THREE ECONOMIC
THEORIES
• an economy will always move towards equilibrium at
full capacity and full employment
• Aggregate demand will adjust to full potential GDP,
assisted by flexible wages and prices (wage contracts
and resource price agreements can be renegotiated)
• Market clearing: an assumption that prices
are flexible and adjust to equate supply and
demand; Market is SELF-CORRECTING!!!!
• In long run, all prices are variable (if price level
increases, wages increase thus profit-maximizing firms
will not change production; price increase, quantity
doesn’t change thus a vertical LRAS)
1) CLASSICAL
• British economist John Maynard Keynes took the viewpoint that
spending induces businesses to supply goods and services.
• If consumers become pessimistic about their futures and cut down
on their spending, then business will reduce their production.
• He rejected the classical viewpoint that unemployment would be
resolved by flexible wage rates; instead, wages are viewed as
being "sticky”
• In the short run, many prices are sticky (fixed); they adjust only
sluggishly in response to supply/demand imbalances; wages are
fixed in SR, then as price increases, total revenue increases and
profit-maximizing firms will increase production (price increase,
quantity increase thus an upward sloping SRAS curve)
2) KEYNESIAN
Downward Price Inflexibility (why prices
do not change during recessions) –
“sticky” wages/prices
•
•
•
•
Fear of price wars
Menu costs
Wage contracts
Morale, effort, and productivity (cutting wages reduces
productivity)
• Minimum wage
3) SUPPLY SIDE
ECONOMICS
FISCAL POLICY
• Changes in federal taxes and federal government
spending designed to affect the level of aggregate
demand in the economy
• Conducted by President, Congress, and Council of
Economic Advisers (CEA)
• DISCRETIONARY SPENDING: when government
stabilizes the economy by passing a law or taking some
other specific action to change its tax and/or spending
policies
What is Fiscal Policy?
• During recessions, AD is usually too low to bring about full
employment of resources.
• Government can:
• Increase government spending
• Cut taxes
• Results in budget deficits because government spends more
than it collects in taxes
• Increased government spending without increasing taxes OR
decreasing taxes without decreasing government spending should
increase AD, increasing employment, the price level, or both.
EXPANSIONARY FISCAL
POLICY
• If increase in
government
spending…
• If there is a GDP gap
of $20 billion and MPC
is .75 (multiplier 4),
then the government
can inject $5 billion
into the economy ( 5
multiplied 4 times
which equals $20
billion)
• Will shift AD curve to
the right
• Economy moves back
to full employment
• If decrease in taxes…
• must be somewhat larger than the
proposed increase in government
spending if it is to achieve the
same amount of rightward shift in
AD curve
• If MPC is .75 and you want to
increase new consumption by
$5B, must cut taxes by $6.67B
because $1.67 B is saved
• If economy has a $20B gap (below full
employment), the government could
increase its spending by $1.25 B and cut
taxes by $5 B
Combined government
spending and tax cuts…
Government Spending Financed by Tax Increases
• Suppose government spending rises by $100 billion and that this
expenditure is financed by a tax increase of $100 billion…such a
“BALANCED BUDGET” change in fiscal policy will cause REAL
GDP TO RISE (AD INCREASE)
• Example…if taxes increase by $100, consumers will not cut their
spending by $100 but will cut it by some fraction, say 9/10, of the
increase; if consumers spend 90% of a change in their disposable
income, then a tax increase of $100 would lower consumption by $90.
• So…the net effect of raising government spending and taxes by the
same amount is an increase in AD (assuming AS is not affected)
• AS may also be affected by increase in taxes
• When taxes increase, workers have less incentive to work because their aftertax income is lower
• The cost of taking a day off or extending a vacation for few extra days is less
than it is when taxes are lower and after-tax income is higher
• When taxes go up, then, output can fall, causing AS to shift to left
(justification of supply-side economics/Laffer Curve)
• Borrowing to finance government spending can also
limit the increase in aggregate demand
• Government borrows funds by selling bonds to public
• debt that must be repaid back at a future date which
means taxes will have to be higher in the future in order
to provide the government with funds to pay off debt
• This can limit expansionary effect of increased
government spending (if taxes increase in
future)…households and businesses will begin to save
more today so they will be able to pay taxes in the future)
Government Spending
Financed by Borrowing
• If AD is too high, creating inflationary pressure,
government can:
• Reduce it spending
• Increase taxes
• both
• Economy will experience less employment, lower price
level, or both
• These actions result in larger budget surplus or smaller
budget deficit
CONTRACTIONARY FISCAL
POLICY
• Increases in AD expand output beyond full
employment, increasing price level but declines
in AD rarely decrease price level back to
previous level.
