1. Section 6 Lecture January 2016 Mr. Gammie
AP Macroeconomics
Section 6 Lecture
January 2016
Mr. Gammie

2. M30: Long-Run Implications of Fiscal Policy: Deficits and the Public Debt

3. $1, 300, 000, 000, 000

4. $2.2 Billion
Surplus --- still a 65 billion of debt

5. Should the budget be balanced?

6. Budget Balance
Is a budget deficit bad and a budget surplus good?

7. The Budget Balance as a Measure of Fiscal Policy
The Budget Balance Formula:
Sgovernment = T- G - TR
Where:
T is the value of tax revenues
G is government purchases of goods and services
TR is the value of government transfers

8. This is affected by fiscal policy.
Budget Balance
Surplus = positive budget balance
Deficit = negative budget balance
This is affected by fiscal policy.

9. Budget Balance and Fiscal Policy
Recessionary Gap > Run __________ fiscal policy. > 3 options to do so: All else equal this will ________ the budget balance.

10. Budget Balance and Fiscal Policy
Inflationary Gap > Run __________ fiscal policy. > 3 options to do so: All else equal this will ________ the budget balance.

11. How can we measure fiscal policy
How can we measure fiscal policy? Will changes in the budget balance always reflect changes fiscal policy?

12. Two Reasons Why it Doesn’t
Reason 1: Two different changes in fiscal policy that have equal-sized effects on the budget balance might have unequal effects on the economy. Example: If government spending increases by $1000, it will have a larger impact on real GDP than a tax decrease of $1000. The budget balance would change by $1000 in each case, but the impacts would be different.

13. Two Reasons Why it Doesn’t
Reason 2: Often, changes in the budget balance are themselves the result, not the cause, of fluctuations in the economy.
- show now

14. The Business Cycle and the Cyclically Adjusted Budget Balance
The budget deficit almost always rises when the unemployment rate rises and falls when the unemployment rate falls.
Explain why this statement is true.

15. Automatic Stabilizers
These are programs built into our tax and transfer system that work to reduce the swings of the business cycle.
When the economy heads into a recession:
Tax revenues decline because incomes and profits are declining.
Transfer payments rise as more people tend to find themselves unemployed and struggling.
This leads to a negative change in the budget surplus without any deliberate fiscal policy.

16. On the reverse side…
When the economy is heading into an inflationary period:
Tax revenues rise because incomes and profits are rising.
Transfer payments fall as fewer people find themselves unemployed and struggling.

17. If we are going to measure fiscal policy, we need a way to separate out two effects on the budget balance:
The impact due to deliberate changes in fiscal policy.
The impact due to the current state of the business cycle.
This is an estimate of what the budget balance would be if there was neither a recessionary or inflationary gap.

18. The Cyclically Adjusted Budget Balance
An estimate of what the budget balance would be if the real GDP were exactly equal to potential output.
Takes into account extra revenue the gov’t would collect and transfers it would save if recessionary gap were eliminated. And vice versa.
If after this adjustment is made the gov’t is still running a deficit, then we might make the conclusion that their fiscal policy decisions are not sustainable over the long run.

19. Should the budget be balanced?
Start Here

20. Balanced Budgets
What would be the result of legislation that required the government to balance the budget on an annual basis?
How would the economy be affected? How would people be affected?

21. Balanced Budgets
If this was the case and there was a recessionary gap…
Falling tax revenue and rising transfer payments push the budget toward deficit
How would we balance this deficit?
We would need to increase taxes or decrease G
How would that impact the recession?
It would worsen it!

22. Balanced Budgets If there was an inflationary gap…
Rising tax revenue and falling transfer payments push the budget toward surplus
How would we balance this surplus?
We would need to decrease taxes or increase G
How would this impact the inflationary period?
It would worsen it!

23. So what should the government do?
Most economists believe that the govt should only balance its budget on average – that is should be allowed to run deficits in bad years, offset by surpluses in good years.
What forces present in the economy make this difficult? Political pressures.

24. Homework Assignment
Go home over the weekend and “interview” a family member/neighbor/etc. who was of voting age in the last federal election.
Ask them the following questions… these will be discussed in class on Tuesday.
What is your opinion about the Federal Liberals running a budget deficit?
Should Canada have a national debt?
Should the government actively work to reduce the national debt? If so what should they do? If not, why not?
Any other comments you would like to make regarding this issue?

25.
Should we be worried?

26. Long-Run Implications of Fiscal Policy
Governments that runs persistent deficits end up with substantial debts.
National Debt: the accumulation of all past deficits, minus all past surpluses.
Public debt: Government debt held by individuals and institutions outside the government.

