1. Explain what the federal funds rate is.
2. Why does the government use expansionary monetary
policy?
3. What is cyclical asymmetry?
4. If a bank has $100,000 in deposits and a 10% reserve
requirement—how much does it have to hold in reserve?
5. Draw an AS/AD graph that shows in increase in AD.
Make sure to label correctly and include the equilibrium
points.
6. Extra Credit—What is demand-pull inflation?
Quiz
Video Clip
• http://www.youtube.com/watch?v=1qhJ
PqyJRo8
Fiscal Policy
Chapter 12
• Fiscal policy is the idea that the government can influence
the economy through taxation and/or government spending
• Employment Act of 1946—requires the government to use
all reasonable measures to keep unemployment under
control
• Act established the Council of Economic Advisors
(CEA)—assists the President on economic issues
• Established the Joint Economic Committee (JEC) to
investigate national economic problems
Legislative Mandates
• There are two types of fiscal policy
• Discretionary—optional, government chooses to do it
• Indiscretionary—occurs automatically or independent
of government choice
• During the first part of the chapter we are only talking
about discretionary
• Expansionary fiscal policy uses increased government
spending or a decrease in taxes to push the economy out of
recession
• There are 3 tools the government can use under fiscal
policy:
1.
2.
3.
Increase spending
Cut taxes
Some combinations of the two
Fiscal Policy and the AD-AS Model
• If the budget is balanced, using fiscal policy will lead to a
budget deficit—why?
• Because an increase in spending and/or a decrease in
taxes with nothing else changing means you go
negative
• If the government increases spending, AD will shift to the
right
• Be aware that the multiplier effect applies
• For example if RGDP was at $490B and the
government increased spending by $5B—RGDP
would only increase to $495B temporarily
• After the multiplier effect it would increase even more
Fiscal Policy and the AD-AS Model
• For example—say our marginal propensity to consume
(MPC) = 0.75
• Remember the multiplier effect = 1 ÷(1-MPC)
• So…1 ÷(1 – 0.75) = 4
• If our original increase in government spending was $5B
and our multiplier effect is 4, what will our final increase
in the economy look like
• $5B ×4 = $20B
Fiscal Policy and the AD-AS Model
PL
G
$5B
AS
multiplier
P1
This model
shows an
overall
increase of
$20B in the
economy after
the multiplier
effect
AD2
AD1
$490
$510
RGDP
Fiscal Policy and the AD-AS Model
• The increase to $510B would result in the economy
pulling out of a recession and a decrease in unemployment
that occurred during the recession because there is now
money to help hire people
• You can also use tax cuts to accomplish the same goals
• You will have to cut taxes by more ($6.67B) to
accomplish the same result because people will save
(MPS) so much
• The larger the MPS/smaller the MPC the more taxes
you have to cut to get the same affect as raising
government spending
• The government could also combine these two policies to
achieve results
Fiscal Policy and the AD-AS Model
• When demand-pull inflation occurs the government will
implement contractionary fiscal policy
• In this case the government cuts spending, increases
taxes, or a combo of both to control inflation
• IF INFLATION, THEN:
• G↓ .: AD  .: RGDP↓ & PL↓ .: u%↑ OR
• T↑ .: DI↓ .: C↓ .: AD  .: RGDP↓ & PL↓ .: u%↑
• IF UNEMPLOYMENT, THEN:
• G↑ or T↓, then AD shifts causing PL and
RGDP which causes u%
Fiscal Policy and the AD-AS Model
T
$5B
PL
AS
multiplier
P1
AD2
$500
$520
This model
shows an
overall
decrease of
$20B in the
economy after
the multiplier
effect
AD1
RGDP
Fiscal Policy and the AD-AS Model
• There are two ways the government can get money to
expand
• They can borrow money (sell interest bearing bonds)
but then they are competing with private companies
which creates new demand and will raise interest
rates—when interest raises, consumer spending will
drop which will weaken the expansionary effect
• The can create new money—new money will allow
them to spend without immediately affecting
consumption; however, it will likely cause an increase
in inflation
Fiscal Policy and the AD-AS Model
• Demand-pull inflation calls for contractionary fiscal policy
which is achieved by either:
• Debt reduction—if the government has a surplus of
money then inflation will occur. To offset that, they
can use the surplus to pay their debts (buy back
bonds). In doing so, it will drive down interest rates,
drive up consumption and cause more money to
circulate which minimizes the effect they were going
for.
• Impounding—means they let the surplus sit idle, if
they aren’t put back into the economy via spending,
then it will bring inflation back down
Fiscal Policy and the AD-AS Model
• So, which is better? Government spending increases or
tax cuts…
• It depends on your point of view
• Democrats tend to believe that government spending
should be used to deal with unmet social needs—this
results in an increase in the size of the government
• Republicans tend to believe that the government is too
large and thus tax cuts should be used—this results in a
decrease in the size of the government
Fiscal Policy and the AD-AS Model
• Government taxes may also be nondiscretionary—
meaning that some tax increases occur naturally within the
business cycle
• If the GDP goes up so will the revenue made from
taxes (a.k.a. sales taxes brings in more money because
people buy more, or income tax revenue increases
because people make more money)
• Consequently, if GDP goes down “negative taxes”
(transfer payments), such as welfare, unemployment,
and subsidies go up
• The US Tax System is a built-in stabilizer—Congress
doesn’t have to change anything to react to recessions or
inflations
Built-In Stability
Government Spending and Taxation
Deficit
Built-In Stability
• A progressive
tax will increase
with GDP where
T
as a regressive
tax will decrease
Surplus
when GDP rises
G • The more
progressive
taxes are the
greater the builtin stability is
RGDP
• A regressive tax is one that puts more of the burden on
people from lower incomes
• Sin tax because people from the lower class purchase
those products more than upper class
• A progressive tax is one that puts more of the burden on
people from higher incomes
• The income tax system (higher wages are taxed at a
higher percentage, while lower wages are taxes at a
lower percentage)
• A proportional tax is neutral
• Fair tax or flat tax
• Built-in stabilizers cannot do all the work, fiscal or monetary
policy is required to stabilize when the economy slips
Built-In Stability
• There are many problems when trying to enact fiscal
policy
• Recognition lag—how long it takes to become aware
of a problem existing
• Administration lag—Congress and the President are
slow to act
• Meanwhile, the Fed acts quickly
• Operational lag—government planning (regarding
spending) take a long time—building roads, etc.
• You also have to include political consideration—
politicians want to get reelected
• They will spend more in election time to look
productive, spend less after the election
Problems, Criticisms, and Complications
• Other problems with fiscal policy:
• Future policy reversals—if the people think the tax
cuts will go away, they will save more making the
policy less effective
• Offsetting state and local finance—when the federal
government moves one direction and the state moves
the other way
• Crowding-Out effect
• A possible side-effect of increased government
spending and reduced taxes is a budget deficit
which may lead to the ‘crowding-out’ of Gross
Private Investment (IG) and Net Exports (XN)
Problems, Criticisms, and Complications
• The Crowding Out effect results in the following linkage:
• G (or T ): G borrows $: Sm : i : Ig
• When investments go down, instead of expanded the
economy (as was hoped for in increasing spending) the
overall GDP will go down
• NOTE: interest sensitive consumption could go down
as well
• Crowding-Out results in businesses being stifled by
government spending
Problems, Criticisms, and Complications
Crowding out
Problems, Criticisms, and Complications
Crowding Out