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Fiscal Policy Objectives. 1. What is the difference between discretionary and nondiscretionary fiscal policy? 2. What is the cause-effect chain for expansionary and contractionary fiscal policy? 3. What are the automatic stabilizers ? - PowerPoint PPT Presentation
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1. What is the difference between discretionarydiscretionary and nondiscretionarynondiscretionary fiscal policy?2. What is the cause-effect chain for expansionaryexpansionary and contractionarycontractionary fiscal policy?3. What are the automatic stabilizersautomatic stabilizers?4. What period is considered the “Golden Age of Fiscal Policy”“Golden Age of Fiscal Policy”?5. What is the “crowding-out”“crowding-out” effect?6. What is the “negative net export effect”“negative net export effect”?7. What are the “lags”“lags” involved in fiscal policy?8. What is “Supply-side”“Supply-side” economists?9. What is the Council of Economic AdvisersCouncil of Economic Advisers and the Joint Economic CommitteeJoint Economic Committee?
Discretionary Fiscal PolicyDiscretionary Fiscal Policy
[“[“GG” ” && “ “TT”]”] can be used if can be used if further smoothing is required.further smoothing is required.
Even if I have to dig a Even if I have to dig a hole and cover it back hole and cover it back up, I do have a job.up, I do have a job.
John Maynard KeynesJohn Maynard Keynes““Father of Fiscal Policy”Father of Fiscal Policy”
PeakPeakPeakPeak
TroughTrough
TroughTrough
PeakPeak PeakPeak
Contraction
Contraction
Contraction
ContractionContractionContraction
ContractionContraction
Nondiscretionary Fiscal PolicyNondiscretionary Fiscal Policy can take can take 3333% to % to 5050% of the% of the curves out of thecurves out of the business cycle. business cycle.[[Automatic stabilizersAutomatic stabilizers, like welfare and unemploy. insur.], like welfare and unemploy. insur.]
Expa
nsio
n
Expa
nsio
n
Expansion
Expansion
• This chapter confronts the following questions:
1. Can government spendinggovernment spending and and tax tax policiespolicies help ensure full employment?
2. What policy actions will help fight inflationfight inflation?
3. What are the roles of roles of government government interventionintervention?
• Up until 19151915, the federal government collected few taxes and spent little.
• In 19021902, it employed fewer than 350,000 350,000 peoplepeople and spentspent $650 $650 millionmillion..
• Today, it employs nearly 5 million5 million peoplepeople and spends more than $3 $3 trilliontrillion.
Government RevenueGovernment Revenue• Government expansion started with the 16th 16th
AmendmentAmendment to the U.S. Constitution (19131913)
which extended the taxing power to incomes.
• Today, the federal government collects over $2.6$2.6 trilliontrillion a year in tax revenues.
Real GDP
Pri
ce L
evel
AD2
AD1SRAS
$490
YYRR$510
YYFF
PL1
RecessionsRecessionsDecrease inDecrease in ADAD
LRAS
Real GDP
Pri
ce L
evel
AD2
AD1
Full $20 Billion Increase in AD
SRAS
$490
YYRR$510
YYFF
PL1
Expansionary Fiscal Expansionary Fiscal PolicyPolicy[Increase “G” or “decrease “T” w. M[Increase “G” or “decrease “T” w. MEE of 4] of 4]
LRAS
$5 Billion in $5 Billion in additionaladditional
G spending G spending
Re
al I
nte
res
t R
ate
, (p
erc
en
t)
Quantity of Loanable Funds
[*Use this graph if there is a chg in savings by consumers or chg in fiscal policy][*Use this graph if there is a chg in savings by consumers or chg in fiscal policy]
[*[*Use theUse the Money Market graphMoney Market graph when there is awhen there is a change in MSchange in MS]]
rr==66%%
DD11
FF11
SS
Starting from a balanced budgetbalanced budget, if theG incr spendingG incr spending or decr Tdecr T to get out ofa recessionrecession, they would now be runninga deficitdeficit and have to borrow, pushing pushing up demand in the LFMup demand in the LFM and increasing increasing the interest ratethe interest rate.
DD22
rr==88%%
FF22
EE11
EE22
BorrowersBorrowers LendersLenders
$$2 T2 T
GG TT
Balanced Budget [G&T=$2 Tr.]Balanced Budget [G&T=$2 Tr.]
$2.2 T$2.2 T $2 T$2 T
Use the “real interest rate”“real interest rate” withLFMLFM, because it is long-termlong-term.Use “nominal interest rate”“nominal interest rate” withmoney marketmoney market, as it is short-termshort-term.
