2. Fiscal Policy and Monetary Policy CHAPTER 19

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

4. 19.1 THE BUDGET AND FISCAL POLICY Fiscal policy is the use of the federal budget to sustain economic growth and smooth the business cycle.  The Federal Budget The federal budget is an annual statement of the expenditures and tax receipts of the government of the United States.

5. 19.1 THE BUDGET AND FISCAL POLICY The government has a budget surplus if tax receipts exceed expenditures. The government has a budget deficit if expenditures exceeds tax receipts. The government has a balanced budget if tax receipts equal expenditures. Budget surplus (+)/deficit (–) = Tax receipts – Expenditures The government’s surplus or deficit is equal to tax receipts minus expenditures.

6. 19.1 THE BUDGET AND FISCAL POLICY The government borrows to finance a budget deficit and repays its debt when it has a budget surplus. The amount of debt outstanding that arises from past budget deficits is called national debt.

7. 19.1 THE BUDGET AND FISCAL POLICY Figure 19.1 shows the federal budget time line for Fiscal year 2007. Budget Time Line The President and Congress make the federal budget on the annual time line.

8. 19.1 THE BUDGET AND FISCAL POLICY Types of Fiscal Policy Fiscal policy can be either Discretionary or Automatic

9. 19.1 THE BUDGET AND FISCAL POLICY Discretionary fiscal policy A fiscal policy action that is initiated by an act of Congress. Automatic fiscal policy 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. 19.1 THE BUDGET AND FISCAL POLICY  Discretionary Fiscal Policy: Demand-Side Effects The Government Expenditure Multiplier The government expenditure multiplier is magnification effect of a change in government expenditure on goods and services on aggregate demand. It works like the investment multiplier.

11. 19.1 THE BUDGET AND FISCAL POLICY The Tax Multiplier The tax multiplier magnification effect of a change in taxes on aggregate demand. A decrease in taxes increases disposable income. And an increase in disposable income increases consumption expenditure. With increased consumption expenditure, employment and incomes rise and consumption expenditure increases yet further.

12. 19.1 THE 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.

13. 19.1 THE 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. 19.1 THE BUDGET AND FISCAL POLICY Discretionary Fiscal Stabilization If real GDP is below potential GDP, the government might use discretionary 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. 19.1 THE 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 19.2 illustrates an expansionary fiscal policy.

16. 19.1 THE 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.

17. 19.1 THE BUDGET AND FISCAL POLICY Figure 19.3 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.

18. 19.1 THE 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.

19. 19.1 THE BUDGET AND FISCAL POLICY  Discretionary Fiscal Policy: Supply-Side Effects An increase in government expenditure that increase the quantities of productive services and capital increases aggregate supply.

20. 19.1 THE BUDGET AND FISCAL POLICY Supply-Side Effects of Taxes Taxes decrease the supply of labor and saving. A decrease in the supply of labor increases the equilibrium real wage rate and decreases the equilibrium quantity of labor employed. Similarly, a decrease in the supply of saving increases the equilibrium real interest rate and decreases the equilibrium quantity of investment and capital employed.

21. 19.1 THE BUDGET AND FISCAL POLICY With smaller quantities of labor and capital, potential GDP decreases, and so does aggregate supply. So an increase in taxes decreases aggregate supply.

22. 19.1 THE BUDGET AND FISCAL POLICY Scale of Government Supply-Side Effects If both government expenditure and taxes increase, the scale of government increases. More productive government expenditure increases potential GDP, but higher taxes to pay for the expenditure decreases potential GDP. Economists disagree on which of these effects is stronger.

23. 19.1 THE 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. Figure 19.4 illustrates the effects of fiscal policy on potential GDP.

24. 19.1 THE BUDGET AND FISCAL POLICY 3. The combined effects of a tax cut on employment and labor productivity increases potential GDP.

25. 19.1 THE BUDGET AND FISCAL POLICY  Combined Demand and Supply 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 19.5 on the next slides shows the supply-side effects of fiscal policy when fiscal policy has no effect on the price level.

26. 19.1 THE 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.

27. 19.1 THE BUDGET AND FISCAL POLICY  Limitations of Discretionary Fiscal Policy The use of discretionary fiscal policy is seriously hampered by three factors: Law-making time lag Estimating potential GDP Economic forecasting

28. 19.1 THE 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.

29. 19.1 THE 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.

30. 19.1 THE 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.

31. 19.1 THE 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.

32. 19.1 THE 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.

