CAN GOVERNMENT CURE A SICK ECONOMY

WITH FISCAL POLICY?????

Government Shutdown Averted- What’s the big Deal??

What is Fiscal Policy Anyway?Usually Countercyclical in nature

Deliberate changes in government spending or taxing to Achieve full employmentControl inflationEncourage economic growth

Highlights of Chapter #13Fiscal Policy

What tools can the federal government use to alter macroeconomic outcomes?

Taxing and spending in a variety of combinations.

Can Taxing and spending alterations ensure full-employment?

What policy actions will help fight inflation/ deflation?

What are possible risks of government intervention?

Where does the power to tax original from?

Article I, Section 8, U.S. Constitution

1789- “to lay and collect taxes, duties, imposts, and excises, to pay the debts and provide for the common defense and general welfare of the United States.”

1913- 16th Amendment allowed the federal government to collect from individuals…

Discretionary Decision by Congress (discretionary spending)

Government can alter aggregate demand by:

Give examples……………….

Purchasing more or fewer goods and services

Raising or lowering taxes Changing the level of income

transfers

Government gets serious about Aggregates in 40’s

Employment Act of 1946After WWII…the unemployment issues needed to be addressed.

“Employment Act of 1946 passed- commits the Federal government to use all practicable means, consistent with the market system, to create economic conditions under which there will be…. employment opportunities, including self-employment for those able, willing, and seeking work, and to promote maximum employment production, and purchasing power.”

The Employment Act:Commits Federal government to take

action through monetary and fiscal policy to maintain economic stability.

**** This charge has specifically been assigned to the Federal Reserve (sans the fiscal part)…

The Executive branch responsible for fulfilling the PURPOSE of the ACT.

Advisory groups to President:CEA (Council of Economic Advisors)JEC (Joint Economic Committee of

Congress)

Purpose is to Shift Aggregate Demand either right or left…

depending on needs for stability.

Expansionary and Contractionary Fiscal Policy: Changes in Government Spending

If there is a recessionary gap in panel (a), fiscal policy can presumably increase aggregate demand

Expansionary and Contractionary Fiscal Policy: Changes in Government Spending

If there is an inflationary gap, fiscal policy can presumably decrease aggregate demand

The Tax Cut Multiplier

First round of spending:

Second round of spending:

Third round of spending:

More income

More consumption

More income

More consumption

Tax Cut

More consumption= MPC X tax cut

More saving= MPS X tax cut

More saving

More saving

Cumulative change in saving: = tax cut

Government Going Into Debt!

If government year after year engages in deficit spending… (more spending less revenue)… then the national debt will mount.

DUH!!! That’s the big controversy right now… Will we spend ourselves into a 3rd world nation.

Government expenditures rise- taxes remain the same- what has to give?

1. Government borrows the difference.

2. Has to offer higher interest rates to attract takers

3. This is the interest rate effect of expansionary fiscal policy

4. When interest rates go up, businesses less apt to invest, consumers less apt to purchase interest sensitive g & s

Figure 13-4 The Crowding-Out Effect

Expansionary policy causing deficit spending initially shifts from AD1 to AD2

Due to crowding out, AD shifts inward to AD3

Equilibrium GDPbelow full-employment GDP—recessionary gap

How does government pull this off? Borrowing from the public..

This is done by selling interest-bearing bonds.*most likely will drive up interest rates and

“crowd out private investments. (*note this is where foreign money is so important to the U.S. government and can put us in considerable peril if overdone)

**also note any decline in private spending will weaken or reduce the expansionary effect of deficit spending.

Possible Offsets to Fiscal Policy

Crowding-Out Effect

The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector; this decrease normally results from the rise of interest rates.

Figure 13-3 The Crowding-Out Effect, Step by Step

Remember Crowding Out

Government comes in and makes financial investments so attractive that it crowds out the private sector…

The big-time investor will want to seek the best rate of return, and anytime government wants, they can make that be the scenario.

Second way for government to overspend

Money Creation The Central Bank creates new money and

private spending is not affected by expansionary efforts of the fiscal aspects.

**** this means that… Federal spending can continue without disrupting private spending or investment….Referred to monetizing the debt.(more $$ in circulation – debt goes “poof.”)

Print money to pay the bill! **** Problem is it is very inflationary… (Too

many $$$ chasing too few goods)

What is the relationship between tax receipts and GDP???

Increased Taxes reduce consumer spending… and aggregate demand…

These reductions would be favored if moving toward inflation… but increases in spending would be favored if economy is slumping.

So… we have inflation Unemployment ?

What % of GDP does consumption take up?

So… answer this question!!

What is the limit for Congress to spend in any given year?

Where does the limit come from?Is it stationary or floating?Is this a question that our current

government is faced with?????

3 Questions to Ask About Economic Stability

1. Can government spending and taxing ensure full employment?

2. What fiscal policy actions will help fight inflation

3. What are the risks of government intervention

What happens if the Fed pulls back andCongress decides to balance the

budget?

Will a tax cut hurt or help the budget?Does it matter who gets the tax cut?How would the multiplier work here?

Who Decides?

Which is the better way to eliminate recession and inflation? (government spending or taxes)

The answer here is whether you want big government or “smaller”

government.

Possible Offsets to Fiscal Policy

Supply-Side Economics

The suggestion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward

Possible Offsets to Fiscal Policy

Question

Would a tax increase cause you to work more or less?

