Fiscal Policy and Monetary Policy

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Can fiscal stimulus end a recession?

Can fiscal stimulus end a recession?

Did the Fed save us from another Great Depression?

Did the Fed save us from another Great Depression?

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20When 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.

CHAPTER CHECKLIST

Fiscal Policy and Monetary Policy

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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 tax revenues, outlays, and surplus or deficit of the government of the United States.

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Budget Time Line

The President and the Congress make the budget and develop fiscal policy on a fixed annual time line.

Fiscal year is a year that begins on October 1 and ends on September 30 of the next year.

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Budget Balance, Surplus, or Deficit

Budget balance = Tax revenues – Outlays

The government has a balanced budget when tax revenues equal outlays (budget balance is zero).

The government has a budget surplus when tax revenues exceed outlays (budget balance is positive).

The government has a budget deficit when outlays exceed tax revenues (budget balance is negative).

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20.1 THE FEDERAL BUDGET

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Surplus, Deficit, and Debt

The government borrows to finance a budget deficit and repays its debt when it has a budget surplus.

The amount of debt outstanding that arises from past budget deficits is called national debt.

Debt at end of 2015 = Debt at end of 2014 + Budget deficit in 2015.

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On the tax revenues side of the budget, the largest item is personal income taxes―taxes that people pay on wages and salaries and on interest.

The second largest item is Social Security taxes―taxes paid by workers and employers to fund Social Security benefits.

Corporate income taxes, which are the taxes paid by corporations on their profits, are much smaller.

Indirect taxes, the smallest revenue source, are sales taxes and customs and excise taxes.

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On the outlays side of the budget, the largest item is transfer payments.

Transfer payments are Social Security benefits, Medicare and Medicaid benefits, unemployment benefits, and other cash benefits paid to individuals and firms.

Expenditure on goods and services includes the government’s defense and homeland security budgets.

Debt interest is the interest on the national debt.

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Types of Fiscal Policy

Fiscal policy actions can be

•Discretionary fiscal policy

•Automatic fiscal policy

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Discretionary 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.

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Automatic Fiscal Policy

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.

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Discretionary Fiscal Policy: Demand-Side EffectsDiscretionary fiscal policy can take the form of a change in government outlays or a change in tax revenues.

Other things remaining the same, a change in any of the items in the government budget changes aggregate demand and …

has a multiplier effect—aggregate demand changes by a greater amount than the initial change in the item in the government budget.

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The Government Expenditure Multiplier

The government expenditure multiplier is the 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.

The increase in real GDP induces an increase in consumption expenditure, which further increases aggregate demand.

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The Tax Multiplier

The tax multiplier is the 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.

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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.

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The Transfer Payments Multiplier

The transfer payments multiplier is the effect of a change in transfer payments on aggregate demand.

This multiplier works like the tax multiplier but in the opposite direction.

An increase in transfer payments increases disposable income, which increases consumption expenditure.

With increased consumption expenditure, employment and real GDP increase and consumption expenditure increases yet further.

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The Balanced Budget Multiplier

The balanced budget multiplier is the 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.

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A Successful Fiscal Stimulus

Fiscal stimulus is an increase in government outlays or a decrease in tax revenue designed to boost real GDP and create or save jobs.

Cash for Clunkers

was a fiscal stimulus.

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Potential GDP is $16 trillion, real GDP is $15 trillion, and

1. There is a $1 trillion recessionary gap.

2. An increase in government expenditure or a tax cut increases expenditure by ∆E.

Figure 20.2 illustrates a fiscal stimulus.

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3. The multiplier increases induced expenditure. The AD curve shifts rightward to AD1.

The price level rises to 105, real GDP increases to $16 trillion, and the recessionary gap is eliminated.

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Discretionary Fiscal Policy: Supply-Side Effects

Fiscal policy has supply-side effects because it influences potential GDP and the growth rate of potential GDP.

These influences on potential GDP arise because

• The government provides public goods and services that increase labor productivity and

• Taxes change the incentives the people face.

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Supply-Side Effects of Government Expenditure

Government provides services such as law and order, public education, and public health that increase production possibilities.

Government also provides social infrastructure capital such as highways, bridges, and dams that increase our production possibilities.

An increase in government expenditure that increases the quantities of productive resources increases potential GDP and increases aggregate supply.

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Supply-Side Effects of Taxes

To pay for its outlays, the government collects taxes.

All taxes create disincentives to work, save, and provide entrepreneurial services.

An increase in taxes decreases the supply of labor, capital, and entrepreneurial services; decreases potential GDP; and decreases aggregate supply.

