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6PFiscalPolicy.pptxFiscal Policy a tool to help manage the Macro Economy
Expansionary and contractionary policy
Deficits and Surpluses
Crowding out effect
Built-in-Stability
Problems of Fiscal Policy
Forecasting the future
Please listen to the audio as you work through the slides.
Creative Commons Attribution 4.0 License, Charles Hackner Houston Community College unless otherwise noted CC BY NC
Learning objectives
Students should be able to thoroughly and completely explain:
Discretionary and Non-discretionary Fiscal Policy
The key elements of non-discretionary fiscal policy and how they interact to support the policy.
Expansionary fiscal policy and the 3 tools that support it.
Contractionary fiscal policy and the 3 tools that support it.
The issues associated with deficit financing.
The 4 problems associated with Fiscal Policy.
The impact of the net export effect and the crowding out effect on the effectiveness of discretionary fiscal policy.
How to use Fiscal Policy to address the problems of Inflation and Recession.
Legislative Mandates
Employment Act of 1946
Council of Economic Advisors (CEA)
US Congress Joint Economic Committee (JEC)
Fiscal Policy and the AD-AS Model
Two Options :
Discretionary Fiscal Policy (action)
Non-Discretionary Fiscal Policy (no action)
Expansionary Fiscal Policy
To Reduce Unemployment…
Increase Government Spending
Tax Reductions
Combinations of the Two
Expansionary Fiscal Policy
Real Domestic Output, GDP
Price Level
AD2
Recessions
Decrease
Aggregate
Demand
AD1
$5 Billion
Additional
Spending
Full $20 Billion
Increase in
Aggregate Demand
AS
$490
$510
P1
To Reduce Inflation…
Decrease Government Spending
Tax Increases
Combinations of the Two
FISCAL POLICY AND THE AD-AS MODEL
Contractionary Fiscal Policy
Contractionary Fiscal Policy
Real Domestic Output, GDP
Price Level
AD3
Reduce
Demand Pull
Inflation
AD4
$3 Billion
Initial Decrease
In Spending
Full $12 Billion
Decrease in
Aggregate Demand
AS
$510
$522
P1
P2
Fiscal Policy - Deficits and Surpluses
Relative to the Federal budget
A deficit represents spending in excess of tax revenues.
A surplus represents tax revenues in excess of government spending.
Expansionary fiscal policy – think deficit
Contractionary fiscal policy – think surplus
Which policy to use – G or T?
Depends on whether one feels government is too large or too small.
Fiscal Policy – Financing Deficits
Borrowing vs. New Money
Borrowing from the public – Federal Government sells bonds which could lead to higher interest rates
The Fed selling bonds increases the supply of bonds in the market and causes the price of bonds to drop. Bond prices and their interest rates are inversely related. The interest rates on bonds go up.
Lower investment spending results, and
Weakens the expansionary action.
This is called the “crowding out effect”
Money Creation by the Federal Reserve System - minimal crowding out effect
More expansionary approach
Crowding Out
5
10
15
20
25
30
35
40
0
2
4
6
8
10
12
14
16
Real Interest Rate (Percent)
Investment (Billions of Dollars)
ID1
ID2
a
b
c
Interest Rate
Rise Will
Decrease
Investment
From a to b
Crowding-
Out Effect
A Large Public Debt to Finance Public Investment Will Cause…
If Public Spending
Spurs More Private
Investment, ID Will
Increase to ID2
Disposing of Surpluses – impact on GDP
Debt Retirement vs. Idle Surplus
Debt Reduction – Federal Government buys bonds, which could lead to lower interest rates.
The Fed buying bonds increases the demand for bonds and causes the price of bonds to rise. Bond prices and their interest rates are inversely related. The interest rates on bonds go down.
Investment spending increases and reduces anti-inflationary impact of the surplus
Impounding the surplus – hold the money
Federal Budget Balance
30-12
Actual and Projected, Fiscal 1994-2014
$300
200
100
0
-100
-200
-300
-400
-500
Budget Deficit (-) or Surplus, Billions
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
Actual
Projected
(as of March 2008)
change
12
Built-in Stability
Net tax revenues vary directly with GDP
Transfer payments behave the opposite way as tax collections
Unemployment compensation and welfare payments decrease during expansions and increase during contractions.
Built-in Stability
Automatic or Built-In Stabilizers
Anything that increases the government’s budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policymakers.
Economic Importance
Taxes reduce spending and aggregate demand
Reductions in spending are desirable when the economy is moving toward inflation
Increases in spending are desirable when the economy is heading toward recession.
Accomplishing these results automatically is important
Built-in Stability – key relationships
30-15
G
T
Deficit
Surplus
GDP1
GDP2
GDP3
Real Domestic Output, GDP
Government Expenses, G
and Tax Revenues, T
Built-in Stability
Tax Progressivity
Progressive Tax System
Average tax rate (tax revenue/GDP) rises with GDP
Proportional Tax System
Average tax rate remains constant as GDP changes
Regressive Tax System
Average tax rate falls with GDP
The more progressive the tax system, the greater the economy’s Built-in Stability.
Fiscal Policy – 4 Issues
Problems, Criticisms, and Complications
Problems of Timing
Recognition Lag (9 to 12 months)
Administrative Lag (9 to 12 months)
Operational Lag (depends)
Political Considerations
Political Business Cycles
Getting re-elected versus doing the right thing for the country
Offsetting State & Local Finance
States must balance their budgets – Federal govt. does not
Crowding-Out Effect
Fiscal Policy: the effects of crowding out and the net export effect
Fiscal Policy:
No Complications
Price level
Real GDP (billions)
AD1
AD2
P1
$490 $510
AS
Fiscal Policy in the Open Economy – The Net Export Effect
Problem
Recession:
Expansionary fiscal policy with deficit financing
Higher US interest rate
Higher foreign demand For dollars
Dollar appreciates
Net exports decline(aggregate
Demand decreases, partially
Offsetting the expansionary
Fiscal policy),
Problem
Inflation:
Contractionary fiscal policy
Lower US interest rates (less borrowing)
Lower foreign demand for dollars
Dollar depreciates
Net exports increase (aggregate
Demand increases, partially offsetting
Contractionary fiscal policy
Fiscal Policy: the effects of crowding out and the net export effect
Fiscal Policy:
Showing
Crowding-out Effect – interest rate increases
or Net Export
Effect – interest rate increases, attracting foreign capital, dollar appreciates, net exports fall
Price level
Real GDP (billions)
AD1
AD2
P1
$490 $510
AS
AD’2
$504
Forecasting the Future
The Leading Indicators
Average Workweek
Initial Claims for Unemployment Insurance
New Orders for Consumer Goods
Vendor Performance
New Orders for Capital Goods
Building Permits for Houses
Money Supply
Interest-Rate Spread
Consumer Expectations
KEY TERMS
