Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives Fiscal Policy: Congress & President (Treasury/OMB) Monetary Policy—ain’t fiscal policy—The Fed does M-policy Fiscal automatic stabilizers Government spending and taxes that automatically increase or decrease with the business cycle progressive income tax/unemployment benefits/food stamps / other entitlements. Tax wedge The difference between the pre-tax and post-tax return to an economic activity.  Disincentive to work???  Supply-side tax cuts Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

Government Purchase and Tax Multipliers The Multiplier Effect and Aggregate Demand

Government Purchase Multiplier The Multiplier Effect of an Increase in Government Purchases This spending multiplier is analogous but not the same as the deposit multiplier

The Government Tax Multiplier Cut in tax rates affects equilibrium real GDP in two ways: (1)disposable income rises  consumption spending rises (2)the rate at which purchasing power leaks from the spending stream declines  the spending multiplier increases The less the marginal propensity to leak, the greater the spending multiplier. Recall: Spending Multiplier = 1/[Marginal Propensity to Leak] = 1/[Propensity Not to Respend Additional Income Domestically] =1/[Propensity to pay taxes, save and buy things from abroad]

Taking into Account the Effects of Aggregate Supply: Slowing the Multiplier The Government Purchases and Tax Multipliers Because the Price Level rises, Real GDP does not increase as much as it otherwise would  The multiplier effect is reduced

An Expansionary Fiscal Policy Increases Interest Rates Crowding out A decline in private expenditures as a result of an increase in government purchases…slowing the multiplier Money market

The Limits of Using Fiscal Policy to Stabilize the Economy Crowding Out in the Short Run

The 1960s: A Policy Menu? The Phillips Curve

Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves Phillips curve A curve showing the short- run relationship between the unemployment rate and the inflation rate. As long as SRAS is stable, get Phillips Curve relation

Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves Phillips curve A curve showing the short- run relationship between the unemployment rate and the inflation rate. As long as SRAS is stable, get Phillips Curve relation If people expect high inflation… Phillips curve shifts…

The Short-Run and Long-Run Phillips Curves The Inflation Rate and the Natural Rate of Unemployment in the Long Run Nonaccelerating inflation rate of unemployment (NAIRU) The unemployment rate at which the inflation rate has no tendency to increase or decrease.  Equilibrium unemploy  “Natural” unemploymt

The Balance of Payments of the United States, 2006 (billions of dollars) CURRENT ACCOUNT Exports of goods$1,023 Imports of goods−1,861 Balance of trade−838 Exports of services423 Imports of services−343 Balance of services80 Income received on investments650 Income payments on investments−614 Net income on investments−36 Net transfers−90 Balance on current account−812 Don’t forget net compensation of nationals working abroad (= Labor Services) FINANCIAL ACCOUNT Increase in foreign holdings of assets in the United States1,860 Increase in U.S. holdings of assets in foreign countries−1,055 Balance on Financial Account805 BALANCE ON CAPITAL ACCOUNT -4 Statistical discrepancy11 Balance of payments0 The Balance of Payments balances: Current Account + Financial Account + Capital Account + Statistical Discrepancy = ZERO

The Effect of a Government Budget Deficit on Current Account Balance The Twin Deficits, 1978–2006 Current Account Deficit = Net Capital Inflows = National Borrowing = (I – S private ) + (G – T) = - NFI = Private Borrowing + Public Borrowing

The Foreign Exchange Market and Exchange Rates: The Operation of Supply and Demand for a Currency Equilibrium in the Market for Foreign Exchange Foreign demand for US dollar: Buy US stuff Currently produced goods and services Buy US assets Stocks Bonds Real estate Hotels and factories (fdi) Hold $ in US banks Transactions demand Speculative demand