• Contractionary policies are to halt rise in price
level (eliminates a continuing positive
inflationary gap)
If decrease government
spending…
• Used to reduce consumption spending
• If there is an inflationary gap
(demand-pull inflation) of $20B and
MPC is .75, the government can
increase taxes by $6.67B
If increase taxes…
• Can do both to reduce AD and control
inflation
Combined government
spending decreases and
tax increases…
• Depends largely on one’s view as to
whether the government is too large or
too small
Policy Options: G or T?
AUTOMATIC/BUILT
IN STABILIZERS
• economy stabilizing by itself as the economic
situation changes due to things that are
already built into the system such as…
Definition
• Transfer Payments
• unemployment compensation (if laid off, you may qualify for
unemployment benefits which helps them buy necessities and
helps AD from falling too much)
• Food Stamps
• Tax Progressivity
• When incomes are high, tax liabilities rise and eligibility for
government benefits falls, without any change in the tax code or
other legislation.
• When incomes slip, tax liabilities drop and more families become
eligible for government transfer programs, such as food stamps
and unemployment insurance, that help buttress their income.
• This process acts as an automatic stabilizer during inflationary
episodes because as income rises, tax collections rise even faster,
accelerating withdrawals from the economy and dampening
inflationary growth of nominal income (vice versa)
Problems of
Fiscal Policy
• Problems of timing
• Recognition lag – time of beginning of recession/inflation to
awareness that it is actually happening
• Administrative lag - time of need for fiscal policy action and time
action is taken (think about DIVIDED GOVERNMENT)
• Operational lag – time fiscal action is taken and the time that action
affects output, employment, or the price level (tax cuts immediate;
government spending takes planning)
• Political considerations
• It’s a human trait to rationalize actions/policies that are in
one’s self-interest
• Decisions may be made according to reelection and not in
best interest of economy
• Future policy reversals
• Fiscal policy actions may fail to achieve its intended
objectives if households expect future reversals of policy
(example, tax cut…if people believe it is temporary, they
may save a large portion of tax saving and vice versa)
• Offsetting state and local finance
• Policies of state/local governments are frequently procyclical (they worsen rather than correct recession or
inflation); many states face challenge of balancing the
budget
• Crowding-out effect (MUST KNOW)
• An expansionary fiscal policy (deficit spending) may increase the
interest rate and reduce private spending, thereby weakening or
canceling the stimulus of the expansionary policy
• If in recession, government increases its spending, and money supply
held constant…to finance its budget deficit, the government borrows
funds in the money market, resulting in an increase in demand for
money; this results raises the price paid for borrowing money (the
interest rate); this increased interest rate will crowd out investments
• Most economists will agree that budget deficit is inappropriate when
economy has achieved full employment (will crowd out private
investment); some economists disagree if this exists under all
circumstances
STOP!!!!!!!!!!!!!
The National/Public Debt
• Define: total accumulation of the deficits (minus the surpluses) the
Federal government has incurred through time
• Deficits occur due to: war financing, recessions, and fiscal policy (and
lack of political will)
• Who owns?
• Public owns 49% of debt (individuals, foreign nations, banks, local/state
governments)
• Federal government/agencies 51% (Federal Reserve, U.S. government
agencies)
• Represents how much Federal government owes to holders of U.S.
securities (financial instruments issued by the Federal government to
borrow money to finance expenditures that exceed tax revenues)
•
•
•
•
Treasury bills (short-term securities)
Treasury notes (medium-term securities)
Treasury bond (long-term securities)
U.S. saving bonds (long-term, nonmarketable bonds)
• Will it bankrupt nation or place tremendous burden on
your children/grandchildren? FALSE CONCERNS
• Does not threaten to bankrupt Federal government. There
are two reasons why:
• Refinancing : public debt easily refinanced by selling new
bonds (high demand…no risk of default by government)
• Taxation: government has authority to levy and collect
taxes; can increase taxes
Concerns of Public Debt
• Public debt doesn’t impose as much burden on future
generations as commonly thought
• Repaying public debt owned by Americans would not
change purchasing power (from Americans to Americans)
• only repaying 25% of public debt owned by foreigners
would negatively impact U.S. purchasing power
Burdening Future
Generations
Public Debt Concerns
• Distribution of ownership of government securities is highly uneven
• Debt necessitates annual interest payments of $184 billion
• Interest charge must be paid out of tax revenues
• Higher taxes may dampen incentives to bear risk, innovate, invest, work
• May impair economic growth
• 25% of U.S. debt held by citizens of foreign countries
• An economic burden to Americans
• Enables foreigners to buy some of our output
• U.S. transfers goods/services to foreign lenders
• Crowding-Out Effect
• Passes on to future generations a smaller stock of capital goods
• Drives up interest rates, which reduces private investment spending
• Future generations may inherit economy with smaller production capacity
and lower standard of living