Figure 13-5 Laffer Curve

Tax rates andtax revenuesrise together

Tax revenues are at a maximum

Tax rates and tax revenues fall together

Terms to Know

Automatic fiscal policya change in fiscal policy caused by the state of the economy. (unemployed- pay fewer taxes.)

Discretionary fiscal policya policy action initiated by an Act of Congress

Expansionary fiscal policygovernment should either increase its purchases of g&s or cut its taxes. (causes govt to borrow.)

Automatic Stabilizers

Automatic or Built-In Stabilizers ( should these be changed today???)

Changes in government spending and taxation that occur automatically without deliberate action of Congress The tax system

Unemployment compensation

Welfare spending

Discretionary Fiscal Policy in Practice: Coping with Time Lags - Fiscal results

Long – a policy designed to correct a recession may not produce results until the economy is experiencing inflation. (9-12 months)

Variable in length – they can be from 1-3 years, and the timing of the desired effect cannot be predicted. (unemployment)

Because fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy.

3 Kinds of Taxes

Progressive tax- = tax rate/GDP rises with GDP.

Proportional tax = average tax rate remains constant as GDP rises.

Regressive tax system = average tax rate falls as GDP rises.

The progressive tax system is greater built-in stabilizer… BUT….proportional tax will ultimately bring in more revenue remember Laffer curve).

Axiom to remember….. Always!

Increased taxes reduce spending and Aggregate Demand

Reductions in spending are desirable when economy is moving toward inflation

Or Increases in spending are desirable when economy is moving toward a slump.

Timing!!!!!

Often times the move either way for Congress and/or Admin is slow to realize

Administrative lag….. Takes time to digest all the fiscal data and decide what to suggest.

Operational Lag…usually a 9 to 12 month period before any fiscal move can actually take affect in the real world… work projects, money into economy… Congress passing the Bill and lots of pork added. Remember… Porkbarrelling!!!

Leading Indicators

1. Average workweek2. Initial claims for unemployment insurance.3. New orders for consumer goods4. Vendor preferences (delivery status)5. New orders for capital goods6. Building permits for houses7. Stock prices8. Money supply9. Interest-rate spread(smaller difference between

short term and long term rates usually spells decline of GDP)

10. Consumer expectations

If government reduces taxes and increases spending… created budget deficit…*this is where we are now

Deficit spending = use of borrowed funds to finance government expenditures that exceed tax revenues

Budget Deficit= amt which govt spending exceeds govt revenues (specific time period)

Surplus= ………..

Discretionary and automatic spending.Each year… Pres/Congress put together

budget blueprint for next fiscal year.OMB and CBO…Fiscal year for federal government = October

1Cyclical Deficits = portion of budget deficit

attributable to unemployment or inflationStructural Deficit = whatever does not fall

into cyclical falls into structural (created deficits by works of Congress)

Let’s Talk about DEBT

Accumulation of Debt: When Treasury borrows funds it issues treasury bonds. Treasury bonds = promissory notes (IOUs) issued by the U.S. Treasury.

Total stock of all outstanding bonds represent national debt.

Who owns the Debt?

National Debt represents a liability as well as an asset in the form of bonds.Liability – obligation to make future payment : debtAsset = anything having exchange value in the marketplace is wealth

*National debt creates as much wealth (for bond holders as liabilities for the U.S. Treasury).

Actual Ownership of the Debt

Federal Agencies hold roughly 43% of outstanding Treasury Bonds

Federal Reserve acquires Treasury bonds in its conduct of monetary policy

SS Trust Fund is the largest owner of U.S. Debt State and local governments hold 7% All debt held by U.S. households, institutions and

governments is called internal debt and equals approximately 88% of the total

External debt- U.S. govt debt (Treasury bonds) held by foreign households and institutions. ** this is increasing

Breakdown

PUBLIC DEBT OWNERSHIP, 2002

10%

33%

11%

18%

11%17%

Debt heldBy FederalReserve &

GovernmentAgencies

Debt heldOutside the

FederalReserve &

GovernmentAgencies

Federal Reserve

U.S.Government

Agencies

Other, IncludingState & Local Governments

U.S. Banks & FinancialInstitutions

ForeignOwnership

U.S. Individuals

Debt Service

This is the interest required to be paid each year on outstanding debt.

Paying interest on the debt restricts government’s ability to balance the budget or fund other public sectors

Most debt servicing is a redistribution of income from taxpayers to bondholders.

Opportunity cost or burden of debt is the OC of the activities financed by the debt (what they could do with the money…in the alternative)

CURRENT PROBLEMS

1. Crude Oil Prices rising2. Instability in Middle East3. Exchange rate of dollar 4. Unemployment rate (8.9%)5. Cost of food rising6. Debt incurred by Congress7. Social Security8. Terrorism prospects9. WHAT SHOULD CONGRESS DO?

WHAT CAN YOU DO?

Be cognizant of economic eventsDon’t be an ostrich

VOTE FOR BEST CANDIDATE

Then appears the Elephant in the Living Room

SOCIAL SECURITY::::::::::::2010?2015?2030?

Where will you be in those years?SS is funded from payroll taxes (then it is

assisted from the General Revenue Fund).AND MEDICARE/MEDICAID

Debt Ceiling – UTube

http://www.youtube.com/watch?v=lzcCoyJBMSU

House Vote

http://politics.nytimes.com/congress/votes/112/house/1/690

Senate Vote

The Senate vote is set for noon Tuesday. Approval would send the measure to President Obama and immediately grant the Treasury $400 billion in additional borrowing authority, just hours before a midnight deadline.