Re
al I
nte
res
t R
ate
, (p
erc
en
t)
Quantity of Loanable Funds
rr==66%%
DD11
FF11
SS11
rr==44%%
FF22
EE11
EE22
BorrowersBorrowers LendersLenders SS22
The following would cause anThe following would cause anincrease in supply in the LFMincrease in supply in the LFMand lower real interest rates:and lower real interest rates:1.1. Fed increases MSFed increases MS2.2. HH save moreHH save more3.3. Business save moreBusiness save more4.4. Government saves moreGovernment saves more5.5. Foreigners save more hereForeigners save more here
[*Use this graph if there is a chg in savings by consumers or chg in fiscal policy][*Use this graph if there is a chg in savings by consumers or chg in fiscal policy]
[*[*Use theUse the Money Market graphMoney Market graph when there is awhen there is a change in MSchange in MS]]
Demand for Loanable Funds Demand for Loanable Funds MarketMarket
(a)(a) (b)(b)
Demand for Loanable
Funds at 3% [no G borrowing]
Business firms demand for
Loanable Funds at 3%[a lot of investment]
RateInterest
3%3%
SSDD1[1[nono G]G]
LFMLFM
AA AA
Trillions of DollarsTrillions of Dollars
3%3%
1.51.5
Trillions of DollarsTrillions of Dollars QIDQID
DDII
Low interest rates, so Low interest rates, so - a lot of investment- a lot of investment
RealReal
BusinessesBusinessesBusinesses
Demand for Loanable Funds Demand for Loanable Funds MarketMarket
(a)(a) (b)(b)
RateRateInterestInterest
3%3%
SSDD1[1[nono G]G]
LFMLFM
AA
Trillions of DollarsTrillions of Dollars
3%3%
1.51.5
Trillions of Trillions of DollarsDollars
DDII
With With “G”“G” borrowing, the borrowing, the
demanddemand for for LFLF goes to goes to 55%%
Business firms dBusiness firms demandemand for for
LoanableLoanable Funds at Funds at 55%%[not as much investment][not as much investment]
DD22(G)(G)
5%5%
QID1QID1Higher interest rates, soHigher interest rates, sonot as much investmentnot as much investment
1.01.0
Government Demand for FundsGovernment Demand for Funds Business Demand for FundsBusiness Demand for Funds
AA
BB
RealReal
BB 55%%
QID2QID2
BBalancedalanced BBudget [$2 Tudget [$2 Tril. ril. “G” = $2 T“G” = $2 Tril. ril. “T”]“T”]
$2 $2 TrillionTrillion $2 $2 TrillionTrillion
GG TT
RecessionRecessionIncr G to $2.2 Incr G to $2.2
or or
Decr T to $1.8 Decr T to $1.8
DeficitDeficit so sohigher I.R.higher I.R.
InflationInflationDecr G to $1.8Decr G to $1.8
or or
Incr T to $2.2Incr T to $2.2
Surplus Surplus sosoLower I.R.Lower I.R.
BudgetBudget
So expansionary fiscal policySo expansionary fiscal policyleads to leads to higher interest rates.higher interest rates. DeficitDeficit
Wow! AWow! Asurplussurplus
So, contractionary fiscal policySo, contractionary fiscal policy
leads to leads to lower interest rateslower interest rates..
Gonna have Gonna have to borrowto borrow
Real GDPReal GDP
PLPL SRASSRASADAD22
YYRR YYFF
[Incr G; Decr T] [[Incr G; Decr T] [But we getBut we get negative negative Xn]Xn]
PPL1L1
ADAD11
PLPL22
GG ADAD Y/Empl./PL;Y/Empl./PL; GG LFMLFM II.R..R.
TT DDII CC ADAD Y/Emp/PL;Y/Emp/PL; TT LFMLFM IIRR
Start from a Start from a Balanced BudgetBalanced BudgetG & T = $2 TrillionG & T = $2 Trillion
$2 tr.$2 tr.
““I can’t I can’t get a job.”get a job.”
““NNowow, , this isthis is better.”better.”
GG TT EE11EE22
LRASLRAS
DD11DD22 SS
Loanable Funds MarketLoanable Funds Market
rr=6=6%%rr=8=8%%
Rea
lR
eal
In.
Ra
te
In.
Ra
te
FF11 FF22
$2 tr.$2 tr.
$2.2 tr.$2.2 tr.
$2.2 $2.2 $2.2 $2.2
$1.8$1.8 $1.8$1.8
$2 T$2 T triltril..
Real Real GDPGDP
PL SRASRASSADAD22
YYIIYYFF
[Decr G; Incr T ] [Again, we get negative Xn][Decr G; Incr T ] [Again, we get negative Xn]
PPL1L1
ADAD11
PLPL22
GG ADAD Y/Empl./PL;Y/Empl./PL; GG LFMLFM I.R.I.R.
TT DDII CC ADAD Y/Emp/PL;Y/Emp/PL; TT LFMLFM IIRR
Start from a Start from a Balanced BudgetBalanced BudgetG & T = $2 TrillionG & T = $2 Trillion
$2$2 tril. tril.
GG TT
[like we have [like we have ““money trees”money trees”]]
EE11
EE22
LRASLRAS
Loanable Funds MarketLoanable Funds Market
rr=3=3%%
rr=6=6%%
DD11DD22
FF11FF22
SS
$2.2 T$2.2 T triltril..
$1.8$1.8 tril. tril...
$$1.81.8
$2.2$2.2 $2.2$2.2
$$1.81.8
Rea
lR
eal
In.
Ra
te
In.
Ra
te
Discretionary Discretionary Fiscal Policy Fiscal Policy
Deliberate use of government spending and/or taxing.
