2. When you have completed your study of this chapter, you will be able to C H A P T E R C H E C K L I S T Describe the federal budget process and explain the effects of fiscal policy. 1 Describe the Federal Reserve’s monetary policy process and explain the effects of monetary policy. 2

3. 21.1 THE BUDGET AND FISCAL POLICY Fiscal policy is the use of the federal budget to smooth the business cycle and encourage economic growth.

4. 21.1 THE BUDGET AND FISCAL POLICY  The Federal Budget The federal budget is an annual statement of the expenditures, tax receipts, and the surplus or deficit of the government of the United States. The government’s surplus or deficit is equal to its tax receipts minus its expenditures. That is, Budget surplus (+)/deficit (–) = Tax receipts – Expenditures

5. 21.1 THE BUDGET AND FISCAL POLICY The government has a budget surplus when tax receipts exceed expenditures. The government has a budget deficit when expenditures exceed tax receipts. The government has a balanced budget when tax receipts equal expenditures. The national debt is the amount of debt outstanding that arises from past budget deficits.

6. 21.1 THE BUDGET AND FISCAL POLICY Figure 21.1 shows the federal budget time line for fiscal 2004. Budget Time Line The President and Congress make the federal budget on the annual time line.

7. 21.1 THE BUDGET AND FISCAL POLICY The Employment Act of 1946 Fiscal policy operates within the framework of the landmark Employment Act of 1946, in which Congress declared that: It is the continuing policy and responsibility of the Federal Government to use all practicable means... to coordinate and utilize all its plans, functions, and resources... to promote maximum employment, production, and purchasing power.

8. 21.1 THE BUDGET AND FISCAL POLICY Council of Economic Advisers and National Economic Council The 1946 Employment Act established the President’s Council of Economic Advisers, which writes an annual Economic Report of the President, a handy review of the current state of the economy.

9. 21.1 THE BUDGET AND FISCAL POLICY Types of Fiscal Policy Fiscal policy can be either: Discretionary Automatic

10. 21.1 THE BUDGET AND FISCAL POLICY Discretionary fiscal policy A fiscal policy action that is initiated by an act of Congress. Automatic fiscal policy A fiscal policy action that is triggered by the state of the economy such as an increase in payments to the unemployed and a decrease in tax receipts triggered by recession.

11. 21.1 THE BUDGET AND FISCAL POLICY  Discretionary Fiscal Policy: Demand-Side Effects The Government Purchases Multiplier The government purchases multiplier is magnification effect of a change in government purchases of goods and services on aggregate demand. It works like the investment multiplier.

12. 21.1 THE BUDGET AND FISCAL POLICY The Tax Multiplier The tax multiplier magnification effect of a change in taxes on aggregate demand. A decrease in taxes increases disposable income. And an increase in disposable income increases consumption expenditure. With increased consumption expenditure, employment and incomes rise and consumption expenditure rises yet further.

13. 21.1 THE BUDGET AND FISCAL POLICY So a decrease in taxes works like an increase in government purchases. Both actions increase aggregate demand and have a multiplier effect. The magnitude of the tax multiplier is smaller than the government purchases multiplier.

14. 21.1 THE BUDGET AND FISCAL POLICY The Balanced Budget Multiplier The balanced budget multiplier is the magnification effect on aggregate demand of a simultaneous change in government purchases and taxes that leaves the budget balance unchanged. The balanced budget multiplier is not zero—it is positive—because the government purchases multiplier is larger than the tax multiplier.

15. 21.1 THE BUDGET AND FISCAL POLICY Discretionary Fiscal Stabilization Suppose the economy is stuck in an unemployment equilibrium. The government might use discretionary fiscal policy in an attempt to restore full employment. What might the government do to restore full employment?

16. 21.1 THE BUDGET AND FISCAL POLICY The government might increase its purchases of goods and services, cut taxes, or do some of both. These actions increase aggregate demand, and if they are timed correctly and are of the correct magnitude, they might eventually restore full employment. Figure 21.2 shows an expansionary fiscal policy.

