Chapter 12
McGraw-Hill/Irwin
Learning Objectives
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Fiscal Policy
Definition: the manipulation of the federal budget to attain price stability, relatively full employment, and a satisfactory rate of economic growth.
Two sides to federal budget: Government spending (outlays) and federal tax revenue.
Focus on level of Government spending (G), not how the funds are allocated. Focus on level of tax revenue (T), not using tax policy to reward certain behavior (e.g., home ownership). Both are responsibility of Congress and President.
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Balanced Budget: G = T
Government expenditures equal tax revenue for the fiscal year.
Before Keynes, economists argued government should always balance its budget. No active fiscal policy.
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John Maynard Keynes invented fiscal policy. Problem in Depression was inadequate Aggregate Demand for output (real GDP). Equilibrium stuck below full-employment level:
C stays low because consumers are unemployed or cutting back. I stays low because businesses have low profit expectations and no incentive to expand inventories or production. The only component of AD that the government can control is G. Increase G to increase AD. Or, by cutting taxes (T), government can hope consumers and businesses will spend additional income.
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Level of output at which everything produced is sold (Aggregate Demand equals Aggregate Supply).
Full-employment GDP tells us the level of spending necessary to reach full employment.
If plant and equipment is operating at between 85 and 90% of capacity, thats considered full employment. If approximately 5% of labor force is unemployed, thats considered full employment.
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Recessionary Gap occurs when equilibrium GDP is less than full-employment GDP.
Inadequate Aggregate Demand (C + I + G + Xn) Fiscal Policy solution is to run a budget deficit (raise G or lower T).
Inflationary Gap occurs when equilibrium GDP is greater than full-employment GDP.
Excess Aggregate Demand sparking inflation Too many dollars chasing too few goods. Fiscal Policy solution is to create a budget surplus (decrease G or raise T).
Which do you think is easier politically for members of Congress and a President to doraise taxes or lower taxes? Which do you think is easier politically for members of Congress and a President to doincrease government spending or cut government programs? Given your answers, which is easier politically to do use fiscal policy to fight recessions or inflation?
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Note that the recessionary gap is less than the gap in output on the horizontal axis.
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Note that the inflationary gap is less than the excess output on the horizontal axis.
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Summary of Graphs
Recessionary Gap:
Difference between full-employment GDP and equilibrium GDP is $2 trillion. Recessionary gap (inadequate spending) is $1 trillion.
Inflationary Gap:
Difference between full-employment GDP and equilibrium GDP is $500 trillion. Inflationary gap (excess spending) is $200 trillion.
Multiplier effects
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Any change in spending (C, I, or G) will set off a chain reaction, leading to a multiplied change in GDP.
C + I + G + Xn
GDP
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Multiplier =
1 1 MPC 1 MPS
Multiplier =
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Multiplier =
1
1 - MPC
1 1 .5
1
.5
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Suppose the government pays you $1,000 to write a report as an economic consultant. The MPC in this economy is 0.5 (or 50%).
You will spend $500 and save $500. Suppose you spend the $500 on a laptop. The seller of the laptop now has $500 in new income. The laptop seller spends $250 and saves $250. Suppose she spends the $250 on used text books. The used bookseller now has $250 in new income, so he spends $125 on concert tickets and saves $125. The concert promoter now has $125 in new income, so she spends $62.50 on a watch and saves $62.50. The watch seller now has $62.50 in new income, so he spends $31.25 buying gas and saves $31.25. And so on
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If you add up all the rounds of spending ($1,000 + $500 + $250, etc.), you would get $2,000. Using the formula is quicker. Question: As the MPC increases, what happens to the multiplier? Answer: It gets bigger!
Denominator is 1 MPC. If MPC increases, (1 MPC) gets smaller. Smaller denominator increases the number. (Hint: Compare with 1/3.)
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Example: GDP = 2,500; C rises by 10; Multiplier = 3 What is the new level of GDP? GDPNew = 2500 + (10 x 3) GDPNew = 2500 + (30) GDPNew = 2530
Amount of increase in GDP
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Formula:
Change in GDP = (Change in spending X Multiplier)
Example: Multiplier = 7; G falls by $5 billion How much will GDP decrease? Change in GDP = 5 x 7 Change in GDP = $35 billion
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This pushes equilibrium GDP down to 1,000 and removes the inflationary gap.
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During recessions, tax receipts decline. During inflations, tax receipts rise.
Personal Savings
During recessions, unemployed tend to use up their savings, so we assume that saving declines. But sometimes saving increases because consumer confidence decreases, so those with jobs try to save more. During prosperity, we would expect that saving rises. But again, reality does not always follow the theory.
Credit Availability
Credit availability often helps get us through recessions, enabling consumers to keep spending. The Great Recession is different because one of its causes was a credit crunch.
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Unemployment Compensation
During recessions more people collect unemployment benefits, putting a floor under purchasing power. But only 40% of those out of work can quality for benefits in the U.S., compared with 90% in Germany and 98% in France. The usual cap on US benefits is 26 weeks, much longer than in Europe. During recessions, Congress may extend the cap.
During economic boom, profits rise quickly but corporate income taxes reduce the inflationary impact.