““G” and “T”G” and “T”
Nondiscretionary Nondiscretionary Fiscal PolicyFiscal Policy
Automatic StabilizersAutomatic Stabilizers1.Welfare & food stamps1.Welfare & food stamps2. Unemploy. insurance2. Unemploy. insurance3. Social security3. Social security4. Corporate Dividends4. Corporate Dividends5. ProgressiveProgressive Tax System Tax System
Unempl. checkUnempl. check
Discretion of CongressDiscretion of Congress
Suppose the economy is in recessionrecession::
Real Real GDPGDP
TaxTaxcollectionscollections
Transfer Transfer paymentspayments
GG > TTThe deficit growsThe deficit grows
[Automatic stabilizers]
AS
ADAD22AD1
““Recession”Recession”YYRR Y*
PLPL
If the economy has an inflationaryinflationary gapgap:
TaxTaxcollectionscollections
Transfer Transfer paymentspayments
G <G < TTThe surplus growsThe surplus grows
Real GDPReal GDPAS
““Inflationary Gap”Inflationary Gap”
ADAD22ADAD11
Y* YYII
PL
[Automatic stabilizers]
[Takes about 1/3 to ½ out of the curves][Takes about 1/3 to ½ out of the curves]
Discretionary [“Active”] Fiscal Policy [“G” & “T”]
YYRR YF YYII
ADAD33 AD1 ADAD22AS
PLPL33
PL1
PLPL22
Contractionary Fiscal PolicyContractionary Fiscal Policy
1.1. Decrease “G”Decrease “G”2.2. Increase “T”Increase “T”
PeakPeak
Trough
Contraction Expa
nsio
n
EExpansionary xpansionary FFiscaliscal Policy Policy
1.1. Increase “G”Increase “G”2.2. Decrease “T”Decrease “T”
[in a nutshellnutshell]
PeakPeak PeakPeak
TroughTrough
YYRR YYFF YYII
ADAD33 ADAD11 ADAD22
““Balance the economy over the Balance the economy over the course of the Business Cycle”course of the Business Cycle”
ASAS
PLPL33
PLPL11
PLPL22
PeakPeak PeakPeak
Raise Raise ““T”T”
Deficit SpendingDeficit SpendingTroughTrough
Raise Raise ““T”T”
““Even if the jobs are digging Even if the jobs are digging holes and filling them up.”holes and filling them up.” Recess – Lower TRecess – Lower T
DeficitsDeficitsInflat – Raise TInflat – Raise T
SurplusesSurpluses
Deficit Deficit SSpendingpending
RaiseRaiseTaxesTaxes
Bus. CycleBus. Cycle
2.2. Just print the moneyJust print the money [Money creation – lower interest rates[Money creation – lower interest rates so this would be more expansionary]so this would be more expansionary]
FINANCING OFFINANCING OF DEFICITSDEFICITS [[IIss borrowingborrowing oror printing the moneyprinting the money more expansionary?]more expansionary?]
1. 1. Government borrows from theGovernment borrows from the public public [results in higher interest rates[results in higher interest rates which crowds out investment]which crowds out investment]
7%7%MS1MS1
ASASADAD22
YY** YY
But the LR increase in MS resultsBut the LR increase in MS results
in an in an increase in inflationincrease in inflationPLPL11
PLPL22 ADAD11
Lower Lower II.R..R.
HigherHigherI.R.I.R.
MS2MS2
4%4%
[Should we hold the surplus or give it back]
1. 1. Debt RetirementDebt Retirement [Give the surplus back during recessionsrecessions to get lower interest rates and expand the economy]
ASADAD22
Y* YYII
2. 2. Impound The SurplusImpound The Surplus [Keep the surplus during inflationsinflations and give it back during recessionsrecessions]
PLPL22AD1
PLPL11
10%10%
8%
6%6%
4%
2%
IIGG Rea
l in
tere
st
rate
DDII
Investment (billions of dollars)
[Incr G incr I.R. [Incr G incr I.R. Decr IgDecr Ig]]
5 10 155 10 15 20 2520 25
CrowdingCrowdingOut EffectOut Effect
ASASADAD11 AD2AD2
44%%
22%%
YYRR
GG
FriedmanFriedmanJust follow theJust follow the
““monetary rule.”monetary rule.”
YY**
DD11DD22 ss
66%%
1010%%
Quantity of LFQuantity of LFFF11 FF22
PLPL
Rea
l I.R
.R
eal I
.R.
Loanable FundsLoanable Funds MarketMarket
1515
In this case, it would be 100% “crowding out”.In this case, it would be 100% “crowding out”.[The higher RIR could also cause crowding-out of Xn.][The higher RIR could also cause crowding-out of Xn.]
G can finance a deficit by:G can finance a deficit by:1. 1. BorrowingBorrowing - this - this raises interest raises interest ratesrates in thein the LFM and LFM and “crowds out”“crowds out” investment. investment.2. 2. MMoney oney CCreation reation - - no no “crowding out”“crowding out” so is so is more expansionarymore expansionary than borrowing. than borrowing.
0
Negative Net Export Effect of Fiscal PolicyNegative Net Export Effect of Fiscal Policy
YYRR Y*Y*
Expansionary Fiscal PolicyExpansionary Fiscal Policy
““Negative XnNegative Xn””
Due to higher interest rates, dollar appreciatesDue to higher interest rates, dollar appreciates
SRASSRAS
+Ig+Ig+C+C
-Xn-Xn
LRASLRAS
ADAD+G+G ADADADAD
Negative Net Export Effect of Fiscal PolicyNegative Net Export Effect of Fiscal Policy
YYRR Y*Y*
DueDue to to lower interestlower interest
ratesrates, dollar depreciates, dollar depreciates
Expansionary Fiscal PolicyExpansionary Fiscal Policy
““Negative XnNegative Xn”” ofof ““Negative XnNegative Xn”” ofofContractionary Fiscal PolicyContractionary Fiscal Policy
DueDue to to higher interesthigher interest
ratesrates, dollar appreciates, dollar appreciates
SRASSRASSRASSRAS
+G+G +Ig+Ig+C+C
-Xn-Xn
-Ig-Ig -C-C
+Xn+Xn
Y*Y* YYII
LRASLRAS
LRASLRASADAD
-G-G
ADAD
ADAD
Liberal (“Liberal (“GG”)”) or Conservative Conservative (“G”)(“G”)
LiberalsLiberalsRRecessionecession: Increase : Increase ““GG”;”; Inflation: Inflation: Increase “T”Increase “T”GG
GG ConservativesConservativesRecession: Recession: Decrease “T”; Decrease “T”; Inflation: Decrease “G”Inflation: Decrease “G”
“The shower starts out too coldstarts out too cold, because the pipes have not yet warmed up. So the fool turns up the hot waterturns up the hot water. Nothing happens, so he turns up the hot water furtherturns up the hot water further. The hot water comes on and scalds himscalds him. He turns up the turns up the cold watercold water. Nothing happens right away, so he turns up turns up the cold furtherthe cold further. When the cold finally starts to come up, he finds the shower too coldtoo cold, and so it goes.”
