Economics multiple parts

ECO 2302, Principles of Macroeconomics 1

Course Learning Outcomes for Unit VI Upon completion of this unit, students should be able to:

6. Discuss the interaction of the federal government and the Federal Reserve Bank in controlling the U.S. economy. 6.1 Describe expansionary and contractionary fiscal policy. 6.2 Describe fiscal policies used to close a recessionary gap and an expansionary gap. 6.3 Explain the rationale for budget deficits.

Course/Unit Learning Outcomes

Learning Activity

6.1

Unit Lesson Chapter 11 Article: “Introduction to U.S. Economy: Fiscal Policy” Unit VI Assignment

6.2 Unit Lesson Chapter 11 Unit VI Assignment

6.3

Unit Lesson Chapter 12 Article: “Budget of the U.S. Government” Unit VI Assignment

Required Unit Resources Chapter 11: Fiscal Policy Chapter 12: Federal Budgets and Public Policy In order to access the following resources, click the links below. Labonte, M. (2019, June 18). Introduction to U.S. economy: Fiscal policy. In Focus.

https://crsreports.congress.gov/product/pdf/IF/IF11253 USAGov. (n.d.). Budget of the U.S. government. https://www.usa.gov/budget

Unit Lesson In Unit VI, you are going to be studying fiscal policy and the federal budget. The information for these subjects can be found in Chapters 11 and 12 of the textbook and is discussed below.

Fiscal Policy Prior to the Great Depression that began in 1929 governments took a passive view in terms of fiscal policy. However, the game changed with the Great Depression as governments began to view their roles differently. Governments began to use fiscal policy in an attempt to stimulate economic growth or slow down the economy when needed. Government purchases, transfer payments, taxes, and borrowing are all used as a means of driving the economic ship in the preferred direction (McEachern, 2019). Some of the means by which the government directs the economy happen automatically, while others require deliberate action by

UNIT VI STUDY GUIDE

Fiscal Policy and the Federal Budget

ECO 2302, Principles of Macroeconomics 2

UNIT x STUDY GUIDE

Title

the federal government. These are addressed below. To learn more on this topic, watch the video Fiscal Policy. A transcript and closed captioning are available once you access the video.

Automatic Stabilizers Think about federal income taxes. The federal government passed legislation that designates the percentage that citizens will have to pay in income taxes. As incomes change, the amount (not the percentage) collected for income taxes changes as well. There is no need for the federal government to debate and pass income tax levels on a yearly basis. That means income tax rates automatically adjust to the ups and downs of the economy. McEachern (2019) goes on to explain that federal income taxes are automatic stabilizers because they allow citizens to keep more disposable income during recessions and avoid paying more during expansions.

Discretionary Fiscal Policy Some fiscal policies do require the government to make new policy on a regular basis. These are called discretionary fiscal policies. McEachern (2019) identifies the tax cut package and spending increases that occurred when the American Recovery and Reinvestment Act (ARRA) was passed in 2009 as an example of a discretionary fiscal policy. These tax cuts and additional government spending could not have taken effect if the new law had not been passed.

Recessionary Gap An economy producing less than its potential creates a recessionary gap. A recessionary gap is shown below where the aggregate demand curve (AD1) intersects the short-run aggregate supply (SRAS) to the left of the long-run potential output (which is also considered to be the long-run aggregate supply, or LRAS). This recessionary gap also results in a price level in the economy (P) that is lower than the potential price level (P’).

Now, the federal government could sit back and wait for the market to adjust and close this recessionary gap naturally. Natural market forces would push the supply curve to the right in the long run (shown as point A below).

ECO 2302, Principles of Macroeconomics 3

UNIT x STUDY GUIDE

Title

However, there are problems with waiting for the economy to naturally correct itself. McEachern (2019) suggests that wages and other resource prices may be slow in responding to the recessionary gap signals, and it can take a long time to close this gap. The federal government can step in and use expansionary fiscal policy (increase government purchases, decrease net taxes, or a combination of both) to close this gap. When the federal government increases purchases and/or decreases taxes, the aggregate demand curve will shift to the right (AD2). When the federal government implements fiscal policy perfectly, the price level will be at P’, output will be equal to the LRAS, and the recessionary gap will be closed.

