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					                       FISCAL POLICY



                                 CHAPTER TWELVE




Fiscal Policy – Changing G & T
        LEGISLATIVE MANDATES
     Employment Act of 1946
       It is the government’s responsibility to maintain economic
       stability through the use of monetary and fiscal policy.




Fiscal Policy – Changing G & T
        LEGISLATIVE MANDATES
     Employment Act of 1946

     Council of Economic Advisors
        (CEA)



Fiscal Policy – Changing G & T
        LEGISLATIVE MANDATES
     Employment Act of 1946

     Council of Economic Advisors
        (CEA) Presidential Advisors

     Joint Economic Committee
        (JEC) Committee of Congress
Fiscal Policy – Changing G & T
          Discretionary Fiscal Policy
         Two Situations....
      • Recession




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




Fiscal Policy – Changing G & T
          Discretionary Fiscal Policy
         Two Situations....
      • Recession
      • Demand-pull Inflation
        Expansionary Fiscal Policy Options....



Fiscal Policy – Changing G & T
          Discretionary Fiscal Policy
         Two Situations....
      • Recession
      • Demand-pull Inflation
        Expansionary Fiscal Policy Options....
      • Increase Government Spending


Fiscal Policy – Changing G & T
          Discretionary Fiscal Policy
         Two Situations....
      • Recession
      • Demand-pull Inflation
        Expansionary Fiscal Policy Options....
      • Increase Government Spending
      • Reduce Taxes

Fiscal Policy – Changing G & T
          Discretionary Fiscal Policy
         Two Situations....
      • Recession
      • Demand-pull Inflation
        Expansionary Fiscal Policy Options....
      • Increase Government Spending
      • Reduce Taxes
      • Some Combination of the Two
Fiscal Policy – Changing G & T
           Expansionary Fiscal Policy
                          P
                                       $5 billion initial
                                    increase in spending
                 Price level




                               P1

                                        AD2

                                       Real GDP (billions)   Q
Fiscal Policy – Changing G & T
           Expansionary Fiscal Policy
                          P
                                       $5 billion initial
                                    increase in spending
                 Price level




                               P1

                                        AD2

                                       Real GDP (billions)   Q
Fiscal Policy – Changing G & T
           Expansionary Fiscal Policy
                          P                   the multiplier at work...
                                       $5 billion initial
                                    increase in spending

                                                             Full $20 billion
                 Price level



                                                              increase in
                                                               aggregate
                                                                demand

                               P1

                                        AD2            AD1

                                       Real GDP (billions)         Q
Fiscal Policy – Changing G & T
           Expansionary Fiscal Policy
             P            the multiplier at work...
                 NOTES:
                  $5 billion initial
                                    increase in spending
                                    Increased government
                                    spending                Full $20 billion
                 Price level



                                    The multiplier makes increase in
                                    GDP increase by a         aggregate
                                    multiple of the original demand
                                    amount
                               P1

                                        AD2            AD1

                                       Real GDP (billions)         Q
Fiscal Policy – Changing G & T
           Expansionary Fiscal Policy
             P            the multiplier at work...
                 NOTES:
                  $5 billion initial
                                    increase in spending
                                    Tax reductions:
                                    The multiplier requiresFull $20 billion
                 Price level



                                    a tax decrease of more increase in
                                    than the desired GDP     aggregate
                                    increase since the        demand
                                    household sector only
                               P1   consumes part of its
                                    income (MPC).
                                        AD2           AD1

                                       Real GDP (billions)        Q
Fiscal Policy – Changing G & T
        Contractionary Fiscal Policy
                          P
                                                      $5 billion initial
                                                        decrease in
                                                         spending
                 Price level




                                                               AD4
                               P1



                                    Real GDP (billions)       Q
Fiscal Policy – Changing G & T
        Contractionary Fiscal Policy
                          P
                                                      $5 billion initial
                                                        decrease in
                                                         spending
                 Price level




