Aggregate Demand and Supply and Fiscal Policy 1

The Collapse of 2008 - Causes There is no consensus (and we are not economists) but some common beliefs are: Deregulation over the past couple of decades was based on beliefs that markets can correct themselves – the recent collapse suggests that if they can it is only after severe consequences. There was a housing bubble  prices increased rapidly before retreating to more reasonable levels. There was too much debt.

The Collapse of 2008 - Causes There is no consensus (and we are not economists) but some common beliefs are: There was too much debt backed by housing of declining value. There was a legacy of subprime lending. There was inflation in the commodity markets. There was mismanagement at many financial institutions. The crisis accelerated as major financial institutions lost massive amounts of money, some became insolvent and credit became very hard to get.

A Very Scary Outlook and Fear of Another Great Depression A Perfect Storm A Very Scary Outlook and Fear of Another Great Depression Job Loss Credit Crunch The 2008 Financial Collapse Commodity Prices Housing Collapse Should follow #41 Global Economy

The Collapse of 2008  Fiscal Policy Responses There has been something of a rebirth in Keynesian economics and the use of fiscal policy. The national deficit has skyrocketed.  Targeted spending did things such as bail out or federalize financial institutions and automakers. The federal government bought bad debt. The federal government extended unemployment benefits. Red ok

The Collapse of 2008  Fiscal Policy Responses Job creation programs have been initiated. Certain tax rebates have been enacted. There have been financial transfers to states. Red ok

How Was the Collapse Limited? The collapse was limited by the belief that governments should intervene. There were policy options both monetary and fiscal. Global institutions were involved and cooperated.

How Successful Were the Interventions? The situation did not turn into another “Great Depression.” But, the situation is still not healthy. It does seem clear that the aggressive use of monetary and fiscal policies limited the impact of the collapse.

The Car Analogy The economy is like a car… You can drive 120mph but it is not sustainable. (Extremely Low unemployment) Driving 20mph is too slow. The car can easily go faster. (High unemployment) 70mph is sustainable. (Full employment) Some cars have the capacity to drive faster then others. (industrial nations vs. 3rd world nations) If the engine (technology) or the gas mileage (productivity) increase then the car can drive at even higher speeds. (Increase LRAS) The government’s job is to brake or speed up when needed as well as promote things that will improve the engine. (Shift the PPC outward)

How does the Government Stabilizes the Economy? The Government has two different tool boxes it can use: 1. Fiscal Policy- Actions by Congress to stabilize the economy. OR 2. Monetary Policy-Actions by the Federal Reserve Bank to stabilize the economy.

For now we will only focus on Fiscal Policy.

Fiscal Policy

Two Types of Fiscal Policy Discretionary Fiscal Policy- Congress creates a new bill that is designed to change AD through government spending or taxation. Problem is time lags due to bureaucracy. Takes time for Congress to act. Ex: In a recession, Congress increase spending. Non-Discretionary Fiscal Policy AKA: Automatic Stabilizers Permanent spending or taxation laws enacted to work counter cyclically to stabilize the economy Ex: Welfare, Unemployment, Min. Wage, etc. When there is high unemployment, unemployment benefits to citizens increase consumer spending. 14

Expansionary Fiscal Policy (The GAS) Contractionary Fiscal Policy (The BRAKE) Laws that reduce inflation, decrease GDP (Close a Inflationary Gap) Decrease Government Spending Tax Increases Combinations of the Two Expansionary Fiscal Policy (The GAS) Laws that reduce unemployment and increase GDP (Close a Recessionary Gap) Increase Government Spending Decrease Taxes on consumers Combinations of the Two How much should the Government Spend? 15

WHY? What type of gap and what type of policy is best? What should the government do to spending? Why? How much should the government spend? The government should increasing spending which would increase AD They should NOT spend 100 billion!!!!!!!!!! If they spend 100 billion, AD would look like this: LRAS AS Price level WHY? P1 AD2 AD1 $400 $500 Real GDP (billions) 16 FE

The Multiplier Effect Why do cities want the Superbowl in their stadium? An initial change in spending will set off a spending chain that is magnified in the economy. Example: Bobby spends $100 on Jason’s product Jason now has more income so he buys $100 of Nancy’s product Nancy now has more income so she buys $100 of Tiffany’s product. The result is an $300 increase in consumer spending The Multiplier Effect shows how spending is magnified in the economy. 17

Fiscal Policy Practice Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .8) LRAS What type of gap? Contractionary or Expansionary needed? What are two options to fix the gap? How much initial government spending is needed to close gap? AS Price level P1 AD2 AD1 $100 Billion $500 $1000FE Real GDP (billions)

Fiscal Policy Practice Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .5) LRAS What type of gap? Contractionary or Expansionary needed? What are two options to fix the gap? How much needed to close gap? AS P2 Price level -$20 Billion AD1 AD $80FE $100 Real GDP (billions)