Fiscal Policy lagsFiscal Policy lags1.1. Data (recognition) lagData (recognition) lag2.2. ““Wait-and-see” lag – short runWait-and-see” lag – short run3.3. Legislative lag (political)Legislative lag (political)4.4. Effect lag [takes months]Effect lag [takes months]
YYFFYYRR YYII
ADAD22ADAD11
LRASLRAS
SRASSRAS11
SRASSRAS22
EE44
EE44
EE22EE11
EE22
EE33
Discretionary fiscal policiesintended to fight a recessionrecessionoften end up feeding a boomfeeding a boomand vice versa.
All too often, policy makers can inadvertentlyexacerbate rather than mitigate the magnitudeof economic fluctuations.
Traditional Fiscal Policy [“G” & “T”]Traditional Fiscal Policy [“G” & “T”]will not work withwill not work with StagStagflationflation
ADAD11LRASLRAS
4%4%
55%%
1010%%
1010%%
YYRR
SRASSRAS22
StagStagflationflation
ADAD22
15%15%
1515%%
AD3AD3
YYFFYYRR
0
100100
l
Tax revenue (dollars)Tax revenue (dollars)
Tax
rat
e (p
erce
nt)
Tax
rat
e (p
erce
nt)
00
100100
m
l
Tax revenue (dollars)Tax revenue (dollars)
Ta
x ra
te (
%)
Ta
x ra
te (
%)
00
100100
mm
nn
l
Tax revenue (dollars)Tax revenue (dollars)
Tax
rat
e (p
erce
nt)
Tax
rat
e (p
erce
nt)
00
100100
m m
n
l
Tax revenue (dollars)Tax revenue (dollars)
Tax
rat
e (%
)T
ax r
ate
(%)
MaximumMaximumTaxTax
RevenueRevenue
Shift the AS curve back to the rightShift the AS curve back to the right1.1. Reduce corporate taxes from 50% to 35% Reduce corporate taxes from 50% to 35%
[they have more money and increase investment, so more jobs][they have more money and increase investment, so more jobs]2. 2. Accelerated depreciation of capital investment from 10 years to 3 yearsAccelerated depreciation of capital investment from 10 years to 3 years [businesses save taxes enabling them to invest more][businesses save taxes enabling them to invest more]3. 3. Reduce personal incomeReduce personal income taxestaxes by $250 billionby $250 billion [keeping more of our money [keeping more of our money makes us work harder & longer; also, we buy more, so more jobs and in makes us work harder & longer; also, we buy more, so more jobs and in addition, we save more, which lowers interest rates, which increases Ig]addition, we save more, which lowers interest rates, which increases Ig]4. 4. Tax CreditsTax Credits for for RR&&DD [businesses have more money, so more Ig and more jobs] [businesses have more money, so more Ig and more jobs]Motto:Motto: Get the government off ourGet the government off our [ regulations] [ regulations] backsbacks & & watch the AS curve shiftwatch the AS curve shift..
10%10%
Supply-Side Economics Supply-Side Economics [Voodoo [Voodoo Economics?]Economics?]
5%5%
ASAS11ADAD
3%3%
ASAS22
1010%%
PLPLWas President Reagan a “closet Keynesian”“closet Keynesian” with all the “G” & “T”? Perhaps he was a ““KeynesianKeynesian in in drag.”drag.”
Tax rate (percent)Tax rate (percent)00 100100bb
bb
ca
Maximum Tax RevenueMaximum Tax Revenue
President Reagan said he was on the Laffer curve. He said that after WWII, when he started making big money, that he could do 4 movies before making$200,000 and hitting the top marginal tax rate of 91%. After four, because he could only keep 9%, he would quit making movies until the next year.
““Yes, I was on the Yes, I was on the Laffer cuve. I Laffer cuve. I couldn’t couldn’t
shoot my way out”shoot my way out”
The “Gipper”The “Gipper”BonzoBonzo
For rich peoplerich people, this was a disincentive to keep working, so they would quitdisincentive to keep working, so they would quit when they hit the top marginal tax rate. For most workersmost workers, this was not the casenot the case.
RReaganeagan
Tax
rev
enu
e T
ax r
even
ue
(do
llar
s)(d
oll
ars)
0
Pri
ce le
vel
Pri
ce le
vel
Real GDPReal GDP
ADAD11ADAD22 ASAS11 ASAS22
PLPL11
PLPL22
PLPL33
QQ11 QQ22 QQ33
Can sustain a much greater increase in AD if the Can sustain a much greater increase in AD if the AS curve is also shifting to the right.AS curve is also shifting to the right.
