Fiscal and Monetary Policy Effects

Outline:

1. What is fiscal and monetary policy and how do they work?

2. The Federal Budget

3. Principles of taxation

4. The automatic stabilizers

2

4

6

8

10

12

14

16

50 55 60 65 70 75 80 85 90 95 00

State and Local Federal

Federal, State & Local Government Spendingas a Percent of GDP

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Fiscal Policy

Fiscal policy is the use of the federal budget to smooth the business cycle and encourage economic growth.

The Employment Act of 1946 establishes a

responsibility for the Federal government to

“promote maximum employment, production, and purchasing power.

The Federal Budget

Let:

•G denote federal spending for goods and services in a fiscal year (Oct. 1 thru Sept. 30).

•TX is federal tax receipts.

•TR is federal transfer payments.

•T is federal net taxes (TX - TR)

The Federal budget is an annual statement of expenditures, tax receipts, and surplus or deficit of the government of the U.S.

If G exceeds T in a fiscal year, then we have a federal deficit.

If, however, T exceeds G, then we have

a federal surplus.

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0

500000

1000000

1500000

2000000

2500000

78 80 82 84 86 88 90 92 94 96 98 00 02

OUTLAYS RECEIPTS

Federal Outlays and Tax Receipts, 1978-2002 (in millions of dollars)

How Fiscal Policy Works

AE

Real GDP0 Y1

AE1

YFE

Full employment GDP

AE2

G

)1(

1

MTRMPIMPCG

Y

The preceding slide illustrates the type of

expansionary fiscal policy that Keynesians recommend for

recession. We will now use the AS-AD

framework to illustrate contractionary fiscal

policy.

Potential GDP

AS

AD1

Real GDP

Price Level

0

AD2

Modeling Expansionary Fiscal Policy

Y1

Question: How is Fed policy “transmitted” to macroeconomic variables such as real GDP, employment, and the general price level?

Fed Open Market Purchase of Securities

Increase in the Money Supply

Decrease in the interest rate

Increase in components of spending that are sensitive to interest rates—specifically, investment and consumer durable goods

Multiplier Effect

Real GDP

00

AE

Real GDP

450

)()1(

1IC

MTRMPIMPCY

6%

4%

MS1 MS2

Y1 Y2

AE1

AE2

Md

Diagrammatic explanation of the transmission mechanism

IC

Nom

inal

In

tere

st R

ate

(%)

Money

The Fed pulled on the string big time

beginning in 1979—it was an anti-inflation

strategy under Chairman Paul Volcker

Potential GDP AS

AD1

Real GDP

Price Level

0

AD2

Modeling Contractionary Monetary Policy

Y1

8

10

12

14

16

18

20

79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01

Federal Funds

Recessions are shaded

6

8

10

12

14

16

18

20

80 82 84 86 88 90 92

Mortgage Interest Rates

Recessions are shadedConventional 30 year

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Mortgage rate

Monthly Payment1

8% $807.14

10% $965.33

12% $1,131.47

14% $1,303.36

16% $1,479.23

1 Does not include prorated insurance or property taxes.

Monthly payments on a $110,000 30 year mortgage note

400

800

1200

1600

2000

2400

80 82 84 86 88 90 92

Monthly Housing Starts

Recessions are shadedData in thousands of units

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More recently, the Fed raised the

federal funds rate six times between May 99 and May 2000—from 4.75% to 6.5

%.

The Fed reversed course at the beginning of 2001 and reduced the

federal funds rate 11 times that year!

•Horizontal equity: Tax code should be written so that those in the same economic circumstances pay the same amount in taxes.

•Vertical equity: Tax code should be written so that those in different economic circumstances should pay an unequal amount in taxes.

•Benefits received principle: Those who derive more benefits from government programs should pay more taxes.

Principles of Taxation

•Taxable income: Gross income - income exempt from taxes. Example: For single filers who use the 1040EZ:

Gross Income: $35,000

Minus: Standard deduction

7,050

Equals: Taxable income

$27,950

•Average tax rate (ATR): Tax payments as a percent of taxable income.

•Marginal tax rate (MTR): The tax rate applied to the last dollar of taxable income.

•Progressive tax: The proportion of taxable income taken in taxes increases as taxable income increases.

•Regressive tax: The proportion of taxable income taken in taxes decreases as taxable income increases.

•Proportional tax: The proportion of taxable income taken in taxes remains constant as taxable income increases.

By making the tax structure

“progressive,” governments can

make the after-tax distribution of income

more equitable (or even).