                                                               AD4
                               P1



                                    Real GDP (billions)       Q
Fiscal Policy – Changing G & T
        Contractionary Fiscal Policy
                          P                  the multiplier at work...
                                                        $5 billion initial
                                                          decrease in
                                                           spending
                 Price level




                                    Full $20 billion
                                     decrease in
                                      aggregate
                                                                  AD4
                                       demand
                               P1                           AD5



                                      Real GDP (billions)         Q
Fiscal Policy – Changing G & T
                           The Federal Budget!
         Total Revenues (Taxes)
       – Total Costs (Expenditures)
         + Budget Surplus
         0 Balanced Budget
         - Budget Deficit      Sum of all yearly
                                     deficits and surpluses
       2005 Deficit:                 is the National Debt of:
       $319 Billion                  8.2 Trillion Dollars!
                                     $28,000 per citizen
Fiscal Policy – Changing G & T
                   Financing Deficits and
                   Disposing of Surpluses
      • Borrowing vs. New Money




Fiscal Policy – Changing G & T
                   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 $
              Impact on Interest Rates??   UP!

            This is a concept called crowding out. It may reduce the
            Expansionary impact of deficit spending.



Fiscal Policy – Changing G & T
                   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!



Fiscal Policy – Changing G & T
                   Financing Deficits and
                   Disposing of Surpluses
      • Borrowing vs. New Money
        • Borrowing
        • Money Creation
      • Debt Retirement vs. Idle Surplus
            What to do with surpluses??




Fiscal Policy – Changing G & T
                   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
Fiscal Policy – Changing G & T
                   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!

Fiscal Policy – Changing G & T
                   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?
Fiscal Policy – Changing G & T
                                 It depends on your political affiliation!
          Expenditures & Revenues (trillions)

                                                3.5

                                                3.0                                                          Taxes

                                                2.5                                                   Surplus
                                                                                                      T>G
                                                2.0                                                       Gov Spending
                                                          Deficit
                                                1.5       G>T
                                                              9       10        11      12       13
                                                      Real domestic product, GDP (trillions of dollars)




Fiscal Policy – Changing G & T
      Nondiscretionary Fiscal Policy:
      Automatic -Built-In Stabilizers
      These are intended to speed the economy or slow the economy
      when needed automatically.

          Two Points....



Fiscal Policy – Changing G & T
       Nondiscretionary Fiscal Policy:
            Built-In Stabilizers
          Two Points....
       Net tax revenues vary directly
                  The higher the GDP the higher the tax
       with GDP revenues.



Fiscal Policy – Changing G & T
       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.

Fiscal Policy – Changing G & T
       Nondiscretionary Fiscal Policy:
            Built-In Stabilizers
       Automatic or Built-In Stabilizers
        Currently existing policies – progressive tax system, welfare,
        unemployment compensation, agricultural subsidies




Fiscal Policy – Changing G & T
       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.




Fiscal Policy – Changing G & T
       Nondiscretionary Fiscal Policy:
            Built-In Stabilizers
       Automatic or Built-In Stabilizers
                  • Tax Progressivity
                     • Progressive




Fiscal Policy – Changing G & T
       Nondiscretionary Fiscal Policy:
            Built-In Stabilizers
       Automatic or Built-In Stabilizers
                  • Tax Progressivity
                     • Progressive
                     • Proportional




Fiscal Policy – Changing G & T
       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.
Fiscal Policy – Changing G & T
       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.




Fiscal Policy – Changing G & T
       Nondiscretionary Fiscal Policy:
            Built-In Stabilizers
       Automatic or Built-In Stabilizers
                  • Tax Progressivity
                  • Actual Budget
                  • Cyclical Budget




Fiscal Policy – Changing G & T
       Nondiscretionary Fiscal Policy:
            Built-In Stabilizers
       Automatic or Built-In Stabilizers
                  • Tax Progressivity
                  • Actual Budget
                  • Cyclical Budget
                     • Cyclical Deficit



Fiscal Policy – Changing G & T
          Expenditures & Revenues (trillions)

                                                3.5

                                                3.0                                                       Taxes

                                                2.5
                                                      A         A
                                                2.0                                               Gov Spending
                                                      B
                                                1.5   C         B
                                                          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).


