Chapter 11 Macroeco

The graph shows an economy's labor market in which labor income is taxed. What is the tax wedge? The tax wedge is _______.

$15 an hour -With no income tax, the wage rate is $30 an hour. When an income tax is imposed, the supply of labor curve is LS + tax. -The before-tax wage rate rises to $35 an hour and the after-tax wage rate falls to $20 an hour. - The tax wedge is the gap created between the before-tax and after-tax wage rates, which is $35 an hour -$20 an hour = $15 an hour.

How do income taxes and taxes consumption expenditure influence potential GDP?

-An increase in income taxes decreases potential GDP, and an increase in taxes on consumption expenditure decreases potential GDP. -An increase in taxes on consumption expenditure decreases the supply of labor, which decreases full employment quantity of labor and decreases potential GDP.

What is the timeline for the U.S. federal budget each year? When does a fiscal year begin? The President submits a fiscal 2022 budget proposal to Congress in _______. After this date, Congress undertakes a detailed committee budget review process through _______.

-February 2021; September 2021 -The President submits a budget proposal to Congress in February 2021. -Then Congress undertakes a detailed committee budget review process through September 2021.

Explain how fiscal policy is used to speed recovery from recession.

-Fiscal policy can be either discretionary or automatic. -Automatic stabilizers arise because tax revenues and outlays fluctuate with real GDP. -Changes in government expenditure and changes in taxes have multiplier effects and aggregate demand and can be used to try to keep real GDP at potential GDP. -In practice, lawmaking time lags, the difficulty of estimating potential GDP and the multiplier, and the limitations of economic forecasting hamper discretionary fiscal policy.

Explain how fiscal policy redistributes benefits and burdens across generations.

-Generational accounting measures the lifetime tax burden and benefits of each generation. -A major study estimated the US fiscal gap to be 3.6 times the value of one year's production. -The next generation will pay for 15% of the benefits of the current generation.

The graph shows the labor market. On the graph, draw a labor supply and demand curves and the market equilibrium. Label them LS0 and LD0, and 1. Now the government increases expenditure on infrastructure capital. Draw a new curve to show the impact of this expenditure on the labor market and label it. Draw a point at the new market equilibrium. Label it 2.

-Government expenditure on infrastructure capital increases labor productivity. -An increase in labor productivity increases the demand for labor. The demand for labor curve shifts rightward. -The equilibrium quantity of labor increases and the real wage rate rises.

Social Infrastructure Capital and Labor Productivity -Taxes and government budget deficit decrease employment and real GDP and slow the growth rate. -But the supply side effects of fiscal policy are not all negative.

-Governments provide a wide range of social infrastructure capital. Some examples are the legal system, public Wi-Fi access, the transportation system (transit, highways, bridgets, and tunnels), security services (firefighting, policing, and national security), all of which increase the nation's productive potential. (Government expenditure on social infrastructure capital includes the legal system, highways, and firefighting services. -To appreciate the contribution of social infrastructure capital, think about the productivity of a truck driver if there is no Interstate highway system and Route 66 is the only highway between Chicago and LA. -Expenditure on social infrastructure capital, financed by the government budget, increases the real GDP that a given amount of labor can produce, which increases the demand for labor and increases potential GDP. -So, taxes and deficits that finance expenditure on social infrastructure capital can result in an overall increase in real GDP and its growth rate.

Successful Fiscal Stimulus

-If real GDP is below potential GDP, the government might pursue fiscal stimulus by: -Increasing government expenditure on goods and services. -Increasing transfer payments -Cutting taxes -Or a combination of all three.

Why are induced taxes and spending called automatic stabilizers?

-In a recession, induced tax revenues fall and outlays increase, and in an expansion, induced tax revenues rise and outlays decrease, which helps to shrink the output gap. Induced tax revenues fall and outlays increase automatically in a recession, which helps to shrink the recessionary gap. And induced tax revenues rise and outlays decrease automatically in an expansion, which helps to shrink an inflationary gap.

To stimulate aggregate demand, the government might use three fiscal policy actions: These policy actions might occur as an automatic response to the state of the economy or because Congress has passed a new spending or tax law. -A fiscal policy action that is triggered by the state of the economy is called an automatic fiscal policy. (Automatic Fiscal Policy is a consequence of tax revenues and outlays that fluctuate with real GDP.) -And a fiscal policy action that is initiated by an act of Congress is called a discretionary fiscal policy.