1010%%
1010%%
Pri
ce L
evel
Pri
ce L
evel
ASAS
ADAD22
Inflation and the Multiplier [4]Inflation and the Multiplier [4]
GDPGDP11 GDPGDP22
PP11
ADAD11
ADAD33
GDPGDP33
PP22
Full Multiplier Full Multiplier EffectEffect ReducedReduced
MultiplierMultiplierEffect DueEffect Dueto Inflationto Inflation
+20+20
+ 80 bil.+ 80 bil.
+20+20
+ 40 + 40 bil.bil.
M(4) = Y/ EM(4) = Y/ E [80] [20][80] [20] M(2) = Y/ EM(2) = Y/ E
[40] [20][40] [20]
Pri
ce l
evel
Pri
ce l
evel
Real GDP (billions)Real GDP (billions)
EXPANSIONARY FISCAL POLICYEXPANSIONARY FISCAL POLICY
Full $20 billionFull $20 billionincrease in ADincrease in AD
ADAD11 ADAD22
$5 billion $5 billion initial direct increase in spendinginitial direct increase in spending
[MPS=.25MPS=.25] the multiplier at work...
PLPL
$485$485
+5+5
ASAS
$505$505
Pri
ce level
Pri
ce level
Real GDP (billions)Real GDP (billions)
CONTRACTIONARY FISCAL POLICYCONTRACTIONARY FISCAL POLICY[MPS=.25MPS=.25] the multiplier at work...
PLPL22
$515$515
Full $20 billionFull $20 billiondecrease in ADdecrease in AD
ADAD11ADAD22
$5 billion initial$5 billion initialdirect decrease in direct decrease in
spendingspending
PLPL11
ASAS
GDPGDP11 GDP2 GDPGDP33
Real Domestic Output, GDP
Go
ve
rnm
en
t E
xp
end
itu
res,
G, a
nd
Tax
Re
ven
ues
, T
DeficitDeficit
More taxMore taxmoneymoney
Taxes
Gov.
purchases
YYRR Y* YYII
More vertical [more progressive], the more stability for the economy.
Transfers
SurplusSurplus
Fewer Fewer TransfersTransfers
MoreMoreTransfersTransfers
Less TaxLess TaxMoneyMoney
12-31-6512-31-65
FewerFewerTransfersTransfers
TaxesTaxes
Even more
Even more
Tax money
Tax money
But larg
er
deficits
55%%
5050%%
1010%%
3535%%
A pilot may pilot may take atake a stroll thru stroll thru and let the co-pilot co-pilot cruisecruise. If there is turbulenceturbulence, the pilot will rush pilot will rush to the cockpitto the cockpit [President & Congress] and use manualuse manual controlscontrols toto correctcorrect turbulence turbulence. DiscretionaryDiscretionary fiscal policy is our manual control systemfiscal policy is our manual control system.
Nondiscretionary [“Passive”] Fiscal Policy (Automatic stabilizers)Nondiscretionary [“Passive”] Fiscal Policy (Automatic stabilizers)1. Transfer PaymentsTransfer Payments D. Corporate dividends
A. Welfare checks E. Social Security B. Food Stamps F. Veteran’s benefitsC. Unemployment checks
2. Progressive Income TaxesProgressive Income Taxes
The automatic stabilizers may be called the automatic pilotautomatic pilot of our economyof our economy,not very well suited for takeoffs and landings, but fine for the smooth part of thethe flight. But when the going getsgoing gets roughrough, the economy must use manual controlsmust use manual controls. [discretionary G&Tdiscretionary G&T]
Automatic stabilizers
take 33-50%33-50% out out.Stabilizers are like a thermostatmaintaining temperature.They are shock absorbers.
YYRR ; ; TT ; ; ADAD22
YYII ; T ; AD ; T ; AD33
ADAD22
ADAD11
ADAD33
YYR R Y*Y* YYII
ASAS
3333%-%-5050%%
Taxes Taxes reduce the drop in reduce the drop in DDII during during recessionsrecessions andand reduces the jump in DI during expansions..
AE
(b
illi
on
s)
o45 o
RGDPRGDP390 390 470470
ConsumptionConsumptionC + IC + Ig g + X+ Xnn
C +C + IIgg ++ XXn n ++ GGGovernmentGovernmentSpending ofSpending of$20 Billion$20 Billion
$20 Billion Government Spending & Impact on Equilibrium Y$20 Billion Government Spending & Impact on Equilibrium Y
Mixed - OpenMixed - OpenPrivate-public - ROW
$20 bil. on National Defense
550550
Increases Y by $80Increases Y by $80[$20 x 4 = $80][$20 x 4 = $80]
$390$390
$470$470
$550$550
-20 x 3 = -$60-20 x 3 = -$60
Incr. T by $20 Incr. T by $20 billion billion [[MTMT = 3] Equilibrium GDP[-60] = 3] Equilibrium GDP[-60]
o45
o
Real domestic product, GDP (billions of dollars)
$550$550
C +C + IIg g + X+ Xnn ++ GG
CCaa ++ I Ig g + X+ Xnn ++ GG
$490$490
Mixed-OpenMixed-Open
$20 $20 bil.bil. incr incr in in TT
$490$490
$550$550
RGDPRGDP
Balanced Budget Multiplier [$20 billion]Balanced Budget Multiplier [$20 billion][[“T”“T” affects AD indirectly thru “C”affects AD indirectly thru “C”;; “G” affects AD directly“G” affects AD directly]]
GDP=$80
Net Change in GDP =Net Change in GDP = The increase in “T” means we The increase in “T” means we would have consumed $15 and would have consumed $15 and kept $5 in our pockets. kept $5 in our pockets.
