Copyright © 2004 South-Western Mods 17-21, 30 Macro Analysis Part IV

Copyright © 2004 South-Western Policy Choices to Affect AD/AS When there are changes occurring in the Macro Economy, as captured through AD/AS analysis and short-run business cycle fluctuations, such as… Downturns with less AD, more Unemp, etc. Upturns with more AD, rising inflation, etc. We have some choices to make about what to do about it!!

Copyright © 2004 South-Western The Case against Policy In the past, economists believed that the economy self-corrects, and so we simply “suffered through” the time of self-correction This is the basis for “laissez faire” policy These “Classical” economists argue that “doing something” to address the problems actually destabilizes the economy: Time lags create more problems. But…the time estimate for laissez-faire approach: 10 years for self-correction!!!

Copyright © 2004 South-Western USING POLICY TO STABILIZE THE ECONOMY Now….Economists will recommend “Active Stabilization” interventions through either monetary or fiscal policy. Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946, and the Humphrey-Hawkins Act of 1978, which require: Full employment Price Stability Positive GDP growth Positive Balance of Trade

Copyright © 2004 South-Western HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND Fiscal policy refers to the government’s choices regarding the overall level of government purchases (G) or taxes (T). Fiscal policy influences saving, investment, and growth in the long run. In the short run, fiscal policy primarily affects the aggregate demand.

Copyright © 2004 South-Western Expansionary and Contractionary Fiscal Policy A Negative demand shock causes a recessionary gap. The price level falls, but so does real GDP. Unemployment becomes a problem. Use Expansionary Fiscal Policy increase G decrease T increase transfers

Copyright © 2004 South-Western Expansionary and Contractionary Fiscal Policy A Positive demand shock causes an inflationary gap. The price level rises and so does real GDP. Unemployment falls, but inflation is the real problem. Use Contractionary Fiscal Policy decrease G increase T decrease transfers

Copyright © 2004 South-Western Decide Which is Which— Contractionary or Expansionary?? 1.The government cuts business and personal income taxes and increases its own spending. 2.The government increases the personal income tax, Social Security tax and corporate income tax. Government spending remains the same. 3.Government spending goes up while taxes remain the same. 4.Government reduces the wages of its employees while raising taxes on consumers and businesses. Other Gov’t spending remains the same.

Copyright © 2004 South-Western Try some scenarios: A recession Use the fiscal policy of taxes to solve a recession Questions: 1.What does Congress need to do to AD? 2.What should Congress do to taxes to change AD? 3.How will this change in taxes affect consumers’ disposable income? 4.How will this change in disposable income affect consumer spending ?

Copyright © 2004 South-Western Try some scenarios: A positive demand shock Use the fiscal policy of G spending to solve inflation Questions: 1.What does Congress need to do to AD? 2.What should Congress do to G spending to change AD? 3.How will this change in G spending affect firms’ production and employment of workers? 4.How will this change in production and employment affect consumers’ disposable income? 5.How will this change in disposable income affect consumer spending ?

Copyright © 2004 South-Western Changes in Government Purchases When the government alters its own purchases of goods or services, it shifts the aggregate- demand curve directly.

Copyright © 2004 South-Western Changes in Taxes/Transfers When the government cuts personal income taxes or increases transfer payments, it affects aggregate-demand indirectly. How? These actions increase households’ take-home pay. Households save some of this additional income, & Households spend some of it on consumer goods. Increased household spending shifts the aggregate- demand curve to the right.

Copyright © 2004 South-Western Fiscal Policy Decisions and Indirect Effects There are two macroeconomic effects from changes in government fiscal policy: The multiplier effect The crowding-out effect

Copyright © 2004 South-Western The Multiplier Effect The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Copyright © 2004 South-Western The Multiplier Effect Government purchases are said to have a multiplier effect on aggregate demand. Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar, because increased govt spending = increased income for businesses and households, which leads to increased spending by them again, and on and on.

Copyright © 2004 South-Western The Multiplier Effect Quantity of Output Price Level 0 Aggregate demand,AD 1 $20 billion AD 2 AD 3 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion but the multiplier effect can amplify the shift in aggregate demand. Copyright © 2004 South-Western

The Crowding-Out Effect An increase in government spending causes the interest rate to rise, b/c gov’t is borrowing to spend. The interest rate rises b/c gov’t borrows in BIG SUMS, so there is less $ available for others—so it costs more The govt borrowing is then “crowding-out” Business opportunity to borrow and spend, b/c interest rates rise, so businesses don’t want to borrow as much to grow with Since Business investment spending is reduced, there is a subsequent reduction in AD from the “I” category in GDP The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand

Copyright © 2004 South-Western The Multiplier vs The Crowding-Out Effect When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.