33. 19. 2 THE FED AND MONETARY POLICY  The Monetary Policy Process The Fed makes monetary policy in a process that has three main elements: Monitoring economic conditions Making policy decisions Reporting to Congress

34. Monitoring Economic Conditions Beige Book A report that summarizes current economic conditions in each Federal Reserve district and each sector of the economy. The Beige Book is a good source of current information about the state of the economy. 19. 2 THE FED AND MONETARY POLICY

35. Meetings of the Federal Open Market Committee (FOMC) The FOMC, which meets eight times a year, makes the monetary policy decisions. After each meeting, the FOMC announces its decisions and describes its view of the likelihood that its goals of price stability and sustainable economic growth will be achieved. 19. 2 THE FED AND MONETARY POLICY

36. The 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. 19. 2 THE FED AND MONETARY POLICY

37.  The Federal Funds Rate Target Following each FOMC meeting, the Fed announces its monetary policy decision. If the federal funds target is changed, the Fed announces an accompanying change in the discount rate. To hits its target for the federal funds rate, the FOMC instructs the New York Fed to conduct open market operations. 19. 2 THE FED AND MONETARY POLICY

38. Commercial banks borrow and lend reserves in the federal funds market. 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 to the quantity supplied. The Fed influences the quantity of funds available by its open market operations. 19. 2 THE FED AND MONETARY POLICY

39. If the Fed sells securities, commercial banks’ reserves decrease. In the federal funds market, the supply of funds decreases, so the federal funds rate rises. If the Fed buys securities, commercial banks’ reserves increase. In the federal funds market, the supply of funds increases, so the federal funds rate falls. By adjusting the quantity of reserves in the banking system, the Fed can move the federal funds rate to its target. 19. 2 THE FED AND MONETARY POLICY

40.  The Ripple Effects of the Fed’s Actions When the Fed changes the federal funds rate, it sets up a ripple effect that runs all the way to a change in real GDP and the price level. Figure 19.6 provides a schematic summary of the ripple effects, which stretch over a period of up to two years. 19. 2 THE FED AND MONETARY POLICY

41. When the Fed decides at the FOMC meeting to raise the federal funds rate:

42. 19. 2 THE FED AND MONETARY POLICY When the Fed decides at the FOMC meeting to lower the federal funds rate:

43. 19. 2 THE FED AND MONETARY POLICY  Monetary Stabilization in the AS-AD Model The Fed Tightens to Fight Inflation Real GDP exceeds potential GDP and the Fed Fears inflation. Figure 19.7 illustrates how the Fed’s policy works.

44. 1. The Fed raises the interest rate and the quantity of investment decreases. 19. 2 THE FED AND MONETARY POLICY The curve ID is the investment demand curve. The interest rate is 5 percent a year and investment is $2 trillion.

45. 2. Expenditure decreases by ∆I. 3. The multiplier induces additional expenditure cuts. The aggregate demand curve shifts to AD 1. 19. 2 THE FED AND MONETARY POLICY Real GDP decreases to potential GDP, and inflation is avoided.

46. The Fed Eases to Fight Recession Real GDP is below potential GDP and the Fed fears recession. Figure 19.8 illustrates how the Fed’s policy works. 19. 2 THE FED AND MONETARY POLICY

47. 1. The Fed lowers the interest rate and the quantity of investment increases. The curve ID is the investment demand curve. The interest rate is 5 percent a year and investment is $2 trillion.

48. 2. Expenditure increases by ∆I. 3. The multiplier induces additional expenditure. The aggregate demand curve shifts to AD 1. 19. 2 THE FED AND MONETARY POLICY Real GDP increases to potential GDP, and recession is avoided.

49. The Size of the Multiplier Effect 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. 19. 2 THE FED AND MONETARY POLICY

50.  Limitations of Monetary Stabilization Policy Monetary policy has an advantage over fiscal policy because it cuts out the law-making time lags. But monetary policy shares the other two limitations of fiscal policy: Estimating potential GDP is hard. Economic forecasting is error-prone. 19. 2 THE FED AND MONETARY POLICY

51. Fiscal Policy and Monetary Policy in YOUR Life Consider the U.S. economy right now. Is the U.S. economy at full employment or is there a recessionary gap or an inflationary gap? What type of fiscal policy or monetary policy would you recommend? What do recent changes in policy say about the government’s and the Fed’s view of the state of the economy? How do you think recent changes in fiscal policy and monetary policy will affect you?