27. Rising Government Debt
Two reasons for concern:
When the government borrows funds in the financial markets, it is competing with firms that plan to borrow funds for investment spending. As a result, the government’s borrowing may “crowd out” private investment spending, increasing interest rates and reducing the economy’s long-run rate of growth.
Today’s deficits, by increasing the government’s debt, place financial pressure on future budgets. Interest must be paid in the future, and this can take dollars away from other future obligations like education, social services, space exploration, etc.
Crowding out, raises interest rates, reduces long-run economic growth
Debt today creates pressure for tomorrow – obligations (interest) to be repaid out of future budgets, takes away money for other services

28. How can the government pay off debt?
Borrowing more to pay it off?
Print more money?
Increase taxes or cut spending?

29. Argentina – touch on article

30. Greece

32. Zimbabwe http://www. cnn

33. Deficits and Debt in Practice
To assess the ability of governments to pay off their debt, we use the debt-GDP ratio
This measures the gov’ts debt as a % of GDP
Why?
GDP is a good indicator of the potential taxes the gov’t can collect. If the gov’ts debt grows more slowly than GDP, the burden of paying that debt is actually falling compared with potential tax revenue.

34. Is the debt-GDP ratio rising, falling, or staying the same?
Check US and Canada

35. Canada Debt to GDP Ratio

36. Implicit Liabilities
Implicit Liabilities are spending promises made by the gov’t that are debt despite the fact they are not included in usual debt statistics.
Examples include social security, Medicare, Medicaid.
How will demographic trends affect future spending on these programs? HW WS TB
CYU #1, 2, 3
MC #1-5

37. Practice Question

38. Practice Question

39. Practice Question

40. M31: Monetary Policy and the Interest Rate

41. Money Market: Fed Increases MS

42. Money Market: Fed Decreases MS

43. Target Rate Target Rate
The Fed adjusts the money supply to target a specific federal funds rate.

44. Monetary Policy – Trace Out the Steps
Expansionary Monetary Policy Contractionary Monetary Policy

45. Monetary Policy – Trace Out the Steps
Expansionary Monetary Policy Recessionary Gap>Increase MS>Decrease Interest Rate>I and C Increase>AD Shifts Right>RGDP Increases Contractionary Monetary Policy Expansionary Gap>Decrease MS>Increase Interest Rate>I and C Decrease >AD Shifts Left>RGDP Decreases

46. Monetary Policy in Practice
Taylor Rule
Inflation Targeting
Transparency
Accountability
Inflation is forward-looking, Taylor rule is backward-looking

47. M31 Summary The Fed uses monetary policy to stabilize the economy.
When the Fed wants to lower interest rates, they engage in expansionary monetary policy. As the money supply curve shifts to the right, interest rates fall. As interest rates fall, private investment increase and aggregate demand shifts to the right.
When the Fed wants to raise interest rates, they engage in contractionary monetary policy. As the money supply curve shifts to the left, interest rates rise. As interest rates rise, private investment decreases and aggregate demand shifts to the left.

48. M32: Money, Output, and Prices in the Long Run

49. Money, Output, and Prices
0.5%
What danger may be associated with an interest rate of …

51. Monetary policy can destabilize the economy.
Expansionary monetary policy, i falls, I and C increase, AD shifts right
Short run, RGDP increases, so does aggregate price level
Nominal wage rise, SRAS shifts left
LR equilibrium at potential GDP and higher price level
In LR, expansionary monetary policy doesn’t increase RGDP, it only causes inflation

52. Key Takeaway
In long-run, expansionary monetary policy doesn’t increase RGDP, it only causes inflation.

53. Money Neutrality
Money Neutrality: changes in the money supply have no real effects on the economy.
In the long run, the only effect of an increase in the money supply is to raise the aggregate price level by an equal percentage.
Economists argue that money is neutral in the long run.

54. How? All prices in the economy double.
Money supply doubles at the same time.
What difference does this make in real terms?
All variables in the economy – real GDP, real value of the money supply (the amount of goods and services it can buy) – are unchanged.
If this is the case, there is no reason for anyone to behave differently.
No difference in real terms.

55. Money Neutrality Takeaway
If the money supply increases by any given percentage, in the long run, the aggregate price level will rise by the same percentage.

56. Changes in the Money Supply and the Interest Rate in the Long Run
Fed has power in the short run.
What happens in the long run?
MS increase (10%), aggregate price level increases (10%), MD increases by 10%, LR equilibrium back at i*

57. M32 Summary
Money neutrality asserts that expansionary monetary policy to boost the economy will result in long run equilibrium at potential GDP with a higher price level (and vice versa for contractionary monetary policy).
Monetary policy is an effective tool for shortening the duration of a recession or cooling off a period of inflation in the short run.