Copyright © 2004 South-Western Automatic Stabilizers Automatic stabilizers are government spending and taxation rules already in place that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands. Discretionary Policy means the government is taking a specific action—passing a law, issuing an exec order—to stabilize the economy.

Copyright © 2004 South-Western Automatic Stabilizers Discretionary and Automatic Fiscal Policy wksht

Copyright © 2004 South-Western A Cautionary Note: Lags in Fiscal Policy TIME LAGS Recognition lag Decision lag Implementation lag Lags make decision-making more difficult

Copyright © 2004 South-Western Deficits Surpluses Good? Bad? The Budget Balance: Its Relation to Fiscal Policy

Copyright © 2004 South-Western Implicit Liabilities Spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics. Social Security Medicare Medicaid

Copyright © 2004 South-Western Deficits, Surpluses, and Debt Deficits, Surpluses, and Debt When spending exceeds tax revenue, government borrows and runs a deficit for that year If revenue exceeds spending, government runs a surplus for that year Fiscal years Public Debt

Copyright © 2004 South-Western What does $1 Trillion dollars look like? We'll start with a $100 dollar bill. Currently, it is the largest U.S. denomination in general circulation. Most everyone has seen them, slightly fewer have owned them. They are guaranteed to make friends wherever they go.

Copyright © 2004 South-Western $100

Copyright © 2004 South-Western A packet of one hundred $100 bills is less than 1/2" thick and contains $10,000. It fits in your pocket easily and is more than enough for week or two of shamefully decadent fun.

Copyright © 2004 South-Western $10,000

Copyright © 2004 South-Western Believe it or not, this next little pile is $1 million dollars (100 packets of $10,000). You could stuff that into a grocery bag and walk around with it.

Copyright © 2004 South-Western $1 Million

Copyright © 2004 South-Western While a measly $1 million looked a little unimpressive, $100 million is a little more respectable. It fits neatly on a standard pallet…

Copyright © 2004 South-Western $100 Million

Copyright © 2004 South-Western And $1 BILLION dollars... now we're really getting somewhere…

Copyright © 2004 South-Western $1 Billion

Copyright © 2004 South-Western Next we'll look at ONE TRILLION dollars. This is that number we've been hearing so much about. What is a trillion dollars? Well, it's a million million. It's a thousand billion. It's a one followed by 12 zeros. You ready for this?

Copyright © 2004 South-Western $1 Trillion

Copyright © 2004 South-Western The Budget Balance as a Measure of Fiscal Policy The Budget Balance as a Measure of Fiscal Policy The formula for figuring out govt budget balances T(axes) – G(ov spending – Transfers = S(Savings) gov In other words, you will either have a + or a – number, once you take Taxes and subtract G and Transfers. A + number = Surplus A – number = Deficit Expansionary policies reduce budget balance Contractionary policies increase budget balance G has a greater impact than T or Transfers Changes in budget balance are often result, not cause, of economic fluctuations

Copyright © 2004 South-Western Should the Budget Be Balanced? Should the Budget Be Balanced? Political motivation for running deficits or balancing the budget Economists argue against balanced budget rule in favor of cyclically balanced budget

Copyright © 2004 South-Western Problems Posed by Rising Government Debt Crowding Out Financial Pressure on Future Budgets Possibility of Default Monetizing the Debt

Copyright © 2004 South-Western The U.S. Government Debt Percent of GDP Revolutionary War 2010 Civil War World War I World War II Copyright©2004 South-Western

Deficits and Debt in Practice: The Debt-GDP Ratio Deficits and Debt in Practice: The Debt-GDP Ratio

Copyright © 2004 South-Western The Recent Recessions: Recession of 2008 Causes Causes: Relaxation of Banking Regs back in late 1990’s led to unprecedented growth in economy from Lax lending rules in Housing market led to bad housing debt Over-investment in bad debt “bundling” by financial markets, with too high ratings of these CDO’s Actual “gambling” on the bad debts thru insurance

Copyright © 2004 South-Western 2008 Recession Outcomes All this led to a point of bank failures, mortgage lending failures, insurance company failures, and a Credit Crunch, that led to layoffs, more foreclosures, less spending Stats:* 8 m. jobs lost—740,000 in Jan 2008 alone *$13 Trillion of wealth lost *Bank failures—incl lgst & 2 nd lgst ever *Home prices fell up to 32% *2.5 m homes foreclosed; >1 out of 2 homes in default by 2009

Copyright © 2004 South-Western Recession of 2008 Monetary Policy Fiscal Expansionary Policy Actions TARP of 2008 Bail-out of failing banks Econ Stimulus Act of 2008 Fiscal expansionary tax credits American Recovery & Reinvestment Act of 2009 Fiscal expansionary spending Additional Measures: unemp support, payroll tax cuts Fiscal Contractionary Policy Actions NOW