The increase in “G” The increase in “G” flows directly into flows directly into the economy.the economy.
ME = 1/MPSME = 1/MPSME = 1/.25 = 4ME = 1/.25 = 4So, So, 4 x $204 x $20 = = $80$80
G $20
MT = MPC/MPS=.75/.25=MT = MPC/MPS=.75/.25=33So, 3 x -$20So, 3 x -$20 = = -$60-$60
GDP= -$60Ca= -$15
Sa= -$5
T $20
$470$470 billion billion
ASAS
AD1AD1
$490 $490 billionbillion
PLPL
ADAD22
+$20+$20
1. With the Employment Act of 1946Employment Act of 1946, the federal government committed itself to accept (total/some) degree of responsibility for employment/prices.2. Fiscal policyFiscal policy is carried out primarily by the (local/state/federal) government.3. Discretionary fiscal policyDiscretionary fiscal policy [G & T] (does/does not) require congressional action.4. In a mixedmixed [private & public) closed economyclosed economy, taxes & (savings/government spending) are leakagesleakages, while Ig and (savings/government spending) are injectionsinjections.5. In a mixedmixed economyeconomy, the equilibrium GDP exists where (C+Ig/C+Ig+G+Xn)=GDP.6. The balanced budget multiplierbalanced budget multiplier indicates that equal increases in G&T tend to (decrease/increase/not change) the equilibrium GDP. [MBB is “1”]7. Assume in a private economy that equilibrium GDP is $400 billionequilibrium GDP is $400 billion & the MPC is .80. Suppose the G collects new taxes of $50 bil.G collects new taxes of $50 bil. & spends the entire amountspends the entire amount on our infrastructure. As a result equilibrium GDP will be ($400/$450/$500) billion.
8. Suppose a constitutional amendmentconstitutional amendment requires that the G always balanceG always balance its budgetits budget. If it desired to increase GDP by $40 billionincrease GDP by $40 billion, G should (increase/decrease) government spending & taxes by ($30/$40/$50) billion.
12. If the F.E. GDP is OCF.E. GDP is OC, then it would be appropriate fiscal policy for government to (increase/decrease) “G”“G” and (increase/decrease) “T”“T”.
13. If the F.E. GDP is OAF.E. GDP is OA, then it would be appropriate fiscal policy for government to (increase/decrease) “G”“G” and (increase/decrease) “T”“T”.
10. If the government tries to eliminate a budget deficit during a depressioneliminate a budget deficit during a depression, these efforts will (help/hurt) the depression.
11. A conservative economistconservative economist who advocates an active fiscal policy
would recommend taxtax (increases/decreases) during a recessionrecession and
(increases/decreases) in government spendinggovernment spending during inflationinflation.
9. In a severe recessionsevere recession, Keynesians would favor a(n) (increase/decrease) in taxes.
YYIICC AA
AEAE11
AEAE22PLPL
YYR R Y*Y*800 800 ??
AEAEPLPL
OO YYRR
14. If G increases its spending during a recessionduring a recession to assist the economy, the funds must come from some source. (Additional taxes/Borrowing from the public/Creating new money) would tend to be the most expansionarymost expansionary.
15. The following fiscal actionsfiscal actions, (incurring a budget surplusand allowing it to accumulate as idle Treasury balances/incurring a budget surplus which is used to retire debt held by the public) is likely to be most effective in curbing inflationcurbing inflation.
16. The greatest anti-inflationary impact of a budgetgreatest anti-inflationary impact of a budget surplussurplus will occur when the G (impounds/uses) the surplus funds & lets them (stand idle/pay off the debt).
17. In describing the built-in stabilizersbuilt-in stabilizers, we can say that
personal personal && corporate income tax collections corporate income tax collectionsautomatically (incr/decr) as as GDP increasesGDP increases & transferstransfers and subsidiesand subsidies (incr/decr) as as GDP increasesGDP increases.
Should I Should I give it back?give it back?
Recognition LagRecognition Lag Action LagAction Lag Effect LagEffect Lag
FISCAL POLICY – Pure and SimpleFISCAL POLICY – Pure and Simple
Fiscal Policy:Fiscal Policy:No ComplicationsNo Complications
Pri
ce le
vel
Real GDP Real GDP (billions)(billions)
ADAD11ADAD22
PLPL
$490 $490 YRYR
ASAS
There are 3 things that could “diminish AD.”“diminish AD.”
$510$510Y*Y*
Crowding-out EffectCrowding-out EffectIncreasing G resultsIncreasing G resultsin in higherhigher interest rates, interest rates,
decreasing decreasing investmentinvestmentand the . . .and the . . .
Real GDP (billions)
ADAD11 ADAD22
PLPL
$490$490 $510$510
ASASAD’AD’22
$503$503
Three things that could “diminish AD.”Three things that could “diminish AD.” 1. Crowding-out Effect 1. Crowding-out Effect 2. Net Export Effect2. Net Export Effect 3. Inflation 3. Inflation
Net Export EffectNet Export EffectExpansionary fiscal policyExpansionary fiscal policyleads to more governmentleads to more governmentborrowing, increasing theborrowing, increasing theinterest rate,interest rate, appreciating appreciatingthe dollar, the dollar, & & decreasingdecreasing Xn. Xn.
