Monetary and Fiscal Policy Chapters 10, 13, and 14

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1 Monetary and Fiscal Policy Chapters 10, 13, and 14! Stabilizing the Economy Controlling unemployment and inflation ((Dual Mandated)! Demand Side Policies Keynesian economics (John Maynard Keynes) Controlled by the Federal Government Pre-Depression - Laissez Faire Post-Depression government active in stabilization Consumer portion of GDP is most important

2 Monetary and Fiscal Policy! Supply-Side Policies Smaller Role of Government (deregulation, less agencies and lower taxes! Laffer Curve hypothetical relationship between tax rates and tax revenue! Monetary Policies (Milton Friedman) Controlling the Money Supply

3 Fiscal Policy Two Types of Fiscal Policy (Discretionary Policies)! Fiscal policy Tools 1.government spending or 2. taxation to achieve particular economic goals.! Expansionary(injection) fiscal policy is an increase in government spending or a reduction in taxes. Contractionary (leakage) fiscal policy is a decrease in government spending or an increase in taxes.

4 Hayek! Hayek No Government involvement Audio on Hayek

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6 Fiscal Policy Rap Fear the Boom and Bust! Copy and paste link into search engine! s=news01n373eqd27! Rap! Second Rap Keynes Hayek!

7 The Issue of Crowding Out! Crowding out occurs when increases in government spending lead to reductions in private spending.! For example, if the government spends more on education, people may decide to spend less on education such as private schooling.

8 The Issue of Crowding In! Crowding in occurs when decreases in government spending leads to increases in private spending.! Crowding in can be complete or incomplete. Complete crowding in is also called zero crowding in.

9 ! Lower tax rates do not necessarily result in lower tax revenues for the government. Lower tax rates will likely give incentive to work more, and may result in increased spending, all of which provides tax revenue for the government.! The Laffer curve, named after economist Arthur Laffer, shows the relationship between tax rates and tax revenues. According to the Laffer curve, as tax rates rise from zero, tax revenues rise, reach a maximum at some point, and then fall.

10 For example, as the tax rate rises from 10 percent to 20 percent, tax revenues might rise from $700 billion to $1,000 billion. (See Transparency 13-2(a)). However, as the tax rate continues to rise, from 80 percent to 90 percent, tax revenues might fall from $1,000 billion to $700 billion. (See Transparency 13-2(b).)

11 ! Lower tax rates do not necessarily result in lower tax revenues for the government. Lower tax rates will likely give incentive to work more, and may result in increased spending, all of which provides tax revenue for the government.! The Laffer curve, named after economist Arthur Laffer, shows the relationship between tax rates and tax revenues. According to the Laffer curve, as tax rates rise from zero, tax revenues rise, reach a maximum at some point, and then fall.

12 For example, as the tax rate rises from 10 percent to 20 percent, tax revenues might rise from $700 billion to $1,000 billion. (See Transparency 13-2(a)). However, as the tax rate continues to rise, from 80 percent to 90 percent, tax revenues might fall from $1,000 billion to $700 billion. (See Transparency 13-2(b).)

13 Hypothetical Laffer Curve! Relationship between tax rates and tax revenues

14 Fiscal Policy and Taxes! After-tax income is the part of income that is left over after taxes are paid.! Disposable income! Alternative Minimum tax! Dividend and Capital Gains! Marginal tax rate! Average tax rate/effective tax rate

15 Types Of Taxations! Progressive taxes: A tax that which the rate increases with income Ex. U.S. Income tax! Regressive taxes: A tax where percentage of income paid in tax goes down as income rises. Ex. U.S. Sales tax! Proportional taxes: A tax that takes the same percent of income from all tax payers! Online Quiz whys_thm03_les04.jsp!

16 31-Jan-11 Historical Highest Marginal Income Tax Rates Year Top Marginal Rate Year Top Marginal Rate Year Top Marginal Rate % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % % Note: This table contains a number of simplifications and ignores a number of factors, such as a maximum tax on earned income of 50 percent when the top rate was 70 percent and the current increase in rates due to income-related reductions in value of itemized deductions. Perhaps most importantly, it ignores the large increase in percentage of returns that were subject to this top rate. Sources: Eugene Steuerle, The Urban Institute; Joseph Pechman, Federal Tax Policy; Joint Committee on Taxation, Summary of Conference Agreement on the Jobs and Growth Tax Relief Reconciliation Act of 2003, JCX-54-03, May 22, 2003; IRS Revised Tax Rate Schedules

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19 Circular Flow! Leakage s money not used for purchases (taxes, imports, savings)! Injections Money used for purchases (gov. spending, exports investing)! L=I equilibrium! L>I high unemployment! I>L high inflation

20 ! Automatic Stabilizers: Actions that take place without deliberate government control Unemployment insurance Entitlement programs Progressive income tax system

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22 To Whom does the Government Owe Money to?

23 Deficit by Year

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25 Fiscal Policy has Critics! Government revenue vs. expenditures Long process to get spending /tax bills passed! Deficit/Debt Video w.youtube.com/user/usatoday?v=knwpr3k4l_m! Political agendas by elected officials! Obama Budget!

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27 ! Percent Income earner