FISCAL FISCAL POLICYPOLICY

Even if I have to dig a hole and cover it back up, I do have a job.

The Demand for Loanable The Demand for Loanable Funds MarketFunds Market

InterestRate

3%3%AA

Trillions of Dollars

AA

1.51.5

(a) (b)

3% 3%3%

Demand for Loanable

Funds at 3% [no G borrowing]

Business firms demand for

Loanable Funds at 3%[a lot of investment]

DDm[m[nono G]G]

QIDQID11

MSMSDDII

Money MarketMoney Market

Low interest rates, so - a lot of investmentTrillions of Dollars

The Demand for Loanable The Demand for Loanable Funds MarketFunds Market

Trillions of Dollars

InterestRate

5%5%

3%3% AA

Government Demand for Funds

BB

Trillions of Dollars

AA

Business Demand for Funds

1.01.0

BB

1.51.5

(a) (b)

5%5%

3%

With “G” borrowing, With “G” borrowing, the demandthe demand for for LFLF at at

55%%

Business firms dBusiness firms demandemand for for

LoanableLoanable Funds at Funds at 55%%[not as much investment][not as much investment]

DDmm

DDmm(G)(G)

QID2QID2 QID1QID1

MSMSDDii

Money MarketMoney Market Higher interest rates, sonot as much investment

BBalancedalanced BBudget [$2 Tudget [$2 Tril. ril. “G” = $2 T“G” = $2 Tril. ril. “T”]“T”]

$2 $2 TrillionTrillion $2 $2 TrillionTrillion

GG TT

RecessionRecessionIncr G to $2.2 Incr G to $2.2

or or

Decr T to $1.8 Decr T to $1.8

DeficitDeficit so sohigher I.R.higher I.R.

InflationInflationDecr G to $1.8Decr G to $1.8

or or

Incr T to $2.2Incr T to $2.2

Surplus Surplus sosoLower I.R.Lower I.R.

BudgetBudget

So expansionary fiscal policySo expansionary fiscal policyleads to leads to higher interest rateshigher interest rates.. DeficitDeficit

Wow! AWow! Asurplussurplus

So, contractionary fiscal policySo, contractionary fiscal policy

leads to leads to lower interest rateslower interest rates..

Gonna have Gonna have to borrowto borrow

Real GDP Q

PL ASASADAD22

YYRR YYFF

Expansionary Fiscal PolicyExpansionary Fiscal Policy

[[Incr GIncr G; ; Decr TDecr T]]

PPL1L1

ADAD11

PLPL22

GG ADAD Y/Empl./PL;Y/Empl./PL; GG LFMLFM I.R.I.R.

TT DIDI CC ADAD Y/Emp/PL;Y/Emp/PL; TT LFMLFM IRIR

Start from a Start from a Balanced BudgetBalanced BudgetG & T = $2 TrillionG & T = $2 Trillion

$$2 T 2 T $2 T$2 T

““I can’t I can’t get a job.”get a job.”

““NNowow, , this isthis is better.”better.”

GG TT EE11EE22

LRASLRAS

Real GDP Q

PL ASAS

ADAD22

YYIIYYFF

Contractionary Fiscal PolicyContractionary Fiscal Policy

[Decr G; [Decr G; Incr TIncr T to close ato close a contractionary gap contractionary gap]]

PPL1L1

ADAD11

PLPL22

GG ADAD Y/Empl./PL;Y/Empl./PL; GG LFMLFM I.R.I.R.

TT DIDI CC ADAD Y/Emp/PL;Y/Emp/PL; TT LFMLFM IRIR

Start from a Start from a Balanced BudgetBalanced BudgetG & T = $2 TrillionG & T = $2 Trillion

$2T$2T $2T$2T GG TT

[like we have [like we have ““money trees”money trees”]]

EE11

EE22

Expansionary Expansionary Fiscal PolicyFiscal Policy

Recessionary GapRecessionary Gap

TTGG

Fiscal Policy DuringFiscal Policy During RecessionRecession

SRASSRAS

AD2AD2

YYRR YY**

AD1AD1

Keynes and Lydia LopokovaKeynes and Lydia Lopokova

Expansionary Expansionary Fiscal PolicyFiscal Policy

Inflationary GapInflationary Gap

TT

GG

Fiscal Policy DuringFiscal Policy During Inflation Inflation

SRASSRAS

AD2AD2

YY** YYII

AD1AD1

Contractionary Contractionary Fiscal PolicyFiscal Policy

GG

TT

The automatic stabilizers may be called the automatic pilot of our economy, not very well suited for takeoffs & landings, but fine for the smooth part of the flight. But when the going gets rough, the economy must use manual controls.(discretionary G&T).

“A pilot may take a stroll thru and let the copilot cruise. I f there is turbulence the pilot will rush back to the cockpit(pres. & congress) & use manual controls to correct economic turbulence. Discretionary fiscal policy is our manual control system.

Nondiscretionary Fiscal Policy (Automatic stabilizers) 1. 1. Transfer Payments AD3

A. Welfare checks B. Unemployment checks PL AD1 C. Food Stamps D. Social Security

E. Corporate dividends F. Veteran’s benefits AD2 2. Progressive Income Taxes

YR Y* YI

Nondiscretionary F iscal Policy – built in stabilizers where G & T occur automatically. They require no congressional action to operate year after year. They automatically insulate DI against the vagaries of the business cycle by 1/ 3 to ½. Further smoothing would require well-timed discretionary fiscal policy.

When income goes up, tax revenues go up – reducing AD(marginal tax rates increase)

When income goes down, tax revenues go down-stimulating AD(marginal tax rates decrease)

Automatic Stabilizers are anything that tends to increase the Gs deficit during a recession. (or reduce its surplus) Automatic Stabilizers are anything that tends to increase its surplus during inflation. (or reduce its deficit)

These stabilizers operate counter-cyclically to stabilize the economy by “increasing injections during depressions” & “increasing withdrawals during booms.” These programs stabilize a person’s income in the event of a layoff, a retirement, or a medical emergency.