3. 3. InflationInflation would be a third factor would be a third factor that couldthat could reduce aggregate demand reduce aggregate demand
Pri
ce level
Real GDP (billions)
ASADAD22
$$495495 $515
PP11
AD1
$$505505
Answer the next 3 questions(18-21) based on the diagram.18. DeficitsDeficits will be realized at GDP levels (below/above) C, and surplusessurpluses (below/above) C.19. If the F.E. GDPF.E. GDP for the economy is at DD, the F.E. budgetF.E. budget will entail a (deficit/surplus).20. If the tax line had a greater slopetax line had a greater slope [more progressive tax system], stabilitystability would be (less/greater).21. If government adhered strictly to an annually balancedadhered strictly to an annually balanced budgetbudget then the government’s budget would tend to (destabilize/stabilize) the economy.
T2
11
10%
35%
5%
[50%]
For Questions 22-24 [graph]22. (T1/T4T4) tax system is characterized by the least built-in stability.
23. (T1/T4T4) tax system is characterized by the most built-in stability.
24. (T1/T4T4) tax system will generate the largest cyclical deficits.
25. Nondiscretionary Fiscal Policy (does/does not) require congressional action.
5%
20%
15%
25%
10%
35%
50%
20%
(represents a m
ore
progressive system)
YYRR Y* YYII GDP
Tax
Rev
enu
e
Flat 20% Tax[T1]
[T2][T2]
[T3][T3]
[T4][T4]
26. If the MPC is .5, a $10 B increase in “G”$10 B increase in “G” will increase “Cincrease “C”” [not incomenot income] by ($20/$10/$5) billion.[G increase in spending of $10 B increases income(Y) by $20 B. With MPC of .5, C increases $10 B]
27. If government tries to give back a surplusgovernment tries to give back a surplus during an during an inflationary FE yearinflationary FE year, this will be (pro-cyclical/counter-cyclical). 28. When politicians use fiscal policy to cause an improvementimprovement in the economy just prior to an electionin the economy just prior to an election, this is a (presidential/Congressional/political) business cycle.
29. When G incurs a deficit which is financed by borrowingG incurs a deficit which is financed by borrowing, causing interest rates to increase which decreases Iginterest rates to increase which decreases Ig, this is called the (crowding-in/crowding out) effect.
30. Supply-sidersSupply-siders argue that the primary effect of tax cutsprimary effect of tax cuts is to shift the AS curve (leftward/rightward).
34. If the MPS is .2MPS is .2 and the economy has a
recessionary spending gap of $5recessionary spending gap of $5 bil.bil.,,
we may conclude that the equilibriumequilibrium level level of of GDPGDP is ($5/$20/$25) below the FE GDP.
33. In a private-closed economy, the MPS MPS is .is .22,
consumption equals income at $200 consumption equals income at $200 billionbillion, & the level of investmentinvestment is is $10 $10 billionbillion. The level of income at the new equilibrium level is ($200/$250) billion.
31. If the MPC is .8MPC is .8, a $2 billion increase in “G”$2 billion increase in “G” will increase
““consumption”consumption” by ($10/$8/$6) billion. [When G increases by $2 billion, Y does increase by $10, but *8 (80%) is consumed, or $8 billion]
32. If the MPC is .9MPC is .9, a $1 billion increase in “G”$1 billion increase in “G” will increase ““consumption”consumption” by ($10/$9/$8) billion.
45°45°
45°45°
C+IgC+Ig
200200
200200 ??
““C”C”
+$10 Ig+$10 Ig
AEAE
AE1AE1
AE2AE2
YYR R ??
AEAE
+$5+$5
SS
SS
36. If the government decreases G&T by $10 billiongovernment decreases G&T by $10 billion, then a
MPS of .10MPS of .10, the equilibrium GDPequilibrium GDP would (increase/decrease) by ($5/$10/$100) billion.
37. With a MPC of .75MPC of .75, government increases G&T by $8 billiongovernment increases G&T by $8 billion.
The equilibrium GDPequilibrium GDP (increases/decreases) by ($75/$32/$8) billion.
38. If the government runs a budgetgovernment runs a budget surplus and desires tosurplus and desires to curb inflationcurb inflation, it should (give the surplus back/keep it in storage).
35. If the MPS is .5MPS is .5 and the economy has an
inflationaryinflationary spending gap of $6 spending gap of $6 billionbillion, we may conclude that the equilibrium level equilibrium level of GDPof GDP is ($6/$12/$18) billion beyond the FE GDP.
-$6-$6
45°45°
AE1AE1
AE2AE2
Y*Y* YYII
AEAESS
1. Expansionary fiscal policy will be most effective [increase GDP] when the AS curve isis (vertical/horizontal)
& (incr/decr) “C” and (incr/decr) unemployment.
2. The paradox of thrift indicates that an increase in saving (matched/unmatched) by an increase in investment will lower equilibrium GDP.
3. A contractionary fiscal policycontractionary fiscal policy [decr G, incr Tdecr G, incr T] would cause a[an] (incr/decr) in output[GDP] and a[an] (incr/decr) in interest rates.
An expansionary fiscal policyexpansionary fiscal policy [incr G, decr Tincr G, decr T] would cause a[an] (incr/decr) in output[GDP] and a[an] (incr/decr) in interest rates.
4. In the AE model, if AE[AD]doesn’t buy up FE output(GDP)AE[AD]doesn’t buy up FE output(GDP), then the equilibrium output is (less than/more then) full employment output.
