Docstoc

THE FEDERAL BUDGET AND FISCAL POLICY

Document Sample
THE FEDERAL BUDGET AND FISCAL POLICY Powered By Docstoc
					Fiscal Policy and
Monetary Policy
                    CHAPTER   20
CHAPTER CHECKLIST

When you have completed your study of this
chapter, you will be able to

1   Describe the federal budget process and explain the
    effects of fiscal policy.
2   Describe the Federal Reserve’s monetary policy
    process and explain the effects of monetary policy.
 20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Fiscal policy is the use of the federal budget to
  achieve the macroeconomic objectives of high and
  sustained economic growth and full employment.

 The Federal Budget
  The federal budget is an annual statement of the
  revenues, outlays, and surplus or deficit of the
  government of the United States.
  The federal budget has two purposes:
  1. To finance the activities of the federal government
  2. To achieve macroeconomic objectives
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Budget surplus (+)/deficit (–) = Tax revenues – Outlays
  The government has a budget surplus when tax
  revenues exceed outlays.
  The government has a budget deficit when outlays
  exceed tax revenues.
  The government has a balanced budget when tax
  revenues equal outlays.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

 The Budget Time Line

 The President and the
 Congress make the
 budget and develop fiscal
 policy on a fixed annual
 time line and fiscal year.
 Fiscal year is a year that
 begins on October 1 and
 ends on September 30.
 Fiscal year 2008 begins
 in 2007.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Types of Fiscal Policy
  Fiscal policy actions can be
     • Discretionary fiscal policy
     • Automatic fiscal policy
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Discretionary fiscal policy is a fiscal policy action
  that is initiated by an act of Congress.
  For example, an increase in defense spending or a cut
  in the income tax rate.
  Automatic fiscal policy is a fiscal policy action that
  is triggered by the state of the economy.
  For example, an increase in unemployment induces an
  increase in payments to the unemployed or in a
  recession tax receipts decrease as incomes fall.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

Discretionary Fiscal Policy: Demand-Side
 Effects
  Changes in government expenditure and changes in
  taxes have multiplier effects on aggregate demand.
  The government expenditure multiplier is the
  magnification effect of a change in government
  expenditure on goods and services on aggregate
  demand.
  An increase in aggregate expenditure increases
  aggregate demand, which increases real GDP, which
  induces increases aggregate demand.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  The Tax Multiplier
  The tax multiplier is the magnification effect of a
  change in taxes on aggregate demand.
  A decrease in taxes increases disposable income.
  The increase in disposable income increases
  consumption expenditure and aggregate demand.
  With increased aggregate demand, employment and
  real GDP increase and consumption expenditure
  increases yet further.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  So a decrease in taxes works like an increase in
  government expenditure.
  Both actions increase aggregate demand and have a
  multiplier effect.
  The magnitude of the tax multiplier is smaller than the
  government expenditure multiplier.
  The reason: A $1 tax cut increases aggregate
  expenditure by less than $1 whereas a $1 increase in
  government expenditure increases aggregate
  expenditure by $1.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  The Balanced Budget Multiplier
  The balanced budget multiplier is the magnification
  effect on aggregate demand of a simultaneous change
  in government expenditure and taxes that leaves the
  budget balance unchanged.
  The balanced budget multiplier is not zero—it is
  positive—because the government expenditure
  multiplier is larger than the tax multiplier.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Discretionary Fiscal Stabilization
  If real GDP is below potential GDP, the government
  might use an expansionary fiscal policy in an attempt to
  restore full employment.
  Expansionary fiscal policy is a discretionary fiscal
  policy designed to increase aggregate demand—a
  discretionary increase in government expenditure or a
  discretionary tax cut.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Figure 20.2 illustrates an
expansionary fiscal policy.

Potential GDP is $10 trillion,
real GDP is $9 trillion, and

1. There is a $1 trillion
   recessionary gap.

2. An increase in government
   expenditure or a tax cut
   increases expenditure by
   ∆E.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

3. The multiplier increases
   induced expenditure. The
   AD curve shifts rightward to
   AD1.
The price level rises to 110,
real GDP increases to $10
trillion, and the recessionary
gap is eliminated.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Contractionary Fiscal Policy
  If an inflationary gap exists, the government might use
  an contractionary fiscal policy to eliminate the
  inflationary pressure.
  Contractionary fiscal policy is a discretionary fiscal
  policy designed to decrease aggregate demand—a
  decrease in government expenditure or a tax increase.
 20.1 THE FEDERAL BUDGET AND FISCAL POLICY

Figure 20.3 illustrates
contractionary fiscal policy.