AffluentNeedy

Total TaxableIncome

Marginal TaxRate (%)

$0 0%

0-36,900 1536,901-89,150 28

89,151-140,000 31

140,001-250,000 36

250,000 and up 39.6

Federal personal Income Tax rates Under the 1993 Tax Reform Act (Married couple filing jointly)

Income Tax Ave. Tax Rate Marginal Tax Rate$10,000 $0 0% 0%20,000 272 1.4 1530,000 1,766 5.9 1550,000 4,766 9.5 1575,000 10,315 13.8 28

150,000 32,140 21.4 31250,000 66,802 26.7 36400,000 128,710 32.2 39.6

Average and Marginal Tax Rates under the Tax Reform Act of 1993 (for a couple with 2 children)

2003 Taxable Income Marginal Tax Rate

$0-$12,000 10.0%

$12,000-$47,500 15.0

$47,500-$114,650 27.0

$114,650-$174,700 30.0

$174,700-$311,950 35.0

Over $311,950 38.6

Tax Brackets for 2003 under the 2001 Tax Reform Act

Source : Wall Street Journal

Quick Facts about President Bush’s Tax Bill

•The current 39.6% tax rate drops to 33%

•The current 36% tax rate drops to 33%

•The current 31% rate drops to 25%

•The current 28% rate drops to 25%

•The current 15% bracket is retained over most of its range

•A new 10% bracket applies to the lowest ¼ of the current 15% range. President Bush comments (wav)

Family

(1)

Income

(2)Spending for items subject to excise tax

(3)=

(2)/(1)

(4)

Excise Tax Paid

(5)=(4)/(1)

ATR

Greens $27,000 $16,200 .60 $1,188 4.4%

Jones 64,000 25,600 .40 1,871 2.9

Lemons 270,000 40,500 .15 2,961 1.0

Assume a 7.13 percent excise tax on groceries, gasoline, cigarettes, and liquor

Moral of the story: Low income families tend to spend a greater proportion of their income on items subject to excise taxes. Hence excise taxes tend to be regressive.

Taxes (TX) and Transfer Payments (TR) are called “automatic stabilizers” because they react to changes in national income in a way that increases the federal deficit (or reduces the surplus) in the event of an economic contraction or reduces the deficit (increases the surplus) when the economy is expanding.The automatic

stabilizers make sure that disposable income (DI) does

not fall too muchwhen national income

is falling, and vice-versa.

Automatic Stabilizers

Remember that the federaldeficit or surplus is

equal to the differencebetween G and Net Tax Receipts,

where Net Taxes are equal toTX - TR

YTX, for example

YTX, and vice versa

YTR, for example

YTR, and vice versa

Note that claims for unemployment compensation and other assistance surges when unemployment rises.

Real GDP0

G, T Potential GDP

G

T = TX - TR

Y1

DeficitBalanced budget at full-employment

In the case of a federal deficit, the Treasury must borrow. The national debt

is the accumulated borrowing of thefederal government in all previous

fiscal years, minus what has been repaid

Is a large national debt a bad thing?

Arguments against a large national debt include:

•The “burden on future generations” argument.

•A large national debt means that a significant share of federal spending must be allocated for interest payments—leaving less for other priorities.

•A large national debt makes the U.S. too dependent on foreign financial inflows.

•Federal borrowing “crowds out” private sector borrowing units—i.e., firms and households.

“[W]e (the U.S.) owe $5.7 trillion in debt and if we don’t pay it off, our children and our grandchildren are going to have to.”

Congressman Marion Berry, in a speech to the Jonesboro Lions Club on April 16, 2001.

Interest as a Percent of Federal Outlays

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Year

20001995199019851980197519701965

Perc

ent

16

14

12

10

8

6

4

As long as the debt grows by the same percentage as nominal GDP, the ratios of debt to GDP will remain constant. In this case, the government can continue to pay interest on its rising debt without increasing the average tax rate in the economy.

Growth Rate of Nominal GDP and the Public Debt

-10

-5

0

5

10

15

20

25

30

35

Year

Pe

rce

nt

Ch

an

ge

Growth Rate of theNational Debt

Growth Rate ofNominal GDP

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Ratio of Gross Federal Debt to GDP in the

U.S.

0

0.2

0.4

0.6

0.8

1

1.2

1.4

Year

De

bt

to G

DP

www.bea.gov

Who Owns the National Debt?

Source: Federal Reserve

3342 / 48%

463 / 7%

1271 / 18%

1814 / 26%

Privately Owned

Fed. Reserve Banks

Foreign Investors

Agencies and Trusts