ECO 2302, Principles of Macroeconomics 4

UNIT x STUDY GUIDE

Title

If the economy were facing an expansionary gap (e.g., the economy was producing more than its potential, and the aggregate demand curve was intersecting the short-run aggregate supply curve to the right of the long-run potential output), the federal government could engage in contractionary fiscal policy (reduce government spending, increase taxes, or a combination of both). The contractionary fiscal policy would cause the aggregate demand curve to shift to the left (decrease). Hopefully, the appropriate measures have been taken, and the aggregate demand curve intersects the short-run aggregate supply curve at the economy’s potential output level.

When the Government Does Not Get It Just Right As you might expect, enacting fiscal policy that perfectly adjusts the aggregate demand curve to exactly intersect the short-run aggregate supply curve at exactly the point where it also intersects the long-run potential output can be difficult. However, you might ask why it would be so bad. The answer is that a fiscal policy that is not perfectly adjusted can have very negative consequences. Let’s look again at expansionary fiscal policy that is used to close an expansionary gap. Expansionary policy is used to shift the aggregate demand curve from AD1 to AD2, as illustrated below.

However, suppose that the federal government made a mistake and reduced taxes and/or increased government spending more than needed. Instead of shifting the aggregate demand curve to AD2, the aggregate demand curve would instead shift to AD3, as shown below.

ECO 2302, Principles of Macroeconomics 5

UNIT x STUDY GUIDE

Title

In the short run, the price level will rise to P’’ and actual output will be above potential. Now, we know that the economy cannot sustain output above its potential. That would mean that the short-run aggregate supply curve would shift to the left (decrease) to SRAS’ (shown below).

ECO 2302, Principles of Macroeconomics 6

UNIT x STUDY GUIDE

Title

When the short-run aggregate supply curve shifts to the left to SRAS’ where it intersects both the aggregate demand (AD3) and the LRAS, we are left with much higher prices. The federal government was attempting to shift the aggregate demand curve to AD2, which would have resulted in a price of P’. However, because the federal government enacted stronger expansionary fiscal policy than necessary, the long-run result was a shift to AD3 and a price level of P’’’.

Problems With Fiscal Policy As you might have already guessed, the ever-changing economy can cause problems with implementing the correct fiscal policy. Imagine being tasked with the chore of determining what the correct long-run potential output of the economy will be (which is already a difficult task). Then add the responsibility of having to select the appropriate expansionary or contractionary fiscal policy to use (decrease or increase taxes and/or increase or decrease government spending). Added on top of these difficult decisions is the fact that the chosen level of change had better be correct, or the choices made could result in the economy being worse than before. Public outcry can be enormous if the appropriate fiscal policy is not enacted. This means that the pressure is on for the federal government to get it right. Even if the federal government gets it right when enacting fiscal policy, there can still be problems. McEachern (2019) points out that it can take time (months or even years) to approve and implement fiscal policy. By the time the appropriate fiscal policy has been approved and implemented, the economy may have already adjusted. This market adjustment could make the new fiscal policy less effective. Take for instance the recession that occurred between January 1980 and July 1980 (McLaughlin, 1982). This recession only lasted 6 months. With a recession taking 6 months to identify after it begins, the recession of 1980 was over before it was ever even identified (McEachern, 2019). That would mean steps could have been taken to enact expansionary fiscal policy when no action was required at all.

Federal Budget Just like individuals, the federal government develops a budget. The federal budget helps to plan for revenue the government will be receiving and expenses it will have; however, when the federal government attempts to develop a budget, it can run into problems that everyday citizens may not face. For one, McEachern (2019) suggests that the continuing resolutions can create problems. Deadlines for developing the federal budget can be missed. This causes the federal government to allow government agencies to continue to operate without having a budget in place. These government agencies are allowed to spend at the rate of the previous year. Continuing resolutions create a situation where successful programs are not provided with additional money to grow. Also, government programs that are unsuccessful are allowed to continue to operate with no modifications. To learn more, watch the brief video Federal Budget. A transcript and closed captioning are available once you access the video. Another issue pointed out by McEachern (2019) regarding the federal budget is that it can take a very long time to be developed and approved. As mentioned above, the federal budget plans for all expenses the federal government will have. This includes everything from social programs to military spending. With so many areas of interest, one can imagine how difficult it is to plan. It does not take long to realize how easy it could be to lose sight of the overall budget when elected officials are trying to determine how much to allocate to each and every segment.

