Module 8 Unit 4: Economic Theory and Fiscal Policy

The three fiscal policy lags are

+Recognition lag +Action lag +Impact lag Lags in making policy decisions provide a limitation on discretionary fiscal policy.

two types of crowding out

+direct crowding out - is when the government spending directly replaces a good or service that people used to buy from private businesses. +indirect crowding out - occurs if the government finances its new spending by borrowing. This increases the demand for loanable funds available in the market, which can increase interest rates. At higher interest rates, there will be less private investment. There can be complete, incomplete, or zero indirect crowding out as well, depending on how much private investment falls after an increase in government deficit spending.

Two types of government spending

1. Discretionary spending ( goods + services) 2. Transfer Payments (payments like this are often called automatic stabilizers b/c their levels adjust with economic conditions) Both types of spending influence aggregate demand (AD) but in different ways.

Deficit Reduction Act

1993 clinton.which also involved both tax increases and spending cuts

If the impact of expansionary fiscal policy is delayed until the economy has already recovered by itself, how is it possible that policy intended to combat?

A recession may simply fuel inflation

regressive tax

A tax for which the percentage of income paid in taxes decreases as income increases Many people object to regressive taxes because of the burden they place on low-income families. General sales taxes, for example, are regressive because as incomes rise, the percentage people pay in taxes falls. To offset the negative effects of sales taxes, food and medicine are usually exempt from sales taxes.

progressive tax

A tax for which the percentage of income paid in taxes increases as income increases The U.S. income tax system is progressive because increases in income will push people into higher tax brackets, which have higher tax rates.

The permanent income hypothesis

A theory of consumption in which an individual determines current consumption based on anticipated average lifetime income.

How fiscal policy works

As consumption spending (C), investment (I), government spending (G), or net exports (NX) fluctuate, aggregate demand changes. Through the expenditure multiplier process, the resulting changes in income, output, and employment are larger than the initial change in C, I, G, or NX. Shifts in aggregate demand lead to changes in the price level, as well as in real output and employment.

Government Purchases

Congress can authorize two different types of government spending. It can approve spending for the purchase of goods and services (discretionary spending), or it can distribute money in the form of transfer payments. These payments are often called automatic stabilizers because their levels adjust with economic conditions. Both types of spending influence aggregate demand (AD) but in different ways.

1990 Budget Agreement

Congress voted for a tax increase. passed the budget enforcement act of 1990 that set limits on discretionary spending. If congress were to spend more on a discretionary program, it would have to cut spending on another discretionary program or raise taxes. Had a small impact on deficit growth

According to the political business cycle theory, when inflation is not a problem, what is a politician seeking reelection likely to pursue?

Expansionary fiscal policy prior to the election, so voters will be satisfied with the state of the economy

When the economy is doing well and income and output are rising at a healthy rate, transfer payments for food stamps, unemployment compensation, and social security are likely to rise.

False: Fewer people will be eligible for these programs when the economy is healthy, so these payments are likely to fall.

Because economic conditions can influence political outcomes, economists are certain that politicians are able to create a political business cycle for their own benefit.

False: Thus far, no economist has been able to show that politicians are actually able to create a political business cycle for their own benefit.False

When the economy is booming, how does income rise?

Faster than normal, so tax revenues are likely to be higher than anticipated. Since the federal government's main source of tax revenue is the federal income tax, higher income results in higher tax revenue.

The permanent income hypothesis has some important implications for fiscal policy.

If consumers fail to respond to a temporary increase in disposable income by spending a large fraction of it, then fiscal policy will have less effect on output. A temporary change in government spending or taxes will still have a first-round effect on output and employment, but subsequent (multiplier) changes in spending will be very small. Temporary changes in taxes or spending will have little impact on consumer spending because a one-time tax cut or a one-year spending increase will affect permanent income much less than current income.

Fiscal policy is most effective when policymakers are motivated to pursue which actions?

Improve the economy's performance

What is the goal of fiscal policy?

Influence employment, inflation, and economic growth

The time it takes after a problem is recognized to choose and enact a fiscal policy in response is the

implementation lag

Four fiscal policy approaches taken since 1964, illustrating the historical, political, and economic processes at work in discretionary fiscal policy.

Kennedy (1964) Economic State: 5.4% unemployment rate and 2.2% economic growth rate Type of fiscal policy: Expansionary Tax Modification: Decrease in personal and corporate income taxes Johnson (1966) Economic State: 3.7% unemployment and inflationary pressures Type of fiscal policy: Contractionary Tax Modification: 10% surcharge on income taxes for 1 year Ford (1975) Economic State: 9% unemployment and high inflation Type of fiscal policy: Expansionary Tax Modification: $23 billion tax rebate Reagan (1981) Economic State: High unemployment and high inflation Type of fiscal policy: Expansionary Tax Modification: Cut personal income taxes by 25% over 3 years; accelerated depreciation for new business investment

Automatic stabilizers might be considered

Keynesian fiscal policy because they lead to changes in transfer payments and tax revenues that offset changes in private economic activity.

