FISCAL POLICY

1. CHAPTERTWELVE FISCAL POLICY

2. LEGISLATIVE MANDATES Employment Act of 1946 It is the government’s responsibility to maintain economic stability through the use of monetary and fiscal policy.

3. LEGISLATIVE MANDATES Employment Act of 1946 Council of Economic Advisors (CEA)

4. LEGISLATIVE MANDATES Employment Act of 1946 Council of Economic Advisors (CEA) Joint Economic Committee (JEC) Presidential Advisors Committee of Congress

5. Discretionary Fiscal Policy Two Situations.... • Recession

6. Discretionary Fiscal Policy Two Situations.... • Recession • Demand-pull Inflation Discretionary – the deliberate manipulation of taxes and government spending by Congress to alter GDP.

7. Discretionary Fiscal Policy Two Situations.... • Recession • Demand-pull Inflation Expansionary Fiscal Policy Options....

8. Discretionary Fiscal Policy Two Situations.... • Recession • Demand-pull Inflation Expansionary Fiscal Policy Options.... • Increase Government Spending

9. Discretionary Fiscal Policy Two Situations.... • Recession • Demand-pull Inflation Expansionary Fiscal Policy Options.... • Increase Government Spending • Reduce Taxes

10. Discretionary Fiscal Policy Two Situations.... • Recession • Demand-pull Inflation Expansionary Fiscal Policy Options.... • Increase Government Spending • Reduce Taxes • Some Combination of the Two

11. Expansionary Fiscal Policy P $5 billion initial increase in spending Price level P1 AD2 Q Real GDP (billions)

12. Expansionary Fiscal Policy P $5 billion initial increase in spending Price level P1 AD2 Q Real GDP (billions)

13. Expansionary Fiscal Policy the multiplier at work... P $5 billion initial increase in spending Full $20 billion increase in aggregate demand Price level P1 AD1 AD2 Q Real GDP (billions)

14. NOTES: Increased government spending The multiplier makes GDP increase by a multiple of the original amount Expansionary Fiscal Policy the multiplier at work... P $5 billion initial increase in spending Full $20 billion increase in aggregate demand Price level P1 AD1 AD2 Q Real GDP (billions)

15. NOTES: Tax reductions: The multiplier requires a tax decrease of more than the desired GDP increase since the household sector only consumes part of its income (MPC). Expansionary Fiscal Policy the multiplier at work... P $5 billion initial increase in spending Full $20 billion increase in aggregate demand Price level P1 AD1 AD2 Q Real GDP (billions)

16. Contractionary Fiscal Policy P $5 billion initial decrease in spending Price level AD4 P1 Q Real GDP (billions)

17. Contractionary Fiscal Policy P $5 billion initial decrease in spending Price level AD4 P1 Q Real GDP (billions)

18. Contractionary Fiscal Policy the multiplier at work... P $5 billion initial decrease in spending Full $20 billion decrease in aggregate demand Price level AD4 P1 AD5 Q Real GDP (billions)

19. The Federal Budget! Total Revenues (Taxes) – Total Costs (Expenditures) + Budget Surplus 0 Balanced Budget - Budget Deficit 2005 Deficit: $319 Billion Sum of all yearly deficits and surpluses is the National Debt of: 8.2 Trillion Dollars! $28,000 per citizen

20. Financing Deficits and Disposing of Surpluses • Borrowing vs. New Money

21. 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 $ UP! Impact on Interest Rates?? This is a concept called crowding out. It may reduce the Expansionary impact of deficit spending.

22. 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!

23. Financing Deficits and Disposing of Surpluses • Borrowing vs. New Money • Borrowing • Money Creation • Debt Retirement vs. Idle Surplus What to do with surpluses??

24. 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

25. Financing Deficits and Disposing of Surpluses • Borrowing vs. New Money • Borrowing • Money Creation • Debt Retirement vs. Idle Surplus • Debt Reduction • Impounding Hold in a “Lock Box” no Inflationary risk!

26. 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? It depends on your political affiliation!

27. Deficits vs Surplus 3.5 3.0 2.5 2.0 1.5 Taxes Surplus T>G Expenditures & Revenues (trillions) Gov Spending Deficit G>T 9 10 11 12 13 Real domestic product, GDP (trillions of dollars)

28. Nondiscretionary Fiscal Policy: Automatic -Built-In Stabilizers These are intended to speed the economy or slow the economy when needed automatically. Two Points....

29. Nondiscretionary Fiscal Policy: Built-In Stabilizers Two Points.... Net tax revenues vary directly with GDP The higher the GDP the higher the tax revenues.

30. 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.

31. Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers Currently existing policies – progressive tax system, welfare, unemployment compensation, agricultural subsidies

32. 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.

33. Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Progressive

34. Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Progressive • Proportional

35. 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.

36. 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.

37. Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Actual Budget • Cyclical Budget

38. Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Actual Budget • Cyclical Budget • Cyclical Deficit

39. Types of Deficits 3.5 3.0 2.5 2.0 1.5 Taxes Expenditures & Revenues (trillions) A A Gov Spending B B C 9 10 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).

40. Nondiscretionary Fiscal Policy: Built-In Stabilizers Automatic or Built-In Stabilizers • Tax Progressivity • Actual Budget • Cyclical Budget • Cyclical Deficit • Full-Employment Budget

41. 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

42. Types of Deficits 3.5 3.0 2.5 2.0 1.5 Taxes Expenditures & Revenues (trillions) A A Gov Spending B B C 9 10 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).

43. 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

44. GLOBAL PERSPECTIVE BUDGET DEFICIT AS A PERCENT OF GDP - 1996 0 2 4 6 8 Greece Italy Britain Japan France Germany Sweden Canada United States

45. GLOBAL PERSPECTIVE BUDGET DEFICIT AS A PERCENT OF GDP - 1996 0 2 4 6 8 Greece Italy Britain Japan France Germany Sweden Canada United States

46. 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

47. Problems, Criticisms, and Complications

48. Problems, Criticisms, and Complications • Problems of Timing • Recognition Lag • Administrative Lag • Operational Lag

49. 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?

50. 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