Fiscal Policy – Changing G & T
       Nondiscretionary Fiscal Policy:
            Built-In Stabilizers
       Automatic or Built-In Stabilizers
                  • Tax Progressivity
                  • Actual Budget
                  • Cyclical Budget
                     • Cyclical Deficit
                  • Full-Employment Budget


Fiscal Policy – Changing G & T
       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

Fiscal Policy – Changing G & T
          Expenditures & Revenues (trillions)

                                                3.5

                                                3.0                                                       Taxes

                                                2.5
                                                      A         A
                                                2.0                                               Gov Spending
                                                      B
                                                1.5   C         B
                                                          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).


Fiscal Policy – Changing G & T
       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
Fiscal Policy – Changing G & T
                                 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

Fiscal Policy – Changing G & T
                                 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

Fiscal Policy – Changing G & T
                         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
Fiscal Policy – Changing G & T
     Problems, Criticisms, and Complications




Fiscal Policy – Changing G & T
     Problems, Criticisms, and Complications
        • Problems of Timing
           • Recognition Lag
           • Administrative Lag
           • Operational Lag




Fiscal Policy – Changing G & T
     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?


Fiscal Policy – Changing G & T
     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

Fiscal Policy – Changing G & T
     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
                                 Debate as to its impact.
Fiscal Policy – Changing G & T
        Aggregate Supply and Inflation
                                               AS
                     P
                    Price level

                                                          Fiscal Policy:
                                                          Pure & Simple


                           P1

                                               AD1      AD2

                                         Q1    Q2                Q
                                  Real GDP (billions)

Fiscal Policy – Changing G & T
        Aggregate Supply and Inflation
                                               AS
                     P
                    Price level

                                                Fiscal Policy:
                                                Pure & Simple
                                           Demonstrating
                                           the crowding-
                           P1              out effect....
                                               AD       AD
                                               1        2

                                         Q1    Q2            Q
                                  Real GDP (billions)

Fiscal Policy – Changing G & T
        Aggregate Supply and Inflation
                                                 AS
                     P
                                                         Fiscal Policy:
                                                      AD does not reach
                                                        potential due to
                    Price level

                                                      crowding out effect
                                                        by government


                           P1


                                            AD1 AD’2 AD2
                                      Q1    Q2                   Q
                                  Real GDP (billions)

Fiscal Policy – Changing G & T
        Aggregate Supply and Inflation
                                                  (the same graph)
                                                 AS
                     P
                                                         Fiscal Policy:
                                                      AD does not reach
                    Price level

                                                      potential due to the
                                                       net export effect
                                           Demonstrating
                                           the effect of
                           P1              inflation....
                                            AD1 AD’2 AD2
                                      Q1    Q2                    Q
                                  Real GDP (billions)

Fiscal Policy – Changing G & T
        Aggregate Supply and Inflation
                                                AS
                     P
                    Price level




                             P1


                                              AD1
                                         Q1     Q2      Q
                                  Real GDP (billions)

Fiscal Policy – Changing G & T
        Aggregate Supply and Inflation
                                                 AS
                     P
                                                         A more realistic
                                                         AS curve in the
                                                          intermediate
                    Price level

                                                              range

                              P2


                             P1


                                               AD1       AD2
                                          Q1     Q2               Q
                                   Real GDP (billions)

Fiscal Policy – Changing G & T
       Fiscal Policy in the Open Economy


      Shocks Originating from Abroad
     AD shocks which alter the effect of fiscal policy




Fiscal Policy – Changing G & T
       Fiscal Policy in the Open Economy


      Shocks Originating from Abroad

     Net Export Effect




Fiscal Policy – Changing G & T
        Aggregate Supply and Inflation
                                                 AS
                     P
                                                         Fiscal Policy:
                                                      AD does not reach
                                                        potential due to
                    Price level

