2003 Tax Rebate Checks by gdj10182

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									                                    Chapter 12
                                      Fiscal Policy

COMMON STUDENT ERRORS
Students often believe the following statements are true. This same list is included in the
student study guide. The correct answer is explained after the incorrect statement is
presented.

1.     Government deficits always lead to inflation. WRONG!
       Government deficits may result from government spending to reach full
       employment with price stability. RIGHT!

       You should focus on what is happening to aggregate supply and demand, not
       just deficits, when looking for the sources of inflation. By looking at the deficit,
       you cannot tell if there is adequate aggregate demand in the economy. If there
       is a shortfall in aggregate demand, government spending and the resulting
       deficits may restore full employment with price stability. If there is an excess
       aggregate demand, demand-pull inflation can result from increased
       consumption, investment, or export expenditures, just as much as from
       increased government spending. It is all too easy to point the finger at the
       government and forget the contribution to inflation from all the other sectors of
       the economy.

2.  When a person invests in stocks, investment expenditures are increased.
WRONG!
    Purchase of stocks has only an indirect relationship to investment expenditure in
    the economy. RIGHT!

       Investment expenditure refers to purchases of new capital goods (plant,
       machinery, etc.) or inventories. A purchase of stock represents a transfer of
       ownership from one person to another. Sometimes such purchases are called
       “financial investments,” but they do no represent economic investment.

3.     Aggregate demand rises when people buy more imports. WRONG!
       Aggregate demand falls when people buy more imports, ceteris paribus.
       RIGHT!

       Students often think of imports as expenditures and therefore believe that
       increased spending on imports will have the same effects on the economy as an
       increase in consumption. Expenditures on imports, however, do not generate
       domestic income. If imports increase, they do so at the expense of purchases of
       U.S. goods, meaning fewer jobs in the United States. Because employment
       declines, there is less income with which to consume goods; consumption falls
       and so does aggregate demand.

4.     Macro equilibrium and full employment are always the same. WRONG!
       Macro equilibrium and full employment are determined in different ways.
       RIGHT!
       Macro equilibrium occurs where aggregate demand and aggregate supply
       intersect. Full employment refers to the use of all available resources in
       production. If macro equilibrium does not occur at full employment, there is a
       GDP gap.

5.     If the government increases spending and taxes by the same amount, there will
       be no effect on income. WRONG!
       An increase of government spending and taxes by the same amount will expand
       the economy. RIGHT!

       The full impact of the increased government spending turns into income for the
       people who provide goods and services to the government. Part of the increased
       taxes, however, comes from people’s savings, which had been leakages from the
       economy. Therefore, consumption decreases by less than the loss of taxes. This
       in turn means that income generated by consumption spending is not cut back
       by the amount of taxes. Therefore, the economy experiences a smaller cutback
       in incomes because of increased taxes than from the stimulus from increased
       government spending. The net effect is an increase in income.


HEADLINES
There are three Headline boxes in this chapter. Their titles and the concepts they
highlight are:

       “Consumer Confidence Plunges to Two-Year Low” (Expectations)
            Consumer confidence plunged to its lowest level in two years as the
            holiday season failed to lift the spirit of Americans rattled by stock-market
            volatility and mounting fears of a significant economic slowdown.
            Expectations for jobs and income affect current spending decisions.
            When expectations diminish, the rate of spending typically slows down.

       “Retailers see results from child tax credit checks” (Fiscal Stimulus)
             Rebate checks for the 2003 income tax child credit caused a sudden jump
             in retail sales. When 24 million families received checks averaging $583,
             spending increased. For example, sales of apparel and furniture jumped
             14 percent in one week.

       “Tax cuts could improve growth” (Boosting C, I)
             The tax cut package passed in 2003 was expected to increase consumer
             spending relatively quickly whereas investment spending was not
             expected to pick up until the next year.


ANNOTATED CONTENTS IN DETAIL

I.     Fiscal Policy
       Definition: Fiscal Policy - The use of government taxes and spending to alter
                   macroeconomic outcomes.
II.   Components of Aggregate Demand
      A.   Aggregate Demand
           Definition: Aggregate Demand - The total quantity of output
                       demanded at alternative price levels in a given time period,
                       ceteris paribus.