As regards individual & corporate income taxes, as the economy booms & people & firms get more income, they automatically pay higher taxes, lessoning DI , C, & AD. As the economy goes into recession, people & firms get less income & they automatically pay fewer taxes, increasing DI , C, & AD. T(more progressive, more stabilizing) G purchases G Transfers T(How much taxes are coming in) & T revenues Deficits Surpluses G(How much G is purchasing)

YR Y* YI GDP

YR ; T ; AD2

YI ; T ; AD3

Automatic StabilizersAutomatic Stabilizers The automatic stabilizers may be called the automatic pilotautomatic pilot of our economyof our economy, not very well suited for takeoffs and landings, but fine for the smooth part of the flight. But when the going getsgoing gets roughrough, the economy must use manual controlsmust use manual controls. [discretionary G&Tdiscretionary G&T]

Automatic stabilizersAutomatic stabilizerstake take 33-50%33-50% out. out.SStabilizerstabilizers are like aare like a thermostat thermostatmaintaining temperature.maintaining temperature.

33-50%33-50%

BUILT-IN STABILITYBUILT-IN STABILITY

GDPGDP11 GDPGDP22 GDPGDP33

Real Domestic Output, GDP

Go

vern

men

t E

xpen

dit

ure

s,G

, an

d T

ax R

even

ues

, T

DeficitDeficit

Surplus

TaxesTaxes

GG

YYRR Y*Y* YYii

More vertical [progressive], theMore vertical [progressive], themore stability for the economy.more stability for the economy.

TransfersTransfers

SurplusSurplus

Fewer Fewer TransfersTransfers

MoreMoreTransfersTransfers

Less TaxLess TaxMoneyMoney

Discretionary Discretionary Fiscal Policy Fiscal Policy

Deliberate use of government spending and/or taxing.

““G” and “T”G” and “T”

Nondiscretionary Nondiscretionary Fiscal PolicyFiscal Policy

Automatic StabilizersAutomatic Stabilizers1.Welfare & food stamps1.Welfare & food stamps2. Unemployment insurance2. Unemployment insurance3. Social security3. Social security4. Corporate Dividends4. Corporate Dividends5. ProgressiveProgressive Tax System Tax System

Unempl. checkUnempl. check

Discretion of CongressDiscretion of Congress

Suppose the economy is in Suppose the economy is in recession:recession:

Real Real GDPGDP

TaxTaxcollectionscollections

Transfer Transfer paymentspayments

GG > TTThe deficit growsThe deficit grows

Fiscal PolicyFiscal Policy Automatic stabilizers.Automatic stabilizers.

ASAS

ADAD22ADAD11

““Recession”Recession”YYRR Y*Y*

PL

If the economy has an If the economy has an inflationary gap:inflationary gap:

TaxTaxcollectionscollections

Transfer Transfer paymentspayments

GG < TTThe surplus growsThe surplus grows

Fiscal PolicyFiscal Policy Automatic Automatic stabilizers.stabilizers.

Real GDPReal GDPASAS

““Inflationary Gap”Inflationary Gap”

ADAD22

ADAD11

Y*Y* YYII

PL

Discretionary Fiscal PolicyDiscretionary Fiscal Policy

Discretionary

Contractionary Contractionary Fiscal PolicyFiscal Policy

1.1. Decrease “G”Decrease “G”2.2. Increase “T”Increase “T”

Expansionary Fis. PolicyExpansionary Fis. Policy1.1. Increase “G”Increase “G”2.2. Decrease “T”Decrease “T”

The Kennedy/Johnson $10 Bil. Tax The Kennedy/Johnson $10 Bil. Tax Cuts of 1964Cuts of 1964

The The “Golden Age of Fiscal Policy”“Golden Age of Fiscal Policy”

When Kennedy came into office:

1. The top marginal tax rate was 9191%%

and drops to 52%drops to 52% compared

to 35%35% today.2. The unemployment rate

was 6.76.7%% and drops below 5%below 5%.3. A recessionrecession becomes a

very good low low unemployment-low unemployment-low inflation inflation (2%)(2%) economy economy

4. The expansionexpansion continued to 1969.

Fiscal Policy and Tax CutsFiscal Policy and Tax Cuts.

YR

Keynesian Policy: Keynesian Policy: ““Balance Balance the the Economy, Economy, not thenot the Budget Budget.”.”

DeficitsDeficits SurplusesSurpluses““Even if the jobsEven if the jobsareare digging holes digging holes and filling them up.”and filling them up.”

FINANCING OF DEFICITSFINANCING OF DEFICITS [Should we[Should we borrowborrow or or justjust printprint the the moneymoney?]?]

1. Borrowing 1. Borrowing from thefrom the public public [results in higher interest rates[results in higher interest rates which crowds out investmentwhich crowds out investment]]

7%7%4%4%

7%7%4%4%

MS1 MS1 MS2MS2

DDM2(g)M2(g)

DDM1M1

ASASADAD22

YY** Y Y

2. Just print the money2. Just print the money [Money creation – lower interest rates[Money creation – lower interest rates so this would be more expansionary]so this would be more expansionary]

But the LR increase in MS resultsBut the LR increase in MS results

in an in an increase in inflationincrease in inflationPLPL11

PLPL22 ADAD11

How To Dispose of SurplusesHow To Dispose of Surpluses[Should we [Should we hold the surplushold the surplus or or give it backgive it back]]

1. Debt Retirement1. Debt Retirement [give the surplus back during recessions to get lower interest rates and expand the economy]

ASASADAD22

Y*Y* YYII

2. Impound The Surplus2. Impound The Surplus [keep the surplus during inflations and give it back during recessions]

PLPLADAD11

IIDD

Investment (billions of dollars)

Rea

l in

tere

st r

ate

(%)

THE “CROWDING OUT” EFFECT [Incr G incr I.R. THE “CROWDING OUT” EFFECT [Incr G incr I.R. Decr IgDecr Ig]]

16

14

12

10

8

6

4

2

05 10 1515 20 25 30 35 40

CrowdingCrowdingOutOut

EffectEffect

ASAS

ADAD11AD2AD2

4%

2%

YYRR

GG

IIGG

G can finance a deficit by:G can finance a deficit by:1. 1. Borrowing Borrowing - this raises interest rates and- this raises interest rates and ““crowds out”crowds out” investment. investment.2. 2. MoneyMoney Creation Creation - - no “crowding outno “crowding out” so is ” so is more expansionarymore expansionary than borrowing. than borrowing.

