Macroeconomic Policy

14

Fiscal Policy & Monetary policy

14-1

Main points

Economic objectiveDiscretionary Fiscal policy Fiscal Policy InstrumentsThe Crowding Out Effect Automatic stabilizersMultiplier

Economic objective

Full employment

Price stabilization

Economic growth

International payment balance

Stabilization policy

• Stabilization policy describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible.

Tax rates are controlled by the government, but tax revenue depends on changes in household income and the size of corporate profits, which the government cannot control.

Discretionary fiscal policy refers to changes in taxes or spending that are the result of deliberate changes in government policy.

Government in the Economy

Fiscal Policy -- the Federal government changing its government position (G , T) in order to stabilize the economy.

Fiscal Policy, by its nature, alters the Federal Budget. This chapter also examines the Federal Budget, what it’s made up of, and when budget deficits can be a problem in the economy.

Fiscal Policy

Fiscal Policy Instruments

Government Revenues

Taxes

Public BondsGovernment Expenditures

Government purchase

Transfer payment

Government Expenditure

Social SecurityLaw and OrderEmergency

ServicesHealthEducationDefenceForeign Aid

EnvironmentAgricultureIndustryTransportRegionsCulture, Media and

Sport

The Federal Budget

Federal Budget (or Budget) = Tax Revenues - Government Expenditure (over a given period).

Federal Budget (or Budget) = Tax Revenues - (Government Purchases of Goods and Services + Transfer Payments + Interest on the National Debt).

Budget Definitions

Budget < 0 -- Budget DeficitBudget > 0 -- Budget SurplusBudget = 0 -- Balanced Budget

Realistic Goal -- Balanced Budget when Y = YF.

The US Federal Budget: 2003 (Billions of Dollars)

Tax Revenues $1877.0Government Expenditure $2241.6Federal Budget -$364.6

Source: Economic Indicators, September 2004.

Breakdown of Tax Revenues

Personal Income Taxes = $775.8Corporate Profits Taxes = $191.4Taxes on Production and Imports (e.g. sales and excise taxes) = $89.4Contributions for Social Insurance = $758.2Other = $62.2

Breakdown of Government ExpenditurePurchases of Goods and Services (G) = $658.6Transfer Payments = $1322.5Interest Payments = $214.1Other = $46.4

Source: Economic Indicators, September 2004.

The Budget: In A Notation

Recall variable definitions: -- T = net taxes = tax revenues - (transfer payments + interest on the national debt) -- G = government purchases of goods and services

The Budget and Budget Position

Budget = T - GBudget Position (or size of deficit)

= G - T

The National Debt

The National Debt -- The total accumulated stock of debt owed by the government to its lenders (holders of government bonds).

Expanded by budget deficitsreduced by budget surpluses.

National Debt -- Realistic Goal

Realistic Goal -- consider the

Debt-Income Ratio =

(National Debt)/(GDP).For the US in 2003 =

($3913.6)/($11004.0) = 0.356. Information Source: Economic Indicators, September

2004.

The Income Tax and Automatic Stabilization

Automatic Stabilization -- due to the income tax system, tax revenues change in directions that help to stabilize the economy, without any change in the tax structure (I.e. fiscal policy).

Automatic Stabilizers

Automatic stabilizers smooth fluctuations in disposable income over the business cycle, thereby boosting aggregate demand during periods of recession and dampening aggregate demand during periods of expansion

Two good examples of automatic stabilizers Progressive income tax Unemployment compensation

Progressive Income TaxThe progressive income tax relieves some

of the inflationary pressures that might otherwise arise when output increases above its potential during an economic expansion

Conversely, when the economy is in a recession, real GDP declines but taxes decline faster, so disposable income does not fall as much as real GDP it cushions declines in disposable income, in consumption, and in aggregate demand

The Income Tax as an Automatic Stabilizer

Y* (maybe > YF) Tax Revenues

helps to cool the economy

Y* (maybe < YF) Tax Revenues

helps to stimulate the economy

Note -- all this takes place without any change in the tax structure, as prescribed by fiscal policy.