17. 21.1 THE BUDGET AND FISCAL POLICY Potential GDP is $10 trillion, real GDP is $9 trillion, and 1. There is a $1 trillion deflationary gap. 2. An increase in government purchases or a tax cut increases expenditure by ∆E.

18. 21.1 THE BUDGET AND FISCAL POLICY 3. The multiplier increases induced expenditure. The AD curve shifts rightward to AD 1, the price level rises to 110, real GDP increases to $10 trillion, and the deflationary gap is eliminated.

19. 21.1 THE BUDGET AND FISCAL POLICY Figure 21.3 shows contractionary fiscal policy. Potential GDP is $10 trillion, real GDP is $11 trillion. 1. There is a $1 trillion inflationary gap. 2. A decrease in government purchases or a tax rise decreases expenditure by ∆E.

20. 21.1 THE BUDGET AND FISCAL POLICY 3. The multiplier decreases induced expenditure. The AD curve shifts leftward to AD 1, the price level falls to 110, real GDP decreases to $10 trillion, and the inflationary gap is eliminated.

21. 21.1 THE BUDGET AND FISCAL POLICY  Discretionary Fiscal Policy: Supply-Side Effects An increase in government purchases that increase the quantities of productive services and capital increases aggregate supply and a decrease in government purchases decreases aggregate supply.

22. 21.1 THE BUDGET AND FISCAL POLICY Taxes decrease the supply of labor and saving. A decrease in the supply of labor increases the equilibrium real wage rate and decreases the equilibrium quantity of labor employed. Similarly, a decrease in the supply of saving increases the equilibrium real interest rate and decreases the equilibrium quantity of investment and capital employed.

23. 21.1 THE BUDGET AND FISCAL POLICY With smaller quantities of labor and capital, potential GDP decreases, and so does aggregate supply. So an increase in taxes decreases aggregate supply. Figure 21.4 on the next slide shows the supply-side effects of fiscal policy.

24. 21.1 THE BUDGET AND FISCAL POLICY

25. Combined Demand and Supply Effects An increase in government purchases or a tax cut increases equilibrium real GDP but might raise, lower, or have no effect on the price level. Figure 21.5 on the next slides shows two views of the supply-side effects of fiscal policy.

26. 21.1 THE BUDGET AND FISCAL POLICY The conventional view is that an expansionary fiscal policy increases aggregate demand by more than it increases aggregate supply. Real GDP increases and the price level rises.

27. 21.1 THE BUDGET AND FISCAL POLICY The supply-side view is that an expansionary fiscal policy increases aggregate supply by more than it increases aggregate demand. Real GDP increases and the price level falls.

28. 21.1 THE BUDGET AND FISCAL POLICY  Limitations of Discretionary Fiscal Policy The use of discretionary fiscal policy is seriously hampered by three factors: Law-making time lag Estimating potential GDP Economic forecasting

29. 21.1 THE BUDGET AND FISCAL POLICY Law-Making Time Lag The amount of time it takes Congress to pass the laws needed to change taxes or spending. This process takes time because each member of Congress has a different idea about what is the best tax or spending program to change, so long debates and committee meetings are needed to reconcile conflicting views.

30. 21.1 THE BUDGET AND FISCAL POLICY Estimating Potential GDP It is not easy to tell whether real GDP is below, above, or at potential GDP. So a discretionary fiscal action might move real GDP away from potential GDP instead of toward it. This problem is a serious one because too much fiscal stimulation brings inflation and too little might bring recession.

31. 21.1 THE BUDGET AND FISCAL POLICY Economic Forecasting Fiscal policy changes take a long time to enact in Congress and yet more time to become effective. So fiscal policy must target forecasts of where the economy will be in the future. Economic forecasting has improved enormously in recent years, but it remains inexact and subject to error. So for a second reason, discretionary fiscal action might move real GDP away from potential GDP and create the very problems it seeks to correct.