FriedmanFriedmanJust follow theJust follow the

““monetary rule.”monetary rule.”

+G +C +Ig

-XN

YR Y*

-I g -C -G +Xn

Y* Yi

AS AS

Ex pansionar y Fiscal Policy & “ Negative X n”

Contr actionar y

Fiscal Policy &

“Negative X n”

Negative Net Export Effect of Fiscal PolicyNegative Net Export Effect of Fiscal Policy

YR Y*

Due to lowerDue to lowerinterest rates,interest rates,dollar deprec.dollar deprec.

Expansionary Fiscal Policy

““Negative Xn”Negative Xn” ““Negative Xn”Negative Xn”CContractionaryontractionary

Fiscal PolicyFiscal PolicyDue to higherDue to higherinterest rates,interest rates,dollar apprec.dollar apprec.

Liberal (“Liberal (“GG”)”) oror Conservative Conservative (“(“GG”)”)

LiberalsLiberalsRecession: Increase “G”;Recession: Increase “G”; Inflation: Increase T “Inflation: Increase T “GG

GG ConservativesConservativesRecession: Decrease “T”; Inflation: Decrease “G”Recession: Decrease “T”; Inflation: Decrease “G”

Fiscal Policy LagsFiscal Policy Lags

“The shower starts out starts out too coldtoo cold, because the pipes have not yet warmed up. So the fool turns up the hot waterturns up the hot water. nothing happens, so he turns up the hotturns up the hot water furtherwater further. The hot water comes on and scalds himscalds him. He turns up the turns up the cold watercold water. Nothing happens right away, so he turns up turns up the cold furtherthe cold further. When the cold finally starts to come up, he finds the shower too coldtoo cold, and so it goes.”

Fiscal Policy lagsFiscal Policy lags1.1. Data (recognition) lagData (recognition) lag2.2. ““Wait-and-see” lag – short runWait-and-see” lag – short run3.3. Legislative lag (political)Legislative lag (political)4.4. Effect lag [takes months]Effect lag [takes months]

The The GG is like a “ is like a “Fool in the ShowerFool in the Shower.”.”

YYFFYYRR YYII

ADAD22ADAD11

LRASLRASSRASSRAS11

SRASSRAS22

EE44

EE44

EE22

EE11

EE22

EE33

Traditional Traditional Fiscal PolicyFiscal Policy [“G”[“G” & “T”]& “T”]will not work with will not work with StagStagflationflation

ADAD11LRASLRAS

4%4%

55%%

1010%%

1010%%

YYRR

SRASSRAS22

StagStagflationflation

ADAD22

15%15%

1515%%

AD3AD3

YYFFYYRR

AD1 AS2 AS1

E2 E1

10% 6% Unemployment

10%

3%

STAGFLATION

SUPPLY-SIDE ECONOMICS [Voodoo Economics?]

1. Shift AS curve rightward 2. Accelerated depreciation 3. Reduce corporate taxes 4. Reduce individual income taxes by $250 billion 5. Tax credits for R&D

Laffer Curve

Arthur Laffer

Laffer Curve and Supply-Side EconomicsLaffer Curve and Supply-Side Economics

Was Reagan a “closet Keynesian”“closet Keynesian” with all the “G” & “T”?Perhaps he was a “Keynesian in drag.”“Keynesian in drag.”

0

100

l

THE LAFFER CURVETHE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

0

100

m

l

THE LAFFER CURVETHE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

0

100

m

n

l

THE LAFFER CURVETHE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

0

100

m m

n

l

THE LAFFER CURVETHE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

MaximumTax

Revenue

SUPPLY-SIDE FISCAL POLICYSUPPLY-SIDE FISCAL POLICY

Emphasis on Expansionary Tax Cuts[which shifts AD to the right, increasing Y & PL]

Impact upon...•Saving and Investment [Lower taxes increase DI & S; less business taxes will

increase investment. Our “national factory” will increase.]

• Work Incentives [Keeping more of our money makes us work harder and longer]

• Risk Taking [Lower tax rates promise a larger potential after-tax reward]

So, the AS Curve will shift right bringing prices down.AS Curve will shift right bringing prices down.

SUPPLY-SIDE FISCAL POLICYSUPPLY-SIDE FISCAL POLICY

0

Pri

ce level

Real domestic output, GDP

AD1

AD2

AS1 AS2

P1

P2

P3

Q1 Q2 Q3

Can sustain a much greaterincrease in AD if the AS curve is also shifting to the right.

LEGISLATIVE MANDATES

Employment Act of 1946Employment Act of 1946

CCouncil of ouncil of EEconomic conomic AAdvisorsdvisors(CEA)(CEA)

JJoint oint EEconomic conomic CCommittee ommittee (JEC)(JEC)

Legislative Mandates for Remedial Fiscal MeasuresLegislative Mandates for Remedial Fiscal Measures

1. Employment Act of 1946Employment Act of 1946 – a law promoting economic stability (by promoting “maximum employment, production, and “maximum employment, production, and purchasing power”purchasing power”) through monetary and fiscal policiesmonetary and fiscal policies. This act was a government commitmentgovernment commitment to ensure prosperity after WWII. [not only “could”“could” but “would”“would” – no more laissez faire] This act gave the Keynesians economistsKeynesians economists the theoretical and legal justificationlegal justification to use fiscal policyuse fiscal policy to stabilize the economy.

