Transcript 16.1 the budget and fiscal policy

Fiscal and Monetary
Policy Effects
CHAPTER
16
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.
16.1 THE BUDGET AND FISCAL POLICY
Fiscal policy is the use of the federal budget to
sustain economic growth and smooth the business
cycle.
The Federal Budget
The federal budget is an annual statement of the
expenditures and tax receipts of the government of the
United States.
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The government’s surplus or deficit is equal to tax receipts
minus expenditures.
Budget surplus (+)/deficit (–) = Tax receipts – Expenditures
The government has a budget surplus if tax receipts
exceed expenditures.
The government has a budget deficit if expenditures
exceeds tax receipts.
The government has a balanced budget if tax
receipts equal expenditures.
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The government borrows to finance a budget deficit
and repays its debt when it has a budget surplus.
The amount of debt outstanding that arises from past
budget deficits is called national debt.
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Budget Time Line
The President and
Congress make the federal
budget on the annual time
line.
Figure 16.1 shows the
federal budget time line
for Fiscal year 2007.
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Types of Fiscal Policy
Fiscal policy can be either
• Discretionary or
• 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
For example, an increase in unemployment induces an
increase in payments to the unemployed or in a
recession tax receipts decrease as incomes fall.
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Discretionary Fiscal Policy: Demand-Side
Effects
The Government Expenditure Multiplier
The government expenditure multiplier is
magnification effect of a change in government
expenditure on 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
increases yet further.
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So a decrease in taxes works like an increase in
government expenditure.
Both actions increase aggregate demand and have a
multiplier effect.
The magnitude of the tax multiplier is smaller than the
government expenditure 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 expenditure and taxes that leaves the
budget balance unchanged.
The balanced budget multiplier is not zero—it is
positive—because the government expenditure
multiplier is larger than the tax multiplier.
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Discretionary Fiscal Stabilization
If real GDP is below potential GDP, the government
might use discretionary fiscal policy in an attempt to
restore full employment.
Expansionary fiscal policy is a discretionary fiscal
policy designed to increase aggregate demand—a
discretionary increase in government expenditure or a
discretionary tax cut.
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Figure 16.2 illustrates an
expansionary fiscal policy.
Potential GDP is $10 trillion,
real GDP is $9 trillion, and
1. There is a $1 trillion
recessionary gap.
2. An increase in government
expenditure 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 recessionary
gap is eliminated.
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Figure 16.3 illustrates
contractionary fiscal policy.
Potential GDP is $10 trillion,
real GDP is $11 trillion, and
1. There is a $1 trillion
inflationary gap.
2. A decrease in government
expenditure 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 expenditure that increase
the quantities of productive services and capital
increases aggregate supply.
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Supply-Side Effects of Taxes
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.
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Scale of Government Supply-Side Effects
If both government expenditure and taxes increase, the
scale of government increases.
More productive government expenditure increases
potential GDP, but higher taxes to pay for the
expenditure decreases potential GDP.
Economists disagree on which of these effects is
stronger.
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Figure 16.4 illustrates the
effects of fiscal policy on
potential GDP.
1. A tax cut strengthens the
incentive to work, increases
the supply of labor, and
increases employment.
2. A tax cut strengthens the
incentive to save and invest,
which increases the quantity
of capital and increases
labor productivity.
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3. The combined effects of a
tax cut on employment
and labor productivity
increases potential GDP.
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Combined Demand and Supply Effects
An increase in government expenditure or a tax cut
increases equilibrium real GDP but might raise, lower,
or have no effect on the price level.
Figure 16.5 on the next slides shows the supply-side
effects of fiscal policy when fiscal policy has no effect
on the price level.
16.1 THE BUDGET AND FISCAL POLICY
1. A tax cut increases disposable
income, which increases
aggregate demand from AD0
to AD1.
A tax cut also strengthens the
incentive to work, save, and
invest, which increases
aggregate supply from AS0 to
AS1.
2. Real GDP increases.
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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
16. 2 THE FED AND MONETARY POLICY
Monitoring Economic Conditions
Beige Book
A report that summarizes current economic conditions
in each Federal Reserve district and each sector of the
economy.
The Beige Book is 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.
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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.
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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.
The press release doe not talk about the quantity of
money or the size of the open market operations it
plans to conduct.
This impression that the Fed determines interest rates
rather than the quantity of money is misleading to two
reason: a lon-run reason and a short-run reason.
16. 2 THE FED AND MONETARY POLICY
In the Long Run
In the long run, the real interest rate is determined in
global financial markets and the inflation rate is
determined by the growth rate of the quantity of money.
So in the long run, the Fed influences the nominal
interest rate by the effects of its policies on the inflation
rate.
The Fed does not directly control the nominal interest
rate, and it has no control over the real interest rate.
16. 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.
16. 2 THE FED AND MONETARY POLICY
The Fed Raises the Interest Rate
Suppose the Fed fears inflation and decides it must
take action.
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 they seek to borrow reserves from
other banks.
The federal funds interest rate rises.
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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 16.6(a) on the next slide illustrates these events.
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1. The current interest rate is
5 percent a year.
2. The FOMC’s 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.
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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 16.6(b) on the next slide illustrates these events.
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1. The current interest rate is
5 percent a year.
2. The FOMC’s interest rate
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.
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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 16.7(a) shows ripple effects of the Fed’s
actions when the Fed raises the interest rate.
16. 2 THE FED AND MONETARY POLICY
Figure 16.7(a) shows ripple effects of the Fed’s
actions when the Fed lowers the interest rate.
16. 2 THE FED AND MONETARY POLICY
Monetary Stabilization in the AS-AD Model
The Fed Tightens to Fight Inflation
Real GDP exceeds potential GDP and the Fed Fears
inflation.
Figure 16.8 illustrates how the Fed’s policy works.
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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
Real GDP is below potential GDP and the Fed fears
recession.
Figure 16.9 illustrates how the Fed’s policy works.
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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 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 multiplier effect 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.
• Economic forecasting is error-prone.
Fiscal Policy and Monetary Policy in
YOUR Life
Consider the U.S. economy right now.
Is the U.S. economy at full employment or is there a
recessionary gap or an inflationary gap?
What type of fiscal policy or monetary policy would you
recommend?
What do recent changes in policy say about the
government’s and the Fed’s view of the state of the
economy?
How do you think recent changes in fiscal policy and
monetary policy will affect you?