Keynesian view of fiscal policy

Keynesians see government spending and taxation as the only hope for stabilization. They argue that only the government can be expected to act in the social interest by using its taxing and spending powers to offset changes in private demand Keynesian economists believe that active fiscal policy is a valuable tool for stabilizing economic activity.

The two types of fiscal policy are

One is put into place and left to respond automatically to changes in the level of economic activity. These policies are called automatic stabilizers. The second is deliberate action to change tax laws or enact new spending programs so as to influence the level of output, employment, and prices.

Using Fiscal Policies to Shift the Aggregate Demand Curve

Over the course of the business cycle, an economy often deviates from its full-employment equilibrium and experiences periods of expansion that create inflation and periods of recession that cause unemployment. Often these fluctuations are caused by changes in AD.

The 1964 and 1981 income tax cuts, which were enacted as permanent changes, appear to have had more effect on income and consumption than the 1968 temporary surcharge or the 1975 one-time tax rebate. What is the most probable explanation for this?

Permanent tax cuts increase permanent income, which in turn increases current consumption.

Which proposed tax cut is likely to have the largest effect on output, according to the permanent income hypothesis?

Permanently reducing tax rates at all income levels by 10 percent

Arguments for and against using fiscal policy

Pros Cons: +lags in making policy decisions provide another limitation on discretionary fiscal policy. + Crowding out of private spending by government spending is also a criticism of fiscal policy.

What is true about automatic stabilizers?

They are put into place and left to respond automatically to changes in the level of economic activity

According to economist Douglas A. Hibbs Jr., what effect do the economic conditions at the time of an election have on the election?

They have a definite effect on the success or failure of the incumbent party

crowding out

This happens when increasing government spending, especially with deficit spending, decreases private consumption and investment expenditures. There are two types of crowding out: direct and indirect.

Congressional legislation over the years, much of it enacted during the Great Depression, has created a system of tax collections and transfer payments that change automatically in response to changes in national income.

True

According to the Keynesian model, there is sometimes a conflict between actions that are in the social interest and actions that are in a person's self-interest.

True: For example, in a recession, social interest calls for increased spending, but self-interest might best be served by saving more money due to concerns about future job loss.

According to Friedman's permanent income hypothesis, a 22-year-old with no children who is about to graduate from college will likely spend more than a 22-year-old with no children who has very little education or job experience.

True: The permanent income hypothesis is the view that current consumption depends on expected income and the soon-to-be graduate will likely spend more based on higher expected income.

When is fiscal policy is most effective?

When a tax cut has a large effect on consumer spending

According to Franco Modigliani, which groups are most likely to engage in dissaving?

Young families and retired individuals

proportional tax

a tax for which the percentage of income paid in taxes remains the same for all income levels A proportional tax is a fixed rate tax.

public choice economics

attempts to integrate politics and economics by examining the motives and rewards for different types of behavior in the public sector. Economists in this area argue that fiscal policy actions increase the size of the government sector to where it's larger than the private sector.

_______partially offset changes in private spending, tend to reduce fluctuations in output and employment, and are triggered by changes in the economy.Therefore, they ______require further action by Congress.

automatic stabilizers, do not

When the economy is in a recession, expansionary fiscal policy can

be used to increase output, reduce unemployment, and move the economy back to full-employment equilibrium. In pursuing expansionary policy, governments increase spending, reduce taxes, or do a combination of the two. A reduction in taxes will leave people with more disposable income, increasing consumption and aggregate expenditure. The increase in aggregate expenditure will increase aggregate demand, shifting the AD curve to the right. By stimulating aggregate demand through increased government spending and decreased taxes, an expansionary fiscal policy increases output, closing the recessionary gap. Because of the expenditure multiplier, the increase in aggregate expenditure does not have to compensate for the entire output gap. The multiplier effect boosts the impact of government spending so the government can stimulate new production with a modest expenditure increase if the people who receive this money use most of it for consumption. This extra spending allows businesses to hire more people, which in turn allows a further increase in spending.2

Any tax

can be regressive, proportional, or progressive

discretionary fiscal policy

consists of changes in tax rates, levels of transfer payments, or government purchases of goods and services in order to change the equilibrium level of national income.