2. Council of Economic Advisers (CEA)Council of Economic Advisers (CEA) [for the PresidentPresident] – 3 distinguished economists3 distinguished economists (on leave from

universities) who assist & advise the Presidentassist & advise the President on economic matters. Their staff is made up of 11 senior and 6 junior economists. They forecast & project the deficit, inflation, GDP growth, deficit, inflation, GDP growth, foreign exchange rates, immigration, & antitrust legislationforeign exchange rates, immigration, & antitrust legislation. The President must submit an annual economic report describing the current economic state with recommendations.““TThe he President’s intelligencePresident’s intelligence arm arm in the warin the war against the against the business cycle.” business cycle.”

Head Head of theof the CEA CEA

Greg MankiwGreg Mankiw of Harvard has ridiculed of Harvard has ridiculed

supply-side tax cuts as supply-side tax cuts as “fad economics”“fad economics” conceived by conceived by ““charlatanscharlatans and cranks,” and cranks,” in his textbook.in his textbook.

Harvey S. RosenHarvey S. Rosen of Princeton of Princetonhas succeeded Mankiw.has succeeded Mankiw.

Joint Economic Committee of CongressJoint Economic Committee of Congressand Humphrey-Hawkins Act of 1978and Humphrey-Hawkins Act of 1978

3. J oint Economic Committee(J EC) of Congress – an advisory group or intelligence arm in the war against contractions in the business cycle. After gathering and analyzing economic data, they make forecasts and formulate programs to improve employment.

4. Humphrey-Hawkins Act of 1978 – (Full Employment & Balanced Growth Act) - requires the government to establish 5-year economic goals and formulate plans to achieve it. The goals were to seek 4% unemployment and zero inflation.

Keynesians Return To Washington Keynesians Return To Washington [1993][1993]

Nobel Prize inNobel Prize inEconomics-2001Economics-2001

ADDING THE PUBLIC SECTOR[“ ”]ADDING THE PUBLIC SECTOR[“ ”]

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

390390 470470 550550

C

C + Ig + Xn

C + IC + Ig g + X+ Xn n + G+ GGovernmentGovernmentSpending ofSpending of$20 Billion$20 Billion

$20 $20 Billion GovernmentBillion Government Purchases and Equilibrium GDP Purchases and Equilibrium GDPS

Mixed - openMixed - open

$$2020 bil. for Nat. Defense bil. for Nat. Defense

““M” = 4M” = 4

$15 B decrease in “C”$15 B decrease in “C”[[&& $60 B $60 B total decreasetotal decrease

in Y from a $20 billionin Y from a $20 billion

increase in taxesincrease in taxes

ADDING THE PUBLIC SECTOR[“ ”]ADDING THE PUBLIC SECTOR[“ ”]

Incr. T by $20 bil.[Incr. T by $20 bil.[MTMT = 3] = 3] Equilibrium GDP[-60] Equilibrium GDP[-60]

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

550

C + Ig + Xn + G

CCaa + I + Ig g + X+ Xn n + G+ G

490490

S

Mixed-OpenMixed-Open

$20 bil. increase in “T”$20 bil. increase in “T”

T $20

GDP = -$60

GDP = +$80

G $20

Sa= -$5

Ca= -$15

Net Change in GDP = +$20

Balanced Budget Multiplier[$20 bil.] “G” affects AD directly “T” affects AD indirectly thru “C”

The increase in “T” means we would have consumed $15 & kept $5 in our pockets.

AS(RAP)

AD(C+Ig+G+Xn)

PL

MT = MPC/ MPS=.75/ .25=3 So, 3 x -$20 = -$60 Or, ME x MPC; 4 x -$15=-$60

ME = 1/ MPS ME = 1/ .25 = 4 So, 4 x $20 = $80

The increase in “G” flows directly into the economy.

470 bil. $490 bil.$490 bil.

1. With the Employment Act of 1946Employment Act of 1946, the federal government committed itself to accept (total/some) degree of responsibility for employment/prices.2. Fiscal policyFiscal policy is carried out primarily by the (local/state/federal) government.3. Discretionary fiscal policyDiscretionary fiscal policy [G & T] (does/does not) require congressional action.4. In a mixedmixed [private & public) closed economyclosed economy, taxes & (savings/government spending) are leakagesleakages, while Ig and (savings/government spending) are injectionsinjections.5. In a mixed economy, the equilibrium GDP exists where (C+Ig/C+Ig+G+Xn) = GDP.6. The balanced budget multiplierbalanced budget multiplier indicates that equal increases in G&T tend to (decrease/increase/not change) the equilibrium GDP. [MBB is “1”]7. Assume in a private economy that equilibrium GDP is $400 billionequilibrium GDP is $400 billion & the MPC is .80. Suppose the G collects new taxes of $50 bil.G collects new taxes of $50 bil. & spends the entire amount spends the entire amount on our infrastructure. As a result equilibrium GDP will be ($400/$450/$500) bil.

8. Suppose a constitutional amendmentconstitutional amendment requires that the G always balanceG always balance its budgetits budget. If it desired to increase GDP by $40 billionincrease GDP by $40 billion, G should (increase/decrease) government spending & taxes by ($30/$40/$50) billion.

Fiscal Policy NS 1-8Fiscal Policy NS 1-8

9. In a severe recession, Keynesians would AE1 favor a(n) (increase/decrease) in taxes. AE [Ask about bal. budget M, T cut, etc.] YR YFE

800 ?

10. I f the G tries to eliminate a budget deficit during a depression, these efforts will (help/hurt) the depression.

11. A conservative economist who advocates an active fiscal policy would recommend T (increases/decreases) during recession & (increases/decreases) in G during inflation.

AE (AE) 0 12. I f the F.E. level of GDP is OC, then it would be appropriate fiscal policy for G to (increase/decrease) “G” and (increase/decrease) “T”.

13. I f the F.E. level of GDP is OA, then it would be appropriate fiscal policy for G to (increase/decrease) “G” and (increase/decrease) “T”. .