Unemployment Insurance-TR

During an economic expansion, unemployment insurance taxes flow from the income stream into the insurance fund, thereby moderating aggregate demand

During a recession, unemployment payments automatically flow from the insurance fund to those who have become unemployed increasing disposable income and consumption

The Income Tax and the Federal Budget

Y* Tax Revenues T (T - G)A strong and growing economy improves the

budget.

Y* Tax Revenues T (T - G) A weak economy generates a lower budget.

Strategy of Fiscal Policy

Expansionary policies seek to induce more

purchasing of goods and services by increasing

(G - T) -- i.e. G or T.Contractionary policies seek to induce less

purchasing of goods and services by decreasing

(G - T) -- i.e. G or T.

Specific Types of Fiscal Policy

Change Government Purchases of Goods and Services (G)

-- Expansionary: G -- Contractionary: GChange Transfer Payments (Tr)

-- Expansionary: Tr -- Contractionary: Tr

Tax Policy as Fiscal PolicyChange Marginal Tax Rates (t)

-- Expansionary: t -- Contractionary: t

Change Tax Deductions -- Expansionary: Bigger Deductions

-- Contractionary: Smaller DeductionsChange Indirect Business Taxes (e.g. Sales or Excise

Taxes) -- Expansionary: Lower Taxes -- Contractionary: Raise Taxes

Fiscal Policy in the AD-AS Model

Expansionary Fiscal Policy shifts the AD

curve rightward, increases Y* and P*.

Contractionary Fiscal Policy shifts the AD

curve leftward, decreases Y* and P*.

Note -- like monetary policy, fiscal policy is

justified only from a short-run perspective.

Obstacles to Fiscal Policy Effectiveness

Difficulties in getting the proper policy passed through Congress and the president.

A tax cut that isn’t used for spending. AD curve does not shift rightward, no change in Y*.

Worries about the Federal Budget within a sluggish economy.

The Crowding Out Effect -- An Adverse “Side Effect”

The Crowding Out Effect -- Expansionary fiscal policy creates an increased demand for more borrowing by the government. This financing increases the demand for financial capital. As a result, long-term interest rates (r*) rise and Investment (I*) decreases.

The Crowding Out Effect -- Fiscal Policy Effectiveness

Crowding Out Effect -- makes fiscal policy

less effective than would be otherwise.

Decrease in investment to some extent offsets Decrease in investment to some extent offsets

rise in (G - T).rise in (G - T).

Smaller shift in AD curve than would be

without the crowding out effect.

The Crowding Out Effect – Impeding Economic Growth

Crowding Out Effect loss of Investment (I).Decrease in Investment retards the buildup of the

capital stock and possible implementation of new technology (i.e. Labor Productivity).

Smaller shifts in LAS curve, smaller increases in YF.

Ways to Avoid the Crowding Out Effect

Bottom line -- get the supply of financial capital to shift rightward at the same time as when expansionary fiscal policy occurs.

-- expansionary monetary policy -- increased private saving -- increase in foreign capital inflows

Distinctive Fiscal Policy Actions in the USWorld War IIThe Kennedy-Johnson Tax Cut of 1964The Nixon Tax Increase of 1969The Reagan Economic Recovery and Tax Act

of 1981Clinton Tax Increases of 1993Bush Tax Cuts of 2001-02?

The Federal Government Surplus/Deficit as a Percentage of GDP, 1970 I2000 IV

The Federal Government Debt as a Percentage of GDP, 1970 I2000 IV

The percentage began to fall in the mid 1990s.

Fiscal Policy Since 1990

The average tax rate rose sharply under President Clinton and fell sharply under President Bush.

The deficit is a concern when tax rates are falling and spending is rising.

