MACRO ECONOMIC FISCAL POLICY

Keynesian Solutions and a critique of Keynesian Policies

NATIONAL ECONOMIC POLICY GOALSSustained economic growth as measured

by gross domestic product (GDP)GDP is total amount of goods and

services produced in the US each yearLow inflationFull employment

FISCAL POLICY

Fiscal Policy is the deliberate attempt by government to meet specific economic goals such as increase GDP, lower unemployment or curb inflation.

Fiscal policy has two main tools: government spending and taxation

Fiscal Policy vs Monetary Policy

Monetary policy is the increasing and decreasing of the money supply and it is carried out by the Federal Reserve. The Fed is independent of Congress and the President.

Fiscal Policy includes increases or decreases in taxes and spending, and is carried out by the Congress and the President.

STIMULATORY FISCAL POLICY

Here the goal is to increase employment and GDP during a recession

Increases in government spending increase aggregate demand

Tax cuts stimulate consumer spending and business investment

Consumption up + Business Investment up + Government up +NX = GDP up

CONTRACTIONARY FISCAL POLICYThis government policy is designed during a

rapid expansion and is primarily designed to bring inflation down

Contractionary policies focus on reducing Government spending, which decreases aggregate demand

Increasing taxes also reduces purchasing powers of consumers and business investment

Tax Multiplier

The tax multiplier is MPC/MPSBoth tax cuts and government spending

increase AD during a recessionHowever, Keynesians believe that government

spending has a more powerful stimulatory effect than tax cuts.

This is because a portion of tax cut income will be saved rather than consumed, whereas government spending is all subject to the multiplier.

AUTOMATIC STABILIZERS

Some economists believe active attempts to manipulate AD with fiscal policy are less necessary because of Keynesian automatic stabilizers built into our government fiscal policies

First, we have unemployment compensation for workers laid off in a recession. This government income program helps maintain consumption, even with people out of work

Secondly, during a recession taxes decline due to progressive tax policy. As incomes fall so do tax rates, again helping incomes and consumption in a recession.

Stabilizers during Expansion Phase

During an expansion tax rates increase with rising income

The government spends less money on government programs like unemployment insurance

This dampens AD bringing inflation down.

Federal Budgets

Annual budget bills originate in the House, but must be passed by the Senate and signed by the President

Each budget includes spending priorities and sources of revenue to pay for the federal programs

If the government spends more than it collects in taxes, it runs a deficit. If it takes in more revenue than it pays out, it runs a surplus.

When revenues are equal to payments for program, the government is said to have a balanced budget.

KEYNESIAN ECONOMICS

Keynesians believe that deficits caused by recessions and expansionary fiscal policy will be offset by fiscal surpluses created during the expansionary phase of the business cycle.

In the expansion phase government increases revenue and creates surpluses by cutting government programs and increasing taxes.

Keynesian solutions have been used since WW II, and were particularly popular during the 1960’s and 1970’s

Phillips Curve

In the late 50’s English Economist A.W. Phillips designed a curve to show the trade off between inflation and unemployment

Using British economic data, he showed the inverse relationship between the two indices.

When inflation was high, unemployment was low and when inflation was low unemployment was high.

This became known as the Phillips Curve

Short-Run Phillips Curve (SRPC)

Phillips Curve and Policy

The short run Phillips curve indicates that governments can make active policy, choosing a level of unemployment and inflation.

The US economy of the 1960’s matched the Phillips curve data. However, in the 1970’s stagflation challenged active Keynesian policy makers, since fiscal policy cannot remedy both high inflation and high unemployment at the same time.

The long-run Phillips curve is a vertical line (like the LRAS) at the natural rate of unemployment, or what we have called Full Employment (FE)

Long Run Phillips Curve (LRPC) at the NAIRU

Northland’s Difficulties

A) Northland is currently operating well below the NAIRU. Draw a macro graph of its economy.

