14 Macroeconomic Policy

Fiscal Policy & Monetary policy 14-1 Fiscal Policy & Monetary policy

Main points Economic objective Discretionary Fiscal policy Fiscal Policy Instruments The Crowding Out Effect Automatic stabilizers Multiplier

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.

Government in the Economy 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.

Fiscal Policy 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 Instruments Government Revenues Taxes Public Bonds Government Expenditures Government purchase Transfer payment

Government Expenditure Social Security Law and Order Emergency Services Health Education Defence Foreign Aid Environment Agriculture Industry Transport Regions Culture, 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 Deficit Budget > 0 -- Budget Surplus Budget = 0 -- Balanced Budget Realistic Goal -- Balanced Budget when Y = YF.

The US Federal Budget: 2003 (Billions of Dollars) Tax Revenues $1877.0 Government Expenditure $2241.6 Federal Budget -$364.6 Source: Economic Indicators, September 2004.

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

Breakdown of Government Expenditure Purchases of Goods and Services (G) = $658.6 Transfer Payments = $1322.5 Interest Payments = $214.1 Other = $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 - G Budget 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 deficits reduced 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 Tax The 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: G Change Transfer Payments (Tr) -- Expansionary: Tr -- Contractionary: Tr

Tax Policy as Fiscal Policy Change Marginal Tax Rates (t) -- Expansionary: t -- Contractionary: t Change Tax Deductions -- Expansionary: Bigger Deductions -- Contractionary: Smaller Deductions Change 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 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 US World War II The Kennedy-Johnson Tax Cut of 1964 The Nixon Tax Increase of 1969 The Reagan Economic Recovery and Tax Act of 1981 Clinton Tax Increases of 1993 Bush Tax Cuts of 2001-02?

The Federal Government Surplus/Deficit as a Percentage of GDP, 1970 I-2000 IV

The Federal Government Debt as a Percentage of GDP, 1970 I-2000 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 a Percent 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 (INCOME) Y NET TAXES T DISPOSABLE INCOME Yd / Y - T CONSUMPTION SPENDING (C = 100 + .75 Yd) SAVING S (Yd – C) PLANNED INVESTMENT SPENDING I GOVERNMENT PURCHASES G PLANNED AGGREGATE EXPENDITURE C + I + G UNPLANNED INVENTORY CHANGE Y - (C + I + G) ADJUSTMENT TO DISEQUILIBRIUM 300 100 200 250 - 50 150 500 - 200 Output8 400 650 - 150 700 600 550 50 800 - 100 900 950 1,100 1,000 850 Equilibrium 1,300 1,200 1,250 + 50 Output9

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

Appendix B: The government spending and tax multipliers The government spending and tax multipliers are derived algebraically as follows: value of autonomous expenditures multiplier

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: 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: Multiplier of government spending Tax multiplier and then: In words, a simultaneous increase in government spending by $1 and lump-sum taxes by $1 will increase equilibrium income by $1.

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 (INCOME) Y NET TAXES T DISPOSABLE INCOME Yd / Y - T CONSUMPTION SPENDING (C = 100 + .75 Yd) PLANNED INVESTMENT SPENDING I GOVERNMENT PURCHASES G PLANNED AGGREGATE EXPENDITURE C + I + G UNPLANNED INVENTORY CHANGE Y - (C + I + G) ADJUSTMENT TO DISEQUILIBRIUM 500 300 200 250 100 650 - 150 Output8 700 400 800 - 100 900 600 550 950 - 50 1,100 Equilibrium 1,300 1,000 850 1,250 + 50 Output9 1,500 1,200 1,400 + 100

Fiscal Policy Multipliers Summary of Fiscal Policy Multipliers POLICY STIMULUS MULTIPLIER FINAL IMPACT ON EQUILIBRIUM Y Government- spending multiplier Increase or decrease in the level of government purchases: Tax multiplier Increase or decrease in the level of net taxes: Balanced-budget multiplier Simultaneous balanced-budget increase or decrease in the level of government purchases and net taxes: 1

The Federal Budget Federal Government Receipts and Expenditures, 2000 (Billions of Dollars) AMOUNT PERCENTAGE OF TOTAL Receipts Personal taxes 774.4 44.9 Corporate taxes 211.9 12.3 Indirect business taxes 91.3 5.3 Contributions for social insurance 645.9 37.5 Total 1,723.4 100.0 Current Expenditures Consumption 463.8 26.5 Transfer payments 795.5 45.4 Grants-in-aid to state and local governments 224.2 12.8 Net interest payments 230.3 13.1 Net subsidies of government enterprises 38.4 2.2 1,752.2 Current 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 operation Reserve ratio Discount rate

★ Open market operation The Tools of Monetary Policy Easy Monetary Policy Buying Securities from commercial banks Bank gives up securities FED pays bank Bank have increased reserve Buying securities from public Public gives up securities Public deposit notes in the bank

The Tools of Monetary Policy Tight Monetary Policy Selling Securities to commercial banks FED gives up securities Bank pays for securities Bank have decreased reserve Selling securities to public Public pays by check from bank

The Tools of Monetary Policy ★ The Reserve Ratio 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

Easy Monetary Policy Tight Monetary Policy Buying securities Lowering reserve ratio Lowering discount rate Tight Monetary Policy Selling securities Raising reserve ratio Raising discount rate

The Federal reserve Assets Liabilities Securities Loans to commercial bank Liabilities Reserves of the commercial banks Treasury deposits Federal reserve notes

Time Lags Regarding Monetary 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.

Coordination between Monetary and Fiscal Policy Cooperation Consistency Macroeconomic Policy Clarity Commitment Economic Stability Sustainable Growth

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?