AE2

YYCC AA

45°45°

45°45°

14. If G increases its spending during a recessionduring a recession to assist the economy, the funds must come from some source. (Additional taxes/Borrowing from the public/Creating new money) would tend to be the most expansionarymost expansionary.

15. The following fiscal actionsfiscal actions, (incurring a budget surplusand allowing it to accumulate as idle Treasury balances/incurring a budget surplus which is used to retire debt held by the public) is likely to be most effective in curbing inflationcurbing inflation.

16. The greatest anti-inflationary impact of a budgetgreatest anti-inflationary impact of a budget surplussurplus will occur when the G (impounds/uses) the surplus funds & lets them (stand idle/pay off the debt).

17. In describing the built-in stabilizersbuilt-in stabilizers, we can say that

personal & corporate income tax collectionspersonal & corporate income tax collectionsautomatically (incr/decr) as GDP increasesas GDP increases and transfers transfers & subsidies& subsidies (incr/decr) as GDP increasesas GDP increases.

Should Should I I give it back?give it back?

Recognition, Action, & Effect Lags of Fiscal Policy

Recognition Lag A ction Lag Eff ect Lag 1. Data lag 2. “Wait-and-see” lag-short run? 3. Legislative lag 4. Effectiveness lag[AD doesn’t move the next day][Takes months for the “M” to work]

Action LagAction Lag

Political Business Cycles?Political Business Cycles?

Political Business Cycles: Politicians manipulate fiscal policy to get voter support. No politician wants to go into the next election known as the “tax-raising, project -cancelling boom killer.” These policies can lead to “Made in Washington” recessions after the election to slow down the inflationary economy . The economy can be corrected prior to the next election.

“The economy is largely a toy to be pulled this way and that for political purposes.”

0 YP Real GDP

Presidential Elections and U.S. Recessions, 1948 -2002 Election Winner Next Recession Election winner Next Recession Nov, 48 Truman Nov. 48 -Oct. 49 Nov. 72 Nixon Dec. 73 -Mar. 75 Nov. 52 Ike June, 53 -May 45 Nov. 76 Carter Jan. 80 - July 80 Nov. 56 Ike June, 57 -Apr. 58 Nov. 80 Reagan May 81 -Nov. 82 Nov. 60 Kennedy Apr. 60 -Feb. 61 Nov. 84 Reagan Incr bor. by $2 tr. Nov. 64 Johnson Viet Nam War Nov. 88 Bush 41 July 90 -Mar. 91 Nov. 68 Nixon Oct. 69 -Nov. 70 Nov. 92 Clinton None Nov. 01 Bush 43 Jan. 01 -Sept. 01

“Voters tend to remember the last one or two years prior to an election.”

*Tell them what they want to hear.*Tell them what they want to hear.

FISCAL POLICY – Pure and Simple

Fiscal Policy:No Complications

Pri

ce le

vel

Real GDP (billions)

ADAD11 ADAD22

P1

$490 $490 YRYR

ASAS

There are 2 things that could “diminish AD.” “diminish AD.”

$510$510Y*Y*

Fiscal Policy: ShowingCrowding-out Effector Net Export Effect

Pri

ce le

vel

Real GDP (billions)

AD1 AD2

P1

$490$490 $510$510

AS

AD’2

$504$504

There are 2 things that could “diminish AD.” “diminish AD.”[Crowding-out and net export effect][Crowding-out and net export effect]

FISCAL POLICY AND INFLATIONFISCAL POLICY AND INFLATION

Pri

ce level

Real GDP (billions)

AS

AD2

$495 $515

P1

AD1

$505

Answer the next 3 questions(18-21) based on the diagram.18. DeficitsDeficits will be realized at GDP levels (below/above) C, and surpluses (below/above) C.19. If the F.E. GDP for the economy is at DD, the F.E. budget will entail a (deficit/surplus).20. If the tax line had a greater slopetax line had a greater slope [more progressive tax system], stabilitystability would be (less/greater).21. If government adhered strictly to an annually balanced budgetadhered strictly to an annually balanced budget then the government’s budget would tend to (destabilize/stabilize) the economy.

T2

NS 18-21NS 18-21

DA B C

NSNS 22-3022-30For Questions 22-2422. (T1/T4) tax system is characterized by the least built-in stabilityleast built-in stability.23. (T1/T4) tax system is characterized by the most built-in stability.24. (T1/T4) tax system will generate the largest cyclical deficitslargest cyclical deficits.25. NondiscretionaryNondiscretionary Fiscal Policy (does/does not) require congressional action.

26. If the MPC is .5, a $10 B increase in “G”$10 B increase in “G” will increase “C”increase “C” [not incomenot income] by ($20/$10/$5) billion.[G increase in spending of $10 B increases income (Y) by $20 B. With MPC of .5, C increases $10 B]

27. If government tries to give back a surplus during an inflationary FE year, this will be (pro-cyclical/counter-cyclical). 28. When politicians use fiscal policy to cause an improvementimprovement in the economy just prior to an electionin the economy just prior to an election, this is called a (presidential/Congressional/political) business cycle.29. When G incurs a deficit which is financed by borrowingG incurs a deficit which is financed by borrowing, causing interest rates to increase which decreases Iginterest rates to increase which decreases Ig, this is called the (crowding-in/crowding out) effect.30. Supply-sidersSupply-siders argue that the primary effect of tax cutsprimary effect of tax cuts is to shift the AS curve (leftward/rightward).

C+Ig+G(AE)

31. I f the MPC is .8, a $2 billion increase in “G” C+Ig(AE) will increase “C” (not income) by: AE +$2G

($10/$8/$6) billion. [“G” would increase spending by $10 bil., which people receive as Y. 800 With MPC of .8, they spend $8 billion and save $2 billion.]