Federal Personal Income Taxes as a Percent of Taxable Income, 1990 I-2003 II

Federal Government Consumption Expenditures as a Percent of GDP, 1990 I-2003 II

Federal Transfer Payments and Grants-in-Aid as a Percent of GDP, 1990 I-2003 II

Federal Interest Payments as aPercent of GDP, 1990 I-2003 II

The Government Spending Multiplier

The government spending multiplier is the ratio of the change in the equilibrium level of output (GDP) to a change in government spending.

government spending multiplier

=1/(1-MPC)

边际消费倾向 MPC=△C/△Y

The Government Spending Multiplier

Finding Equilibrium After a $50 Billion Government Spending Increase(All Figures in Billions of Dollars; G Has Increased From 100 in Table 25.1 to 150 Here)

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

OUTPUT(INCOM

E)Y

NETTAXE

ST

DISPOSABLE

INCOMEYd Y T

CONSUMPTION

SPENDING(C = 100 + .75 Yd)

SAVINGS

(Yd – C)

PLANNEDINVESTME

NTSPENDING

I

GOVERNMENT

PURCHASESG

PLANNEDAGGREGAT

EEXPENDIT

URE C + I + G

UNPLANNED

INVENTORY

CHANGEY (C + I +

G)

ADJUSTMENT

TODISEQUILIBR

IUM

300 100

200 250 50 100 150 500 200 Output

500 100

400 400 0 100 150 650 150 Output

700 100

600 550 50 100 150 800 100 Output

900 100

800 700 100 100 150 950 50 Output

1,100

100

1,000

850 150 100 150 1,100 0 Equilibrium

1,300

100

1,200

1,000 200 100 150 1,250 + 50 Output

The Tax Multiplier

A tax cut increases disposable income, which is likely to lead to added consumption spending. Income will increase by a multiple of the decrease in taxes.

However, a tax cut has no direct impact on spending. The tax multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

The Tax Multiplier

YM P S

( in itia l in c rease in ag g reg a te ex p en d itu re )

1

Y T M P CM P S

TM P C

M P S

( )

1

T ax m ultipM P C

M P Slier

Appendix B:The government spending and tax multipliers

The government spending and tax multipliers are derived algebraically as follows:Y C I G

C a b Y T ( )

Y Y Td T T 0

I I 0

G G 0

Y a b Y T I G ( )Y a bY bT I G Y bY a bT I G Y b a bT I G( )1

Yb

a bT I G* ( )

1

1multiplier value of autonomous

expenditures

Yb b t

a bT I G

1

1 0( )

Appendix A:The government spending and tax multipliers

The government spending and tax multipliers when taxes are a function of income are derived as follows:

Y C I G C a b Y T ( )

Y Y Td

I I 0

G G 0

T T tY 0

Y a bY bT btY I G 0

Y bY btY a bT I G 0

Y b b t a bT I G( )1 0

multiplier value of autonomous expenditures

The Balanced-Budget Multiplier

The balanced-budget multiplier is the ratio of change in the equilibrium level of output to a change in government spending where the change in government spending is balanced by a change in taxes so as not to create any deficit.

However, a tax cut has no direct impact on spending. The tax multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

Appendix A: The Balanced-Budget Multiplier

If we combine the effects of the government spending multiplier and the tax multiplier, we obtain:

Y

G M P S=

1and

Y

T

M P C

M P S

Taxmultiplier

Multiplier ofgovernmentspending

11

M P S

M P C

M P S

M P S

M P S

• In words, a simultaneous increase in government In words, a simultaneous increase in government spending by $1 and lump-sum taxes by $1 will spending by $1 and lump-sum taxes by $1 will increase equilibrium income by $1.increase equilibrium income by $1.

then:

The Balanced-Budget Multiplier

Finding Equilibrium After a $200 Billion Balanced Budget Increase in G and T(All Figures in Billions of Dollars; G and T Have Increased From 100 in Table 25.1 to 300 Here)

(1) (2) (3) (4) (5) (6) (7) (8) (9)

OUTPUT(INCOM

E)Y

NETTAXES

T

DISPOSABLE

INCOMEYd Y T

CONSUMPTION

SPENDING(C = 100 + .75 Yd)

PLANNEDINVESTME

NTSPENDING

I

GOVERNMENT

PURCHASESG

PLANNEDAGGREGAT

EEXPENDITU

RE C + I + G

UNPLANNED

INVENTORY

CHANGEY (C + I +

G)

ADJUSTMENTTO

DISEQUILIBRIUM

500 300 200 250 100 300 650 150 Output700 300 400 400 100 300 800 100 Output900 300 600 550 100 300 950 50 Output1,10

