Fiscal Policy a tool to help manage the Macro Economy Expansionary and contractionary policy Deficits and Surpluses Crowding out effect Built-in-Stability Problems of Fiscal Policy Forecasting the future Please listen to the audio as you work through the slides.

Learning objectives Students should be able to thoroughly and completely explain: Discretionary and Non-discretionary Fiscal Policy The key elements of non-discretionary fiscal policy and how they interact to support the policy. Expansionary fiscal policy and the 3 tools that support it. Contractionary fiscal policy and the 3 tools that support it. The issues associated with deficit financing. The 4 problems associated with Fiscal Policy. The impact of the net export effect and the crowding out effect on the effectiveness of discretionary fiscal policy. How to use Fiscal Policy to address the problems of Inflation and Recession.

Legislative Mandates Employment Act of 1946 Council of Economic Advisors (CEA) US Congress Joint Economic Committee (JEC)

Expansionary Fiscal Policy Fiscal Policy and the AD-AS Model Two Options : Discretionary Fiscal Policy (action) Non-Discretionary Fiscal Policy (no action) Expansionary Fiscal Policy To Reduce Unemployment… Increase Government Spending Tax Reductions Combinations of the Two

Expansionary Fiscal Policy Recessions Decrease Aggregate Demand $5 Billion Additional Spending AS Price Level Full $20 Billion Increase in Aggregate Demand P1 AD1 AD2 $490 $510 Real Domestic Output, GDP

FISCAL POLICY AND THE AD-AS MODEL Contractionary Fiscal Policy To Reduce Inflation… Decrease Government Spending Tax Increases Combinations of the Two

Contractionary Fiscal Policy $3 Billion Initial Decrease In Spending Reduce Demand Pull Inflation AS Price Level Full $12 Billion Decrease in Aggregate Demand P1 P2 AD4 AD3 $510 $522 Real Domestic Output, GDP

Fiscal Policy - Deficits and Surpluses Relative to the Federal budget A deficit represents spending in excess of tax revenues. A surplus represents tax revenues in excess of government spending. Expansionary fiscal policy – think deficit Contractionary fiscal policy – think surplus Which policy to use – G or T? Depends on whether one feels government is too large or too small.

Fiscal Policy – Financing Deficits Borrowing vs. New Money Borrowing from the public – Federal Government sells bonds which could lead to higher interest rates The Fed selling bonds increases the supply of bonds in the market and causes the price of bonds to drop. Bond prices and their interest rates are inversely related. The interest rates on bonds go up. Lower investment spending results, and Weakens the expansionary action. This is called the “crowding out effect” Money Creation by the Federal Reserve System - minimal crowding out effect More expansionary approach

Crowding Out A Large Public Debt to Finance Public Investment Will Cause… 2 4 6 8 10 12 14 16 If Public Spending Spurs More Private Investment, ID Will Increase to ID2 b c Real Interest Rate (Percent) a Interest Rate Rise Will Decrease Investment From a to b Crowding- Out Effect ID2 ID1 5 10 15 20 25 30 35 40 Investment (Billions of Dollars)

Disposing of Surpluses – impact on GDP Debt Retirement vs. Idle Surplus Debt Reduction – Federal Government buys bonds, which could lead to lower interest rates. The Fed buying bonds increases the demand for bonds and causes the price of bonds to rise. Bond prices and their interest rates are inversely related. The interest rates on bonds go down. Investment spending increases and reduces anti-inflationary impact of the surplus Impounding the surplus – hold the money

Federal Budget Balance Actual and Projected, Fiscal 1994-2014 Actual Projected (as of March 2008) $300 200 100 -100 -200 -300 -400 -500 Budget Deficit (-) or Surplus, Billions 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Built-in Stability Net tax revenues vary directly with GDP Transfer payments behave the opposite way as tax collections Unemployment compensation and welfare payments decrease during expansions and increase during contractions.

Built-in Stability Automatic or Built-In Stabilizers Anything that increases the government’s budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policymakers. Economic Importance Taxes reduce spending and aggregate demand Reductions in spending are desirable when the economy is moving toward inflation Increases in spending are desirable when the economy is heading toward recession. Accomplishing these results automatically is important

Built-in Stability – key relationships Surplus Government Expenses, G and Tax Revenues, T G Deficit GDP1 GDP2 GDP3 Real Domestic Output, GDP

Built-in Stability Tax Progressivity Progressive Tax System Average tax rate (tax revenue/GDP) rises with GDP Proportional Tax System Average tax rate remains constant as GDP changes Regressive Tax System Average tax rate falls with GDP The more progressive the tax system, the greater the economy’s Built-in Stability.

Political Business Cycles Fiscal Policy – 4 Issues Problems, Criticisms, and Complications Problems of Timing Recognition Lag (9 to 12 months) Administrative Lag (9 to 12 months) Operational Lag (depends) Political Considerations Political Business Cycles Getting re-elected versus doing the right thing for the country Offsetting State & Local Finance States must balance their budgets – Federal govt. does not Crowding-Out Effect

Fiscal Policy: the effects of crowding out and the net export effect AS Fiscal Policy: No Complications P1 Price level AD1 AD2 $490 $510 Real GDP (billions)

Fiscal Policy in the Open Economy – The Net Export Effect Problem Recession: Expansionary fiscal policy with deficit financing Higher US interest rate Higher foreign demand For dollars Dollar appreciates Net exports decline(aggregate Demand decreases, partially Offsetting the expansionary Fiscal policy), Problem Inflation: Contractionary fiscal policy Lower US interest rates (less borrowing) Lower foreign demand for dollars Dollar depreciates Net exports increase (aggregate Demand increases, partially offsetting

Fiscal Policy: the effects of crowding out and the net export effect Showing Crowding-out Effect – interest rate increases or Net Export Effect – interest rate increases, attracting foreign capital, dollar appreciates, net exports fall AS P1 Price level AD1 AD’2 AD2 $490 $510 $504 Real GDP (billions)

Forecasting the Future The Leading Indicators Average Workweek Initial Claims for Unemployment Insurance New Orders for Consumer Goods Vendor Performance New Orders for Capital Goods Building Permits for Houses Money Supply Interest-Rate Spread Consumer Expectations

KEY TERMS fiscal policy Employment Act of 1946 Council of Economic Advisers (CEA) expansionary fiscal policy budget deficit contractionary fiscal policy budget surplus built-in stabilizer progressive tax system proportional tax system regressive tax system full-employment budget cyclical deficit political business cycle crowding-out effect net export effect