Fiscal Policy. Principles of Macroeconomics Module 5.1

Transcription

1 Fiscal Policy Principles of Macroeconomics Module 5.1

2 Government s Role in the Economy The federal government can affect economic outcomes in two ways: 1. Through government spending 2. Through taxes These two factors also directly affect the government s budget

3 Government Budget Government Spending (G) depends on tax revenue (T) If T > G: Budget Surplus If T < G: Budget Deficit If T < G then the government must finance (borrow money) by issuing bonds

4 Government Budget Government Spending (G) depends on tax revenue (T) If T < G then the government must finance (borrow money) by issuing bonds National Debt: Reflects the accumulated amount of money borrowed by the government to finance its spending activity The longer the government runs a budget deficit, the more the national debt grows

5 Government Spending Types of Government Spending: Spending on Goods and Services by local, state and national government: National Defense Education Infrastructure Transfer Payments/Welfare Payments

6 Taxes Corporate Taxes Sales Taxes Personal Income Taxes Property Taxes Other taxes Hotel Tax Sin Tax Estate Tax

7 Taxes Progressive Tax: Tax rate increases as the taxable amount increases Tax rate progresses from low to high Taxpayer's average tax rate is less than the person's marginal tax rate Regressive Tax: Tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases. Distribution effect on income or expenditure progresses from high to low Average tax rate exceeds the marginal tax rate.

8 Fiscal Policy Government spending (G) and taxes (T) impact the AD curve G à part of AD curve: C + I + G + NX T à impacts Consumption If income taxes are HIGH à If income taxes are LOW à Consumption will be low Consumption will be high

9 Stimulating Growth Suppose the economy is in a low-growth phase The government wants to stimulate growth It needs to enact fiscal policy to increase AD (real GDP) in the short run 1. Increase government spending 2. Decrease taxes 3. Combination of both

10 Stimulating Growth Suppose the economy is in a low-growth phase The government wants to stimulate growth P SRAS 1. Boost spending on infrastructure by $20 billion 2. Cut personal income tax from 30% to 25% P.2 Low growth corresponds to high gov t deficit Boost from stimulating fiscal policy will lead to higher inflation but lower unemployment P.1 AD.1 AD.2 Y.1 Y.2

11 Principles of Macroeconomics Module 5.1 (A) Macroeconomic Equilibrium and Fiscal Policy 208

12 Government Policy Impact on AD Government influence over the aggregate economy comes from: Fiscal Policy: Impact of government spending (G) and taxes on AD Monetary Policy: Impact of changes in MS and interest rates on AD 209

13 Fiscal Policy Changes in government spending directly shift the AD curve (change in G): Multiplier Effect: Increase in G leads to an even greater increase in AD ΔAD > Δ G Crowding-out Effect: Increase in G leads to a smaller increase in AD ΔAD < Δ G 210

14 Fiscal Policy Changes in government spending directly shift the AD curve (change in G): Multiplier Effect: Increase in G leads to an even greater increase in AD ΔAD > Δ G Crowding-out Effect: Increase in G leads to a smaller increase in AD ΔAD < Δ G 211

15 Multiplier Effect Extra boost or shift in AD resulting from expansionary fiscal policy that increases income and therefore consumption G + C = Greater AD 212

16 Multiplier Effect Marginal Propensity to Consume (MPC): Share of income spent on consumption (rather than saved). Multiplier Effect on AD = S STUVW X 213

17 Test your understanding Suppose Congress approves a budget for the US government with an additional $20 billion in spending in Assume MPC is 3/4 What will be the increase in AD? By how much does consumption increase? Illustrate the change in AD. 214

18 Test your understanding Y. [ =??T@.\A M.E. = G + C $20 ^/''. = 4*20 M.E. = 4* $20 billion= $80 billion P +$20 billion Increase in G = $20 billion Increase in C = $60 billion Total increase in AD = $80 billion +$80 billion AD.1 AD.2 Y 215

19 Test your understanding Y. [ =??T@.\A M.E. = G + C $20 ^/''. = 4*20 M.E. = 4* $20 billion= $80 billion P + G + C +$20 billion +$60 billion Increase in G = $20 billion Increase in C = $60 billion Total increase in AD = $80 billion AD.1 AD.2 Y 216

20 Crowding Out Effect The offset in AD that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending G + I = Smaller AD 217

21 Crowding Out Effect If G is financed with new bonds this will take away some loanable funds from businesses crowding out funding available for business investment spending Higher interest rates è Lower investment 218