32. I f the MPC is .9, a $1 billion increase in “G” will increase “C” by: ($10/$9/$8) billion. 36. I f “G” decreases “G” & “T” by $10 billion, then with a MPS of .10, the equilibrium GDP would (increase/decrease) by ($5/$10/$100) billion.

37. With a MPC of .75, “G” increases “G” & “T” by $8 billion. The equilibrium GDP (increases/decreases) by ($75/$32/$8) billion.

38. I f the “G” runs a budget surplus & desires to curb inflation, it should (give the surplus back to taxpayers/keep it in storage).

33. In a private-closed economy, the MPS is .2, AE C+Ig “C”=I ncome at $200 billion, & the level of investment is $10 billion. The equilibrium C level of income at the new level is: 200 +10

($200/$210/$250) billion.

$200 ?

34. I f the MPS is .2 & the economy has a AE S AE2 recessionary spending gap of $5 bil., we can conclude that the equilibrium +5 AE1 level of GDP is ($5//$20/$25/$30)

billion below the full-employment GDP. YR ?

35. I f the MPS is .5 & the economy has an AE C inflationary[negative] spending gap of -6 AE1 $6 billion, we can conclude that the AE2

equilibrium level of GDP is ($46/$12/$18) billion above the full-employment GDP.

? YI

NS 31-34NS 31-34 C+Ig+G(AE)

45°45°

45°45°

45°45°

C+Ig+G(AE)

31. I f the MPC is .8, a $2 billion increase in “G” C+Ig(AE) will increase “C” (not income) by: AE +$2G

($10/$8/$6) billion. [“G” would increase spending by $10 bil., which people receive as Y. 800 With MPC of .8, they spend $8 billion and save $2 billion.]

32. I f the MPC os .9, a $1 billion increase in “G” will increase “C” by: ($10/$9/$8) billion. 36. I f “G” decreases “G” & “T” by $10 billion, then with a MPS of .10, the equilibrium GDP would (increase/decrease) by ($5/$10/$100) billion.

37. With a MPC of .75, “G” increases “G” & “T” by $8 billion. The equilibrium GDP (increases/decreases) by ($75/$32/$8) billion.

38. I f the “G” runs a budget surplus & desires to curb inflation, it should (give the surplus back to taxpayers/keep it in storage).

33. In a private-closed economy, the MPS is .2, AE C+I g “C”=Income at $200 billion, & the level of investment is $10 billion. The equilibrium C level of income at the new level is: 200 +10

($200/$210/$250) billion.

$200 ?

34. I f the MPS is .2 & the economy has a AE S AE2 recessionary spending gap of $5 bil., we can conclude that the equilibrium +5 AE1 level of GDP is ($5//$20/$25/$30)

billion below the full-employment GDP. YR ?

35. I f the MPS is .5 & the economy has an AE C inflationary[positive] spending gap of AE1 $6 billion, we can conclude that the AE2

equilibrium level of GDP is ($46/$12/$18) billion beyond the full-employment GDP.

Y* YI

NS 35 - 38NS 35 - 38

If G decreases G and T by $10 billion,

G increases G & T by $8 billion.

-6-6

36.

37.

38.

45°45°

1. Expansionary Expansionary fiscal policyfiscal policy will be most effective [increase GDP] when the AS curve is (vertical/horizontal)

& (incr/decr) “C” and (incr/decr) unemployment.

2. The paradox of thriftparadox of thrift indicates that an increase in saving (matched/ unmatched) by an increase in investment will lower equilibrium GDP.

3. A contractionary fiscal policycontractionary fiscal policy [decr G, incr Tdecr G, incr T] would cause a[an] (incr/decr) in output[GDP] and a[an] (incr/decr) in interest rates. An expansionary fiscal policyexpansionary fiscal policy [incr G, decr Tincr G, decr T] would cause a[an] (incr/decr) in output[GDP] and a[an] (incr/decr) in interest rates.

4. In the AE model, if AE[AD]doesn’t buy up FE output(GDP)AE[AD]doesn’t buy up FE output(GDP), then the equilibrium output is (less than/more then) full employment output.

Fiscal Policy Test Review 1-4Fiscal Policy Test Review 1-4

[G ; LFM ; In. Rates ][G ; LFM ; In. Rates ]

[G ; LFM ; In. Rates ][G ; LFM ; In. Rates ]

G G $2 Tr.$2 Tr. T T $2 Tr$2 Tr..[On #3, start froma balanced budget]

““Recessionary Gap”Recessionary Gap” ““Inflationary Gap”Inflationary Gap”

5. To decrease AD the greatest amountdecrease AD the greatest amount, the government should: (decrease “G” only/increase “T” only/both decr G & incr T)6. To increase AD the greatest amount, the “G” should: (increase “G” only/increase “T” only/both incr G and decr T)7. In a recessionaryrecessionary gapgap (AE model) at the equilibrium point[actualequilibrium point[actual GDP]GDP] planned investmentplanned investment is (greater than/equal to/less than) savingsaving,, but at the FEFE GDP levelGDP level, planned investment[backup] is (greater than/equal to/less than) savingsaving.8. In an inflationaryinflationary gapgap(AE model), at the equilibrium point [actual GDP]

planned investment [backup] is (greater than/equal to/less than) saving, but at the FE level, planned investment is (greater than/equal to/less than) saving.9. If businesses are experiencing an unplanned increase in inventoriesunplanned increase in inventories, AE is (less than/greater than) FE output & spendingFE output & spending will (increase/decrease).10. If businesses are experiencing an unplanned decrease in inventoresunplanned decrease in inventores [disinvestmentdisinvestment] AE is (less than/greater than) FE output & spendingFE output & spending will (increase/decrease)

11. If “C” equals income at $500 billion“C” equals income at $500 billion, & MPC is .9MPC is .9, then an increase in Ig of $10 billion will change equilibrium GDP to ($400/$490/$510/$600) billion.12. A conservative conservative economisteconomist would want tax (incr/decr) during a recessionrecession & (incr/decr) in “G” during inflationary timesinflationary times.13. A liberal economistliberal economist would want tax (incr/decr) during an inflationinflation & (incr/decr) in “G” during recessionary periodsrecessionary periods.14. An inflationary gapinflationary gap indicates AE[actual GDP] (exceeds/falls short of) FE GDP.

