-$311,950
35.0
Over $311,950
38.6
Source : Wall Street Journal
Quick Facts about President Bush’s
Tax Bill
•The current 39.6% tax rate drops to 33%
•The current 36% tax rate drops to 33%
•The current 31% rate drops to 25%
•The current 28% rate drops to 25%
•The current 15% bracket is retained over most of its range
•A new 10% bracket applies to the lowest ¼ of the current
15% range.
President Bush comments (wav)
Assume a 7.13 percent excise tax on groceries,
gasoline, cigarettes, and liquor
(1)
Family
Income
(2)
Spending for
items subject
to excise tax
(3)
=
(2)/(1)
(4)
(5)=
(4)/(1)
Greens
$27,000
$16,200
.60
$1,188
4.4%
Jones
64,000
25,600
.40
1,871
2.9
Lemons
270,000
40,500
.15
2,961
1.0
Excise Tax
Paid
ATR
Moral of the story: Low income families tend
to spend a greater proportion of their income on
items subject to excise taxes. Hence excise taxes
tend to be regressive.
Automatic Stabilizers
Taxes (TX) and Transfer Payments (TR) are
called “automatic stabilizers” because they react
to changes in national income in a way that
increases the federal deficit (or reduces the
surplus) in the event of an economic contraction
or reduces the deficit (increases the surplus)
when the economy is expanding.
The automatic
stabilizers make sure
that disposable income (DI) does
not fall too much
when national income
is falling, and vice-versa.
Remember that the federal
deficit or surplus is
equal to the difference
between G and Net Tax Receipts,
where Net Taxes are equal to
TX - TR
YTX, for example
YTX, and vice versa
YTR, for example
YTR, and vice versa
Note that claims for unemployment compensation
and other assistance surges when unemployment rises.
G, T
Potential
GDP
T = TX - TR
G
Deficit
0
Balanced budget at
full-employment
Y1
Real GDP
In the case of a federal deficit, the
Treasury must borrow. The national debt
is the accumulated borrowing of the
federal government in all previous
fiscal years, minus what has been repaid
Is a large national debt a bad thing?
Arguments against a large national debt include:
•The “burden on future generations” argument.
•A large national debt means that a significant
share of federal spending must be allocated for
interest payments—leaving less for other priorities.
•A large national debt makes the U.S. too
dependent on foreign financial inflows.
•Federal borrowing “crowds out” private sector
borrowing units—i.e., firms and households.
“[W]e (the U.S.) owe
$5.7 trillion in debt and if we
don’t pay it off, our children
and our grandchildren are
going to have to.”
Congressman Marion Berry, in a
speech to the Jonesboro Lions
Club on April 16, 2001.
Interest as a Percent of Federal Outlays
16
14
12
10
8
6
4
1965
1970
1975
1980
1985
Yea r
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1990
1995
2000
As long as the debt grows by the same
percentage as nominal GDP, the ratios of debt to
GDP will remain constant. In this case, the
government can continue to pay interest on its
rising debt without increasing the average tax
rate in the economy.
Growth Rate of Nominal GDP and the Public Debt
www.economagic.com
35
30
20
15
Growth Rate of the
National Debt
10
Growth Rate of
Nominal GDP
5
0
-5
Year
00
20
95
19
90
19
85
19
80
19
75
19
70
19
65
19
60
19
55
19
50
19
45
-10
19
Percent Change
25
Ratio of Gros s Federal Debt to GDP in the
U.S.
1.4
1.2
1
0.8
0.6
0.4
0.2
0
19
40
19
45
19
50
19
55
19
60
19
65
19
70
19
75
19
80
19
85
19
90
19
95
20
00
Debt to GDP
www.bea.gov
Year
Who Owns the National Debt?
Agencies and Trusts
1814 / 26%
Privately Owned
3342 / 48%
Foreign Inves tors
1271 / 18%
Fed. Reserve Banks
463 / 7%
Source: Federal Reserve