22 Crowding Out Effect Suppose the government increases spending by $100 million. Assume that for each 1% increase in the interest rate, investment spending falls by $15 million. As a result of the change in government spending, interest rates rise from 5% to 8%. What will be the increase in AD? By how much does investment change? Illustrate the change in AD. 219

23 Test your understanding Change in G = +$100 million Change in interest rates = +3% Change in I = 3*$15 million = -$45 million C.E. = G + I C.E. = $100 mil + (-$45 mil) = $55 mil P + G +$100 million +$55 million Increase in G = $100 million Decrease in I = $45 million Total increase in AD = $55 million AD.1 AD.2 Y 220

24 Test your understanding Change in G = +$100 million Change in interest rates = +3% Change in I = 3*$15 million = -$45 million C.E. = G + I C.E. = $100 mil + (-$45 mil) = $55 mil P + G +$100 million - I -$45 million Increase in G = $100 million Decrease in I = $45 million Total increase in AD = $55 million AD.1 AD.2 Y 221

25 Key Takeaways The government can influence the aggregate economy through changes in AD Changes in AD will come from change in G (fiscal policy) or monetary policy Effect of Fiscal Policy depends on the strength of the Multiplier Effect and Crowding out Effect Motivation to influence the aggregate economy à Stabilization! 222

26 Principles of Macroeconomics Module 5.1 (B) Macroeconomic Equilibrium and Monetary Policy 223

27 Government Policy Impact on AD Government influence over the aggregate economy comes from: Monetary Policy: Impact of changes in MS and interest rates on AD Fiscal Policy: Impact of government spending (G) and taxes on AD Recall that changes in AD come only from a change in C, I, G or NX Monetary Policy impacts AD via Investment (I) 224

28 Monetary Policy Federal Reserve s goal in controlling MS: Control inflation Promote economic growth Provide economic stabilization 225

29 Increasing Money Supply Expansionary Monetary Policy MS.2 DECREASE IN INTEREST RATES 226

30 Increasing Money Supply Expansionary Monetary Policy MS.2 DECREASE IN INTEREST RATES INCREASE IN SUPPLY OF LF INCREASE IN INVESTMENT SPENDING 227

31 Increasing Money Supply Expansionary Monetary Policy MS.2 DECREASE IN INTEREST RATES B A S.2 INCREASE IN SUPPLY OF LF AD.2 INCREASE IN INVESTMENT SPENDING NEW SHORT RUN EQUILIBRIUM (B) HIGHER PRICE LEVEL HIGHER OUTPUT 228

32 Increasing Money Supply Expansionary Monetary Policy MS.2 DECREASE IN INTEREST RATES EXPANSIONARY MONETARY POLICY LEADS TO: HIGHER OUTPUT à LOWER UNEMPLOYMENT PROMOTES LONG-RUN ECONOMIC GROWTH A B S.2 But at the cost of HIGHER INFLATION INCREASE IN SUPPLY OF LF INCREASE IN INVESTMENT SPENDING NEW SHORT RUN EQUILIBRIUM (B) AD.2 HIGHER PRICE LEVEL HIGHER OUTPUT 238

33 Decreasing Money Supply Contractionary Monetary Policy MS.2 INCREASE IN INTEREST RATES 230

34 Decreasing Money Supply Contractionary Monetary Policy MS.2 INCREASE IN INTEREST RATES DECREASE IN SUPPLY OF LF DECREASE IN INVESTMENT SPENDING 231

35 Decreasing Money Supply Contractionary Monetary Policy MS.2 INCREASE IN INTEREST RATES A DECREASE IN SUPPLY OF LF DECREASE IN INVESTMENT SPENDING B NEW SHORT RUN EQUILIBRIUM (B) LOWER PRICE LEVEL LOWER OUTPUT 232

36 Decreasing Money Supply Contractionary Monetary Policy MS.2 DECREASE IN INTEREST RATES CONTRACTIONARY MONETARY POLICY LEADS TO: LOWER PRICE LEVEL à CONTROL INFLATION B A But at the cost S.2of INCREASE IN SUPPLY OF LF LOWER OUTPUT à HIGHER UNEMPLOYMENT INCREASE IN INVESTMENT SPENDING AD.2 NEW SHORT RUN EQUILIBRIUM (B) LOWER PRICE LEVEL LOWER OUTPUT 233

37 Key Takeaways Federal Reserve influences the aggregate economy through changing the money supply The impact is indirect because: Change in MS à Change in interest rates à Change in Investment à Change in AD The Federal Reserve chooses the appropriate monetary policy depending on its goals: Control Inflation Promote Economic Growth 234