-Increase government expenditure on goods and services. -Increase government transfer payments. -Decrease taxes.

Structural Surplus or Deficit

-Is the budget balance that would occur if the economy were at full employment. -That is, the structural balance is the balance that the full employment level of real GDP would generate given the spending programs and tax laws that Congress has created. -The actual budget balance equals the sum of the structural balance and cyclical balance. -A cyclical deficit corrects itself when full employment returns, but a structural deficit requires action by Congress.

Fiscal Policy Changes Discretionary fiscal policy legislation changes in taxes our outlays - is difficult to conduct and faces four challenges: -Lawmaking time lag -Estimating potential GDP -Estimating the multiplier -Economic Forecasting

-Lawmaking Time Lag The lawmaking time lag is 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. The economy might benefit from fiscal stimulus today, but by the time Congress acts, a different fiscal medicine might be needed. -Estimating Potential GDP Potential GDP is not directly observed, so it must be estimated. Because it is not easy to tell whether real GDP is below, above, or at potential GDP, a discretionary fiscal action might move real GDP away from potential GDP instead of toward it. This problem is a serious one because too large a fiscal stimulus brings inflation and too little might lengthen recession. -Estimating the Multiplier The magnitude of the multiplier effects of fiscal policy actions are estimated using economic models, and economists have a range of views on the best model. A difference of a few percentage points in the size of the multiplier can have a large impact on the calculation of the appropriate amount of stimulus needed. -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 fourth reason, discretionary fiscal action might move real GDP away from potential GDP and create the problem that it seeks to correct.

Needs-Tested Spending

-On the expenditure side of the budget, government programs entitle suitably qualified people and businesses to receive benefits. -The spending on these programs is called needs-tested spending, and it results in transfer payments that depend on the economic state of individual citizens and businesses. -In a recession, as the unemployment rate increases, needs-tested spending on unemployment benefits and food stamps increases. -In an expansion, the unemployment rate falls and needs-tested spending decreases.

Induced Taxes

-On the revenue side of the budget, tax laws define tax rates, not tax dollars. Tax dollars paid depend on tax rates and incomes. -But income very with real GDP, so tax revenues depend on real GDP. -Taxes that vary with real GDP are called induced taxes. In a recession, wages and profits fall, so the taxes on these incomes fall. -In an expansion, wages and profits rise, so the taxes paid on these incomes rises. Income taxes are induced taxes.

This graph uses the AS AD model to illustrate a successful stimulus package. -We measure real GDP on the x-axis and the price level on the y-axis In the graph, how does fiscal stimulus restore full employment? Fiscal stimulus increases aggregate demand, which restores full employment. -Fiscal stimulus works by increasing aggregate demand, which shifts the AD curve rightward.

-Potential GDP is $20 trillion. -The aggregate supply curve is AS1, and initially, the aggregate demand curve is AD0. -The economy is at point A, where real GDP is $19 trillion and there is a recessionary gap of $1 trillion. -To eliminate the recessionary gap and restore full employment, the government introduces a fiscal stimulus. -Aggregate expenditure increases by AE and the curve AD curve shifts rightward to AD0+AE. -A multiplier process increases consumption expenditure, which shifts the AD curve father rightward to AD1. -With no change in the price level, the economy would move from initial point A to point B on AD1. -But the increase in aggregate demand combined with the upward-sloping aggregate supply curve brings a rise in the price level. -The price level rises to 110, real GDP increases to $20 trillion, and the economy returns to full employment at point C.

The first graph shows an economy's labor market. In this graph, draw a point that shows the market equilibrium. The second graph shows the economy's production function. On the production function, draw a point that shows potential GDP.

-Potential GDP is the real GDP produced by the full-employment quantity of labor. -The full-employment quantity of labor is the equilibrium quantity. -The full-employment quantity of labor is 200 billion hours a year, and potential GDP is the real GDP produced by 200 billion hours of labor, which is $12 trillion.

This graph illustrates structural budget balances Structural Deficit -If the government decreases tax rates, the tax revenues curve shifts downward, and the budget goes into a structural deficit. -Oulay curve goes upward -In a recession, with real GDP below potential GDP, the budget goes into a cyclical deficit. -With lower tax revenues and higher outlays, the budget has a structural deficit.

-Return to the starting point with a structural budget balance of zero. -Congress now decreases tax rates, and tax revenues are now lower at all levels of real GDP. -Congress also increases Social Security benefits, and outlays are now higher at all levels of real GDP. -If real GDP equals potential GDP, outlays exceed tax revenues, and the government has a structural deficit.

