Fiscal Policy and Monetary Policy by malj


									    Fixing an
Economy’s Health:
  Fiscal Policy

  Taxes, Entitlement
 Programs (Transfer Payments),
    and Government
      CHAPTERS 14 & 15
The 3 “tools” of Fiscal Policy:
  1. Government Purchases/Spending

  2. Entitlement Programs (also called Transfer Payments)

  3. Taxes
      …these three tools impact macroeconomic variables such
      as real GDP, employment, the price level, and economic
How just a little Fiscal Policy can
effect our economy in a BIG way.

          $150                 $150

           $400                           $50 (already in
                                            his pocket)

                     $200 already in
                       his pocket)

Multiplier Effect: each dollar spent will tend to
 generate more than 1 dollar added to GDP.
When does the government use fiscal policy?
               It is pretty simple.
1. When the economy is in a slump
   (recession or depression) the economy
   has contracted.
     Sothe government will enact an
     Expansionary Fiscal Policy to
     help boost the economy.
2. When the economy is booming (peak) the
   economy has expanded.
     So the government will enact an
      Contractionary Fiscal Policy to help slow
      down the economy.
Closing a Contractionary Gap
                                                                               This is where
     using Fiscal Policy                                                       we should be!
 Begin with a aggregate supply                                     output

curve (AS) and the CPI turns out

                                      Price level
  to be 2300, the economy will
produce its potential output at e*

                                     2300                               e*

   Suppose that AD intersects        2250
    AS at point e, therefore a
    Contractionary Gap of
        $1 trillion exists.
      So unemployment
   exceeds the natural rate                         0                                     Real GDP
          (4%-5%)!                                        14.0       15.0
                                                                               (trillions of dollars)
                                                        Contractionary gap
Closing a Contractionary Gap
                                                                                This is where
     using Fiscal Policy                                                        we should be!
  A $0.5 trillion increase in                                       output
government purchases reflects

                                       Price level
an Expansionary Fiscal Policy
that increases AD (as shown by
the rightward shift from AD to AD*)

   In the long-run the price          2300                               e*
 level will rise until AD equals
    AS at e* where the price          2250
                                                            e                     e'
 level is 2300 and the nation is
      at its potential GDP.                                                                      AD*


                                                                      15.0        16.0     Real GDP
                                                                                (trillions of dollars)
                                                         Contractionary gap
       Notice that the government only increased spending by $0.5 trillion and yet
           GDP increased by $1 trillion. This is known as the multiplier effect.
Closing a Contractionary Gap
                                                                                 This is where
     using Fiscal Policy                                                         we should be!

                                      Price level
A $0.5 trillion decrease in taxes
reflects an expansionary fiscal
  policy that increases AD, as
 shown by the rightward shift
       from AD to AD*                2300                                 e*

                                                             e                     e'

 Also, a $0.5 trillion increase in                                                                AD*
   Social Progams reflects an
 expansionary fiscal policy that                                                    AD
 increases AD, as shown by the
rightward shift from AD to AD*                      0
                                                            14.0       15.0        16.0 Real GDP
                                                                                 (trillions of dollars)
                                                          Contractionary gap
   Transfer payments are those payments
                                                            Closing an Contractionary Gap
  given to help the needy and unemployed.
                                                        through fiscal policy results in a higher
                                                         price level and lower unemployment .
   Closing an Expansionary Gap using
      Contractionary Fiscal Policy
                                             Potential aggregate

                           Price level
Suppose that aggregate
    demand exceeds
  potential output and
  inflation results (we
                           2400                                      e
could be in an economic

  As a result, output is
  $16.0 trillion and an
 expansionary gap of $1
     trillion exists.
                                                                            Real GDP
                                                     15.0          16.0
                                                                       (trillions of
                                                   Expansionary gap       dollars)
     Closing an Expansionary Gap using
        Contractionary Fiscal Policy
                                                               Potential aggregate
   If left alone, this gap                                           output

                              Price level
   could be closed by a                                                                          AS
 leftward shift of the AS                                                  e”
   curve, returning the
       economy to the
                             2400                                                     e
potential level of output
   but at a higher price
level, shown by point e"     2300                                           e*                      AD

