Copyright 2008 The McGraw-Hill Companies 11-1 Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show 11 Fiscal Policy, Deficits, and Debt O 11.1

Copyright 2008 The McGraw-Hill Companies 11-2 Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Chapter Objectives Purposes, Tools, and Limitations of Fiscal Policy Role of Built-In Stabilizers in Moderating Business Cycles How the Standardized Budget Reveals the Status of U.S. Fiscal Policy The Size, Composition, and Consequences of the U.S. Public Debt

Copyright 2008 The McGraw-Hill Companies 11-3 Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Fiscal Policy and the AD-AS Model Fiscal Policy-financial policy which achieves full employment, controls inflation and encourages economic growth. Council of Economic Advisers (CEA) –3 appointed by president to provide expertise and advise on economic issues Discretionary Fiscal Policy –Actions that promote change in the economy such as increasing taxes or increasing spending Nondiscretionary Fiscal Policy –Automatic changes to the economy based on policy-Passive or Automatic

Copyright 2008 The McGraw-Hill Companies 11-4 Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Fiscal Policy and the AD-AS Model Expansionary Fiscal Policy- instituted when decreases in GDP require fiscal or monetary changes to policy –Increased Government Spending –Tax Reductions –Some Combination of the Two If budget is balanced at onset of recession, Expansionary Fiscal Policy creates a Budget Deficit- –Government spending in excess of tax revenues

Copyright 2008 The McGraw-Hill Companies 11-5 Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Fiscal Policy and the AD-AS Model Real Domestic Output, GDP Price Level AD 2 Recessions Decrease Aggregate Demand AD 1 $5 Billion Additional Spending Full $20 Billion Increase in Aggregate Demand AS $490$510 P1P1 Expansionary Fiscal Policy

Copyright 2008 The McGraw-Hill Companies 11-6 Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Fiscal Policy and the AD-AS Model Contractionary Fiscal Policy used when Demand-Pull inflation occurs –Decreased Government Spending –Increased Taxes –Some Combination of the Two Budget Surplus-if budget is initially balanced, policy will cause an excess in tax revenue beyond government spending. G 11.1

Copyright 2008 The McGraw-Hill Companies 11-7 Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Fiscal Policy and the AD-AS Model Real Domestic Output, GDP Price Level AD 3 Recessions Decrease Aggregate Demand AD 4 $5 Billion Initial Decrease In Spending Full $20 Billion Decrease in Aggregate Demand AS $510$522 P1P1 Contractionary Fiscal Policy

Copyright 2008 The McGraw-Hill Companies 11-8 Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Policy Options: G or T? Most Preferred Policy? –View-Is government too small or too large? Government too Small –Expansionary beliefs-Government Spending used to meet unmet social or infrastructure needs –Contractionary-tax increases Government too Large/Inefficiant –Expansionary- Tax cuts for businesses –Contractionary-cuts in Government spending

Copyright 2008 The McGraw-Hill Companies 11-9 Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Built-In Stability Automatic or Built-In Stabilizers –Automatic changes to tax revenue as economy moves through business cycles which help in stabilizing the economy. –These Automatic or built-in responses to the economy act as non-discretionary budgetary policy –As GDP rises tax receipts increase, unemployment decreases –AS GDP declines, tax receipts fall and transfer payments increase such as unemployment compensation and welfare payments

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Built-In Stability G T Deficit Surplus GDP 1 GDP 2 GDP 3 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Tax Progressivity Progressive Tax System Progressive Tax System (Federal Income Tax)- steepness of the T depends on the depth of the marginal tax rates but as GDP rises so do tax revenues Proportional Tax System (Property Tax) - average tax rate remains constant as GDP rises however will increase tax revenue as GDP grows Regressive Tax System (Sales tax or Fees)- Average tax rate falls as GDP rises. The more progressive the tax system, the greater built-in stability within the economy Built-in stabilizers can only diminish, not eliminate swings in real GDP.

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Evaluating Fiscal Policy How do you determine if policy is expansionary, neutral, or contractionary? Standardized Budget (Full-Employment Budget) Measures what the Federal budget deficit or surplus would be with existing tax rates and government spending levels if the economy had achieved it full-employment level of GDP. Compares actual government expenditures with tax revenues that would have occurred in that year if the economy had achieved full employment.

