Transcript 21.1 the budget and fiscal policy

CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
2
Describe the federal budget process and explain the
effects of fiscal policy.
Describe the Federal Reserve’s monetary policy
process and explain the effects of monetary policy.
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Fiscal policy is the use of the federal budget to
smooth the business cycle and encourage economic
growth.
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The Federal Budget
The federal budget is an annual statement of the
expenditures, tax receipts, and the surplus or deficit of
the government of the United States.
The government’s surplus or deficit is equal to its tax
receipts minus its expenditures.
That is,
Budget surplus (+)/deficit (–) = Tax receipts – Expenditures
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The government has a budget surplus when tax
receipts exceed expenditures.
The government has a budget deficit when
expenditures exceed tax receipts.
The government has a balanced budget when tax
receipts equal expenditures.
The national debt is the amount of debt outstanding that
arises from past budget deficits.
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Budget Time Line
The President and
Congress make the federal
budget on the annual time
line.
Figure 21.1 shows the
federal budget time line
for fiscal 2004.
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The Employment Act of 1946
Fiscal policy operates within the framework of the
landmark Employment Act of 1946, in which Congress
declared that:
• It is the continuing policy and responsibility of the
Federal Government to use all practicable means .
. . to coordinate and utilize all its plans, functions,
and resources . . . to promote maximum
employment, production, and purchasing power.
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Council of Economic Advisers and National
Economic Council
The 1946 Employment Act established the President’s
Council of Economic Advisers, which writes an annual
Economic Report of the President, a handy review of
the current state of the economy.
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Types of Fiscal Policy
Fiscal policy can be either:
• Discretionary
• Automatic
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Discretionary fiscal policy
A fiscal policy action that is initiated by an act of
Congress.
Automatic fiscal policy
A fiscal policy action that is triggered by the state of the
economy such as an increase in payments to the
unemployed and a decrease in tax receipts triggered by
recession.
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Discretionary Fiscal Policy: Demand-Side
Effects
The Government Purchases Multiplier
The government purchases multiplier is
magnification effect of a change in government
purchases of goods and services on aggregate
demand.
It works like the investment multiplier.
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The Tax Multiplier
The tax multiplier magnification effect of a change in
taxes on aggregate demand.
A decrease in taxes increases disposable income. And
an increase in disposable income increases
consumption expenditure.
With increased consumption expenditure, employment
and incomes rise and consumption expenditure rises
yet further.
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So a decrease in taxes works like an increase in
government purchases.
Both actions increase aggregate demand and have a
multiplier effect.
The magnitude of the tax multiplier is smaller than the
government purchases multiplier.
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The Balanced Budget Multiplier
The balanced budget multiplier is the magnification
effect on aggregate demand of a simultaneous change
in government purchases and taxes that leaves the
budget balance unchanged.
The balanced budget multiplier is not zero—it is
positive—because the government purchases multiplier
is larger than the tax multiplier.
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Discretionary Fiscal Stabilization
Suppose the economy is stuck in an unemployment
equilibrium.
The government might use discretionary fiscal policy in
an attempt to restore full employment.
What might the government do to restore full
employment?
21.1 THE BUDGET AND FISCAL POLICY
The government might increase its purchases of goods
and services, cut taxes, or do some of both.
These actions increase aggregate demand, and if they
are timed correctly and are of the correct magnitude,
they might eventually restore full employment.
Figure 21.2 shows an expansionary fiscal policy.
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Potential GDP is $10 trillion, real
GDP is $9 trillion, and
1. There is a $1 trillion
deflationary gap.
2. An increase in government
purchases or a tax cut
increases expenditure by ∆E.
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3. The multiplier increases
induced expenditure.
The AD curve shifts rightward
to AD1, the price level rises to
110, real GDP increases to
$10 trillion, and the
deflationary gap is eliminated.
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Figure 21.3 shows
contractionary fiscal policy.
Potential GDP is $10 trillion, real
GDP is $11 trillion.
1. There is a $1 trillion
inflationary gap.
2. A decrease in government
purchases or a tax rise
decreases expenditure by ∆E.
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3. The multiplier decreases
induced expenditure.
The AD curve shifts leftward to
AD1, the price level falls to
110, real GDP decreases to
$10 trillion, and the inflationary
gap is eliminated.
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Discretionary Fiscal Policy: Supply-Side
Effects
An increase in government purchases that increase the
quantities of productive services and capital increases
aggregate supply and a decrease in government
purchases decreases aggregate supply.
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Taxes decrease the supply of labor and saving.
A decrease in the supply of labor increases the
equilibrium real wage rate and decreases the
equilibrium quantity of labor employed.