Based on the Keynesian model, policymakers are able to use _______ fiscal policy to reduce inflation and ______ fiscal policy to reduce unemployment. Used correctly, active fiscal policy should _____ the ups and downs of the business cycle.

contracitonnary , expannsionary, decrease

If the economy is producing above potential GDP, then the appropriate fiscal policy would be to ________government spending and __________taxes

decrease, increase

contractionary fiscal policy

economy is in an inflationary gap To reduce the problems caused by high inflation, governments can cut government spending, raise taxes, or do a combination of both. Reductions in government spending reduce aggregate expenditures, thereby reducing aggregate demand. Increasing taxes also reduce aggregate expenditures, decreasing disposable income, and reducing consumer spending. By decreasing government spending and increasing taxes, contractionary fiscal policy can diminish a government deficit or generate a budget surplus. Under these circumstances, contractionary fiscal policy can pay government debt and reduce inflation.2However, a decrease in real output that brings the economy back to potential GDP means that unemployment will increase. The expenditure multiplier works here as well. A decrease in disposable income from higher taxes and a decrease in government spending will reduce aggregate demand by more than the fall in aggregate expenditures.

True or False Discretionary fiscal policy makes an economy more stable when there are lengthy policy lags.

false: Discretionary fiscal policy combined with lags could actually make an economy less stable.

Public choice economists have also suggested that

fiscal policy combined with the U.S. political system can create a political business cycle.

Two components of discretionary fiscal policy that they can use to expand the economy.

government spending (G) and taxes

The tools of fiscal policy are:

government spending and taxation

The _____lag is the time that elapses between the implementation of a fiscal policy and its full effect on economic activity.

impact lag

If a politician is seeking to reduce unemployment and increase economic growth prior to an election, the fiscal policies that would most likely achieve these goals would be to____government spending and ____taxes

increase, decrease

When the economy is in a recession, increasing government spending and decreasing taxes will cause AD to ___________, shifting the curve to the _________, This leads to an ___________ in the price level and an ________ in real GDP.

increase, right, increase, increase

Which of the following will occur from a contractionary fiscal policy?

increased unemployment

The centerpiece of the Keynesian model

is the expenditure multiplier, 1/(1 - MPC) to increase the level of income and output, the government can cut taxes (raising Yd directly) or increase government spending. The multiplier effect results in further rounds of consumption spending. If the consumption function is very stable, the value of the expenditure multiplier derived from the consumption function will also be stable.

recognition lag

is the length of time required to become aware of, or recognize, an economic problem. Statistical measures (unemployment rate, consumer price index, and GDP) take from 1 to 3 months to compile. When these measures become available, they describe economic conditions for the previous month or previous quarter. These measures provide the basis for forecasting whether a recession will continue or end; whether unemployment will rise, fall, or remain the same; how fast output will grow; or what the rate of inflation will be. Such forecasts are difficult to make and prone to errors. An inaccurate forecast can result in the wrong fiscal policy.

implementation lag

is the time it takes after a problem is recognized to choose and enact a fiscal policy in response. Once a problem is recognized, more time passes as the president and Congress choose a fiscal policy solution and enact it into law. Policymakers must decide what kind of action to take—taxes, transfers, or government spending—and at what level. They must decide whose taxes to cut, what kinds of spending programs to undertake, and what section of the country should get the initial benefit.

impact lag

is the time that elapses between the implementation of a fiscal policy and its full effect on economic activity. After a fiscal policy has become law, more time must pass before the economy responds. Tax changes can be implemented fairly quickly through payroll withholding, but most spending programs take time to design and carry out. Once the initial round of spending takes place, then the multiplier effects are felt over a period of 18 to 24 months.

The length of time needed to become aware of an economic problem is called the

recognition lag

The Employment Act of 1946

requires the federal government to actively promote full employment, steady growth, and stable prices through the use of fiscal and monetary policy.

Fiscal policy is most effective when policy lags are

short Short policy lags mean that policymakers quickly recognize the problem and implement a solution, and that the policy works quickly to improve the economy's performance.

Which category of transfer programs is least likely to change in response to changing economic conditions?

social security survivor benefits: A family is eligible for a survivor's benefits when a covered employee (parent or spouse) dies; this is not an event that depends on the state of the economy.

Lags in Fiscal Policy

the time required to approve and implement fiscal legislation Taken together, the recognition, implementation, and impact lags add up to a long period of time. It is quite possible that the combined lags can take up so much time that the full impact of a tax cut or an increase in spending will not be felt until after the economy has begun to move out of the recession by itself. If the economy has already self-corrected and moved out of the recession, by the time an expansionary policy takes hold, the policy could push the economy into an inflationary period. Similar mistiming on contractionary policy could aggravate a recession. Discretionary fiscal policy combined with lags could actually make an economy less stable. Learning Check

Automatic stabilizers are considered

transfer payments, and many of them date back to the Great Depression. Transfer programs include unemployment compensation, Social Security, farm price supports, food assistance, and welfare benefits. All of these programs involve payments for which no production is expected in exchange. They are merely a transfer of money from the government to the individual.