     By decreasing
 Government Spending,                                                                       AD*
  increasing Taxes, or
   decreasing Social
 Program spending, the                      0
                                                                                                    Real GDP
    government can                                                      15.0 16.0
                                                                                                (trillions of
      implement a                                                     Expansionary gap          dollars)
 Contractionary Fiscal
                                                  Closing an expansionary gap through
   Policy designed to
                                                fiscal policy results in a lower price level,
       reduce AD
                                                        but higher unemployment .
     Problems with Fiscal Policy
Other concerns also caused economists and policy makers
to question the effectiveness of discretionary fiscal policy.
    1. The difficulty of estimating the natural rate
       of unemployment. natural rate of unemployment
        (4% to 5%)
         • Before adopting discretionary policies, public
           officials must correctly estimate this natural rate
           of unemployment.
    2. The time lags involved in implementing
       fiscal policy (takes the government a long time to do
    3. Various government agencies can
       somehow coordinate their fiscal efforts.
    4. Possible feedback effects of fiscal policy on
       aggregate supply by effecting labor.
   Problems with Fiscal Policy
Policy makers sometimes question the effectiveness of
             Discretionary Fiscal Policy.
  The government experiences a budget
  deficit during Expansionary Fiscal Policy.
  If the deficit continues, it is likely that
  public debt will rise.

      GOV.   +           TAXES =           BUDGET
                        (Revenue for
    SPENDING               Gov.)
  Problems with Fiscal Policy:
       Closing a Contractionary Gap

    What if policy makers
   overshoot the mark and
stimulate aggregate demand
more than needed to achieve
       potential GDP?
                     When Discretionary Fiscal Policy
Suppose that the economy  Overshoots the Mark
 is producing its potential
output of $15 trillion where
     the natural rate of               Potential output
   unemployment is 4%.

  However, suppose that
public officials mistakenly
believe the rate is predicted                                  AS
to increase to 7% and they
attempt to increase output                                 a
     and employment.
   Cut Taxes & Increase         2200
  Government Spending:
  Aggregate demand shifts
         AD to AD*.                                         AD
In the short-run, this policy
increases GDP and reduces         0
 unemployment, but causes                    15.0       15.5
                                                    (trillions of dollars)
 inflation in the long-run.
                                                              Real GDP
                      When Discretionary Fiscal Policy
However, this shift in AD  Overshoots the Mark
 creates an expansionary
  gap, which pushes up
          prices.                                Potential output
Suppliers will react and in
the short-run and produce
 more, but in the long run
   (due to high prices for    2600                        b               AS
 resources) suppliers will
limit the amount supplied     2400                                    a
causing a leftward shift in                                                  AD*
         AS to AS*.
  Lay-offs would occur in     2200
  the workforce and AD*
would decrease to AD** as                                             AD**
       income falls.

                                                      15.0        15.5
                                                              (trillions of dollars)
 This could cause prices to increase then GDP to decline.
                                                                        Real GDP
 Fiscal Policy’s
Effects on Labor
  Fiscal Policy’s Effects on Labor
What about Fiscal policy’s effect on
 the labor supply?
   If the government does anything to
    pump money into the economy, then
    the labor supply should increase along
    with the number of jobs available.
   However, the unemployed, who benefit
    from increased transfer payments
    (Expansionary Fiscal Policy), may have
    less incentive to find work.
  Fiscal Policy’s Effects on Labor
Inversely, during Contractionary Fiscal
 Policy, workers who find their wage
 reduced by the higher tax rates may be
 less willing to work.

