Fiscal and Monetary Policy Effects Outline: 1.What is fiscal and monetary policy and how do they work? 2.The Federal Budget 3.Principles of taxation 4.The automatic stabilizers

Federal, State & Local Government Spending as a Percent of GDP

Fiscal Policy Fiscal policy is the use of the federal budget to smooth the business cycle and encourage economic growth. The Employment Act of 1946 establishes a responsibility for the Federal government to “promote maximum employment, production, and purchasing power.

The Federal Budget Let: G denote federal spending for goods and services in a fiscal year (Oct. 1 thru Sept. 30). TX is federal tax receipts. TR is federal transfer payments. T is federal net taxes (TX - TR) The Federal budget is an annual statement of expenditures, tax receipts, and surplus or deficit of the government of the U.S.

If G exceeds T in a fiscal year, then we have a federal deficit. If, however, T exceeds G, then we have a federal surplus.

Federal Outlays and Tax Receipts, (in millions of dollars)

How Fiscal Policy Works AE Real GDP 0 Y1Y1 AE 1 Y FE Full employment GDP AE 2 GG

The preceding slide illustrates the type of expansionary fiscal policy that Keynesians recommend for recession. We will now use the AS-AD framework to illustrate contractionary fiscal policy.

Potential GDP AS AD 1 Real GDP Price Level 0 AD 2 Modeling Expansionary Fiscal Policy Y1Y1

Question: How is Fed policy “transmitted” to macroeconomic variables such as real GDP, employment, and the general price level?

Fed Open Market Purchase of Securities Increase in the Money Supply Decrease in the interest rate Increase in components of spending that are sensitive to interest rates—specifically, investment and consumer durable goods Multiplier Effect Real GDP

0 0 AE Real GDP % 4% MS 1 MS 2 Y1Y1 Y2Y2 AE 1 AE 2 MdMd Diagrammatic explanation of the transmission mechanism Nominal Interest Rate (%) Money

The Fed pulled on the string big time beginning in 1979—it was an anti-inflation strategy under Chairman Paul Volcker

Potential GDP AS AD 1 Real GDP Price Level 0 AD 2 Modeling Contractionary Monetary Policy Y1Y1

Conventional 30 year

Mortgage rateMonthly Payment 1 8%$ %$ %$1, %$1, %$1, Does not include prorated insurance or property taxes. Monthly payments on a $110, year mortgage note

Data in thousands of units

More recently, the Fed raised the federal funds rate six times between May 99 and May 2000— from 4.75% to 6.5 %.

The Fed reversed course at the beginning of 2001 and reduced the federal funds rate 11 times that year!

Horizontal equity: Tax code should be written so that those in the same economic circumstances pay the same amount in taxes. Vertical equity: Tax code should be written so that those in different economic circumstances should pay an unequal amount in taxes. Benefits received principle: Those who derive more benefits from government programs should pay more taxes. Principles of Taxation

Taxable income: Gross income - income exempt from taxes. Example: For single filers who use the 1040EZ: Average tax rate (ATR): Tax payments as a percent of taxable income. Marginal tax rate (MTR): The tax rate applied to the last dollar of taxable income.

Progressive tax: The proportion of taxable income taken in taxes increases as taxable income increases. Regressive tax: The proportion of taxable income taken in taxes decreases as taxable income increases. Proportional tax: The proportion of taxable income taken in taxes remains constant as taxable income increases.

By making the tax structure “progressive,” governments can make the after-tax distribution of income more equitable (or even). Affluent Needy

Federal personal Income Tax rates Under the 1993 Tax Reform Act (Married couple filing jointly)

Average and Marginal Tax Rates under the Tax Reform Act of 1993 (for a couple with 2 children)

2003 Taxable IncomeMarginal Tax Rate $0-$12, % $12,000-$47, $47,500-$114, $114,650-$174, $174,700-$311, Over $311, Tax Brackets for 2003 under the 2001 Tax Reform Act Source : Wall Street Journal

Quick Facts about President Bush’s Tax Bill The current 39.6% tax rate drops to 33% The current 36% tax rate drops to 33% The current 31% rate drops to 25% The current 28% rate drops to 25% The current 15% bracket is retained over most of its range A new 10% bracket applies to the lowest ¼ of the current 15% range. President Bush comments President Bush comments (wav)

Family (1) Income (2) Spending for items subject to excise tax (3) = (2)/(1) (4) Excise Tax Paid (5)= (4)/(1) ATR Greens$27,000$16, $1,1884.4% Jones64,00025, , Lemons270,00040, , Assume a 7.13 percent excise tax on groceries, gasoline, cigarettes, and liquor Moral of the story: Low income families tend to spend a greater proportion of their income on items subject to excise taxes. Hence excise taxes tend to be regressive.

Taxes (TX) and Transfer Payments (TR) are called “automatic stabilizers” because they react to changes in national income in a way that increases the federal deficit (or reduces the surplus) in the event of an economic contraction or reduces the deficit (increases the surplus) when the economy is expanding. The automatic stabilizers make sure that disposable income (DI) does not fall too much when national income is falling, and vice-versa. Automatic Stabilizers

Remember that the federal deficit or surplus is equal to the difference between G and Net Tax Receipts, where Net Taxes are equal to TX - TR   Y  TX, for example   Y  TX, and vice versa   Y  TR, for example   Y  TR, and vice versa Note that claims for unemployment compensation and other assistance surges when unemployment rises.

Real GDP 0 G, T Potential GDP G T = TX - TR Y1Y1 Deficit Balanced budget at full-employment

In the case of a federal deficit, the Treasury must borrow. The national debt is the accumulated borrowing of the federal government in all previous fiscal years, minus what has been repaid

Is a large national debt a bad thing? Arguments against a large national debt include: The “burden on future generations” argument. A large national debt means that a significant share of federal spending must be allocated for interest payments—leaving less for other priorities. A large national debt makes the U.S. too dependent on foreign financial inflows. Federal borrowing “crowds out” private sector borrowing units—i.e., firms and households.

“[W]e (the U.S.) owe $5.7 trillion in debt and if we don’t pay it off, our children and our grandchildren are going to have to.” Congressman Marion Berry, in a speech to the Jonesboro Lions Club on April 16, 2001.

As long as the debt grows by the same percentage as nominal GDP, the ratios of debt to GDP will remain constant. In this case, the government can continue to pay interest on its rising debt without increasing the average tax rate in the economy.