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show (1) Year (2) Actual Deficit (-) or Surplus (+) (3) Standardized Deficit (-) or Surplus (+) Recent U.S. Fiscal Policy % -4.4% -4.5% -3.8% -2.9% -2.2% -1.4% -0.3% +0.8% +1.4% +2.5% +1.3% -1.5% -3.4% -3.5% -2.6% -2.2% -2.5% -2.9% -2.1% -2.0% -1.2% -1.0% -0.4% +0.1% +1.1% -1.1% -2.7% -2.4% -1.8% Federal Deficits and Surpluses – as a Percentage of Potential GDP Source: Congressional Budget Office

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show GLOBAL PERSPECTIVE Recent U.S. Fiscal Policy Full-Employment Budget Deficits or Surpluses as a Percentage of Potential GDP, 2005 Source: Organization for Economic Cooperation and Development New Zealand Denmark Canada Ireland France Norway United Kingdom United States Japan Deficits Surpluses

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Recent U.S. Fiscal Policy Federal Budget Deficits and Surpluses Actual and Projected, Fiscal Source: Congressional Budget Office

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Recent U.S. Fiscal Policy Problems of Timing –Recognition Lag-time lapse from the beginning of the recession or inflation and the awareness it is actually happening (Nov 2007 start of Great Recession, not identified until summer of 2008) –Administrative Lag-time lapse from fiscal action identified to when it takes action –Operational Lag-time lapse from fiscal action taken to when it affects output, employment or price level Problems, Criticisms, and Complications

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show continued Political Considerations –Political Business Cycle-the effect of politicians considering fiscal policy based on electability. Future Policy Reversals –Expectations by households on the stability of the policy Offsetting State and Local Finance –Policies established at the state and local levels are pro-cyclical-meaning they may counter act Federal actions by worsening rather than correcting recessions or inflations.

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Crowding out is the idea that an increase in one component of spending will cause a decrease in other spending components. An increase in G may cause a decrease in C, I P, or both—that is, government spending may “crowd out” private spending.

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Crowding-Out Effect Interest Rate Trillions of Dollars Total Supply of Funds (Saving) D 1 = I P + G 1 - T H 5% D 2 = I P + G 2 - T 7% A C B Increase in G = AH Decrease in C = AC Decrease in I P = CH

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show The Public Debt National or Public Debt $14 Trillion Ownership –U.S. Securities Treasury bills (short-term security) Treasury notes (medium-term security) Treasury bonds (long-term security) US Savings bonds –51% Owned by Federal Government and Federal Reserve –49% Held Outside the Federal Government and Federal Reserve Graphically…

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show The Public Debt Debt Held by the Federal Government and Federal Reserve (51%) Debt Held Outside The Federal Government and Federal Reserve (49%) Federal Reserve U.S. Government Agencies U.S. Individuals Foreign Ownership U.S. Banks And other Financial Institutions Other – Including State and Local Governments Source: U.S. Treasury 9% 8% 25% 8% 42% Total Debt $14 Trillion

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Debt and GDP

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show GLOBAL PERSPECTIVE Debt and GDP Publicly Held Debt: International Comparisons As a Percentage of GDP Italy Belgium Japan Germany France United States Hungary Netherlands United Kingdom Spain Canada Poland Source: Organization for Economic Cooperation and Development

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Debt and GDP Interest Charges –Interest charge that is accrued on bonds sold to finance debt False Concerns –Bankruptcy not likely Refinances debt by the selling of more Treasury securities –Taxation Increase the tax burden through increases or new taxation –Burdening Future Current taxpayer burden is ~$45000 Securities reflect an Asset to debt holders

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Debt and GDP Substantive Issues –Income Distribution Inequality of holders of national debt However income payments on debt only mildly impact low-income –Incentives Investment may be reduced do to higher burdens of taxation –Foreign-Owned Public Debt Interest payments are made to foreign investors impacting the burden –Crowding-Out Effect Revisited Graphically…

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Debt and GDP The Investment Demand Curve and the Crowding-Out Effect Real Interest Rate (Percent) Investment Demand (Billions of Dollars) ID 1 ID 2 a bc Interest Rate Rise Will Decrease Investment a to b Crowding- Out Effect A Large Public Debt to Finance Public Investment Will Cause… If Public Spending Spurs More Private Investment Will Increase to ID 2

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Debt and GDP Public Investments and Public-Private Complementarities Public Investments –Public Goods Spending –Human Capital Spending –Reduction on Crowding- Out Effect

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show The Leading Indicators 1.Average Workweek 2.Initial Claims for Unemployment Insurance 3.New Orders for Consumer Goods 4.Vendor Performance 5.New Orders for Capital Goods 6.Building Permits for Houses 7.Stock Prices 8.Money Supply 9.Interest-Rate Spread 10.Consumer Expectations Last Word Source: The Conference Board

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Key Terms fiscal policy 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 standardized budget cyclical deficit political business cycle crowding-out effect public debt U.S. Securities external public debt public investments

Copyright 2008 The McGraw-Hill Companies Fiscal Policy and the AD- AS Model Built-In Stability Evaluating Fiscal Policy Recent U.S. Fiscal Policy The Public Debt Debt and GDP Last Word Key Terms End Show Next Chapter Preview… Money and Banking