The Dreaded Budget Deficit Listen to news stories about government spending, and you will likely hear about budget deficits. Listen to political debates, and the subject of budget deficits will likely come up. Prior to the Great Depression, running a budget deficit was not much of a consideration. Except for during wartime, fiscal policy focused on running a balanced budget before the Great Depression (McEachern, 2019). Such a philosophy relies on markets correcting themselves when they encounter problems. However, as we have learned, the Great Depression resulted in an economy that could not correct itself. It was at this point that John Maynard Keynes introduced a theory that the federal government could stimulate economic growth through spending (McEachern, 2019). Keeping taxes at the same level (or even reducing them) can also lead to increased economic activity. However, increasing government spending while keeping taxes at the current level (or even reducing them),

ECO 2302, Principles of Macroeconomics 7

UNIT x STUDY GUIDE

Title

creates a situation where the federal government is spending more than it is receiving. This is where a budget deficit is created. One theory behind running a budget deficit is that excess money spent during recessions can be paid for by surplus money collected during expansions (McEachern, 2019). This theory is called a cyclically balanced budget. Basically, this theory revolves around the theory of saving money during the good times and using those savings when needed to stimulate economic growth during difficult times. The budget is effectively balanced over the long term. Another theory—functional finance—focuses more on ensuring that the economy produces at its potential output than on balancing the budget (McEachern, 2019). A drawback to this theory is that it can lead to deficits that occur year after year and result in massive amounts of federal debt. Looking back through the history of federal budgets in the United States, there have been only 14 years when the budget was in surplus since the Great Depression.

Effects of Budget Deficits and Surpluses When looking at the effects of budget deficits and surpluses, we need to first focus on interest rates. As we know from previous units, the level of interest rates affects investment (one component of gross domestic product). If the federal government increases spending without increasing taxes, we know the result will be a budget deficit. The increased deficit reduces the supply of national saving, leading to higher interest rates (McEachern, 2019). Higher interest rates result in less private investment. This is called crowding out private investment and reduces the positive impact of the increased government spending on economic growth. On the other hand, an economy that is operating well below its potential output could see a crowding in effect. In this situation, the increased government deficit encourages firms to invest more, as businesses expect growth to occur from the increased government spending (McEachern, 2019). The crowding out effect can be applied to our own personal decisions. Think about a time when you might not have wanted to stop at a shopping mall (maybe during the holiday season) because you did not want to fight the large crowd. The thought of having to park a great distance from the entrance, fight the large number of people, stand in long lines, and so on crowded you out from visiting the mall. On the other hand, you may have walked by a store and noticed that no one was shopping there. Your thought may have been that the merchandise in the store must not be worth the price if no one is shopping in the store. On the other hand, if only a few people had been in the store, you would have entered and looked around. Effectively, you would have been crowded in to the store.

National Debt When people do not have enough cash money or money available in their checking or savings accounts to make purchases, they might use credit cards to make the purchases. This would be an example of running a budget deficit and financing additional spending through borrowing money from the credit card companies. The borrowed money is a debt that they will have to repay in the future. The federal government is no different in terms of accumulating debt. When the federal government runs a budget deficit, the money to fund additional spending comes from federal debt. That means running budget deficits adds to federal debt. There are distinctions between who holds the debt owed by the federal government. If the federal government chooses to borrow money by selling U.S. Treasury securities to itself, then, essentially, the federal government owes this debt to itself. On the other hand, the federal government can also sell government securities to households, firms, banks, and foreign entities (McEachern, 2019). The second way of financing deficit spending is the one on which most economists focus their attention. There are debates regarding national debt and its impact. One theory is that future generations bear the burden of paying the debt (McEachern, 2019). This is true. However, the same generation that is paying the debt gets to reap the benefits of the debt. For instance, if the federal government sells bonds to its citizens today to finance spending today, those citizens are delaying purchases of goods and services to own those bonds. When those bonds mature, those citizens will be paid their initial investment plus interest. This argument does not apply when it comes to those government securities that are sold to foreign entities. It is

ECO 2302, Principles of Macroeconomics 8

UNIT x STUDY GUIDE

Title

the foreign entities that receive the future benefits. Future generations, in this instance, do bear the burden of the debt.

References McEachern, W. A. (2019). Macro ECON6: Principles of macroeconomics (6th ed.). 4LTR Press. McLaughlin, R. L. (1982, January/March). A model of an average recession and recovery. Journal of

Forecasting, 1(1), 55–65. https://doi- org.libraryresources.columbiasouthern.edu/10.1002/for.3980010107