38 Government Policy Responses to Short Run Economic Shocks Principles of Macroeconomics Module 5.1 (C)

39 Long Run Equilibrium Economy produces at the Natural Rate of Output (NRO) Price Level Long Run Equilibrium Natural Rate of Output NRO: GDP when the economy operates at full employment Full Employment = Natural Rate of Unemployment Unemployment rate with only structural and frictional factors

40 Deviations from Long Run Equilibrium Price Level Long Run Equilibrium Shocks can occur in the economy to cause deviations away from the Long Run Equilibrium Caused by change in AD or in SRAS Unemployment rate NRU Monetary and Fiscal Policy government can stabilize the effects of these shocks Natural Rate of Output

41 Government Policy Impact on AD Government influence over the aggregate economy comes from: Monetary Policy: Impact of changes in MS and interest rates on AD Fiscal Policy: Impact of government spending (G) and taxes on AD

42 Short Run Economic Fluctuations Deviations from the long run equilibrium in the AD/AS model are the source of short run economic fluctuations

43 Short Run Economic Fluctuations Demand-side shocks: Change in AD Increase in AD à Higher price level and higher output Decrease in AD à Lower price level and lower output

44 Short Run Economic Fluctuations Supply-side shocks: Changes in SRAS Increase in SRAS à Lower price level and higher output Decrease in SRAS à Higher price level and lower output

45 Demand-side Shock Consider the impact of a recession in Europe on the US economy. How will this impact the AD/AS model for the US? What is the impact on the price level and output in the US? What government policies can be enacted to curb the negative effects in the US?

46 Curbing the Demand-side Shock B A This shock leads AD to shift down (left) Lower Price Level Lower Output à Higher unemployment Recession in US is possible AD.2

47 Curbing the Demand-side Shock B C What can the US government do? 1.Expansionary Monetary Policy à Shift AD up (right) via change in I 2.Expansionary Fiscal Policy à Shift AD up (right) via change in G (or C with taxes) AD.2

48 Supply-side Shock Consider a situation where the price of copper skyrockets. Copper is heavily used in manufacturing, construction, and technology in the US economy. How will this impact the AD/AS model for the US? What is the impact on the price level and output in the US? What government policies can be enacted to curb the negative effects in the US?

49 Curbing the Supply-side Shock B A This shock leads SRAS to shift in (left) Higher Price Level Lower Output à Higher unemployment Recession in US is possible What can the US government do? Problem!! What is more important? Curb inflation? Lower unemployment?

50 Curbing the Supply-side Shock Curbing Inflation P.1 B P.2 A C If the government chooses to curb inflation: Contractionary Monetary Policy à decrease MS and therefore decrease AD CURB INFLATION COST: HIGHER UNEMPLOYMENT AS OUTPUT FALLS

51 Curbing the Supply-side Shock Lowering Unemployment P.2 P.1 B C A If the government chooses to lower unemployment: Expansionary Monetary Policy à increase MS and therefore increase in AD via I Expansionary Fiscal Policy à increase G increases in AD

52 To Stabilize or Not? Stabilization : Fiscal and Monetary Policy are used to counter negative fluctuations (recessions) in the economy and to lessen the blow of economic downturns. PROS Helps alleviate the negative effects of short run economic fluctuations on households and firms Mitigate effects of a supply shock May help bring economy out of recession Can be implemented easily with Congressional approval

53 To Stabilize or Not? Stabilization : Fiscal and Monetary Policy are used to counter negative fluctuations (recessions) in the economy and to lessen the blow of economic downturns. CONS Takes time to implement may take effect too late May overshoot/undershoot target goals Can create budget deficits Automatic stabilizers already exist

54 Government Policy Responses to Short Run Economic Shocks - Practice Principles of Macroeconomics Module 5.1 (D)

55 Further Practice - 1 Consider an economy where the unemployment rate is 20% and the inflation rate is 2%. What policies can the government enact to help the economy?

56 Further Practice 1 P.A A (1)With such high unemployment we can assume the economy is in a recession: Producing below full employment (Y.A) Inflation is low 2% Y.A AD.2

57 P.A Further Practice 1 A Y.A AD.2 (2) Best policies to enact: BOOST GROWTH to curb unemployment à INCREASE AD Monetary Policy: Expansionary MS increases Purchase Gov t Securities from public Discount rate (Interest rate) falls Fiscal Policy: Expansionary Increase Government Spending Cut Taxes (stimulates C)

58 Further Practice - 2 Consider an economy that is at full employment (long run equilibrium). The central bank has decided to increase interest rates (contractionary monetary policy). At the same time, Congress decides to increase spending on new military equipment. What is the impact on the economy?