58. M33: Inflation, Disinflation, and Deflation

59. Very high inflation, like the type suffered by Zimbabwe, is associated with rapid increases in the money supply.

60. Moderate inflation, the type experienced in countries like Canada and the United States, are quite different.
To understand inflation we need to revisit changes in the money supply on the overall price level.

61. Money Supply and the Price Level
Draw the long-run equilibrium in the AD/AS model.
Show the short-run impact of expansionary monetary policy.
Show the long-run adjustment in the graph and explain how it happens.

62. Real Money Supply A change in the nominal money supply, M.
Leads in the long run to a change in the aggregate price level, P.
That leaves the real quantity of money, M/P, at its original level.
As a result there is no long-run effect on the aggregate demand or real GDP.

64. Let’s think about this process for a second…
Put yourself in the shoes of an employee.

65. 1%
How would you act if inflation was 1% annually. What would be your views toward annual inflation?

66. 100% Now how might your behaviour change if inflation was 100%?
You would demand your wage to increase accordingly.
You CAN’T afford to wait 2 or 3 years to get that raise.

67. The Classical Model of Money and Prices
Presumes that the adjustment from the first long-run equilibrium point to the second is automatic and instantaneous.

68. The Classical Model of Money and Prices
The Classical Model is not representative of how economies react to low levels of inflation.
The Classical Model is a good indication of how the economy reacts to very high levels of inflation.
Workers become sensitized. Adjustments are quicker.

69. Back to paying off the debt…
Does the US print money to pay off it’s debt?
Yes.

70. The Inflation Tax
The Federal Reserve issues money, but works hand in hand with the Treasury.
The Treasury issues debt to finance the gov’ts purchases of goods and services, while the Fed monetizes the debt by creating money and buying the debt back from the public through open market purchases of T-Bills.
The US gov’t can and does raise revenue by printing money.
The fed wants more money, so the treasury prints it.
Very small amount

71. Printing Money
The Fed creates money as it purchases gov’t securities from the private sector.
The Fed gets interest from these T-Bills, paid by the Treasury. The Fed then hands this interest back over to the Treasury.
The Fed’s actions allow the gov’t to pay off billions in outstanding gov’t debt by printing money (the gov’t owns it’s own debt).

72. Seignorage: a government’s right to print money
The US budget – only about 1% is siegnorage

73. The Inflation Tax We know this leads to inflation.
When the gov’t prints money, the people who currently hold money pay.
They pay because inflation erodes the purchasing power of their money holdings.
The gov’t, in essence, imposes an inflation tax, by printing money to cover its budget deficit.

74. The logic of hyperinflation

75. How does inflation get so out of control?

76. Let’s imagine that the gov’t wants to collect revenue from a tax imposed on taxi’s. The tax results in a higher price for taxis, and therefore fewer people take them. In order to earn the revenue they need, the gov’t raises the tax on taxis, making them more expensive, making fewer people want to take them, resulting in an even higher tax, and etc.
Substitute the real money supply for taxi rides and the inflation rate for the increase in the fee on taxi rides, and we have the story of hyperinflation.

77. A race develops between the government printing presses and the public --- the press churns out money at a faster and faster rate to try to compensate for the fact that the public is reducing it’s real money holdings. At some point the inflation rate explodes, and people aren’t willing to hold any money at all.

78. Hyperinflation How does it start? Therefore… print money.
Large budget deficit.
Inability or incompetence to eliminate deficit by raising taxes or cutting government spending.
Government unable to borrow as lenders refuse to extend loans based on weakness.
Therefore… print money.

79. Hyperinflation
Suppose the gov’t needs to print enough money to pay for a given quantity of goods and serves each month.
As the gov’t prints money to do so, it causes inflation.
As people hold smaller amounts of money due to higher inflation, the gov’t has to respond by accelerating the rate of growth of the money supply.
This will lead to an even higher rate of inflation.
People respond to this higher rate of inflation by reducing their money holdings yet again.
This sequence spirals out of control as inflation skyrockets.
High inflation arises when the gov’t must print a large quantity of money, imposing a large inflation tax, to cover a large budget deficit.