This graph illustrates cyclical budget balances. What levels of real GDP is there a cyclical budget deficit? Below $20 trillion-See graph

-Suppose that potential GDP $20 trillion. -If real GDP equals potential GDP, the government's budget is balanced at full employment. -If the real GDP is below potential GDP, outlays exceed tax revenues, and the government has a cyclical deficit. -If real GDP is above potential GDP, tax revenues exceed outlays, and the government has a cyclical surplus.

Institutions, Laws, and the Roles of the President and Congress

-The President & Congress with input from the Congressional Budget Office (CBO) make the budget and develop fiscal policy on a fixed annual timeline and fiscal year. -The US fiscal year runs from 10/1 - 9/30 in the next calendar year. -Fiscal 2022 is the fiscal year that begins on 10/1/2021. -The President proposes a budget to Congress each February. -After Congress has passed the budget acts in September, the President, either signs those acts into law or vetoes the entire budget bill. -The President does not have to veto power to eliminate specific items in a budget bill and approve others-know as a line-item veto. -Although the President proposes and ultimately approves the budget, the task of making the tough decisions on spending and taxes rests with Congress. -Congress begins its work on the budget with the President's proposal. The House of Representatives and the Senate develop their budget ideas in their respective House and Senate Budget Committees. -Formal conferences between the two houses resolve differences of view, and a series of spending acts and an overall budget act are usually passed by both houses before the start of the fiscal year.

Describe the Federal Budget, the process that creates it, and its recent history.

-The federal budget is an annual statement of the outlays, tax revenues, and budget surplus or deficit of government of the US. -Fiscal policy is the use of the federal budget to finance the federal government and to influence macroeconomic performance. -An ever rising national debt and large fiscal gap is a major fiscal policy challenge.

Tax Revenues and Outlays

-The federal government's tax revenues are personal income taxes, corporate income taxes, Social Security taxes, and indirect taxes. -The federal government's outlays are transfer payments, expenditure on goods and services; and interest on the national debt. -Transfer payments are Social Security benefits, Medicare, and Medicaid benefits, unemployment benefits, and other cash benefits paid to individuals and firms.

The Tax Wedge

-The gap created by a tax between what a buyer pays and what a seller receives. In the labor market, it is the gap between the before tax wage rate and the after tax wage rate. -The income tax is not the only tax that affects decisions to supply labor. A tax on consumption expenditure raises the prices paid for consumption goods and services, which is equivalent to a cut in the real wage rate. -The incentive to supply labor depends on the goods and services that an hour of labor can buy. As the tax on consumption expenditure rises, the quantity of goods and services that an hour of labor buys decreases and weakens the incentive to supply labor. -To find the total tax wedge on labor income, we must add the expenditure tax rate to the income tax rate. If the income tax rate is 25% and the tax rate on consumption expenditure is 10%, a dollar earned buys only 65 cents worth of goods and services. The tax wedge is 35%.

The graph shows an economy in a full employment equilibrium. To restore full employment, government increases government expenditure by $0.5 trillion. On the graph, draw a curve that shows the initial effect of this increases government expenditure. Label it AD0+AE. The increases in real GDP sets off a multiplier process. Draw a curve that shows the multiplier effect that returns the economy to full employment. Label it AD1. Draw a point at the economy's long run equilibrium.

-The increase in government expenditure of $0.5 trillion increases aggregate demand and shifts the AD curve rightward by $0.5 trillion. -Real GDP increases, which increases consumption expenditure and sets off a multiplier process. The AD curve shift rightward and returns the economy to a full employment equilibrium.

On the tax revenues side of the budget:

-The largest item in personal income taxes-taxes that people pay on wages and salaries and on interest. -The second largest item is Social Security taxes-taxes paid by workers and employers to fund Social Security benefits. -Corporate income taxes, which are the taxes paid by corporations on their profits, are much smaller. -Indirect taxes, the smallest revenue sources, are sales taxes and customs and excise taxes.

Explain how fiscal policy influences potential GDP and economic growth.

-The provision of social infrastructure capital increases productivity and increases potential GDP. -Income taxes create a wedge between the wage rate paid by firms and received by workers and lower both employment and potential GDP. -A tax on interest income creates a wedge between the interest rate paid by firms and received by lenders, lowers saving and investment, and reduces the growth rate of real GDP. -A government budget deficit raises the real interest rate and crowds out some private investment, which slows real GDP growth.