0300 800 700 100 300 1,100 0 Equilibriu

m

1,300

300 1,000 850 100 300 1,250 + 50 Output

1,500

300 1,200 1,000 100 300 1,400 + 100 Output

Fiscal Policy MultipliersSummary of Fiscal Policy Multipliers

POLICY STIMULUS MULTIPLIER

FINAL IMPACT ON

EQUILIBRIUM Y

Government-spendingmultiplier

Increase or decrease in thelevel of governmentpurchases:

Tax multiplier

Increase or decrease in thelevel of net taxes:

Balanced-budgetmultiplier

Simultaneous balanced-budgetincrease or decrease in thelevel of government purchasesand net taxes:

1

1

M P S

M P C

M P S

GM P S

1

TM P C

M P S

G

The Federal BudgetFederal Government Receipts and Expenditures, 2000 (Billions of Dollars)

AMOUNT

PERCENTAGE

OF TOTALReceipts

Personal taxes 774.4 44.9Corporate taxes 211.9 12.3Indirect business taxes 91.3 5.3Contributions for social insurance 645.9 37.5

Total 1,723.4 100.0Current Expenditures

Consumption 463.8 26.5Transfer payments 795.5 45.4Grants-in-aid to state and local governments 224.2 12.8Net interest payments 230.3 13.1Net subsidies of government enterprises 38.4 2.2

Total 1,752.2 100.0Current Surplus (+) or deficit () (Receipts Current Expenditures)

28.8

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

The Tools of Monetary Policy

Open market operationReserve ratioDiscount rate

Monetary Policy

★ Open market operation

Easy Monetary Policy Buying Securities from commercial

banks Bank gives up securities FED pays bank Bank have increased reserveBuying securities from public Public gives up securities Public deposit notes in the bank Bank have increased reserve

• The Tools of Monetary Policy

The Tools of Monetary Policy

Tight Monetary PolicySelling Securities to

commercial banks FED gives up securities Bank pays for securities Bank have decreased reserveSelling securities to public FED gives up securities Public pays by check from bank Bank have decreased reserve

The Tools of Monetary Policy

Raising The Reserve Ratio Bank must hold more reserve Bank decreasing lending Monetary supply decreasing

Lowering The Reserve Ratio Bank must hold less reserve Bank increasing lending Monetary supply increasing

★ Discount Rate

★ The Reserve Ratio

Easy Monetary Policy

Buying securitiesLowering reserve ratioLowering discount rateTight Monetary PolicySelling securitiesRaising reserve ratioRaising discount rate

The Federal reserve

Assets Securities Loans to commercial bankLiabilities Reserves of the commercial

banks Treasury deposits Federal reserve notes

Time Lags RegardingMonetary and Fiscal Policy

Time lags are delays in the economy’s response to stabilization policies.

Two Possible Time Paths for GDP

Path A is less stable—it varies more over time—than path B. Other things being equal, society prefers path B to path A.

Stabilization: “The Fool in the Shower”

Attempts to stabilize the economy can prove destabilizing because of time lags.

Milton Friedman likened these attempts to a “fool in the shower.” The government is constantly stimulating or contracting the economy at the wrong time.

Stabilization: “The Fool in the Shower”

An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing.

Stabilization: “The Fool in the Shower”

Hence, the policy pushes the economy to points F’ and G’ (instead of F and G). Income varies more widely than it would have if no policy had been implemented.

Recognition Lags

The recognition lag refers to the time it takes for policy makers to recognize the existence of a boom or a slump.

Implementation Lags

The implementation lag is the time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump.

The implementation lag for monetary policy is generally much shorter than for fiscal policy.

Response Lags

The response lag is the time it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself.

The delay in the multiplier of government spending occurs because neither individuals nor firms revise their spending plans instantaneously.

Macroeconomic Policy

Sustainable Growth

Consistency

CommitmentClarity

Coordination

Cooperation

Economic Stability

Coordination between Monetary and Fiscal Policy

Questions

What are targets of economic polices?What are the instruments of fiscal policy?How does the automatic stabilizer work?Why the fiscal policy has the crowding out

effect to private investment? What are the multipliers of Government

spending, taxes, balanced budget?