Similarly, a decrease in the supply of saving increases
the equilibrium real interest rate and decreases the
equilibrium quantity of investment and capital employed.
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With smaller quantities of labor and capital, potential
GDP decreases, and so does aggregate supply.
So an increase in taxes decreases aggregate supply.
Figure 21.4 on the next slide shows the supply-side
effects of fiscal policy.
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Combined Demand and Supply Effects
An increase in government purchases or a tax cut
increases equilibrium real GDP but might raise, lower,
or have no effect on the price level.
Figure 21.5 on the next slides shows two views of the
supply-side effects of fiscal policy.
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The conventional view is that an
expansionary fiscal policy
increases aggregate demand by
more than it increases aggregate
supply.
Real GDP increases and the
price level rises.
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The supply-side view is that an
expansionary fiscal policy
increases aggregate supply by
more than it increases aggregate
demand.
Real GDP increases and the
price level falls.
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Limitations of Discretionary Fiscal Policy
The use of discretionary fiscal policy is seriously
hampered by three factors:
• Law-making time lag
• Estimating potential GDP
• Economic forecasting
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Law-Making Time Lag
The amount of time it takes Congress to pass the laws
needed to change taxes or spending.
This process takes time because each member of
Congress has a different idea about what is the best tax
or spending program to change, so long debates and
committee meetings are needed to reconcile conflicting
views.
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Estimating Potential GDP
It is not easy to tell whether real GDP is below, above,
or at potential GDP.
So a discretionary fiscal action might move real GDP
away from potential GDP instead of toward it.
This problem is a serious one because too much fiscal
stimulation brings inflation and too little might bring
recession.
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Economic Forecasting
Fiscal policy changes take a long time to enact in
Congress and yet more time to become effective.
So fiscal policy must target forecasts of where the
economy will be in the future.
Economic forecasting has improved enormously in
recent years, but it remains inexact and subject to error.
So for a second reason, discretionary fiscal action might
move real GDP away from potential GDP and create the
very problems it seeks to correct.
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Automatic Fiscal Policy
A consequence of tax receipts and expenditures that
fluctuate with real GDP.
Automatic stabilizers are features of fiscal policy
that stabilize real GDP without explicit action by the
government.
Induced Taxes
Induced taxes are taxes that vary with real GDP.
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Needs-Tested Spending
Needs-tested spending is spending on programs
that entitle suitably qualified people and businesses to
receive benefits— benefits that vary with need and with
the state of the economy.
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The Monetary Policy Process
The Fed makes monetary policy in a process that has
three main elements:
• Monitoring economic conditions
• Making policy decisions
• Reporting to Congress
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Monitoring Economic Conditions
Beige Book
A report that summarizes current economic conditions
in each Federal Reserve district and each sector of the
economy.
A good source of current information about the state of
the economy.
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Meetings of the Federal Open Market Committee
(FOMC)
The FOMC, which meets eight times a year, makes the
monetary policy decisions.
After each meeting, the FOMC announces its decisions
and describes its view of the likelihood that its goals of
price stability and sustainable economic growth will be
achieved.
21. 2 THE FED AND MONETARY POLICY
The Monetary Policy Report to Congress
Twice a year, in February and July, the Fed prepares a
Monetary Policy Report to Congress, and the Fed
chairman testifies before the House of Representatives
Committee on Financial Services.
21. 2 THE FED AND MONETARY POLICY
Influencing the Interest Rate
When the FOMC announces a policy change, its press
release talks about the federal funds interest rate or the
discount rate.
21. 2 THE FED AND MONETARY POLICY
In the Long Run
In the long run, the Fed influences the nominal interest
rate by the effects of its policies on the inflation rate.
But it does not directly control the nominal interest rate,
and it has no control over the real interest rate.
21. 2 THE FED AND MONETARY POLICY
In the Short Run
In the short run, the Fed can determine the nominal
interest rate and take actions to set the federal funds
rate.
But to do so, the Fed must undertake open market
operations that change the quantity of money.
Also, in the short run, the expected inflation rate is
determined by recent monetary policy and inflation
experience.
So when the Fed changes the nominal interest rate, the
real interest rate also changes, temporarily.
21. 2 THE FED AND MONETARY POLICY
The Fed Raises the Interest Rate
The FOMC instructs the New York Fed to sell securities
in the open market.
This action mops up bank reserves. Some banks are
short of reserves and seek to borrow reserves from
other banks.
The federal funds interest rate rises.
21. 2 THE FED AND MONETARY POLICY
With fewer reserves, the banks make a smaller quantity
of new loans each day until the quantity of loans
outstanding has fallen to a level that is consistent with
the new lower level of reserves.