A tax cut strengthens the incentives to work, save, and provide entrepreneurial services. So a tax cut increases potential GDP and increases aggregate supply.

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Supply-Side Effects on Potential GDP

A tax cut strengthens the incentive to work, which increases the supply of labor and increases the equilibrium level of employment at full employment.

Figure 20.3 (on the next slide) illustrates the effects of a tax cut on potential GDP.

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Initially, the full employment quantity of labor is 200 billion hours and potential GDP is $16 trillion.

1. A tax cut strengthens the incentive to work and

employment increases.

The tax cut also strengthens the incentive to save and invest, which increases the quantity of capital.

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2. With more capital per worker, labor productivity increases and the production function shifts upward.

3. The combined effect is anincrease in potential GDP.

An increase in potential GDP increases aggregate supply, which also increases actual real GDP.

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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.

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Shrinking Area of Law-Maker Discretion

Expenditure on the military and on homeland security and very large expansion in expenditure on entitlement programs such as Medicare has increased.

The result is that around 80 percent of the federal budget is effectively off limits for discretionary fiscal policy action.

The 20 percent that is available for discretionary change include items such as education and the space program, which are hard to cut.

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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.

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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.

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Automatic Fiscal PolicyA consequence of tax revenues and outlays that fluctuate with real GDP.

Automatic stabilizers are features of fiscal policy that stabilize real GDP without explicit action by the government.

Induced taxes are taxes that vary with real GDP.

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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.

Induced taxes and needs-tested spending decrease the multiplier effects of change in autonomous expenditure and moderate both expansions and recessions and make real GDP more stable.

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Because government tax revenues fall and outlays increase in a recession, the budget provides automatic stimulus that helps to shrink the recessionary gap.

Similarly, because tax revenues rise and outlays decrease in a boom, the budget provides automatic restraint to shrink an inflationary gap.

Fluctuations in the government budget balance over the business cycle create a need to distinguish between the budget’s cyclical balance and structural balance.

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Cyclical and Structural Budget BalancesA structural surplus or deficit is the budget balance that would occur if the economy were at full employment.

A cyclical surplus or deficit is the budget balance that arises because tax revenues and outlays are not at their full-employment levels.

The actual budget balance is the sum of the structural balance and the cyclical balance.

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In February 2009, in the depths of the 2008–2009 recession, Congress passed the American Recovery and Reinvestment Act, a $787 billion fiscal stimulus package.

This Act of Congress is an example of discretionary fiscal policy.

Did this action by Congress contribute to ending the 2008–2009 recession and making the recession less severe than it might have been?

The Obama Administration economists are confident that the stimulus package made a significant contribution to easing and ending the recession.

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But many, and perhaps most, economists don’t agree.

They think that the stimulus package played a small role and that the truly big story is not discretionary fiscal policy but the role played by automatic stabilizers.

What were the fiscal policy actions and their likely effects?

Discretionary Fiscal Policy

President Obama promised that fiscal stimulus would save or create 650,000 jobs by the end of the 2009 summer.

In October 2009, the Administration economists declared that the fiscal stimulus had saved or created the promised 650,000 jobs.

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This claim of success might be correct, but it isn’t startling and it isn’t a huge claim. Why?

How much GDP would 650,000 people produce?

In 2009, each employed person produced $100,000 of real GDP on average. So 650,000 people would produce $65 billion of GDP.

But only 20 percent of the $787 billion stimulus package had been spent (or taken in tax breaks), so the stimulus was only about $160 billion.

If government outlays of $160 billion created $65 billion of GDP, the multiplier was 0.4 (65/160 = 0.4).

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This multiplier is much smaller than the 1.6 that the Obama economists say will eventually occur.

They believe, like Keynes, that the multiplier starts out small and gets larger over time as spending plans respond to rising incomes.

An initial increase in expenditure increases aggregate expenditure.

But the increase in aggregate expenditure generates higher incomes, which in turn induces greater consumption expenditure.

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Automatic Fiscal Policy

Government revenue is sensitive to the state of the economy.

When personal incomes and corporate profits fall, income tax revenues fall too.

When unemployment increases, outlays on unemployment benefits and other social welfare benefits increase.

These fiscal policy changes are automatic. They occur with speed and without help from Congress.

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In 2009, real GDP fell to 6 percent below potential GDP—a recessionary gap of $800 billion. Tax revenues crashed and transfer payments skyrocketed.

The figure shows that the automatic stabilizers were much larger than the discretionary actions.

Automatic action played the major role in limiting job losses.

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Monetary policy is the adjustment of interest rates and the quantity of money to achieve the dual objective of price stability and full employment.

