F ISCAL P OLICY

T HE C AR A NALOGY The economy is like a car… You can drive 120mph but it is not sustainable. (Extremely Low unemployment) Driving 20mph is too slow. The car can easily go faster. (High unemployment) 70mph is sustainable. (Full employment) Some cars have the capacity to drive faster then others. (industrial nations vs. 3 rd world nations) If the engine (technology) or the gas mileage (productivity) increase then the car can drive at even higher speeds. (Increase LRAS) The government often speeds up or slows down the economy by using fiscal and/or monetary policy. 2

How does the Government Stabilizes the Economy? The Government has two different tool boxes it can use: 1. Fiscal Policy- Actions by Congress to stabilize the economy. OR 2. Monetary Policy- Actions by the Federal Reserve Bank to stabilize the economy. 3 Copyright ACDC Leadership 2015

For now we will only focus on Fiscal Policy. 4 Copyright ACDC Leadership 2015

Laws that reduce inflation, decrease GDP (Close a Inflationary Gap) Decrease Government Spending Increase Taxes (Decreasing disposable income) Combinations of the Two Contractionary Fiscal Policy (The BRAKE) Laws that reduce unemployment and increase GDP (Close a Recessionary Gap) Increase Government Spending Decrease Taxes (Increasing disposable income) Combinations of the Two Expansionary Fiscal Policy (The GAS) 5 Copyright ACDC Leadership 2015

Discretionary vs Non-Discretionary Discretionary Fiscal Policy Congress creates a new bill that is designed to change AD through government spending or taxation. Ex: In a recession, Congress increase spending. Why might this be a difficult way to fix the economy? Recognition Lag – Takes time to identify a recession rather than just natural fluctuations Administrative Lag - Takes time for Congress to act. Operational Lag – Govt. spending usually spread over a period of time 6 Copyright ACDC Leadership 2015

Non-Discretionary Fiscal Policy AKA: Automatic Stabilizers Permanent spending or taxation laws enacted to work counter cyclically to stabilize the economy Ex: Welfare, Unemployment, Min. Wage, Tax progressivity Discretionary vs Non-Discretionary The more progressive the tax system, the greater the economy’s built-in stability. Why?

Three Types of Taxes 1. Progressive Taxes -takes a larger percent of income from high income groups (takes more from rich people). Example? Ex: Current Federal Income Tax system 3. Regressive Taxes –takes a larger percentage from low income groups (takes more from poor people). Example? Ex: Sales tax; any consumption tax. 2. Proportional Taxes (flat rate) –takes the same percent of income from all income groups. Example? Ex: 20% flat income tax on all income groups 8

30-9 T HE MORE PROGRESSIVE THE TAX SYSTEM, THE STEEPER THE TAX CURVE, AND THE MORE BUILT IN STABILITY G T Deficit Surplus GDP 1 GDP 2 GDP 3 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T Do you see any problems with this model in regard to the real world?

Price level Real GDP (billions) The government should increase spending which would increase AD How much? They should NOT spend $100 billion!!!!!!!!!! If they spend $100 billion, AD would look like this: AD 1 AD 2 What type of gap and what type of policy is best? What should the government do to spending? Why? How much should the government spend? P1P1 $400 $500 AS LRAS FE WHY? 10 Copyright ACDC Leadership 2015

The Multiplier Effect Let’s practice calculating the spending multiplier 11 Spending Multiplier OR Copyright ACDC Leadership 2015

Price level Real GDP (billions) Fiscal Policy Practice 1.What type of gap? 2.Contractionary or Expansionary needed? 3.What are two options to fix the gap? 4.What is the least amount of initial government spending to close gap? AD 2 AD 1 $10 Billion Congress uses discretionary fiscal policy to the manipulate the following economy (MPC =.8) P1P1 $50 $100 AS LRAS 12 Copyright ACDC Leadership 2015

Price level Real GDP (billions) Fiscal Policy Practice AD 1 AD P2P2 $80 $100 AS 1.What type of gap? 2.Contractionary or Expansionary needed? 3.What are two options to fix the gap? 4.How much needed to close gap? LRAS Congress uses discretionary fiscal policy to the manipulate the following economy (MPC =.5) -$10 Billion Copyright ACDC Leadership 2015

What about taxing? The multiplier effect also applies when the government cuts or increases taxes. But, changing taxes has less of an impact then government spending. Why? Expansionary Policy (Cutting Taxes) Assume the MPC is.75 so the multiplier is 4 If the government cuts taxes by $4 million how much will consumer spending increase? NOT 16 Million!! When they get the tax cut, consumers will save $1 million and spend $3 million. The $3 million is the amount magnified in the economy. $3 x 4 = $12 Million increase in consumer spending.14 Copyright ACDC Leadership 2015

Calculating the Tax Multiplier If the MPC is.75 how much is the tax multiplier? If the spending multiplier is 4, then the tax multiplier is only 3 But remember that an increase in taxes decreases GDP so the tax multiplier is negative. Total change in GDP = Tax Multiplier x Initial Change in Taxes Simple Tax Multiplier OR MPC x MPC MPS Copyright ACDC Leadership 2015

Price level Real GDP (billions) Cutting Tax Practice 1. What to options does the government have? 2. How much should they increase government spending? $10 Billion 3. How much should they cut taxes? AD 2 AD 1 -$20 Billion Congress uses discretionary fiscal policy to the manipulate the following economy (MPC =.5) P1P1 $80 $100 AS LRAS 16 Copyright ACDC Leadership 2015

F ISCAL P OLICY Which is preferable in response to a recessionary gap? Govt. Spending? Taxes? Which is preferable in response to an inflationary gap? Govt. Spending? Taxes? Why? 30-17