Chapter 12

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LECTURE NOTES

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Introduction A. One major function of the government is to stabilize the economy (prevent unemployment or inflation). B. Stabilization can be achieved in part by manipulating the public budgetgovernment spending and ta collectionsto increase output and employment or to reduce inflation. !. "his chapter #ill e amine a number of topics. $. %t #ill loo& at the legislative mandates given government to pursue stabilization. '. %t e plores the tools of government fiscal stabilization policy using A()AS model. *. Both discretionary and automatic fiscal adjustments are e amined. +. "he problems, criticisms, and complications of fiscal policy are addressed. Legislative mandatesThe Employment Act of 1946 A. !ongress proclaimed government-s role in promoting ma imum employment, production, and purchasing po#er. B. "he Act created the !ouncil of .conomic Advisers to advise the /resident on economic matters. !. %t created the 0oint .conomic !ommittee of !ongress to investigate economic problems of national interest. iscal !olicy and the A"#A$ %odel A. (iscretionary fiscal policy refers to the deliberate manipulation of ta es and government spending by !ongress to alter real domestic output and employment, control inflation, and stimulate economic gro#th. 1(iscretionary2 means the changes are at the option of the 3ederal government. B. Simplifying assumptions4 $. Assume initial government purchases don-t depress or stimulate private spending. '. Assume fiscal policy affects only demand, not supply, side of the economy. !. 3iscal policy choices4 . pansionary fiscal policy is used to combat a recession (see e amples illustrated in 3igure $')$). $. . pansionary /olicy needed4 %n 3igure $')$, a decline in investment has decreased A( from A( $ to A(' so real 5(/ has fallen and also employment declined. /ossible fiscal policy solutions follo#4 a. An increase in government spending (shifts A( to right by more than change in 5 due to multiplier), b. A decrease in ta es (raises income, and consumption rises by 6/! change in income7 A( shifts to right by a multiple of the change in consumption). c. A combination of increased spending and reduced ta es. d. %f the budget #as initially balanced, e pansionary fiscal policy creates a budget deficit. '. !ontractionary fiscal policy needed4 8hen demand)pull inflation occurs as illustrated by a shift from A( * to A(+ in the vertical range of aggregate supply in 3igure $')'. "hen contractionary policy is the remedy4 a. A decrease government spending shifts A( + bac& to A(* once the multiplier process is complete. 9ere price level returns to its preinflationary level / * but 5(/ remains at full)employment level. b. An increase in ta es #ill reduce income and then consumption at first by 6/! fall in income, and then multiplier process leads A( to shift left#ard still further. %n 3igure $')' a ta increase of :;.;< billion decreases consumption by = and multiplier causes eventual shift to A( *. c. A combined spending decrease and ta increase could have the same effect #ith the right combination (:' billion decline in 5 and :+ billion rise in " #ill have this effect). (. 3inancing deficits or disposing of surpluses4 "he method used influences fiscal policy effect. $. 3inancing deficits can be done in t#o #ays. a. Borro#ing4 "he government competes #ith private borro#ers for funds and could drive up interest rates7 the government may 1cro#d out2 private borro#ing, and this offsets the government e pansion.

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b. 6oney creation4 8hen the 3ederal >eserve loans directly to the government by buying bonds, the e pansionary effect is greater since private investors are not buying bonds. (?ote4 6onetarists argue that this is monetary, not fiscal, policy that is having the e pansionary effect in such a situation.) '. (isposing of surpluses can be handled t#o #ays. a. (ebt reduction is good but may cause interest rates to fall and stimulate spending. "his could be inflationary. b. %mpounding or letting the surplus funds remain idle #ould have greater anti)inflationary impact. "he government holds surplus ta revenues #hich &eeps these funds from being spent. .. /olicy options4 5 or "@ $. .conomists tend to favor higher 5 during recessions and higher ta es during inflationary times if they are concerned about unmet social needs or infrastructure. '. Others tend to favor lo#er " for recessions and lo#er 5 during inflationary periods #hen they thin& government is too large and inefficient. 'uilt(In $ta)ility A. Built)in stability arises because net ta es (ta es minus transfers and subsidies) change #ith 5(/ (recall that ta es reduce incomes and therefore, spending). %t is desirable for spending to rise #hen the economy is slumping and vice versa #hen the economy is becoming inflationary. 3igure $')* illustrates ho# the built)in stability system behaves. $. "a es automatically rise #ith 5(/ because incomes rise and ta revenues fall #hen 5(/ falls. '. "ransfers and subsidies rise #hen 5(/ falls7 #hen these government payments (#elfare, unemployment, etc.) rise, net ta revenues fall along #ith 5(/. B. "he size of automatic stability depends on responsiveness of changes in ta es to changes in 5(/4 "he more progressive the ta system, the greater the economy-s built)in stability. %n 3igure $')* line " is steepest #ith a progressive ta system. $. A $AA* la# increased the highest marginal ta rate on personal income from *$ percent to *A.; percent and corporate income ta rate to *=B by $ percentage. "his helped prevent demand)pull inflation. '. Automatic stability reduces instability, but does not correct economic instability. Evaluating iscal !olicy A. A full)employment budget in Cear $ is illustrated in 3igure $')+(a) because budget revenues eDual e penditures #hen full)employment e ists at 5(/$. B. At 5(/' there is unemployment and assume no discretionary government action, so lines 5 and " remain as sho#n. $. Because of built)in stability, the actual budget deficit #ill rise #ith decline of 5(/7 therefore, actual budget varies #ith 5(/. '. "he government is not engaging in e pansionary policy since budget is balanced at 3... output. *. "he full)employment budget measures #hat the 3ederal budget deficit or surplus #ould be #ith e isting ta es and government spending if the economy is at full employment. +. Actual budget deficit or surplus may differ greatly from full)employment budget deficit or surplus estimates. !. %n 3igure $')+b, the government reduced ta rates from "$ to "', no# there is a 3... deficit. $. Structural deficits occur #hen there is a deficit in the full)employment budget as #ell as the actual budget. '. "his is e pansionary policy because true e pansionary policy occurs #hen the full)employment budget has a deficit. (. %f the 3... deficit of zero #as follo#ed by a 3... budget surplus, fiscal policy is contractionary. .. >ecent E.S. fiscal policy is summarized in "able $')$. $. Observe that 3... deficits are less than actual deficits.