What about taxing? Expansionary Policy (Cutting Taxes) The multiplier effect also applies when the government cuts or increases taxes. But, changing taxes has less of an impact then government spending. Why? Expansionary Policy (Cutting Taxes) Assume the MPC is .75 so the multiplier is 4 If the government cuts taxes by $4 million how much will consumer spending increase? NOT 16 Million!! When they get the tax cut, consumers will save $1 million and spend $3 million. The $3 million is the amount magnified in the economy. $3 x 4 = $12 Million increase in consumer spending

Cutting Tax Practice $10 Billion Price level -$20 Billion Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .5) LRAS 1. What two options does the government have? 2. How much should they increase government spending? $10 Billion 3. How much should they cut taxes? AS Price level P1 AD2 AD1 -$20 Billion $80 $100FE Real GDP (billions) 21

Multiplier Effect

Non-Discretionary Fiscal Policy

Non-Discretionary Fiscal Policy AKA: Automatic Stabilizers Legislation that act counter cyclically without explicit action by policy makers. AKA: Automatic Stabilizers The U.S. Progressive Income Tax System acts counter cyclically to stabilize the economy. When GDP is down, the tax burden on consumers is low, promoting consumption, increasing AD. When GDP is up, more tax burden on consumers, discouraging consumption, decreasing AD. The more progressive the tax system, the greater the economy’s built-in stability.

Review Identify the two types of tool boxes the government has to fix the economy Explain and give examples of Expansionary Fiscal Policy Explain and give examples of Contractionary Fiscal Policy Explain the Multiplier Effect Explain how to calculate the spending multiplier 25

Draw and Practice Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .9) LRAS What type of gap? Contractionary or Expansionary needed? What are two options to fix the gap? How much needed to close gap? AS P2 Price level AD1 AD -$5 Billion $50FE $100 Real GDP (billions) 26

Draw and Practice Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .8) LRAS What type of gap? Contractionary or Expansionary needed? What are two options to fix the gap? How much initial government spending is needed to close gap? AS Price level P1 AD2 AD1 +$40 Billion $800 $1000FE Real GDP (billions) 27

Problems With Fiscal Policy 28

Problems With Fiscal Policy When there is a recessionary gap what two options does Congress have to fix it? What’s wrong with combining both? Deficit Spending!!!! A Budget Deficit is when the government’s expenditures exceeds its revenue. The National Debt is the accumulation of all the budget deficits over time. If the Government increases spending without increasing taxes they will increase the annual deficit and the national debt. Most economists agree that budget deficits are a necessary evil because forcing a balanced budget would not allow Congress to stimulate the economy.

Explain this cartoon 2003

Who ultimately pays for excessive government spending?

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Additional Problems with Fiscal Policy Problems of Timing Recognition Lag- Congress must react to economic indicators before it’s too late Administrative Lag- Congress takes time to pass legislation Operational Lag- Spending/planning takes time to organize and execute ( changing taxing is quicker) Politically Motivated Policies Politicians may use economically inappropriate policies to get reelected. Ex: A senator promises more welfare and public works programs when there is already an inflationary gap.

Additional Problems with Fiscal Policy 3. Crowding-Out Effect In basketball, what is “Boxing Out”? Government spending might cause unintended effects that weaken the impact of the policy. Example: We have a recessionary gap Government creates new public library. (AD increases) Now consumers spend less on books (AD decreases) Another Example: The government increases spending but must borrow the money (AD increases) This increases the price for money (the interest rate). Interest rates rise so Investments fall. (AD decrease) The government “crowds out” consumers and/or investors

Additional Problems with Fiscal Policy 4. Net Export Effect International trade reduces the effectiveness of fiscal policies. Example: We have a recessionary gap so the government spends to increase AD. The increase in AD causes an increase in price level and interest rates. U.S. goods are now more expensive and the US dollar appreciates… Foreign countries buy less. (Exports fall) Net Exports (Exports-Imports) falls, decreasing AD.

Explain this cartoon 37

Activity 38

Congressional Committees As a group, analyze the situation, identify the problem, and identify your solution The Good, the Bad, and the Ugly   Unemployment Inflation GDP Growth Good 6% or less 1%-4% 2.5%-5% Worry 6.5%-8% 5%-8% 1%-2% Bad 8.5 % or more 9% or more .5% or less

1.) 1933 Situation: GDP fell -1.2% Inflation rate= -.5% Unemployment Rate=25% Your Solution: What actually happened: FDR increased public works via the New Deal programs.

2.) 1944 Situation: GDP grew 8% Inflation rate= 3.7% Unemployment Rate=1.2% Your Solution: What actually happened: War ended the next year and government orders for war materials decreased. Many public works programs were discontinued

3.) 1980 Situation: GDP fell -0.3% Inflation rate= 13.5% Unemployment Rate=7.1% Your Solution: What actually happened: The next year, President Reagan and congress lowered taxes on individuals and corporations by about 30%. (Supply-side Economics)

4.) 2003 Situation: GDP fell 0.5% Inflation rate= 1.5% Unemployment Rate=12.0% Your Solution: What actually happened: Congress voted to give tax cuts to citizens. (Bush Tax Cuts)