80. Types of Inflation

81. Cost-Push Inflation

82. Demand-Pull Inflation

83. Key Terms
Disinflation: a decrease in the inflation rate. Deflation: a decreasing aggregate price level.

84. M33 Summary
Hyperinflation is almost always the result of a government that is increasing the money supply to cover national debts, while gradual inflation is the result of market forces and the business cycle.
When the government funds deficit spending with newly printed money, the people who currently hold money end up paying an inflation tax. This is not a tax that is explicitly paid like an income tax, it acts as an implicit tax because inflation erodes the purchasing power of their money holdings.
Cost-push inflation is caused by a significant increase in the price of an input with economy-wide importance. This creates a leftward shift in SRAS and an increase in the price level.
Demand-pull inflation is caused by a rightward shift of the AD curve and is the result of too much spending relative to the economy’s capacity for production.

85. M34: Inflation and Unemployment: The Phillips Curve

86. The Three Macroeconomic Goals
Low Rate of Unemployment
Stable price Level
Economic Growth

87. Inflation
Unemployment
Short run trade off

88. The Phillips Curve Think about the AD-AS Model.
When AD increases (shifts to the right), unemployment falls, inflation increases.
This would be a movement from point a to b.
When AD decreases (shifts to the left), unemployment increases, inflation falls.
Point b to a.

89. Proof?

90. Supply Shocks
When SRAS increases, both unemployment and inflation rates fall.
Downward shift of the SRPC.
When SRAS decreases, both the unemployment and inflation rates rise. Upward Shift of SRPC.
Can the SRPC curve extend beyond these axes?

91. One day you will all say this as you head home from your first day on a new dream job.
But let’s think about how we get there. Often, jobs require negotiation in terms of salary, benefits and pay structure. What factors would you consider when negotiating these elements?

92. Expected Rate of Inflation
Changes in the expected rate of inflation affect the short-run trade-off between unemployment and inflation.
Changes in expectations result in a shift of the short-run Phillips curve.
Higher expected inflation = shift up.
Lower expected inflation = shift down.
Change is 1-1
Inflation was 0% for years. Now it has been 3%. Nominal wages and other contracts will begin to reflect future increases of 3%

93. Inflation and the Unemployment Rate in the Long-Run
Draw the long-run equilibrium in the AD-AS model.
Show what happens to the SRPC in the short-run when AD increases.
Now show what happens to the SRPC in the long run.

94. Long-Run Phillips Curve
Start Here
In the long-run, most macroeconomists believe there is no trade off between lower unemployment rate and higher inflation rates.
“*** It is not possible to achieve lower unemployment in the long run by accepting higher inflation.
SR AD shifts right, movement from point A to point B
LR SRAS shifts left, inflation expectations adjust to 2%, upward shift of SRPC
To reduce inflation, gov’t shifts AD to the right, movement to point c

95. Key Takeaways
As aggregate demand shifts to the right or left in the short-run, eventually the economy returns to long-run equilibrium, but at a higher, or lower rate of inflation.
To avoid accelerating inflation over time, the unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation.

96. NAIRU
The unemployment rate at which inflation does not change over time is referred to as the non-accelerating inflation rate of unemployment.
Keeping the unemployment rate below NAIRU leads to ever accelerating inflation and cannot be maintained.

97. NAIRU = Natural Rate of Unemployment

98. Disinflation

99. Debt and Deflation
Isn’t a falling price level a good thing for consumers?
Lenders who are owed money gain under deflation
Borrowers lose because the real burden of their debt rises
--- what do borrowers do? Cut back on spending, weak spending causes deflation, which causes less spending, etc.

100. The Liquidity Trap
A situation in which conventional monetary policy is ineffective because nominal interest rates are up against the zero bound.
Nominal rate = real rate + expected inflation
rr = 2% ei = 3% nr = ?
What if expected inflation = -2%?
R = n – I
2 = 5 – 3
N = r + I
If expected inflation changes to -2%, N = 0
0 = 2 + (-2)
Zero bound

101. The Liquidity Trap
Interest rates cannot fall below 0%, so deflation creates a situation where lenders receive nominal interest rates that approach zero.
If this happens, lending will stop.
If the economy is depressed, which caused the deflation in the first place, monetary policy becomes completely ineffective.

102. The Liquidity Trap R = n – I 2 = 5 – 3 N = r + I
If expected inflation changes to -2%, N = 0
0 = 2 + (-2)
Zero bound

103. M34 Summary
The Phillips curve depicts the nature of the short-run trade-off between inflation and unemployment.
A shift of the AD curve is represented by a movement along the SRPC.
The SRPC will shift right if the SRAS shifts left or inflationary expectations increase. The SRPC will shift left if SRAS shifts right or inflationary expectations decrease.
There is not long-run trade off between inflation and unemployment due to the effect of expectations of inflation.
Even moderate levels of inflation can be hard and painful for an economy to reduce through increased unemployment.
Deflation is a problem for economic policy (namely monetary policy). This leads policy makers to prefer a low but positive inflation rate.