15. A recessionary gaprecessionary gap indicates AE[actual GDP] (exceeds/falls short of) FE GDP.

16. To increase GDP[but reduce military spending]increase GDP[but reduce military spending], we would combine two (domestic/overseas) bases into one (domestic/overseas) base.17. A tax cut to expand the economytax cut to expand the economy would (incr/decr) Y & (incr/decr) in. rates.18. A tax increase to contract the economytax increase to contract the economy would (incr/decr) Y & (incr/decr) IR.

500500

500500

19.To increase equilibrium GDP by increase equilibrium GDP by $400,000$400,000, with a MPC of .5, a Keynesian economist would (decrease “T”/increase “G”) by $200,000.

20. Assume equilibrium GDP is equilibrium GDP is $500$500 billion billion & MPS is .4. Now “G” collects taxes of of “G” collects taxes of of $22$22 billion and spends billion and spends the entire amountthe entire amount. As a result, equilibrium GDP will change to: ($445/$478/$522/$555).21. With a MPC of .5MPC of .5, a $12 billion$12 billion increase in “G” will increaseincrease “C” “C” by ($12/$24/$36) bil.

22. With a MPC of .5MPC of .5 and the economy in a recessionaryrecessionary spending gapspending gap of of $$1212 billion billion, we may conclude that the equilibrium is ($12/$24/$36) billion short of FE GDPshort of FE GDP.

Test Review 19-22Test Review 19-22

Test Review – AE & Fiscal PolicyTest Review – AE & Fiscal Policy23. An increase in Igincrease in Ig of $25Bof $25B results in an increase in

equilibrium income(GDP) of $50B, so the MPS is?24. A contractionary fiscal policycontractionary fiscal policy results in a(n) (incr/decr) in

output, and a(n) (incr/decr) in interest rates.

25. Increasing T &/or decreasing GIncreasing T &/or decreasing G will (increase/decrease) consumption, and (increase/decrease) unemployment.

26. With a MPC of .5.5, and the economy with an inflationaryinflationary GDP GGDP Gapap of $50B, G could eliminate this inflationaryinflationary GDP GDP GGapap by reducing government spendingreducing government spending by?

27. With a MPC of .5.5 & current output at $500 bil. but FEcurrent output at $500 bil. but FE output is $700 biloutput is $700 bil., correct fiscal policy would be to (increase G/decrease T) by $100 billion.

.5.5

$25 bil.$25 bil.

[Incr T or Decr G][Incr T or Decr G]

Test Review – AE & Fiscal PolicyTest Review – AE & Fiscal Policy28. An increase in Igincrease in Ig in an economy

(incr)/decr) GDP & (incr/decr) C.

29. In a recessionary economyrecessionary economy, at at FE GDPFE GDP,

savingsaving is (less than/more than) Ig.

30. In a recessionary economyrecessionary economy, (actual Y/

potential Y) exceeds (actual Y/potential Y).

31. In a mixed-closed economymixed-closed economy (no Xnno Xn), the leakagesleakages are?

and the injectionsinjections are?

32. If the economy has an inflationary Gapinflationary Gap, at FE GDPat FE GDP,

savingsaving (exceeds/is less than) planned investment.

33. If there is an equal increase in Gequal increase in G&&T of $25 bilT of $25 bil., then outputoutput will (incr/decr) & interest ratesinterest rates [based on PL][based on PL] will (incr/decr).

[S & T][S & T] [G & Ig][G & Ig]

The EndThe End

E-conE-conE-conE-con

Review for Review for AE and Fiscal AE and Fiscal

PolicyPolicy

TheThe MMEE,, M MTT,, & & MMBBBB MultipliersMultipliersMME[G, Ig, E[G, Ig, or or Xn] = Xn] = 1/MPS = 1/.25 = 41/MPS = 1/.25 = 4So, G increaseincrease of $20 bil. will incr Y by $80 bil. [$20x4=$80]And a G decreasedecrease of $20 bil. will decrease Y by $80 bil. [-$20x4=-$80 bil.]

MMT = T = MPC/MPSMPC/MPS = . = .75/.25 = 375/.25 = 3So, T decreasedecrease of $20 bil. will incr Y by $60 bil. [$20 x 3=$60]And a T increaseincrease of $20 bil. will decr Y by $60 bil. [-$20x3=-$60]

MMBB = BB = 11So, an increaseincrease in G&T of $20 bil. will incr Y by $20 bil. [$20x1=$20]

And a decreasedecrease in G&T of $20 bil. will decr Y by $20 bil.[-$20x1=-$20]

Any increase in expendituresincrease in expenditures x the M will increase GDPincrease GDP.Any decreasedecrease in in expendituresexpenditures x the M will decrease GDPdecrease GDP.

AE

AE

[[ CC ++

Ig

Ig

]] (b

illion

s o

f d

ollars

)

o45

o

CConsumptiononsumption

C + IC + Igg

Ig = $20 BillionEquilibriumEquilibrium

Real domestic product, GDP (billions of dollars)370 390390 410 430 450 470470 490 510 530 550

Equilibrium GDP Equilibrium GDP afterafter $20 bil. Ig [MPC=.75] $20 bil. Ig [MPC=.75]AE[C+Ig] [AE[C+Ig] [“Basic”“Basic” or or “Simple”“Simple” economy] economy]

C =$450 Billion

$530

510

490

470470

450

430

410

390390

370+ 2

0 Ig

+ 20 Ig

+80+80

S

PrivatePrivate ClosedClosed

AE [

C+

Ig]

AE [

C+

Ig] (

billion

s o

f d

ollars

)

o45

o

Consumption

C + Ig+XnC + Ig+Xn

IIg g = $20 = $20 BillionBillion

EquilibriumEquilibrium

Real domestic product, GDP (billions of dollars) 370 390390 410 430 450 470470 490 510 530 550