      B.   Four major components of aggregate demand. (Figure 12.1)
           1.    Consumption
           2.    Investment
           3.    Government spending
           4.    Net exports (exports minus imports)
      C.   Consumption (Figure 12.1)
           Definition: Consumption - Expenditure by consumers on final goods
                         and services.
           Note: Consumption expenditures such as tax services, concert tickets,
                 tuition, sporting event tickets, cars, etc., account for about two-
                 thirds of total spending in U.S. economy.

      D.   Headline: “Consumer Confidence Plunges to Two-Year Low”
           (Expectations) Consumer confidence plunged to its lowest level in two
           years as the holiday season failed to lift the spirit of Americans rattled by
           stock-market volatility and mounting fears of a significant economic
           slowdown. Expectations for jobs and income affect current spending
           decisions. When expectations diminish, the rate of spending typically
           slows down.

      E.   Investment (Figure 12.1)
           Definition: Investment - Expenditures on (production of) new plant
                         and equipment (capital) in a given time period, plus
                         changes in business inventories.
           Note: Investment expenditures, such as farmers replacing old tractors,
                 factories installing robotics or new computers, etc., accounts for
                 15% of U.S. spending.

      F.   Government Spending (Figure 12.1)
           1.   Includes federal, state and local spending on highways, schools,
                police, national defense and all other goods and services provided
                by public sector.
           2.   Government expenditures account for 18% of total spending.
           3.   Income transfers are not counted because they are counted in
                consumption expenditures when recipients spend their payments.

      G.   Net exports (Figure 12.1)
           Definition: Net Exports - Exports minus imports (X - M)

           Note: In 2000 the U.S. bought more goods from abroad than foreigners
                 bought from U.S.

      H.   Equilibrium (Macro) (Figure 12.2)
           Definition: Equilibrium - The combination of price level and real
                       output that is compatible with both aggregate demand and
                       aggregate supply.
           1.    Aggregate demand is not a single number but instead a schedule of
                 planned purchases.
           2.    Inadequate demand and excessive demand
                 a.    Formula:

                               AD = C + I + G + (X - M)


                  b.      There is no evident reason why AD will always produce
                          equilibrium at full employment. Sometimes there will be
                          too little demand and sometimes there will be too much.

III. The Nature of Fiscal Policy
      A.   It would be a minor miracle if C + I + G + (X - M) added up to exactly the
           right amount of aggregate demand.

      B.   The use of government spending and taxes to adjust aggregate demand is
           the essence of fiscal policy. (Figure 12.3)

IV.   Fiscal Stimulus
      A.   GDP gap
           Definition: GDP gap - The difference between full-employment
                       output and the amount of output demanded at current
                       price levels.

      B.   More Government Spending.
           1.   Increased government spending is a form of fiscal stimulus.
           2.   Definition: Fiscal Stimulus -Tax cuts or spending hikes
                intended to                    increase (shift) aggregate demand.
           3.   Multiplier effects (Figure 12.4)
                a.     An increase in spending results in increased incomes.
                b.     Each dollar is spent and respent several times. As a result,
                       every dollar has a multiplied impact on aggregate income.
                c.     All income is either spent or saved.
                d.     Saving
                       Definition: Saving - Income minus consumption: that
                                       part of disposable income not spent.
           4.   Marginal propensity to consume (MPC)
                Definition: Marginal Propensity to Consume (MPC) -
                               The fraction of each additional (marginal) dollar of
                               disposable income spent on consumption.
           5.   Marginal propensity to save (MPS)
                Definition: Marginal Propensity to Save (MPS) - The
                               fraction of each additional (marginal) dollar of
                               disposable income not spent on consumption; 1 -
                               MPC.
     6.    Formula:

                           MPS = (1 - MPC)


     7.    MPC and MPS are decisions that are connected (Figure 12.5)
     8.    The fiscal stimulus to aggregate demand includes both the initial
           increase in government spending and all subsequent increases in
           consumer spending triggered by the government outlays.
     9.    Income is spent and respent in the circular flow. (Figure 12.6)
     10.   Spending Cycles (Table 12.1)
     11.   Multiplier Formula
           a.      Definition: Multiplier - The multiple by which an
                          initial change in aggregate spending will alter total
                                  expenditure after an infinite number of
                          spending       cycles.

                  Formula:
                                             1
                          Multiplier 
                                         1  mpc


           b.     The multiplier process at work (Table 12.1)
                  Formula:

           Total change in spending  multiplier  initial change in spending

           c.     The circular flow process (Figure 12.6)
           d.     Every dollar of fiscal stimulus has multiplied impact on
                  aggregate demand. (Figure 12.7)
     12.   Headline: “Retailers see results from child tax credit
           checks” (Fiscal Stimulus)
           Rebate checks for the 2003 income tax child credit caused a
           sudden jump in retail sales. When 24 million families received
           checks averaging $583, spending increased. For example, sales of
           apparel and furniture jumped 14 percent in one week.