The Board of Governors of the Federal Reserve System conducts monetary policy independently of the government but under the terms of the Federal Reserve Act of 1913 and its subsequent amendments.

20.2 FEDERAL RESERVE AND MONETARY POLICY

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Monetary Policy ProcessThe 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

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Monitoring Economic Conditions

The Fed constantly gathers information and brings the results together in the Beige Book, which is published eight times a year.

The Beige Book summarizes current economic conditions in each Federal Reserve district and each sector of the economy.


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Decisions of the Federal Open Market Committee (FOMC)

The FOMC, which meets eight times a year, makes the monetary policy decisions.

After each meeting, the FOMC announces its decisions and describes its view of the likelihood that its goals of price stability and full employment will be achieved.


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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 monetary policy and economic developments of the past year and the economic outlook for the coming year.

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The Federal Funds Rate TargetFollowing the FOMC meeting, the Fed announces its monetary policy decisions as a target for the federal funds rate.

The figure on the next slide shows the federal funds rate since 2000.

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Figure 20.4 shows the federal funds rate since 2000.

The Fed sets a target for the federalfunds rate and then takes actions tokeep the rate close to target.


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When the Fed wants to slow inflation,it raises the federal funds rate target.

When the inflation rate is below targetand the Fed wants to avoid recession,it lowers the federal funds rate.


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

The Ripple Effects of the Fed’s ActionsFigure 20.5 summarizes the ripple effects.


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1. The first effect of a monetary policy decision by the FOMC is a change in the federal funds rate.

2. Other interest rates then change quickly and

relatively predictably.

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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.


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The Quantity of Money and Bank Loans

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.


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The Long-Term Real Interest Rate

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.


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Expenditure Plans

5. A change in the real interest rate changes consumption expenditure, investment, and net exports.

Aggregate Demand

6. A change consumption expenditure, investment, and net exports changes aggregate demand.


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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.


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Monetary Stabilization in the AS-AD Model

The Fed Eases to Fight Recession

If real GDP is above potential GDP, an inflationary gap exists.

If the Fed fears inflation rising, it takes action to lower the inflation rate and restore price stability.

Figure 20.6 on the next slide illustrates.


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1. The FOMC lowers the federal funds rate target from 5 percent to 4 percent a year.

Investment and other interest-sensitive components of expenditure increase.


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2. Expenditure increases by the change in investment.

3. The multiplier induces an additional increase in expenditure.

Aggregate demand increases.

Real GDP increases to potential GDP and recession is avoided.


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The Fed Tightens to Fight Inflation

If real GDP is above potential GDP, an inflationary gap exists.

If the Fed fears inflation rising, it takes action to lower the inflation rate and restore price stability.

Figure 20.7 on the next slide illustrates.


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1. The FOMC raises the federal funds rate target from 5 percent to 6 percent a year.

Investment and other interest-sensitive components of expenditure decrease.


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2. Expenditure decreases by the change in investment.

3. The multiplier induces an additional decrease in expenditure.

Aggregate demand decreases.

Real GDP decreases to potential GDP and inflation is avoided.


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An increase in financial risk drove the banks to increase their holdings of reserves and everyone else to lower their bank deposits and hold more currency.

Between 1929 and 1933, the banks’ desired reserve ratio increased from 8 percent to 12 percent and …

the currency drain ratio increased from 9 percent to 19 percent.

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The money multiplier fell from 6.5 to 3.8.

The quantity of money crashed by 35 percent.

This massive contraction in the quantity of money was accompanied by a similar contraction of bank loans.

A large number of banks failed.

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Friedman and Schwartz say that this contraction of money and bank loans and the failure of banks could (and should) have been avoided by a more alert and wise Fed.

The Fed could have accommodate the banks’ increased desired reserve ratio and …

offset the rise in currency holdings as people switched out of bank deposits.

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Bernanke did what Friedman and Schwartz said the Fed needed to do.

At the end of 2008, the Fed flooded the banks with the reserves that they wanted.

The money multiplier fell from 9.1 in 2008 to 2.5 in 2015—much more than it had fallen from 1929 to 1933.

The quantity of money did not contract as it did in 1933.

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The quantity of M2 increased by 37.5 percent in the 5 years to August 2015, a 6.6 percent annual rate.

We can’t be sure that the Fed averted a Great Depression in 2009.

But we can be confident that the Fed’s actions helped to limit the depth and duration of the 2008–2009 recession.

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In 2015, the “dual mandate” put the Fed in a dilemma.

The recovery was slow and unemployment was not falling quickly enough.

The Fed’s dilemma was when to stop fighting the slow recovery and start worrying about unleashing inflation.

Business

Fiscal Policy and Monetary Policy