Potential GDP is $10 trillion,
real GDP is $11 trillion, and

1. There is a $1 trillion
   inflationary gap.

2. A decrease in government
   expenditure or a tax rise
   decreases expenditure by ∆E.
 20.1 THE FEDERAL BUDGET AND FISCAL POLICY

3. The multiplier decreases
    induced expenditure.
    The AD curve shifts
    leftward to AD1.

 The price level falls to 110,
 real GDP decreases to
 $10 trillion, and the
 inflationary gap is
 eliminated.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

Discretionary Fiscal Policy: Supply-Side
 Effects
  Fiscal policy has important effects on aggregate supply.
  Supply-Side Effects of Government Expenditure
  Government provides services such as law and order,
  public education, and public health that increase
  production possibilities.
  An increase in government expenditure that increases the
  quantities of productive services and capital increases
  potential GDP and increases aggregate supply.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Supply-Side Effects of Taxes
  To pay for the productive services and capital that the
  government provides, it collects taxes. All taxes create
  disincentives to work, save, and provide entrepreneurial
  services.
  Taxes on labor income decrease the supply of labor,
  which raises the equilibrium real wage rate and
  decreases the equilibrium quantity of labor employed.
  With a smaller quantity of labor employed, potential
  GDP and aggregate supply are smaller than they would
  otherwise be.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Taxes on the income from capital decrease saving and
  decrease the supply of capital.
  The equilibrium real interest rate rises and the
  equilibrium quantity of investment and capital employed
  decrease.
  With a smaller quantity of capital, potential GDP and
  aggregate supply are smaller than they would otherwise
  be.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Taxes on the incomes of entrepreneurs weaken the
  incentive to take risks and create new businesses.
  With fewer firms, less labor and capital are employed
  and potential GDP and aggregate supply are smaller
  than they would otherwise be.
  An increase in taxes strengthens these disincentive
  effects.
  It decreases the supply of labor, capital, and
  entrepreneurial services; decreases potential GDP; and
  decreases aggregate supply.
  A tax cut has the opposite effects.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY
Supply-Side Effects on Potential GDP

Figure 20.4 illustrates the
effects of fiscal policy on
potential GDP.
Initially, the production
function is the full-
employment quantity of
labor is 200 billion hours,
and potential GDP is $10
trillion.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

1. A tax cut strengthens the
   incentive to work,
   increases the supply of
   labor, and increases
   employment.

2. A tax cut strengthens the
   incentive to save and
   invest, which increases
   the quantity of capital
   and increases labor
   productivity.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

3. The combined effect of a
   tax cut on employment
   and labor productivity
   increases potential GDP.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

Combined Demand-Side and Supply-Side
 Effects
  An increase in government expenditure or a tax cut
  increases equilibrium real GDP but might raise, lower,
  or have no effect on the price level.
  Figure 20.5 on the next slide shows the combined
  effects of fiscal policy when fiscal policy has no effect
  on the price level.
 20.1 THE FEDERAL BUDGET AND FISCAL POLICY

 1. A tax cut increases
    disposable income, which
    increases aggregate
    demand from AD0 to AD1.
  A tax cut also strengthens
  the incentive to work, save,
  and invest, which increases
  aggregate supply from AS0
  to AS1.
2. Real GDP increases.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

Limitations of Fiscal Policy
  The use of discretionary fiscal policy is seriously
  hampered by four factors:
     • Law-making time lag
     • Estimating potential GDP
     • Economic forecasting
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Law-Making Time Lag
  The amount of time it takes Congress to pass the laws
  needed to change taxes or spending.
  This process takes time because each member of
  Congress has a different idea about what is the best tax
  or spending program to change.
  So long debates and committee meetings are needed to
  reconcile conflicting views.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Estimating Potential GDP
  It is not easy to tell whether real GDP is below, above,
  or at potential GDP.
  So a discretionary fiscal action might move real GDP
  away from potential GDP instead of toward it.
  This problem is a serious one because too much fiscal
  stimulation brings inflation and too little might bring
  recession.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Economic Forecasting
  Fiscal policy changes take a long time to enact in
  Congress and yet more time to become effective.
  So fiscal policy must target forecasts of where the
  economy will be in the future.
  Economic forecasting has improved enormously in
  recent years, but it remains inexact and subject to error.
  So for a second reason, discretionary fiscal action might
  move real GDP away from potential GDP and create
  the very problems it seeks to correct.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