B) What fiscal policies should Northland implement?

Draw a short run Phillips curve. Indicate a point where Northland would be in part A. Then put a point B after the fiscal policies have been implemented.

TIME LAG PROBLEM IN ECONOMIC POLICYThe problem with government economic

problem is that each policy takes time to work. It may takes months or even years between the

time the problem is diagnosed and fiscal policy is implemented

Therefore, some economists do not think that tax and spending measures can solve problems in an economy in a timely fashion.

GOVERNMENT BORROWING

Keynes believed that during a recession governments should deficit spend to fund programs (not increase taxes)

Governments borrow by selling Treasury bills. T-bills are purchased by wealthy individuals,

businesses, and foreign investorsDeficits are yearly, the national debt is the

accumulation of yearly deficits.

The Impact of Deficit Spending

Keynesians believe that deficits during recessions will be paid off with surpluses during the expansionary phase of the business cycle.

Classical economists argue that deficit spending or increasing debt creates “offsets” that negatively effect AD.

The “Crowding Out” Effect - A critique of Keynesian policiesSome economists say that the positive impact of

government spending is lessened when the government borrows money

It is argued that public borrowing, “crowds out” private borrowing, and drives up interest rates

Higher interest rates reduce private investment and consumption

Therefore, deficit spending may not stimulate economy as much as the Keynesians argue.

Indirect Crowding Out

US borrows money to deficit spend --> increased govt. demand for money -->

Interest rates increase --> private borrowing by business and consumer declines

Therefore, AD declines due higher interest rates

Direct Crowding Out or Expenditure OffsetsSome government spending has no comparable

private sector product substitute, e.g. military spending.

However, in some cases increases in government spending lead to a decline in private sector spending or investment.e.g increases in government spending in public education may lead to decreases in private education.

Therefore, increases in G may lead declines in C and I in the private sector.

Ricardian Equivalence Theorem and Rational Expectations TheoryIncreases in government budget deficits

has no effect on ADPeople anticipate that a larger deficit

today will mean higher taxes in the future, people adjust their spending down today.

The Rational expectations theory is similar --> people believe budget deficits will increase prices in future --> cut back on spending and investment

Open Economy Effect

Classical economists also believe that increased interest rates from the crowding out effect will increase the value of the dollar

Foreign investors will want dollars to invest in our bonds with their higher interest rates.

A stronger dollar will make imports cheaper, thus leading to a trade deficit

This deficit in NX may offset increases created by government spending.

The Laffer Curve - supply side

In the 1970’s Arthur Laffer postulated that if the government cuts marginal tax rates, it would NOT lose tax revenue.

He argued that decreases in marginal tax rates would stimulate private investment and raise incomes.

The government would then actually receive more revenues in the long run from the tax cuts.

These economists favor cutting the marginal tax rates, especially for business.

Reagan employed this theory, instituting lower marginal tax rates during the 1980’s

Supply Side Economics

Supply Side economists believe that the main way the economy should be stimulated is through tax cuts for businesses and households, combined with decreases in government spending.

These cuts lead to increased investment and ultimately increase aggregate supply within the economy, thus the name “supply-side.”

Supply-siders want to shrink government and increase private investment. They also oppose many business regulations, which they believe cuts down on business profitability

Critique of Supply Side

“Reaganomics” did not lower budget deficit by bringing in more revenues, especially since he increased the military budget.

Some critics point out that tax rates don’t significantly influence investment and Real GDP. For example, The Clinton tax rates were higher than the Bush tax rates, but incomes climbed during the Clinton years. We currently have the lower Bush rates, but have a worse economic environment.

Criticisms continued

Critics also point out that decreasing marginal tax rates does not necessarily mean business will invest. Businesses may choose to save, rather than increase employment.

Supply side is viewed by Keynesian critics as an extension of the a discredited “trickle down” economics, in which Republican politicians have given tax breaks are given to the wealthiest at the expense of the poor and middle classes.

