2. Fiscal Policy and Monetary Policy CHAPTER 20

3. C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to 1 Describe the federal budget process and explain the effects of fiscal policy. 2 Describe the Federal Reserve’s monetary policy process and explain the effects of monetary policy.

4. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Fiscal policy is the use of the federal budget to achieve the macroeconomic objectives of high and sustained economic growth and full employment.  The Federal Budget The federal budget is an annual statement of the revenues, outlays, and surplus or deficit of the government of the United States. The federal budget has two purposes: 1. To finance the activities of the federal government 2. To achieve macroeconomic objectives

5. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Budget surplus (+)/deficit (–) = Tax revenues – Outlays The government has a budget surplus when tax revenues exceed outlays. The government has a budget deficit when outlays exceed tax revenues. The government has a balanced budget when tax revenues equal outlays.

6. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY The Budget Time Line The President and the Congress make the budget and develop fiscal policy on a fixed annual time line and fiscal year. Fiscal year is a year that begins on October 1 and ends on September 30. Fiscal year 2008 begins in 2007.

8. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Types of Fiscal Policy Fiscal policy actions can be Discretionary fiscal policy Automatic fiscal policy

9. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Discretionary fiscal policy is a fiscal policy action that is initiated by an act of Congress. For example, an increase in defense spending or a cut in the income tax rate. Automatic fiscal policy is a fiscal policy action that is triggered by the state of the economy. For example, an increase in unemployment induces an increase in payments to the unemployed or in a recession tax receipts decrease as incomes fall.

10. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY  Discretionary Fiscal Policy: Demand-Side Effects Changes in government expenditure and changes in taxes have multiplier effects on aggregate demand. The government expenditure multiplier is the magnification effect of a change in government expenditure on goods and services on aggregate demand. An increase in aggregate expenditure increases aggregate demand, which increases real GDP, which induces increases aggregate demand.

11. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY The Tax Multiplier The tax multiplier is the magnification effect of a change in taxes on aggregate demand. A decrease in taxes increases disposable income. The increase in disposable income increases consumption expenditure and aggregate demand. With increased aggregate demand, employment and real GDP increase and consumption expenditure increases yet further.

12. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY So a decrease in taxes works like an increase in government expenditure. Both actions increase aggregate demand and have a multiplier effect. The magnitude of the tax multiplier is smaller than the government expenditure multiplier. The reason: A $1 tax cut increases aggregate expenditure by less than $1 whereas a $1 increase in government expenditure increases aggregate expenditure by $1.

13. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY The Balanced Budget Multiplier The balanced budget multiplier is the magnification effect on aggregate demand of a simultaneous change in government expenditure and taxes that leaves the budget balance unchanged. The balanced budget multiplier is not zero—it is positive—because the government expenditure multiplier is larger than the tax multiplier.

14. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Discretionary Fiscal Stabilization If real GDP is below potential GDP, the government might use an expansionary fiscal policy in an attempt to restore full employment. Expansionary fiscal policy is a discretionary fiscal policy designed to increase aggregate demand—a discretionary increase in government expenditure or a discretionary tax cut.

15. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Potential GDP is $10 trillion, real GDP is $9 trillion, and 1. There is a $1 trillion recessionary gap. 2. An increase in government expenditure or a tax cut increases expenditure by ∆E. Figure 20.2 illustrates an expansionary fiscal policy.

16. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY 3. The multiplier increases induced expenditure. The AD curve shifts rightward to AD 1. The price level rises to 110, real GDP increases to $10 trillion, and the recessionary gap is eliminated.

18. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Contractionary Fiscal Policy If an inflationary gap exists, the government might use an contractionary fiscal policy to eliminate the inflationary pressure. Contractionary fiscal policy is a discretionary fiscal policy designed to decrease aggregate demand—a decrease in government expenditure or a tax increase.

19. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Figure 20.3 illustrates contractionary fiscal policy. Potential GDP is $10 trillion, real GDP is $11 trillion, and 1. There is a $1 trillion inflationary gap. 2. A decrease in government expenditure or a tax rise decreases expenditure by ∆E.

20. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY 3. The multiplier decreases induced expenditure. The AD curve shifts leftward to AD 1. The price level falls to 110, real GDP decreases to $10 trillion, and the inflationary gap is eliminated.

22. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY  Discretionary Fiscal Policy: Supply-Side Effects Fiscal policy has important effects on aggregate supply. Supply-Side Effects of Government Expenditure Government provides services such as law and order, public education, and public health that increase production possibilities. An increase in government expenditure that increases the quantities of productive services and capital increases potential GDP and increases aggregate supply.

23. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Supply-Side Effects of Taxes To pay for the productive services and capital that the government provides, it collects taxes. All taxes create disincentives to work, save, and provide entrepreneurial services. Taxes on labor income decrease the supply of labor, which raises the equilibrium real wage rate and decreases the equilibrium quantity of labor employed. With a smaller quantity of labor employed, potential GDP and aggregate supply are smaller than they would otherwise be.

24. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Taxes on the income from capital decrease saving and decrease the supply of capital. The equilibrium real interest rate rises and the equilibrium quantity of investment and capital employed decrease. With a smaller quantity of capital, potential GDP and aggregate supply are smaller than they would otherwise be.

25. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Taxes on the incomes of entrepreneurs weaken the incentive to take risks and create new businesses. With fewer firms, less labor and capital are employed and potential GDP and aggregate supply are smaller than they would otherwise be. An increase in taxes strengthens these disincentive effects. It decreases the supply of labor, capital, and entrepreneurial services; decreases potential GDP; and decreases aggregate supply. A tax cut has the opposite effects.

26. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Supply-Side Effects on Potential GDP Figure 20.4 illustrates the effects of fiscal policy on potential GDP. Initially, the production function is the full- employment quantity of labor is 200 billion hours, and potential GDP is $10 trillion.

27. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY 1.A tax cut strengthens the incentive to work, increases the supply of labor, and increases employment. 2.A tax cut strengthens the incentive to save and invest, which increases the quantity of capital and increases labor productivity.

28. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY 3.The combined effect of a tax cut on employment and labor productivity increases potential GDP.

30. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY  Combined Demand-Side and Supply-Side Effects An increase in government expenditure or a tax cut increases equilibrium real GDP but might raise, lower, or have no effect on the price level. Figure 20.5 on the next slide shows the combined effects of fiscal policy when fiscal policy has no effect on the price level.

31. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY 1. A tax cut increases disposable income, which increases aggregate demand from AD 0 to AD 1. A tax cut also strengthens the incentive to work, save, and invest, which increases aggregate supply from AS 0 to AS 1. 2. Real GDP increases.

33. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY  Limitations of Fiscal Policy The use of discretionary fiscal policy is seriously hampered by four factors: Law-making time lag Estimating potential GDP Economic forecasting

34. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Law-Making Time Lag The amount of time it takes Congress to pass the laws needed to change taxes or spending. This process takes time because each member of Congress has a different idea about what is the best tax or spending program to change. So long debates and committee meetings are needed to reconcile conflicting views.

35. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Estimating Potential GDP It is not easy to tell whether real GDP is below, above, or at potential GDP. So a discretionary fiscal action might move real GDP away from potential GDP instead of toward it. This problem is a serious one because too much fiscal stimulation brings inflation and too little might bring recession.

36. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Economic Forecasting Fiscal policy changes take a long time to enact in Congress and yet more time to become effective. So fiscal policy must target forecasts of where the economy will be in the future. Economic forecasting has improved enormously in recent years, but it remains inexact and subject to error. So for a second reason, discretionary fiscal action might move real GDP away from potential GDP and create the very problems it seeks to correct.

37. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY  Automatic Fiscal Policy A consequence of tax receipts and expenditures that fluctuate with real GDP. Automatic stabilizers are features of fiscal policy that stabilize real GDP without explicit action by the government. Induced Taxes Induced taxes are taxes that vary with real GDP.

38. 20.1 THE FEDERAL BUDGET AND FISCAL POLICY Needs-Tested Spending Needs-tested spending is spending on programs that entitle suitably qualified people and businesses to receive benefits— benefits that vary with need and with the state of the economy.

39.  The Monetary Policy Process The Fed makes monetary policy in a process that has three main elements: Monitoring economic conditions Meetings of the Federal Open Market Committee (FOMC) Monetary Policy Report to Congress 20.2 THE FED AND MONETARY POLICY

40. Monitoring Economic Conditions Each Federal Reserve Bank constantly gathers information on its district by talking with business leaders, economists, market experts, and others. The Fed brings the results together in the Beige Book, which is published eight times a year. The Beige Book serves as a background document for the members of the FOMC. 20.2 THE FED AND MONETARY POLICY

41. The FOMC makes a monetary policy decision at eight schedules meetings a year and publishes the minutes three weeks after each meeting. Monetary Policy Report to Congress Twice a year, in February and July, the Fed prepares a Monetary Policy Report to Congress, and the Fed chairman testifies before the House of Representatives Committee on Financial Services. The report and the chairman’s testimony review the past year’s monetary policy and the future outlook. 20.2 THE FED AND MONETARY POLICY

42.  The Federal Funds Rate Following each FOMC meeting, the Fed announces its monetary policy decision as a target for the federal funds rate. Federal funds rate is the interest rate at which banks can borrow and lend reserves in the federal funds market. To hit its target for the federal funds rate, the FOMC instructs the New York Fed to conduct open market operations. 20.2 THE FED AND MONETARY POLICY

43. The higher the federal funds rate, the greater is the supply of funds and the smaller is the demand for funds. The equilibrium federal funds rate makes the quantity of funds demanded equal the quantity supplied. If the New York Fed sells securities, the supply of funds decreases, so the federal funds rate rises. If the New York Fed buys securities, the supply of funds increases, so the federal funds rate falls. 20.2 THE FED AND MONETARY POLICY

