MACRO ECONOMIC
FISCAL POLICY
Keynesian Solutions and a
critique of Keynesian Policies
NATIONAL ECONOMIC POLICY
GOALS
Sustained economic growth as measured
by gross domestic product (GDP)
GDP is total amount of goods and services
produced in the US each year
Low inflation
Full employment
FISCAL POLICY
Fiscal Policy is the deliberate attempt by
government to meet specific economic
goals such as increase GDP, lower
unemployment or curb inflation.
Fiscal policy has two main tools:
government spending and taxation
Fiscal Policy vs Monetary Policy
Monetary policy is the increasing and
decreasing of the money supply and it is
carried out by the Federal Reserve. The
Fed is independent of Congress and the
President.
Fiscal Policy includes increases or
decreases in taxes and spending, and is
carried out by the Congress and the
President.
STIMULATORY FISCAL POLICY
Here the goal is to increase employment
and GDP during a recession
Increases in government spending
increase aggregate demand
Tax cuts stimulate consumer spending
and business investment
Consumption up + Business Investment
up + Government up +NX = GDP up
CONTRACTIONARY FISCAL
POLICY
 This government policy is designed during a
rapid expansion and is primarily designed to
bring inflation down
 Contractionary policies focus on reducing
Government spending, which decreases
aggregate demand
 Increasing taxes also reduces purchasing
powers of consumers and business investment
Tax Multiplier
 The tax multiplier is MPC/MPS
 Both tax cuts and government spending
increase AD during a recession
 However, Keynesians believe that government
spending has a more powerful stimulatory effect
than tax cuts.
 This is because a portion of tax cut income will
be saved rather than consumed, whereas
government spending is all subject to the
multiplier.
AUTOMATIC STABILIZERS
 Some economists believe active attempts to
manipulate AD with fiscal policy are less
necessary because of Keynesian automatic
stabilizers built into our government fiscal
policies
 First, we have unemployment compensation for
workers laid off in a recession. This government
income program helps maintain consumption,
even with people out of work
 Secondly, during a recession taxes decline due
to progressive tax policy. As incomes fall so do
tax rates, again helping incomes and
consumption in a recession.
Stabilizers during Expansion Phase
During an expansion tax rates increase
with rising income
The government spends less money on
government programs like unemployment
insurance
This dampens AD bringing inflation down.
Federal Budgets
 Annual budget bills originate in the House, but
must be passed by the Senate and signed by
the President
 Each budget includes spending priorities and
sources of revenue to pay for the federal
programs
 If the government spends more than it collects in
taxes, it runs a deficit. If it takes in more revenue
than it pays out, it runs a surplus.
 When revenues are equal to payments for
program, the government is said to have a
balanced budget.
KEYNESIAN ECONOMICS
 Keynesians believe that deficits caused by
recessions and expansionary fiscal policy will be
offset by fiscal surpluses created during the
expansionary phase of the business cycle.
 In the expansion phase government increases
revenue and creates surpluses by cutting
government programs and increasing taxes.
 Keynesian solutions have been used since WW
II, and were particularly popular during the
1960’s and 1970’s
Phillips Curve
 In the late 50’s English Economist A.W. Phillips
designed a curve to show the trade off between
inflation and unemployment
 Using British economic data, he showed the
inverse relationship between the two indices.
 When inflation was high, unemployment was low
and when inflation was low unemployment was
high.
 This became known as the Phillips Curve
Short-Run Phillips Curve (SRPC)
Phillips Curve and Policy
 The short run Phillips curve indicates that
governments can make active policy, choosing a
level of unemployment and inflation.
 The US economy of the 1960’s matched the
Phillips curve data. However, in the 1970’s
stagflation challenged active Keynesian policy
makers, since fiscal policy cannot remedy both
high inflation and high unemployment at the
same time.
 The long-run Phillips curve is a vertical line (like
the LRAS) at the natural rate of unemployment,
or what we have called Full Employment (FE)
Long Run Phillips Curve (LRPC)
at the NAIRU
Northland’s Difficulties
A) Northland is currently operating well
below the NAIRU. Draw a macro graph of
its economy.