59 Further Practice 2 P.A A (1)Economy starts in long run equilibrium at point A Producing at full employment LRAS = SRAS = AD NRO

60 Further Practice 2 (2.A) Monetary Policy: Contractionary MS decreases Sale of Gov t Securities to public Discount rate (Interest rate) increases AD decreases P.B B More responsive investment spending is to changes in interest rates à the larger the impact of M.P. on AD Y.B AD.2 UNEMPLOYMENT INCREASES Lower growth in the economy Price level falls

61 Further Practice 2 P.C C AD.2 (2.B) Fiscal Policy: Expansionary Increase Government Spending Cut Taxes (stimulates C) Causes AD to increase Larger Multiplier Effect: Larger impact of G on AD More people consume (less saving) bigger effect Amplifies the impact of fiscal policy UNEMPLOYMENT FALLS More growth in the economy Price level rises Y.C

62 Further Practice 2 C (3) Contradictory Effects of Government Policy: Which Effect Dominates? Depends on which is stronger Monetary Policy Change Fiscal Policy Change Possible Scenarios: Congress passes stimulus package Fed is concerned about the inflation it will cause

63 Returning to Long Run Equilibrium When there are short run shocks in the economy, if the government does not enact policies to stabilize, eventually the economy will return to long run equilibrium With demand-side shocks: Initially: businesses do not expect the change in the price level Once they factor in the new price level into their business decisions and wages/prices are not sticky SRAS will adjust Expectations are critical

64 Returning to LRE: Demand-side Shock P.AA P.B B A AD.2 After the shock: Price level is lower than expected (P.B. rather than P.A) Movement along SRAS in short run indicates businesses adjust Q produced since prices/wages are sticky

65 Returning to LRE: Demand-side Shock P.AA P.B B A C AD.2 SRAS.2 If the Government does nothing: Businesses will eventually adjust expectations to lower price level (P.B.) In the long run: they can adjust wages/prices too Once those adjustments happen: SRAS shifts

66 Returning to Long Run Equilibrium With supply - shocks: If it is a temporary resource shock eventually return back to LR levels If it is a permanent resource/technology shock -- both LRAS and SRAS shift and now we have a new LRE

67 Returning to LRE: Supply-side Shock SRAS.2 P.A A P.B B NRO Y.B

68 Key Takeaways Both Congress and the Federal Reserve can act to influence the aggregate economy Goal behind their policies should always be to stabilize the economy and not to contribute/cause greater fluctuations Whether stabilization is necessary and/or effective is debated among economists

69 Principles of Macroeconomics Module 5.2 Inflation and Unemployment: The Phillips Curve 252

70 Goals of Gov t Policies Recall that monetary and fiscal policy should be used to stabilize the economy: Decrease unemployment (promote economic growth) Decrease inflation But there is a short run tradeoff: To decrease inflation leads to increase unemployment To decrease unemployment leads to increase inflation 253

71 Phillips Curve Phillips Curve illustrates the tradeoff between inflation and unemployment In the LR: due to monetary neutrality and classical dichotomy à NO TRADEOFF In the SR: the tradeoff is based on the short run equilibrium in the AD-AS model 254

72 Unemployment in the long run is determined by: - Structural Barriers - Frictional Unemployment Prices do not affect the natural rate of unemployment 255

73 Understanding the Phillips Curve Consider the impact of expansionary monetary policy on the AD-AS model. - What happens to the price level? How does this impact inflation? - What happens to output? How does this affect unemployment? - Illustrate this effect on the Short Run Phillips Curve 256

74 257

75 B A Interest rates fall as a result of increase in MS AD shifts out because of increase in investment spending from decrease in interest rates Higher Price Higher Output Move along the Phillips curve Higher inflation Lower Unemployment 258

76 Test your understanding What if the economy faced a short run negative supply shock? SRAS shifts in or left - Higher Inflation - Higher unemployment Government must choose what to control! 259

77 Negative Supply Shock SRAS B A A B 260

78 If they want to control inflation SRAS B C A A B C 261

79 If they want to promote growth SRAS C B A A C B 262

80 Short Run Tradeoffs To stabilize the economy in times of shocks or recessions, the government faces a tradeoff Act to lower inflation (decrease AD) at the cost of higher unemployment Act to lower unemployment (increase AD) at the cost of higher inflation Can t do both! 263

81 Key Takeaways The Phillips Curve provides guidance for policymakers in the short run in deciding to reach inflation or unemployment targets Links what happens in the aggregate economy (AD-AS model) to inflation and unemployment outcomes in the economy 264