32. 21.1 THE BUDGET AND FISCAL POLICY  Automatic Fiscal Policy A consequence of tax receipts and expenditures that fluctuate with real GDP. Automatic stabilizers are features of fiscal policy that stabilize real GDP without explicit action by the government. Induced Taxes Induced taxes are taxes that vary with real GDP.

33. 21.1 THE BUDGET AND FISCAL POLICY Needs-Tested Spending Needs-tested spending is spending on programs that entitle suitably qualified people and businesses to receive benefits— benefits that vary with need and with the state of the economy.

34. 21. 2 THE FED AND MONETARY POLICY  The Monetary Policy Process The Fed makes monetary policy in a process that has three main elements: Monitoring economic conditions Making policy decisions Reporting to Congress

35. Monitoring Economic Conditions Beige Book A report that summarizes current economic conditions in each Federal Reserve district and each sector of the economy. A good source of current information about the state of the economy. 21. 2 THE FED AND MONETARY POLICY

36. Meetings of the Federal Open Market Committee (FOMC) The FOMC, which meets eight times a year, makes the monetary policy decisions. After each meeting, the FOMC announces its decisions and describes its view of the likelihood that its goals of price stability and sustainable economic growth will be achieved. 21. 2 THE FED AND MONETARY POLICY

37. The Monetary Policy Report to Congress Twice a year, in February and July, the Fed prepares a Monetary Policy Report to Congress, and the Fed chairman testifies before the House of Representatives Committee on Financial Services. 21. 2 THE FED AND MONETARY POLICY

38.  Influencing the Interest Rate When the FOMC announces a policy change, its press release talks about the federal funds interest rate or the discount rate. 21. 2 THE FED AND MONETARY POLICY

39. In the Long Run In the long run, the Fed influences the nominal interest rate by the effects of its policies on the inflation rate. But it does not directly control the nominal interest rate, and it has no control over the real interest rate. 21. 2 THE FED AND MONETARY POLICY

40. In the Short Run In the short run, the Fed can determine the nominal interest rate and take actions to set the federal funds rate. But to do so, the Fed must undertake open market operations that change the quantity of money. Also, in the short run, the expected inflation rate is determined by recent monetary policy and inflation experience. So when the Fed changes the nominal interest rate, the real interest rate also changes, temporarily. 21. 2 THE FED AND MONETARY POLICY

41. The Fed Raises the Interest Rate The FOMC instructs the New York Fed to sell securities in the open market. This action mops up bank reserves. Some banks are short of reserves and seek to borrow reserves from other banks. The federal funds interest rate rises. 21. 2 THE FED AND MONETARY POLICY

42. With fewer reserves, the banks make a smaller quantity of new loans each day until the quantity of loans outstanding has fallen to a level that is consistent with the new lower level of reserves. The quantity of money decreases. Figure 21.6(a) on the next slide illustrates these events. 21. 2 THE FED AND MONETARY POLICY

43. 1. The current interest rate is 5 percent a year. 2. The FOMC target interest rate is 6 percent a year. 3. To raise the interest rate to the target, the Fed must sell securities in the open market and decrease the quantity of money to $0.9 trillion. 21. 2 THE FED AND MONETARY POLICY

44. The Fed Lowers the Interest Rate If the Fed fears recession, it acts to increase aggregate demand. The FOMC announces that it will lower the short-term interest rates. To achieve this goal, the FOMC instructs the New York Fed to buy securities in the open market. 21. 2 THE FED AND MONETARY POLICY

45. This action increases bank reserves. Flush with reserves, banks now seek to lend reserves to other banks. The federal funds rate falls. With more reserves, the banks increase their lending and the quantity of money increases. Figure 21.6(b) on the next slide illustrates these events. 21. 2 THE FED AND MONETARY POLICY

46. 1. The current interest rate is 5 percent a year. 2. The FOMC target is 4 percent a year. 3. To lower the interest rate to the target, the Fed must buy securities in the open market and increase the quantity of money to $1.1 trillion. 21. 2 THE FED AND MONETARY POLICY