44. When the Fed changes the federal funds rate, events ripple through the economy and lead to the ultimate policy goals.  Quick Overview Figure 20.6 summarizes the ripple effects. 20.2 THE FED AND MONETARY POLICY

46. 1.The first effect of a monetary policy decision by the FOMC is a change in the federal funds rate. Other Interest Rates Change 2.Other interest rates then change quickly and relatively predictably. 20.2 THE FED AND MONETARY POLICY

47. The Exchange Rate Changes The exchange rate responds to changes in the interest rate in the United States relative to the interest rates in other countries—the U.S. interest rate differential. When the Fed raises the federal funds rate, the U.S. interest rate differential rises and, other things remaining the same, the U.S. dollar appreciates. And when the Fed lowers the federal funds rate, the U.S. interest rate differential falls and, other things remaining the same, the U.S. dollar depreciates. 20.2 THE FED AND MONETARY POLICY

48. Money and Bank Loans Change 3.To change the federal funds rate, the Fed must change the quantity of bank reserves, which in turn changes the quantity of deposits and loans that the banking system can create. 20.2 THE FED AND MONETARY POLICY

49. Long-Term Real Interest Rate Changes 4. Changes in the federal funds rate change the supply of bank loans, which changes the supply of loanable funds and changes the real interest rate in the loanable funds market. 20.2 THE FED AND MONETARY POLICY

50. Expenditures Change 5.A change in the real interest rate changes consumption expenditure, investment, and net exports. 6.A change consumption expenditure, investment, and net exports changes aggregate demand. 20.2 THE FED AND MONETARY POLICY

51. 7.About a year after the change in the federal funds rate occurs, real GDP growth changes. 8.About two year after the change in the federal funds rate occurs, the inflation rate change. 20.2 THE FED AND MONETARY POLICY

52.  Monetary Stabilization in the AS–AD Model The Fed Tightens to Fight Inflation Figure 20.7 illustrates how the Fed’s policy works. Initially, the interest rate is 5 percent a year in Figure 20.7(a) and investment is $20 trillion. Assume that there is no inflation, so the interest rate is the real interest rate as well as nominal interest rate. With $20 trillion of investment, real GDP is $11 trillion and there is an inflationary gap in Figure 20.7(b). 20.2 THE FED AND MONETARY POLICY

54. 1.The Fed conducts an open market sales of securities that raises the interest rate from 5 percent to 6 percent a year. Investment decreases to $1.5 trillion a year. To remove the inflation pressure …

56. 20.2 THE FED AND MONETARY POLICY 3.The multiplier induces additional expenditure cuts and shifts the AD curve to AD 1. Real GDP decreases to potential GDP and inflation is avoided. 2.The decrease in investment decreases aggregate demand and shifts the AD curve to AD 0  I.

58. The Fed Eases to Fight Recession Real GDP is below potential GDP and the Fed fears recession. Figure 20.8 illustrates how the Fed’s policy works. Initially, the interest rate is 5 percent a year in Figure 20.8(a) and investment is $20 trillion. With $20 trillion of investment, real GDP is $9 trillion and there is a recessionary gap in Figure 20.8(b). 20.2 THE FED AND MONETARY POLICY

60. 1.The Fed conducts an open market purchase of securities that lowers the interest rate from 5 percent to 4 percent a year. Investment increases to $2.5 trillion a year. To remove avoid recession …

62. 20.2 THE FED AND MONETARY POLICY 3.The multiplier induces additional expenditure and shifts the AD curve to AD 1. Real GDP increases to potential GDP and recession is avoided. 2.The increase in investment increases aggregate demand and shifts the AD curve to AD 0 +  I.

64. Loose Link from Federal Funds Rate to Spending The long-term real interest rate that influences spending plans is linked only loosely to the federal funds rate. Also, the response of the long-term real interest rate to a change in the nominal rate depends on how inflation expectations change. The response of expenditure plans to changes in the real interest rate depends on many factors that make the response hard to predict. 20.2 THE FED AND MONETARY POLICY

65. The Size of the Multiplier The size of the multiplier effect of monetary policy depends on the sensitivity of expenditure plans to the interest rate. The larger the effect of a change in the interest rate on aggregate expenditure, the greater is the multiplier effect and the smaller is the change in the interest rate that achieves the Fed’s objective. 20.2 THE FED AND MONETARY POLICY

66.  Limitations of Monetary Policy Monetary policy has an advantage over fiscal policy because it cuts out the lawmaking time lags. Monetary policy is a continuous policy process and is not subject to the long decision lag and the need to create a broad political consensus that confronts fiscal policy. 20.2 THE FED AND MONETARY POLICY

67. But monetary policy shares the other two limitations of fiscal policy: Estimating potential GDP is hard Economic forecasting is error-prone. Monetary policy suffers an additional limitation: Its effects are indirect and depend on how private decisions respond to a change in the interest rate. Also the time lags in the operation of monetary policy are longer than those for fiscal policy. So the forecasting horizon must be longer. 20.2 THE FED AND MONETARY POLICY