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'. !olumn * indicates e pansionary fiscal policy of early $AAFs became contractionary in the later years sho#n. *. Actual deficits have disappeared and the E.S. budget has actual surpluses since $AAA. (Gey Huestion <) 3. 5lobal /erspectives $')$ gives a fiscal policy snapshot for selected countries. !ro)lems* +riticisms and +omplications A. /roblems of timing $. >ecognition lag is the elapsed time bet#een the beginning of recession or inflation and a#areness of this occurrence. '. Administrative lag is the difficulty in changing policy once the problem has been recognized. *. Operational lag is the time elapsed bet#een change in policy and its impact on the economy. B. /olitical considerations4 5overnment has other goals besides economic stability, and these may conflict #ith stabilization policy. $. A political business cycle may destabilize the economy4 .lection years have been characterized by more e pansionary policies regardless of economic conditions. a. political business cycle@ '. State and local finance policies may offset federal stabilization policies. "hey are often procyclical, because balanced)budget reDuirements cause states and local governments to raise ta es in a recession or cut spending ma&ing the recession possibly #orse. %n an inflationary period, they may increase spending or cut ta es as their budgets head for surplus. *. "he cro#ding)out effect may be caused by fiscal policy. a. 1!ro#ding)out2 may occur #ith government deficit spending. %t may increase the interest rate and reduce private spending #hich #ea&ens or cancels the stimulus of fiscal policy. (See 3igure $')=) b. Some economists argue that little cro#ding out #ill occur during a recession. c. .conomists agree that government deficits should not occur at 3..., it is also argued that monetary authorities could counteract the cro#ding)out by increasing the money supply to accommodate the e pansionary fiscal policy. !. 8ith an up#ard sloping AS curve, some portion of the potential impact of an e pansionary fiscal policy on real output may be dissipated in the form of inflation. (See 3igure $')=c) iscal !olicy in an ,pen Economy -$ee Ta)le 1.(./ A. Shoc&s or changes from abroad #ill cause changes in net e ports #hich can shift aggregate demand left#ard or right#ard. B. "he net e port effect reduces effectiveness of fiscal policy4 3or e ample, e pansionary fiscal policy may affect interest rates, #hich can cause the dollar to appreciate and e ports to decline (or rise). $upply($ide iscal !olicy A. 3iscal policy may affect aggregate supply as #ell as demand (see 3igure $'); e ample). B. Assume that AS is up#ard sloping for simplicity. !. "a changes may shift aggregate supply. An increase in business ta es raises costs and shifts supply to left7 decrease shifts supply to the right. $. Also, lo#er ta es could increase saving and investment. '. Io#er personal ta es may increase effort, productivity and, therefore, shift supply to the right. *. Io#er personal ta es may also increase ris&)ta&ing and, therefore, shift supply to the right. (. %f lo#er ta es raise 5(/, ta revenues may actually rise. .. 6any economists are s&eptical of supply)side theories. $. .ffect of lo#er ta es on a supply is not supported by evidence. '. "a impact on supply ta&es e tended time, but demand impact is more immediate. LA$T 0,1"2 The Leading Indicators A. "his inde comprises $F variables that have indicated forthcoming changes in real 5(/ in the past.

B. "he variables are the foundation of this inde consisting of a #eighted average of ten economic measurements. A rise in the inde predicts a rise in the 5(/7 a fall predicts declining 5(/. !. "en components comprise the inde 4 $. Average #or&#ee&4 A decrease signals future 5(/ decline. '. %nitial claims for unemployment insurance4 An increase signals future 5(/ decline. *. ?e# orders for consumer goods4 A decrease signals 5(/ decline. +. Jendor performance4 Better performance by suppliers in meeting business demand indicates decline in 5(/. =. ?e# orders for capital goods4 A decrease signals 5(/ decline. ;. Building permits for houses4 A decrease signals 5(/ decline. <. Stoc& mar&et prices4 (eclines signal 5(/ decline. K. 6oney supply4 A decrease is associated #ith falling 5(/. A. %nterest)rate spread4 #hen short)term rates rise, there is a smaller spread bet#een short)term and long) term rates #hich are usually higher. "his indicates restrictive monetary policy. $F. %nde of consumer e pectations4 (eclines in consumer confidence foreshado# declining 5(/. (. ?one of these factors alone is sufficient to predict changes in 5(/, but the composite inde has correctly predicted business fluctuations many times (although not perfectly). "he inde is a useful signal, but not totally reliable.