B) What fiscal policies should Northland
implement?
Draw a short run Phillips curve. Indicate a
point where Northland would be in part A.
Then put a point B after the fiscal policies
have been implemented.
TIME LAG PROBLEM IN
ECONOMIC POLICY
 The problem with government economic
problem is that each policy takes time to work.
 It may takes months or even years between the
time the problem is diagnosed and fiscal policy
is implemented
 Therefore, some economists do not think that
tax and spending measures can solve problems
in an economy in a timely fashion.
GOVERNMENT BORROWING
 Keynes believed that during a recession
governments should deficit spend to fund
programs (not increase taxes)
 Governments borrow by selling Treasury bills.
 T-bills are purchased by wealthy individuals,
businesses, and foreign investors
 Deficits are yearly, the national debt is the
accumulation of yearly deficits.
The Impact of Deficit Spending
Keynesians believe that deficits during
recessions will be paid off with surpluses
during the expansionary phase of the
business cycle.
Classical economists argue that deficit
spending or increasing debt creates
“offsets” that negatively effect AD.
The “Crowding Out” Effect A critique of Keynesian policies
 Some economists say that the positive impact of
government spending is lessened when the
government borrows money
 It is argued that public borrowing, “crowds out”
private borrowing, and drives up interest rates
 Higher interest rates reduce private investment
and consumption
 Therefore, deficit spending may not stimulate
economy as much as the Keynesians argue.
Indirect Crowding Out
US borrows money to deficit spend -->
increased govt. demand for money -->
Interest rates increase --> private borrowing
by business and consumer declines
Therefore, AD declines due higher interest
rates
Direct Crowding Out or
Expenditure Offsets
 Some government spending has no comparable
private sector product substitute, e.g. military
spending.
 However, in some cases increases in
government spending lead to a decline in private
sector spending or investment.e.g increases in
government spending in public education may
lead to decreases in private education.
 Therefore, increases in G may lead declines in C
and I in the private sector.
Ricardian Equivalence Theorem and
Rational Expectations Theory
Increases in government budget deficits
has no effect on AD
People anticipate that a larger deficit today
will mean higher taxes in the future,
people adjust their spending down today.
The Rational expectations theory is similar
--> people believe budget deficits will
increase prices in future --> cut back on
spending and investment
Open Economy Effect
 Classical economists also believe that increased
interest rates from the crowding out effect will
increase the value of the dollar
 Foreign investors will want dollars to invest in
our bonds with their higher interest rates.
 A stronger dollar will make imports cheaper, thus
leading to a trade deficit
 This deficit in NX may offset increases created
by government spending.
The Laffer Curve - supply side
 In the 1970’s Arthur Laffer postulated that if the
government cuts marginal tax rates, it would
NOT lose tax revenue.
 He argued that decreases in marginal tax rates
would stimulate private investment and raise
incomes.
 The government would then actually receive
more revenues in the long run from the tax cuts.
 These economists favor cutting the marginal tax
rates, especially for business.
 Reagan employed this theory, instituting lower
marginal tax rates during the 1980’s
Supply Side Economics
Supply Side economists believe that the main way
the economy should be stimulated is through tax
cuts for businesses and households, combined
with decreases in government spending.
 These cuts lead to increased investment and
ultimately increase aggregate supply within the
economy, thus the name “supply-side.”
 Supply-siders want to shrink government and
increase private investment. They also oppose
many business regulations, which they believe
cuts down on business profitability
Critique of Supply Side
 “Reaganomics” did not lower budget deficit by
bringing in more revenues, especially since he
increased the military budget.
 Some critics point out that tax rates don’t
significantly influence investment and Real GDP.
For example, The Clinton tax rates were higher
than the Bush tax rates, but incomes climbed
during the Clinton years. We currently have the
lower Bush rates, but have a worse economic
environment.
Criticisms continued
 Critics also point out that decreasing marginal
tax rates does not necessarily mean business
will invest. Businesses may choose to save,
rather than increase employment.
 Supply side is viewed by Keynesian critics as an
extension of the a discredited “trickle down”
economics, in which Republican politicians have
given tax breaks are given to the wealthiest at
the expense of the poor and middle classes.