Fixing the Budget

Did you shave a little off most spending categories, or did you go after large cuts in big programs? Explain.

Did you make more cuts in military or social spending? Explain.

Did you increase revenue primarily through spending cuts, or primarily through increasing taxes? Explain.

Which tax areas did you decide to increase?What did you learn from this activity?

Budget Puzzle: You Fix the Budget

Read the related article in the NY Times Budget Puzzle

Then return to the You Fix the Budget activityGo ahead and begin to craft a long term budget

that will fix the deficits by 2015 and 2030Which programs did you want to cut, and which

did you want to maintain?What was your plan for taxes?

MONETARY POLICY

US government can expand money supply during a recession or contract money supply during an expansion

Money supply is controlled by the Federal Reserve Banks

FEDERAL RESERVE BANK

14 districtsFederal Reserve chairman - Benjamin

BernankeFederal Reserve

MONEY SUPPLY

Total amount of money circulating in the economy

Money supply is determined by the federal reserve banks

“LOOSE” MONEY

Federal reserve can expand the money supply during a recession by

1. Lowering reserve rate required for member banks

2. Lowering rediscount rate (interest rate charged by the Fed)

3. Buying Bonds, which puts more money in bond holders hands

Rational Expectations

Milton Friedman argued people and businesses will anticipate the impact of government policy on future economic decisions.

For example, if they see increased government spending or money supply increase, they will anticipate future inflation and act accordingly.

His theory became part of the new classical theory.

Small Menu Keynesians

Monetarists

“TIGHT” MONEY

Federal Reserve can try to slow down inflation by:

1. Raising reserve rate2. Raising rediscount rate3. Selling bonds, which takes money out

of the private economy

World trade

US imports 14% of GDPExports 12% of GDPLast several years, US running large trade

deficits (value of imports higher than exports)

Some Americans suggesting tariffs (taxes on foreign goods) or quotas on foreign goods to reduce imports.

Free Trade versus Protectionism

Free Trade advocates say US benefits from lower prices on foreign goods and the ability to export US products to foreign countries

Protectionists argue US not being treated fairly in foreign markets and are losing important jobs at home to foreign competition.

Globalization and Trade Organizations

World Trade Organization (WTO) - 140 member countries monitors and negotiates trade disputes

North American Free Trade Organization (Canada, US and Mexico)

European Union (EU)

AP Macro Economics

AP Macro Economics Test Thursday May 11thReport 7:15 AMMat Room behind Old GymReview for AP EconomicsWednesday May 10th Room 207Suggestion: Purchase AP Economics

Review Book

BUSINESS CYCLE

Periods of GDP growth are called expansions or boom periods

6 months of falling GDP is called a recession.

Severe GDP drop is depressionTop of the business cycle is peakBottom recession called trough

UNEMPLOYMENT

Measured by the Bureau of Labor Statistics

Definition “members of the labor force who are looking for work, but unable to find jobs.”

Unemployment rate = % unemployedEstimate is low - “discouraged workers”

not included

INFLATION

Defined as the sustained rise in pricesMeasured by the Consumer Price Index

(CPI)Inflation reduces purchasing power of

consumersComparing real GDP between years

means accounting for inflation (GDP deflator)

Taxes

Largest source of government income is individual income taxes

US has progressive income tax structure (wealthier groups pay higher percentage)

Social Security taxes (FICA) are tax on wages

Additional taxes include: corporate taxes, estate taxes, state income tax, sales

Social Security

Passed during Depression to create a pension for all Americans

6.2 % of incomeNot a fund, current workers pay for retiring

workersRatio of retiress to workers rising,

therefore long term not enough to cover retirees

Solutions to Social Security

Increase social security taxGet rid of income cap on taxesIncrase age of beneficiariesPrivatize social security to make IRAIncrease immigration to increase

percentage of current workers to retirees