The quantity of money decreases.
Figure 21.6(a) on the next slide illustrates these events.
21. 2 THE FED AND MONETARY POLICY
1. The current interest rate is 5
percent a year.
2. The FOMC target interest
rate is 6 percent a year.
3. To raise the interest rate to
the target, the Fed must sell
securities in the open
market and decrease the
quantity of money to $0.9
trillion.
21. 2 THE FED AND MONETARY POLICY
The Fed Lowers the Interest Rate
If the Fed fears recession, it acts to increase aggregate
demand.
The FOMC announces that it will lower the short-term
interest rates.
To achieve this goal, the FOMC instructs the New York
Fed to buy securities in the open market.
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This action increases bank reserves.
Flush with reserves, banks now seek to lend reserves to
other banks.
The federal funds rate falls.
With more reserves, the banks increase their lending
and the quantity of money increases.
Figure 21.6(b) on the next slide illustrates these events.
21. 2 THE FED AND MONETARY POLICY
1. The current interest rate is 5
percent a year.
2. The FOMC target is 4 percent
a year.
3. To lower the interest rate to
the target, the Fed must buy
securities in the open market
and increase the quantity of
money to $1.1 trillion.
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The Ripple Effects of the Fed’s Actions
Suppose that the Fed increases the interest rate.
Three main events follow:
• Investment and consumption expenditure
decrease.
• The dollar rises, and net exports decrease.
• A multiplier process induces a further decrease in
consumption expenditure and aggregate demand.
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Investment and Consumption Expenditure
The interest rate influences investment and
consumption expenditure.
When the Fed increases the nominal interest rate, the
real interest rate rises temporarily, and investment and
expenditure on consumer durables decrease.
21. 2 THE FED AND MONETARY POLICY
The Dollar and Net Exports
The higher price of the dollar means that foreigners
must now pay more for U.S.-made goods and services.
So the quantity demanded and the expenditure on U.S.made items decrease. U.S. exports decrease.
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Similarly, the higher price of the dollar means that
Americans now pay less for foreign-made goods and
services.
So the quantity demanded and the expenditure on
foreign-made items increase.
U.S. imports increase.
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The Multiplier Process
Taking these effects together, investment, consumption
expenditure, and net exports are all interest-sensitive
components of expenditure.
So a rise in the interest rate brings a decrease in
aggregate expenditure.
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The decrease in expenditure decreases incomes, and
the decrease in income induces a decrease in
consumption expenditure.
The decreased consumption expenditure lowers
aggregate expenditure.
Real GDP and disposable income decrease further, and
so does consumption expenditure.
Real GDP growth slows, and the inflation rate slows.
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Figure 21.7(a) shows ripple effects of the Fed’s
actions when the Fed raises the interest rate.
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Figure 21.7(a) shows ripple effects of the Fed’s
actions when the Fed lowers the interest rate.
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Monetary Stabilization in the AS-AD Model
The Fed Tightens to Fight Inflation
In Figure 21.8, part (a) shows investment demand and
part (b) shows aggregate demand and aggregate
supply.
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The curve ID is the
investment demand curve.
The interest rate is 5 percent
a year and investment is $2
trillion.
1. The Fed raises the interest
rate and the quantity of
investment decreases.
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2. Expenditure decreases by ∆I.
3. The multiplier induces
additional expenditure cuts.
The aggregate demand curve
shifts to AD1, real GDP
decreases to potential GDP,
and inflation is avoided.
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The Fed Eases to Fight Recession
Figure 21.9 is similar to Figure 21.8, which you’ve just
examined.
The starting point in part (a) is the same.
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The curve ID is the
investment demand curve.
The interest rate is 5 percent
a year and investment is $2
trillion.
1. The Fed lowers the interest
rate and the quantity of
investment increases.
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2. Expenditure increases by ∆I.
3. The multiplier induces
additional expenditure.
The aggregate demand curve
shifts to AD1, real GDP
increases to potential GDP,
and recession is avoided.
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The Size of the Money Multiplier Effect
The size of the multiplier effect of monetary policy
depends on the sensitivity of expenditure plans to the
interest rate.
The larger the effect of a change in the interest rate on
aggregate expenditure, the greater is the money
multiplier and the smaller is the change in the interest
rate that achieves the Fed’s objective.
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Limitations of Monetary Stabilization Policy
Monetary policy has an advantage over fiscal policy
because it cuts out the law-making time lags.
But monetary policy shares the other two limitations of
fiscal policy:
Estimating potential GDP is hard, and economic
forecasting is error-prone.