Automatic Fiscal Policy
  A consequence of tax receipts and expenditures that
  fluctuate with real GDP.
  Automatic stabilizers are features of fiscal policy
  that stabilize real GDP without explicit action by the
  government.
  Induced Taxes
  Induced taxes are taxes that vary with real GDP.
20.1 THE FEDERAL BUDGET AND FISCAL POLICY

  Needs-Tested Spending
  Needs-tested spending is spending on programs
  that entitle suitably qualified people and businesses to
  receive benefits— benefits that vary with need and with
  the state of the economy.
20.2 THE FED AND MONETARY POLICY

The Monetary Policy Process
  The Fed makes monetary policy in a process that has
  three main elements:
  • Monitoring economic conditions
  • Meetings of the Federal Open Market Committee
    (FOMC)
  • Monetary Policy Report to Congress
20.2 THE FED AND MONETARY POLICY

  Monitoring Economic Conditions
  Each Federal Reserve Bank constantly gathers
  information on its district by talking with business
  leaders, economists, market experts, and others.
  The Fed brings the results together in the Beige Book,
  which is published eight times a year.
  The Beige Book serves as a background document for
  the members of the FOMC.
20.2 THE FED AND MONETARY POLICY
  The FOMC makes a monetary policy decision at eight
  schedules meetings a year and publishes the minutes
  three weeks after each meeting.
  Monetary Policy Report to Congress
  Twice a year, in February and July, the Fed prepares a
  Monetary Policy Report to Congress, and the Fed
  chairman testifies before the House of Representatives
  Committee on Financial Services.
  The report and the chairman’s testimony review the
  past year’s monetary policy and the future outlook.
20.2 THE FED AND MONETARY POLICY
The Federal Funds Rate
  Following each FOMC meeting, the Fed announces its
  monetary policy decision as a target for the federal
  funds rate.
  Federal funds rate is the interest rate at which banks
  can borrow and lend reserves in the federal funds
  market.
  To hit its target for the federal funds rate, the FOMC
  instructs the New York Fed to conduct open market
  operations.
20.2 THE FED AND MONETARY POLICY

  The higher the federal funds rate, the greater is the
  supply of funds and the smaller is the demand for funds.
  The equilibrium federal funds rate makes the quantity of
  funds demanded equal the quantity supplied.
  If the New York Fed sells securities, the supply of funds
  decreases, so the federal funds rate rises.
  If the New York Fed buys securities, the supply of funds
  increases, so the federal funds rate falls.
20.2 THE FED AND MONETARY POLICY

  When the Fed changes the federal funds rate, events
  ripple through the economy and lead to the ultimate
  policy goals.


Quick Overview
  Figure 20.6 summarizes the ripple effects.
20.2 THE FED AND MONETARY POLICY

1. The first effect of a monetary
   policy decision by the FOMC
   is a change in the federal
   funds rate.
Other Interest Rates Change
2. Other interest rates then
   change quickly and
   relatively predictably.
20.2 THE FED AND MONETARY POLICY

The Exchange Rate Changes
The exchange rate responds to changes in the interest
rate in the United States relative to the interest rates in
other countries—the U.S. interest rate differential.
When the Fed raises the federal funds rate, the U.S.
interest rate differential rises and, other things remaining
the same, the U.S. dollar appreciates.
And when the Fed lowers the federal funds rate, the U.S.
interest rate differential falls and, other things remaining
the same, the U.S. dollar depreciates.
20.2 THE FED AND MONETARY POLICY

Money and Bank Loans
Change
3. To change the federal funds
   rate, the Fed must change
   the quantity of bank
   reserves, which in turn
   changes the quantity of
   deposits and loans that the
   banking system can create.
20.2 THE FED AND MONETARY POLICY

Long-Term Real Interest Rate
Changes
4. Changes in the federal funds
   rate change the supply of
   bank loans, which changes
   the supply of loanable funds
   and changes the real interest
   rate in the loanable funds
   market.
20.2 THE FED AND MONETARY POLICY