B.   Tax Cuts
     1.    Disposable income
           Definition: Disposable Income - After-tax income of
                                        consumers.

     2.    Taxes and consumption
           a.    If MPC is greater than zero consumers spend some of the
                 tax cut. How much of an AD shift we get from a personal
                 tax cut depends on the MPC.
           b.    Formula:
                 Initial change in consumption = MPC x tax cut (increase)
           c.    Formula:
                          Cumulative change in spending=multiplier x initial change
                          in consumption
                    d.    The effect of a tax cut, that increases disposable incomes, is
                          to stimulate consumer spending.
                    e.    Cumulative increase in aggregate demand is a multiple of
                          initial tax cut.
             3.     Taxes and investment
                    a.    Tax cuts for consumers or investors provide alternative to
                          increased government spending for stimulating aggregate
                          spending.
                    b.    President John F. Kennedy in 1963 reduced taxes to
                          stimulate spending.
                    c.    President Ronald Reagan in 1981 - largest tax cut in history
                          to pull U.S. economy out of recession.
                    d.    President Clinton in 1992 promised to cut taxes and
                          increase government spending to create stimulus.
                    e.    Headline: “Tax cuts could improve growth”
                          (Boosting C, I)
                          The tax cut package passed in 2003 was expected to
                          increase consumer spending relatively quickly whereas
                          investment spending was not expected to pick up until the
                          next year.


      D.     Inflation Worries
             1.     Clinton raised taxes partly because he feared inflationary
                    pressures were building.
             2.     Whenever the aggregate supply curve is upward sloping, an
                    increase in aggregate demand increases prices as well as output.

IV.   Fiscal Restraint (Figure 12.8)
      A.     Budget Cuts
             1.   Government cutbacks have multiplied effect on aggregate demand.

      B.     Multiplier Cycles
             1.    Government cutbacks (expansions) have a multiplied effect on
                   aggregate demand.
             2.    Formula:
                    Cumulative change in spending  multiplier  initial budget change


      C.    Tax Hikes
            1.     Shift aggregate demand curve to the left.
            2.     Tax hikes reduce disposable income and thus a reduction in
      consumption.
            3.     The Equity and Fiscal Responsibility Act of 1982 increased taxes,
                   shifting the AD leftward and thus reducing inflationary pressures.
            4.     President Clinton restrained aggregate demand in 1993 with tax
                   increase, but increased AD in 1997 with a five-year package of tax
                   cuts.
     D.   Fiscal Guidelines (Table 1.2)
          1.     The fiscal strategy for attaining the goal of full employment is to
                 shift the aggregate demand curve.
          2.     Fiscal Policy Guidelines

                      Problem                 Solution                 Policy Tools
          Unemployment                 Increase aggregate      Increase government
          (Recession)                  demand                  spending and/or cut taxes


          Inflation                    Reduce aggregate        Cut government spending
                                       demand                  and/or raise taxes

V.   Policy Perspectives
     A.   Unbalanced budgets (Figure 12.9)
          1.   The use of the budget to manage aggregate demand implies that
               the budget will often be unbalanced.
          2.   Budget deficit
               a.     Definition: Budget deficit - The amount by which
                                             government expenditures exceed
                      government                    revenues in a given time
                      period.
               b.     Formula:

                          Budget deficit  government spending  tax revenues

                 c.   In 1997, the federal budget deficit was $22 billion. To pay,
                      the government had to borrow money. By 1992, the deficit
                      had peaked at $300 billion.
          3.     Budget surplus
                 a.   Definition: Budget surplus - An excess of government
                                             revenues over government
                      expenditures in a given                      time period.
                 b.   By 1998, the deficit had completely vanished and a budget
                      surplus appeared. This occurred primarily because of an
                      economic expansion and a stock market boom that swelled
                      tax collections.

                 c.       budget surplus  tax revenues  government spending

          4.     Countercyclical Policy – In the Keynesian view, an unbalanced
                 budget was perfectly appropriate if macro conditions called for a
                 deficit or a surplus. Such a policy appears to have been followed by
                 President Bush in 2001 – 2003.

								
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