(C[450] + Ig[20] +M[10] + X[10] = GDP)Equilibrium GDP after X of $10 & M of $10Equilibrium GDP after X of $10 & M of $10

C = $450 BillionC = $450 Billion

$530

510

490

470470

450

430

410

390390

370

SPrivatePrivate OpenOpen

ADDING THE PUBLIC SECTORADDING THE PUBLIC SECTOR[“ ”][“ ”]

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

390390 470470 550550

ConsumptionC + Ig + Xn

C + IC + Ig g + X+ Xn n + G+ GGovernmentGovernmentSpending ofSpending of$20 Billion$20 Billion

$20 $20 Billion GovernmentBillion Government Purchases and Equilibrium GDP Purchases and Equilibrium GDPS

Mixed - OpenMixed - OpenPrivate-public - ROW

$20 bil. on National Defense

$20 bil. incr in T$20 bil. incr in T[-$20 x 3 = -$60][-$20 x 3 = -$60]

ADDING THE PUBLIC SECTOR[“ ”]ADDING THE PUBLIC SECTOR[“ ”]Incr. T by $20 bil.[Incr. T by $20 bil.[MMT = T = 33] Equilibrium GDP[-60]] Equilibrium GDP[-60]

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

550

C + Ig + Xn + G

CCaa + I + Ig g + X+ Xn n + G+ G

490490

SS

Mixed-OpenMixed-OpenPrivate–public-ROWPrivate–public-ROW

$20 billion$20 billion

BBalancedalanced BBudget [$2 Tudget [$2 Tril. ril. “G”=$2 T“G”=$2 Tril. ril. “T”]“T”]

$2 $2 TrillionTrillion $2 $2 TrillionTrillion

GG TT

RecessionRecessionIncr G to $2.2 Incr G to $2.2

or or

Decr T to $1.8 Decr T to $1.8

DeficitDeficit so sohigher I.R.higher I.R.

InflationInflationDecr G to $1.8Decr G to $1.8

or or

Incr T to $2.2Incr T to $2.2

Surplus Surplus sosoLower I.R.Lower I.R.

BudgetBudget

So expansionary fiscal policySo expansionary fiscal policyleads to leads to higher interest rateshigher interest rates.. DeficitDeficit

Wow! AWow! Asurplussurplus

So, contractionary fiscal policySo, contractionary fiscal policy

leads to leads to lower interest rateslower interest rates..

Gonna have Gonna have to borrowto borrow

Test Review – AE & Fiscal PolicyTest Review – AE & Fiscal Policy1. An increase in Igincrease in Ig of $75Bof $75B results in an increase in

equilibrium income(GDP) of $300B$300B, so the MPS is?2. An expansionary fiscal policyexpansionary fiscal policy results in a(n) (incr/decr) in

output, and a(n) (incr/decr) in interest rates.

3. Increasing T &/or decreasing GIncreasing T &/or decreasing G will (increase/decrease) consumption, and (increase/decrease) unemployment.

4. With a MPC of .75.75, and the economy with an inflationaryinflationary GDP GGDP Gapap of $80B$80B, G could eliminate this positive equilibriumpositive equilibrium GDP GGDP Gapap by reducing government spendingreducing government spending by?

5. With a MPC of .60.60 & current output at $650 bil. but FEcurrent output at $650 bil. but FE output is $700 biloutput is $700 bil., correct fiscal policy would be to (increase G/decrease T) by $20 billion.

.25.25

$20 bil.$20 bil.

[Decr T or Incr G][Decr T or Incr G]

$2 Tr.$2 Tr. $2 Tr.$2 Tr.

GG TT

Test Review – AE & Fiscal PolicyTest Review – AE & Fiscal Policy6. An increase in Igincrease in Ig in an economy will

(incr)/decr) GDP and (incr/decr) C.

7. In a recessionary economyrecessionary economy, at at FE GDPFE GDP,

saving is (less than/more than) Ig.

8. In an inflationary economyinflationary economy, (actual Y/

potential Y) exceeds (actual Y/potential Y).

9. In the complex complex economyeconomy (C+Ig+G+IgC+Ig+G+Ig), the leakagesleakages are?

and the injectionsinjections are?

10. If the economy has an inflationary Gapinflationary Gap, at FE GDPat FE GDP,

saving (exceeds/is less than) planned investment.

11. If there is an equal increase in G&T of $10 bilequal increase in G&T of $10 bil., then

output will (incr/decr) & interest rates will (incr/decr).

[S, T, & M][S, T, & M] [G, Ig, X][G, Ig, X]

1. At income level “OT”“OT”, the volume of consumptionconsumption is _____.2. At income level “OT“OT””, the volume of savingsaving is _____.3. The “APC”“APC” is equal to “1” at income level _____.4. If Ig is Ig1Ig1, then “equilibrium GDP”“equilibrium GDP” is _____.5. If Ig is Ig2Ig2, then “equilibrium GDP”“equilibrium GDP” is _____.6. If Ig increases from Ig1Ig1 to Ig2Ig2, equilibrium GDPequilibrium GDP increases by _____.7. If Ig increases from Ig1Ig1 to Ig2Ig2, the “MPC”“MPC” is equal to __________.8. As we move from income level OVOV to OUOU, the “MPS”“MPS” is ________.9. The economy is “dissaving”“dissaving” at income level _____.10. Consumption will be equal to incomeConsumption will be equal to income at income level _____.

TCTCCFCF

OVOVOUOUOTOT

UTUTBC/UTBC/UT

AEAE//VUVUOWOW

OVOV

W W V V UU TT

BBAA

00

AE

(C

+Ig

)A

E (

C+

Ig)

AE (C+Ig2)AE (C+Ig2)AE (C+Ig1)AE (C+Ig1)ConsumptionConsumption

FF

EE DDCC

Real GDPReal GDP

[Revised]

45°45°