Expenditures Change
5. A change in the real interest
   rate changes consumption
   expenditure, investment,
   and net exports.
6. A change consumption
   expenditure, investment,
   and net exports changes
   aggregate demand.
20.2 THE FED AND MONETARY POLICY
7. About a year after the
   change in the federal funds
   rate occurs, real GDP
   growth changes.
8. About two year after the
   change in the federal funds
   rate occurs, the inflation rate
   change.
20.2 THE FED AND MONETARY POLICY

Monetary Stabilization in the AS–AD Model
  The Fed Tightens to Fight Inflation
  Figure 20.7 illustrates how the Fed’s policy works.
  Initially, the interest rate is 5 percent a year in Figure
  20.7(a) and investment is $20 trillion.
  Assume that there is no inflation, so the interest rate is
  the real interest rate as well as nominal interest rate.
  With $20 trillion of investment, real GDP is $11 trillion
  and there is an inflationary gap in Figure 20.7(b).
20.2 THE FED AND MONETARY POLICY
20.2 THE FED AND MONETARY POLICY

To remove the inflation
pressure …

1. The Fed conducts an
   open market sales of
   securities that raises the
   interest rate from 5
   percent to 6 percent a
   year.

   Investment decreases to
   $1.5 trillion a year.
20.2 THE FED AND MONETARY POLICY

2. The decrease in
   investment decreases
   aggregate demand and
   shifts the AD curve to
   AD0I.
3. The multiplier induces
   additional expenditure
   cuts and shifts the AD
   curve to AD1.
Real GDP decreases to
potential GDP and inflation
is avoided.
20.2 THE FED AND MONETARY POLICY

  The Fed Eases to Fight Recession
  Real GDP is below potential GDP and the Fed fears
  recession.
  Figure 20.8 illustrates how the Fed’s policy works.
  Initially, the interest rate is 5 percent a year in Figure
  20.8(a) and investment is $20 trillion.
  With $20 trillion of investment, real GDP is $9 trillion
  and there is a recessionary gap in Figure 20.8(b).
20.2 THE FED AND MONETARY POLICY
20.2 THE FED AND MONETARY POLICY

To remove avoid recession
…

1. The Fed conducts an
   open market purchase of
   securities that lowers the
   interest rate from 5
   percent to 4 percent a
   year.

   Investment increases to
   $2.5 trillion a year.
20.2 THE FED AND MONETARY POLICY

2. The increase in
   investment increases
   aggregate demand and
   shifts the AD curve to
   AD0+I.
3. The multiplier induces
   additional expenditure
   and shifts the AD
   curve to AD1.
Real GDP increases to
potential GDP and
recession is avoided.
20.2 THE FED AND MONETARY POLICY

  Loose Link from Federal Funds Rate to Spending
  The long-term real interest rate that influences spending
  plans is linked only loosely to the federal funds rate.
  Also, the response of the long-term real interest rate to
  a change in the nominal rate depends on how inflation
  expectations change.
  The response of expenditure plans to changes in the
  real interest rate depends on many factors that make
  the response hard to predict.
20.2 THE FED AND MONETARY POLICY

  The Size of the Multiplier
  The size of the multiplier effect of monetary policy
  depends on the sensitivity of expenditure plans to the
  interest rate.
  The larger the effect of a change in the interest rate on
  aggregate expenditure, the greater is the multiplier
  effect and the smaller is the change in the interest rate
  that achieves the Fed’s objective.
20.2 THE FED AND MONETARY POLICY

Limitations of Monetary Policy
  Monetary policy has an advantage over fiscal policy
  because it cuts out the lawmaking time lags.
  Monetary policy is a continuous policy process and is
  not subject to the long decision lag and the need to
  create a broad political consensus that confronts fiscal
  policy.
20.2 THE FED AND MONETARY POLICY

  But monetary policy shares the other two limitations of
  fiscal policy:
  • Estimating potential GDP is hard
  • Economic forecasting is error-prone.
  Monetary policy suffers an additional limitation: Its
  effects are indirect and depend on how private
  decisions respond to a change in the interest rate.
  Also the time lags in the operation of monetary policy
  are longer than those for fiscal policy. So the
  forecasting horizon must be longer.

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:0
posted:10/7/2012
language:English
pages:58