Welfare (or public assistance) payments, Medicaid payments, and food stamps rise during recessions.
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Example: Extending unemployment benefits beyond 6 months. Due to the Great Recession and the jobless recovery, unemployment benefits were extended for as long as 79 weeks. Corporate incomes taxes can be raised during periods of inflation and lowered when recessions occur.
Public Works
New Deal programs built bridges, post offices, park trails, etc.
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To fight inflation, the government can raise taxes. This may generate a budget surplus, or at least reduce the deficit.. To fight recession, the government can cut taxes. This may increase the budget deficit.
To fight recession, increase government spending. This may increase the budget deficit. To fight inflation, decrease government spending. This may generate a budget surplus.
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The U.S. economy has been more stable for most of the postwar period.
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Public works projects are often labeled pork barrel spending. Members of Congress negotiate to bring spending projects to their local communities, even if it is wasteful. Some projects make headlines, like Bridge to Nowhere in Alaska. Our roads, bridges, and other public infrastructure are crumbling. We need new public investment. Green-collar jobs is the idea that government should create jobs that improve the environment.
Pros:
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Pros:
Extending benefits strengthens automatic stabilizers to maintain Aggregate Demand. People who are unemployed during a recession and jobless recovery may not be able to find jobs through not fault of their own. Monetary incentives are only one reason to work. Many unemployed would rather have a job than benefits anyway, because jobs provide intrinsic rewards (like dignity, self-respect, identity, and purpose).
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President submits budget to Congress. Congress amends budget and passes individual appropriation bills.
Both House and Senate have to reconcile differences between their versions.
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Fiscal Policy takes time due to three types of lags (or delays):
Recognition lag: Policy makers must identify that there is a problem. (Recessions only declared after 6 months, at minimum.) Decision lag: President and Congress must agree on policy approach and pass legislation.
Impact lag: It takes time for their actions to have effect.
Changing Aggregate Demand through fiscal policy is more like navigating a super-tanker than driving a car.
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President Bush used fiscal policy to stimulate the economy in response to The Great Recession:
Recognition lag: Although there were strong signs of an economic slowdown during Fall 2007, the Bush administration and many members of Congress did not use the word recession until the unemployment rate rose to 5.0% in January 2008. Decision lag: The Bush administration and Congress took just a few weeks to agree to a $168 billion economic stimulus package that focused on taxpayer rebates (tax cuts). Impact lag: The IRS did not mail out the rebates until May 2008. And many people used the rebates to pay down det rather than increasing spending. It was too small to have much of an impact.
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$233 billion in tax cuts for individuals and families $106 billion for education and job training, including aid to states to prevent cutbacks and layoffs $87 billion to states for increased Medicaid costs $78 billion for programs for jobless workers $48 billion for highway and bridge construction and mass transit $44 billion for energy programs, modernization of electric grid $41 billion for other infrastructure and environment projects $29 gillion for health, science, and research $21 billion for energy investments $20 billion to expand food stamp benefits
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Great Recession ended during the summer. But the unemployment rate is still high. It may have averted layoffs, especially by state and local governments. Additional funds spent in 2010 and 2011 may support more job creation.
FY 2008 budget deficit was $459 billion. FY 2009 budget deficit was $1.4 trillion. But it was only 9.8 percent of GDP. In 1944, the budget deficit was 24.5 percent of GDP.
Discussion Question: How did the government get rid of deficits in the 1990s? What led to the return of deficits after 2000? In 2009?
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2.
3.
Government borrowing pushes up interest rates. Deficit is increasingly financed by foreign savers, giving U.S. less control over financial markets. Money used to invest in government bonds is not being used to finance private sector investment.
Conclusion: We dont need to balance the federal budget every year, but deficit spending has limits.
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Monetarists emphasize crowding out Any expansionary impact of budget deficits will be offset by higher interest rates and crowding out private sector borrowing. Go back to Laissez-Faire policy of Classical economics!
Keynesians emphasize crowding in Stimulus of increased government spending or tax cuts will encourage consumption and investment.
Government primes the pump to get the private sector growing again.
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Deficits occurs when federal government spending is greater than tax revenue in a single fiscal year. Debt is the cumulative total of all the federal budget deficits less any surpluses.
Example:
Suppose that our deficit declined one year from $200 billion to $150 billion. The national debt would still go up by $150 billion. So every year that we have a deficiteven a declining one the national debt will go up.
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Percentage of National Debt Publically Held and Held by U.S. Government Agencies, 2010
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Each year about $4 trillion dollars worth of federal securities fall due. By selling new ones, the Treasury keeps us going.
But even if we never pay back one penny of the debt, our children and our grandchildren will have to pay hundreds of billions of dollars in interest.
At least to that degree, the public debt will be a burden to future generations.
But it will also be income to Americans, since we owe much of it to ourselves.
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Baby Boomer retirements will increase outlays for Social Security and Medicare. (Both programs now run surpluses each year.) What are the options to avoid massive budget deficits when Boomers retire?
Raise payroll taxes or eliminate the earnings cap on social security taxes to increase revenue (T). Raise retirement age or cut benefits to reduce spending (G). Combine both approaches. Which would you recommend?
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