                                                      crowding out effect
                                                        by government
                                           Demonstrating
                                           the net export
                           P1              effect....
                                            AD1 AD’2 AD2
                                      Q1    Q2                   Q
                                  Real GDP (billions)

Fiscal Policy – Changing G & T
        Aggregate Supply and Inflation
                                                  (the same graph)
                                                 AS
                     P
                                                         Fiscal Policy:
                                                      AD does not reach
                    Price level

                                                      potential due to the
                                                       net export effect



                           P1


                                            AD1 AD’2 AD2
                                      Q1    Q2                    Q
                                  Real GDP (billions)

Fiscal Policy – Changing G & T
                             Problems in Macro
                                         Not all problems are
                                          demand side
                                          problems!
                                         Errors in timing and
                                          interpretation!
            It’s all
            BS???




Fiscal Policy – Changing G & T
        Supply-Side Fiscal Policy




Fiscal Policy – Changing G & T
        Supply-Side Fiscal Policy
      Emphasis on spending restraint
        and expansionary tax cuts
          Three primary tools – taxes, regulation, interest rates
                             This will shift AS to the right.




Fiscal Policy – Changing G & T
        Supply-Side Fiscal Policy
      Emphasis on spending restraint
        and expansionary tax cuts

        Impact upon....
                • Saving and Investment


Fiscal Policy – Changing G & T
        Supply-Side Fiscal Policy
      Emphasis on spending restraint
        and expansionary tax cuts

        Impact upon....
                • Saving and Investment
                • Work Incentives

Fiscal Policy – Changing G & T
        Supply-Side Fiscal Policy
      Emphasis on spending restraint
        and expansionary tax cuts


        Impact upon....
                • Saving and Investment
                • Work Incentives
                • Risk Taking
Fiscal Policy – Changing G & T
     Problems, Criticisms, and Complications
                  Or “It’s all BS!”
       • Incentive argument isn’t very strong

          •AS movements take longer than AD




Fiscal Policy – Changing G & T
       Forecasting the Future
        The leading indicators....




Fiscal Policy – Changing G & T
       Forecasting the Future
        The leading indicators....
     • Average Workweek




Fiscal Policy – Changing G & T
       Forecasting the Future
        The leading indicators....
     • Average Workweek
     • Initial Claims for Unemployment Insurance




Fiscal Policy – Changing G & T
       Forecasting the Future
        The leading indicators....
     • Average Workweek
     • Initial Claims for Unemployment Insurance
     • New Orders for Consumer Goods




Fiscal Policy – Changing G & T
       Forecasting the Future
        The leading indicators....
     • Average Workweek
     • Initial Claims for Unemployment Insurance
     • New Orders for Consumer Goods
     • Vendor Performance




Fiscal Policy – Changing G & T
       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




Fiscal Policy – Changing G & T
       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




Fiscal Policy – Changing G & T
       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
     • Stock Prices




Fiscal Policy – Changing G & T
       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
     • Stock Prices
     • Money Supply


Fiscal Policy – Changing G & T
       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
     • Stock Prices
     • Money Supply
     • Interest-Rate Spread

Fiscal Policy – Changing G & T
       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
     • Stock Prices             January 2006 grew .1%
     • Money Supply
     • Interest-Rate Spread
     • Consumer Confidence
Fiscal Policy – Changing G & T
       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
     • Stock Prices
     • Money Supply
     • Interest-Rate Spread
     • Consumer Confidence
Fiscal Policy – Changing G & T
          Employment Act of        progressive tax system
           1946                     proportional tax system
       Council of Economic         regressive tax system
           Advisers                 actual budget
       discretionary fiscal
                                    cyclical budget
           policy
                                    full-employment budget
       expansionary fiscal
           policy                   structural budget
       budget deficit
                                    political business cycle
       contractionary fiscal
                                    crowding-out effect
           policy                   net export effect
       budget surplus              supply-side fiscal policy
       built-in stabilizer
Fiscal Policy – Changing G & T
         Chapter 13


           Money
            and
             Banking
                                 Next...
Fiscal Policy – Changing G & T

				
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