[G ; LFM ; In. Rates ][G ; LFM ; In. Rates ]
[G ; LFM ; In. Rates ]
[On #3, start froma balanced budget]
““Recessionary Gap”Recessionary Gap” ““Inflationary Gap”Inflationary Gap”
G $2 Trillion T $2 Trillion
[T ; LFM ; In. Rates ]
[T ; LFM ; In. Rates ][T ; LFM ; In. Rates ]
5. To decrease AD the greatest amountdecrease AD the greatest amount, the government should: (decrease “G” only/increase “T” only/both decr G & incr T)6. To increase AD the greatest amount, the “G” should: (increase “G” only/decrease “T” only/both incr G and decr T)7. In a recessionary gaprecessionary gap (AE model) at the equilibrium point[actualequilibrium point[actual GDP]GDP] planned investmentplanned investment is (greater than/equal to/less than) saving,saving, but at the FEFE GDP levelGDP level, planned investment[backup] is (greater than/equal to/less than) savingsaving.8. In an inflationaryinflationary gap gap (AE modelAE model), at the equilibrium point [actual GDP]
planned investment [backup] is (greater than/equal to/less than) saving, but at the FE level, planned investment is (greater than/equal to/less than) savingsaving.9. If businesses are experiencing an unplanned increase in inventoriesunplanned increase in inventories, AE is (less than/greater than) FE output & spendingFE output & spending will (increase/decrease).10. If businesses are experiencing an unplanned decrease in inventoriesunplanned decrease in inventories [disinvestmentdisinvestment] AE is (less than/greater than) FE output & spendingFE output & spending will (increase/decrease).
11. If “C” equals income at $500 billion“C” equals income at $500 billion, & MPC is .9MPC is .9, then an increase in Ig of $10 billion will change equilibrium GDP to ($400/$490/$510/$600) billion.12. A conservative conservative economisteconomist would want tax (incr/decr) during a recessionrecession & (incr/decr) in “G” during inflationary timesinflationary times.13. A liberal economistliberal economist would want tax (incr/decr) during an inflationinflation & (incr/decr) in “G” during recessionary periodsrecessionary periods.14. An inflationary gapinflationary gap indicates AE[actual GDP] (exceeds/falls short of) FE GDP.
15. A recessionary gaprecessionary gap indicates AE[actual GDP] (exceeds/falls short of) FE GDP.
16. To increase GDP increase GDP [but [but reduce military spendingreduce military spending]], we would combine two (domestic/overseas) bases into one (domestic/overseas) base.17. A tax cut to expand the economytax cut to expand the economy would (incr/decr) Y & (incr/decr) in. rates.18. A tax increase to contract the economytax increase to contract the economy would (incr/decr) Y & (incr/decr) IR.
500500
500500
19. To increase equilibrium GDP by increase equilibrium GDP by $400,000$400,000, with a MPC of .5, a Keynesian economist would (decrease “T”/increase “G”) by $200,000.
20. Equilibrium GDP is $500 billionquilibrium GDP is $500 billion and MPS is .4. Now “G” collects taxes of $22 billion and spends the entire amount. As a result, equilibrium GDP will change to: ($445/$478/$522/$555).21. With a MPC of .5MPC of .5, a $12 billion$12 billion increase in “G” will increaseincrease “C” “C” by ($12/$24/$36) bil.
22. With a MPC of .5MPC of .5 and the economy in a recessionaryrecessionary spending gapspending gap of of $$1212 billion billion, we may conclude that the equilibrium is ($12/$24/$36) billion short of FE GDPshort of FE GDP.
23. An increase in Ig of $25 increase in Ig of $25 billionbillion results in an increase in equilibrium income (GDP) of $50B, so the MPS is?24. A contractionary fiscal policycontractionary fiscal policy results in a(n) (incr/decr)
in output, and a(n) (incr/decr) in interest rates.
25. Increasing T or decreasing GIncreasing T or decreasing G will (increase/decrease) consumption, and (increase/decrease) unemployment.
26. With a MPC of .5.5, and the economy with an inflationaryinflationary GDP GDP GapGap of $50B$50B, GG could eliminate this inflationaryinflationary GDP GapGDP Gap by reducing government spendingreducing government spending by?
27. With a MPC of .5MPC of .5 and current output at $500 billion but FEcurrent output at $500 billion but FE output is $700 biloutput is $700 billion, correct fiscal policycorrect fiscal policy would be to
(increase G/decrease T) by $100 billion.
[Incr T or Decr G][Incr T or Decr G]
.5.5
$25 billion$25 billion
28. An increase in Igincrease in Ig in an economy (increase)/decrease) GDP & (increase/decrease) C.
29. In a recessionary economyrecessionary economy, at FEFE GDPGDP, savingsaving is (less than/more than) IgIg. 30. In a recessionary economyrecessionary economy, (actual Y/potential Y) exceeds (actual Y/potential Y). 31. In a mixed-closed economymixed-closed economy (no Xnno Xn), the leakagesleakages are? and the injectionsinjections are?32. If the economy has an inflationary Gapinflationary Gap, at
FE GDPFE GDP, savingsaving (exceeds/is less than) Ig.
33. If there is an equal increase inequal increase in GG&&T T of of $25 $25 bilbillion, then outputoutput will (increase/decrease) & interest ratesinterest rates [based on PL][based on PL] will (increase/decrease).
[S & T][S & T] [G & Ig][G & Ig]
The EndThe End
E-conE-conE-conE-con