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FISCAL POLICY Tool #1. Expansionary and contractionary policy Deficits and Surpluses Crowding out effect Built-in-Stability Problems of Fiscal Policy Forecasting the future . LEGISLATIVE MANDATES. Employment Act of 1946 Council of Economic Advisors (CEA)

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fiscal policy tool 1

FISCALPOLICYTool #1

Expansionary and contractionary policy

Deficits and Surpluses

Crowding out effect

Built-in-Stability

Problems of Fiscal Policy

Forecasting the future

slide2

LEGISLATIVE MANDATES

Employment Act of 1946

Council of Economic Advisors (CEA)

US Congress Joint Economic Committee (JEC)

slide3

Fiscal Policy and the AD-AS Model

Two Options

  • Discretionary Fiscal Policy (action)
  • Non-Discretionary Fiscal Policy (no action)

Expansionary Fiscal Policy

  • To Reduce Unemployment…
  • Increase Government Spending
  • Tax Reductions
  • Combinations of the Two
expansionary fiscal policy
Expansionary Fiscal Policy

Recessions

Decrease

Aggregate

Demand

$5 Billion

Additional

Spending

AS

Price Level

Full $20 Billion

Increase in

Aggregate Demand

P1

AD1

AD2

$490

$510

Real Domestic Output, GDP

slide5

FISCAL POLICY AND THE AD-AS MODEL

Contractionary Fiscal Policy

  • To Reduce Inflation…
  • Decrease Government Spending
  • Tax Increases
  • Combinations of the Two
contractionary fiscal policy
Contractionary Fiscal Policy

Reduce

Demand Pull

Inflation

$3 Billion

Initial Decrease

In Spending

AS

Price Level

Full $12 Billion

Decrease in

Aggregate Demand

P1

AD4

AD3

$510

$522

Real Domestic Output, GDP

slide7

Fiscal Policy - Deficits and Surpluses

  • Relative to the Federal budget
    • A deficit represents spending in excess of tax revenues.
    • A surplus represents tax revenues in excess of government spending.
    • Expansionary fiscal policy – think deficit
    • Contractionary fiscal policy – think surplus
    • Which policy to use – G or T?
      • Depends on whether one feels government is too large or too small.
slide8

Fiscal Policy – Financing Deficits

  • Borrowing vs. New Money
    • Borrowing from the public – Federal Government sells bonds which could lead to higher interest rates
    • The Fed selling bonds increases the supply of bonds and causes the price of bonds to drop. Bond prices and their interest rates are inversely related. The interest rates on bonds go up.
        • Lower investment spending results, and
        • Weakens the expansionary action.
      • This is called the “crowding out effect”
    • Money Creation by the Federal Reserve System - minimal crowding out effect
      • More expansionary approach
crowding out

16

14

12

10

8

6

4

2

0

5

10

15

20

25

30

35

40

Crowding Out

A Large Public Debt to Finance Public Investment Will Cause…

If Public Spending

Spurs More Private

Investment, ID Will

Increase to ID2

b

c

Real Interest Rate (Percent)

a

Interest Rate

Rise Will

Decrease

Investment

From a to b

Crowding-

Out Effect

ID2

ID1

Investment (Billions of Dollars)

slide10

Disposing of Surpluses – impact on GDP

  • Debt Retirement vs. Idle Surplus
    • Debt Reduction – Federal Government buys bonds, which could lead to lower interest rates.
    • The Fed buying bonds increases the demand for bonds and causes the price of bonds to rise. Bond prices and their interest rates are inversely related. The interest rates on bonds go down.
    • Investment spending increases and reduces anti-inflationary impact of the surplus
    • Impounding the surplus – hold the money
federal budget balance

Actual

Projected

(as of March 2008)

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

Federal Budget Balance

Actual and Projected, Fiscal 1994-2014

$300

200

100

0

-100

-200

-300

-400

-500

Budget Deficit (-) or Surplus, Billions

slide12

BUILT-IN STABILITY

  • Net tax revenues vary directlywith GDP
  • Transfer payments behave the oppositeway as tax collections
  • Unemployment compensation and welfare payments decrease during expansions and increase during contractions.
slide13

BUILT-IN STABILITY

  • Automatic or Built-In Stabilizers
  • Anything that increases the government’s budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policymakers.
  • Economic Importance
  • Taxes reduce spending and aggregate demand
  • Reductions in spending are desirable when the economy is moving toward inflation
  • Increases in spending are desirable when the economy is heading toward recession.
  • Accomplishing these results automatically is important
built in stability
Built-In Stability

T

Surplus

Government Expenses, G

and Tax Revenues, T

G

Deficit

GDP1

GDP2

GDP3

Real Domestic Output, GDP

slide15

BUILT-IN STABILITY

  • Tax Progressivity
  • Progressive Tax System
    • Average tax rate (tax revenue/GDP) rises with GDP
  • Proportional Tax System
    • Average tax rate remains constant as GDP changes
  • Regressive Tax System
    • Average tax rate falls with GDP

The more progressive the tax system, the greater the economy’s built-in stability.

slide16

Fiscal Policy

Problems, Criticisms, and Complications

  • Problems of Timing
    • Recognition Lag (9 to 12 months)
    • Administrative Lag (9 to 12 months)
    • Operational Lag (depends)
  • Political Considerations
    • Political Business Cycles
      • Getting re-elected versus doing the right thing for the country
  • Offsetting State & LocalFinance
    • States must balance their budgets – Federal govt. does not
  • Crowding-Out Effect
slide17

Fiscal Policy: the effects of crowding out and the net export effect

AS

Fiscal Policy:

No Complications

P1

Price level

AD1

AD2

$490 $510

Real GDP (billions)

slide18

Fiscal Policy in the Open Economy – The Net Export Effect

Problem

Recession:

Expansionary fiscal policy with deficit financing

Higher US interest rate

Higher foreign demand For dollars

Dollar appreciates

Net exports decline(aggregate

Demand decreases, partially

Offsetting the expansionary

Fiscal policy),

Problem

Inflation:

Contractionary fiscal policy

Lower US interest rates

Lower foreign demand For dollars

Dollar depreciates

Net exports increase (aggregate

Demand increases, partially offsetting

Contractionary fiscal policy

slide19

Fiscal Policy: the effects of crowding out and the net export effect

Fiscal Policy:

Showing

Crowding-out Effect – interest rate increases

or Net Export

Effect – interest rate increases, attracting foreign capital, dollar appreciates, net exports fall

AS

P1

Price level

AD1

AD’2

AD2

$490 $510

$504

Real GDP (billions)

slide20

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
  • Money Supply
  • Interest-Rate Spread
  • Consumer Expectations
slide21
fiscal policy

Employment Act of 1946

Council of Economic Advisers (CEA)

expansionary fiscal policy

budget deficit

contractionary fiscal policy

budget surplus

built-in stabilizer

progressive tax system

proportional tax system

regressive tax system

full-employment budget

cyclical deficit

political business cycle

crowding-out effect

net export effect

KEY TERMS

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