47.  The Ripple Effects of the Fed’s Actions Suppose that the Fed increases the interest rate. Three main events follow: Investment and consumption expenditure decrease. The dollar rises, and net exports decrease. A multiplier process induces a further decrease in consumption expenditure and aggregate demand. 21. 2 THE FED AND MONETARY POLICY

48. Investment and Consumption Expenditure The interest rate influences investment and consumption expenditure. When the Fed increases the nominal interest rate, the real interest rate rises temporarily, and investment and expenditure on consumer durables decrease. 21. 2 THE FED AND MONETARY POLICY

49. The Dollar and Net Exports The higher price of the dollar means that foreigners must now pay more for U.S.-made goods and services. So the quantity demanded and the expenditure on U.S.- made items decrease. U.S. exports decrease. 21. 2 THE FED AND MONETARY POLICY

50. Similarly, the higher price of the dollar means that Americans now pay less for foreign-made goods and services. So the quantity demanded and the expenditure on foreign-made items increase. U.S. imports increase. 21. 2 THE FED AND MONETARY POLICY

51. The Multiplier Process Taking these effects together, investment, consumption expenditure, and net exports are all interest-sensitive components of expenditure. So a rise in the interest rate brings a decrease in aggregate expenditure. 21. 2 THE FED AND MONETARY POLICY

52. The decrease in expenditure decreases incomes, and the decrease in income induces a decrease in consumption expenditure. The decreased consumption expenditure lowers aggregate expenditure. Real GDP and disposable income decrease further, and so does consumption expenditure. Real GDP growth slows, and the inflation rate slows. 21. 2 THE FED AND MONETARY POLICY

53. Figure 21.7(a) shows ripple effects of the Fed’s actions when the Fed raises the interest rate. 21. 2 THE FED AND MONETARY POLICY

54. Figure 21.7(a) shows ripple effects of the Fed’s actions when the Fed lowers the interest rate.

55. 21. 2 THE FED AND MONETARY POLICY  Monetary Stabilization in the AS-AD Model The Fed Tightens to Fight Inflation In Figure 21.8, part (a) shows investment demand and part (b) shows aggregate demand and aggregate supply.

56. 1. The Fed raises the interest rate and the quantity of investment decreases. 21. 2 THE FED AND MONETARY POLICY The curve ID is the investment demand curve. The interest rate is 5 percent a year and investment is $2 trillion.

57. 2. Expenditure decreases by ∆I. 3. The multiplier induces additional expenditure cuts. The aggregate demand curve shifts to AD 1, real GDP decreases to potential GDP, and inflation is avoided. 21. 2 THE FED AND MONETARY POLICY

58. The Fed Eases to Fight Recession Figure 21.9 is similar to Figure 21.8, which you’ve just examined. The starting point in part (a) is the same. 21. 2 THE FED AND MONETARY POLICY

59. 1. The Fed lowers the interest rate and the quantity of investment increases. The curve ID is the investment demand curve. The interest rate is 5 percent a year and investment is $2 trillion.

60. 2. Expenditure increases by ∆I. 3. The multiplier induces additional expenditure. The aggregate demand curve shifts to AD 1, real GDP increases to potential GDP, and recession is avoided. 21. 2 THE FED AND MONETARY POLICY

61. The Size of the Money Multiplier Effect The size of the multiplier effect of monetary policy depends on the sensitivity of expenditure plans to the interest rate. The larger the effect of a change in the interest rate on aggregate expenditure, the greater is the money multiplier and the smaller is the change in the interest rate that achieves the Fed’s objective. 21. 2 THE FED AND MONETARY POLICY

62.  Limitations of Monetary Stabilization Policy Monetary policy has an advantage over fiscal policy because it cuts out the law-making time lags. But monetary policy shares the other two limitations of fiscal policy: Estimating potential GDP is hard, and economic forecasting is error-prone. 21. 2 THE FED AND MONETARY POLICY