1. Aggregate Demand and Supply and Fiscal Policy1

3. 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.

4. 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.

5. 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

6. 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

7. 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

8. 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.

9. 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.

10. 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)

11. 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.

12. For now we will only focus on Fiscal Policy.

13. Fiscal Policy

14. 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

15. 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

16. 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
$ $500
Real GDP (billions) 16 FE

17. 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

18. 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
$ $1000FE
Real GDP (billions)

19. 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)

20. 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

21. 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
$ $100FE
Real GDP (billions) 21

22. Multiplier Effect

23. Non-Discretionary Fiscal Policy

24. 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.

25. 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

26. 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

27. 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
$ $1000FE
Real GDP (billions) 27

28. Problems With Fiscal Policy28

29. 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.

30. Explain this cartoon
2003

31. Who ultimately pays for excessive government spending?

32. 32

33. 33

34. 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.

35. 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

36. 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.

37. Explain this cartoon 37

38. Activity 38

39. 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

40. 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.

41. 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

42. 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)

43. 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)