The supply of labor could decrease as a
 result of increased tax rates or increased
 transfer payments resulting in aggregate
 supply declining.
   Which will cause an economy’s GDP to
   Simply, there is not enough workers so
    wages increase. (Let’s see this graphically...)
 Fiscal Policy’s Effects on Labor
    The dangers of INCREASING transfer payments.
                                   Increased Transfer Payments
              Wages $    Demand for workers
                                                         Supply of workers

Shortage of    $7.50

                                       50         Quantity of Workers
                                                     (in millions)
              What would higher wages do to EMPLOYERS?
  Automatic Stabilizers
    Types of Taxes
 Who Should Pay Taxes?
        Automatic Stabilizers
Automatic Stabilizers will smooth the fluctuations
in disposable income over the business cycle:
      …thereby boosting aggregate demand
       during periods of recession and…
      …reducing aggregate demand during
       periods of expansion

Examples of automatic stabilizers:
   1. Progressive Income Tax
   2. Unemployment Compensation (social spending)
    Let’s look at the vocab then let’s see a graphic example…
 1.) Progressive Income Tax Table

  Single filers       Married filing jointly   Head of household      Tax Rate

                              Up to
   Up to $7,150
                                                  Up to $10,200         10%

 $7,151 - $29,050        $14,301 - $58,100       $10,201 - $38,900      15%

 $29,051 - $70,350      $58,101 - $117,250      $38,901 - $100,500      25%

$70,351 - $146,750      $117,251 - $178,650     $100,501 - $162,700     28%

$146,751 - $319,100     $178,651 - $319,100     $162,701 - $319,100     33%

     $319,101                $319,101                $319,101
     or more                 or more                 or more            35%

    NOTE: A small % is added on top of the lowest income in each range.
   1. ) Progressive Income Tax
 The Progressive Income Tax relieves some
  of the expansionary pressures that arise
  when demand increases and causes GDP to
  rise too much.
    It stabilizes the expansion so that aggregate
     demand does not increase TOO much
 On the other hand, when the economy is in a
  recession, taxes decline automatically, so
  disposable income does not fall too much.
    It stabilizes the contraction so that aggregate
     demand does not decline TOO much
   2.) Unemployment Insurance
     One thing to remember, when taxes are taken out of your
  paycheck, some of that money goes into a government savings
          account so it can be used on the unemployed.

 During an economic EXPANSION, MORE money
  from taxes flow INTO the unemployment
  insurance fund, thereby stabilizing aggregate
      Taking MONEY OUT of the economy.
 During a RECESSION, unemployment payments
  automatically flow OUT of the unemployment
  insurance fund to those who have become
  unemployed (thereby stabilizing aggregate
      Thus, putting money INTO the economy
    Progressive Income Tax
                 How it works.

      INCOME =        INCOME =   GDP & AD


     INCOME =        INCOME =    GDP & AD
Unemployment Insurance & Taxes
                   GRAPHIC EXAMPLE

                        STATE & FEDERAL
  MORE     MORE                      LESS MONEY TO THE
SPENDING   TAXES                        UNEMPLOYED
   IN      COME
ECONOMY     OUT                                AS


Unemployment Insurance & Taxes
                   GRAPHIC EXAMPLE

                        STATE & FEDERAL
  LESS      LESS
                                     MORE MONEY TO THE
   IN      COME
ECONOMY     OUT                                AS


Property Taxes
            These help pay for
             schools in Cherokee

            What is one argument
             you can think of
             AGAINST this type of
            SHOULD PAY TAXES
1. Benefits-Received Principle
  Only those who receive benefits should pay taxes.
     EXAMPLE: City of Canton is building a new parkway to
     limit the amount of traffic so a tax is raised to pay for it.
     ONLY those who use the parkway should pay (the citizen of
     Canton, NOT the citizens of Hickory Flat)
     EXAMPLE: Gasoline Sales Tax goes toward road
     construction (you ride on them, you pay for them)

2. Ability-to-Pay Principle
  Only those with the ability to pay should pay MORE of
   the tax.
     EXAMPLE: Same Canton situation, but those who pay
     more of the tax should be the wealthy.
  Benefits-Received Principle
             QUESTION TO PONDER???

Why isn’t it smart for the US Government
to try to pay for a Welfare program by
imposing a benefits-received principle
   Those who would pay would have to be those
   who receive Welfare. (making them pay more,
   when they have little money to begin with is
       Identify whether progressive, regressive, or proportional

1. Personal Income Tax
2. Sales Tax
            Regressive & Proportional
3. Corporate Income Tax (28% for all corporations)
            Regressive & Proportional

4. Property Taxes (based on value of property)
            Regressive & Proportional

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