Fixing the Budget
 Did you shave a little off most spending
categories, or did you go after large cuts in big
programs? Explain.
 Did you make more cuts in military or social
spending? Explain.
 Did you increase revenue primarily through
spending cuts, or primarily through increasing
taxes? Explain.
 Which tax areas did you decide to increase?
 What did you learn from this activity?
Budget Puzzle: You Fix the Budget
 Read the related article in the NY Times Budget
Puzzle
 Then return to the You Fix the Budget activity
 Go ahead and begin to craft a long term budget
that will fix the deficits by 2015 and 2030
 Which programs did you want to cut, and which
did you want to maintain?
 What was your plan for taxes?
MONETARY POLICY
US government can expand money supply
during a recession or contract money
supply during an expansion
Money supply is controlled by the Federal
Reserve Banks
FEDERAL RESERVE BANK
14 districts
Federal Reserve chairman - Benjamin
Bernanke
Federal Reserve
MONEY SUPPLY
Total amount of money circulating in the
economy
Money supply is determined by the federal
reserve banks
“LOOSE” MONEY
Federal reserve can expand the money
supply during a recession by
1. Lowering reserve rate required for
member banks
2. Lowering rediscount rate (interest rate
charged by the Fed)
3. Buying Bonds, which puts more money
in bond holders hands
Rational Expectations
 Milton Friedman argued people and businesses
will anticipate the impact of government policy
on future economic decisions.
 For example, if they see increased government
spending or money supply increase, they will
anticipate future inflation and act accordingly.
 His theory became part of the new classical
theory.
Small Menu Keynesians
Monetarists
“TIGHT” MONEY
Federal Reserve can try to slow down
inflation by:
1. Raising reserve rate
2. Raising rediscount rate
3. Selling bonds, which takes money out of
the private economy
World trade
US imports 14% of GDP
Exports 12% of GDP
Last several years, US running large trade
deficits (value of imports higher than
exports)
Some Americans suggesting tariffs (taxes
on foreign goods) or quotas on foreign
goods to reduce imports.
Free Trade versus Protectionism
Free Trade advocates say US benefits
from lower prices on foreign goods and the
ability to export US products to foreign
countries
Protectionists argue US not being treated
fairly in foreign markets and are losing
important jobs at home to foreign
competition.
Globalization and Trade
Organizations
World Trade Organization (WTO) - 140
member countries monitors and negotiates
trade disputes
North American Free Trade Organization
(Canada, US and Mexico)
European Union (EU)
AP Macro Economics
AP Macro Economics Test
Thursday May 11th
Report 7:15 AM
Mat Room behind Old Gym
Review for AP Economics
Wednesday May 10th Room 207
Suggestion: Purchase AP Economics
Review Book
BUSINESS CYCLE
Periods of GDP growth are called
expansions or boom periods
6 months of falling GDP is called a
recession.
Severe GDP drop is depression
Top of the business cycle is peak
Bottom recession called trough
UNEMPLOYMENT
Measured by the Bureau of Labor
Statistics
Definition “members of the labor force
who are looking for work, but unable to
find jobs.”
Unemployment rate = % unemployed
Estimate is low - “discouraged workers”
not included
INFLATION
Defined as the sustained rise in prices
Measured by the Consumer Price Index
(CPI)
Inflation reduces purchasing power of
consumers
Comparing real GDP between years
means accounting for inflation (GDP
deflator)
Taxes
Largest source of government income is
individual income taxes
US has progressive income tax structure
(wealthier groups pay higher percentage)
Social Security taxes (FICA) are tax on
wages
Additional taxes include: corporate taxes,
estate taxes, state income tax, sales
Social Security
Passed during Depression to create a
pension for all Americans
6.2 % of income
Not a fund, current workers pay for retiring
workers
Ratio of retiress to workers rising,
therefore long term not enough to cover
retirees
Solutions to Social Security
Increase social security tax
Get rid of income cap on taxes
Incrase age of beneficiaries
Privatize social security to make IRA
Increase immigration to increase
percentage of current workers to retirees