Equilibrium employment is 12,000 hours and the equilibrium real wage rate is $11/hour. What is potential GDP? Potential GDP is the quantity of real GDP produced by the full employment quantity of labor. -The full employment quantity of labor is 12k hours. The table shows that 12k hours of labor produce real GDP of $16 million.

-The real wage rate is $11/hr and the equilibrium quantity of labor is 12,000 hours. The row in the table where the quantity of labor supplied equals the quantity of labor demanded.

This graph illustrates structural budget balances Structural Surplus -If the government increase tax rates, the tax revenue curves shifts upward, and the budget goes into a structural surplus. -Outlay curve goes downward -In a boom, with real GDP above potential GDP, the budget goes into a cyclical surplus. -With higher taxes and lower outlays, the budget has a structural surplus.

-The starting point is the graph you've just made with a structural balance of zero. -Congress now increases tax rates, tax revenues are now higher at all levels of real GDP. -Congress also slashes Social Security benefits, and outlays are now lower at all levels of real GDP. -If real GDP equals potential GDP, tax revenues exceed outlays, and the government has a Structural surplus.

This graph explores the US federal budget balance and its cyclical and structural components. This graph shows the most recent structural surplus around year 2000.

-We graph the variables as percentages of potential GDP. -Actual budget balance -And here is the cyclical budget balance. -The structural balance is the gap between the actual and cyclical balances. -The US federal budget has not been in structural surplus since the early 2000s.

Graph illustrate the effect of real GDP on the government budget. In the graph you've just made, what is the upward-sloping line, what does it show? The upward sloping line is the tax revenues curve, and it shows that an increase in real GDP increases tax revenues.

-We measure real GDP on the x-axis and tax revenues, outlays, and the government budget balance on the y-axis. -An increase in real GDP increases tax revenues. -And an increase in real GDP decreases outlays. -If real GDP is $20 trillion, the government's budget is balanced. -If real GDP is $18 trillion, outlays exceed tax revenues, and the government has a budget deficit. -If real GDP is $22 trillion, tax revenues exceed outlays, and the government has a budget surplus.

This graph explores the US fiscal and generational gap in 2018, 2020, and 2022.

-We measure the gap as a percentage of payrolls, which shows the addition to current Social Security taxes needed to maintain current benefits. -To keep paying Social Security and Medicare benefits at the current level, the 2022 tax rate needs to be 14.8% points higher than the current tax rate. -Notice that the gap gets wider each year. -Defining the current generation as those born before 1988, here is how the fiscal gap is shared: 85% falls on the current generation and 15% falls on the next generation. -To see the social security tax rate needed to maintain current benefits, we need to add the fiscal gap to the current 12.4% tax rate. -Starting in 2022, the Social Security tax rate needs to rise from 12.4% to 27.2%. And the rise gets bigger, the longer the tax increase is delayed. In the data you've just explored, by how much would the Social Security tax have to rise to close the fiscal gap? 14.8% The Social Security tax would have to rise by 14.8% 27.2 - 12.4 = 14.8

Graph illustrates the effect of the income tax on employment and potential GDP

-We start with a labor market with no income tax. -An income tax of $30 an hour decreases the supply of labor and shifts the supply curve leftward to LS + tax. -The vertical distance between the LS curve and the LS + tax curve measures the $30 of income tax wedge. -The demand for labor curve remains at LD, equilibrium real wage rate rises to $70 an hour, and 200 billion hours of labor a year are employed. -Switching to the production function, the decrease in the full employment quantity of labor decreases potential GDP.

Graph that illustrates the determination of potential GDP. See below for last part of graph Graph part 1

-We start with the economy's aggregate production function, PF, which shows how real GDP changes when labor hours change. -An increase in labor hours brings an increase in real GDP. -We now look at the labor market and the y axis measures the real wage rate. -The demand for labor curve is LD and the supply of labor curve is LS. -The equilibrium real wage rate is $55 an hour, and 250 billion hours of labor a year are employed. -Returning to the production function, the full employment quantity of labor produces potential GDP.

The government budget balance is equal to government saving, which might be: zero (balanced budget) positive (budget surplus) negative (budget deficit)

-When the government has a budget deficit, it incurs debt. That is, the government borrows to finance its budget deficit. -When the government has a budget surplus, it repays some of its debts. The National Debt: -(The amount of government debt outstanding-debt that has arisen from past budget deficits-is called national debt.) -The national debt at the end of the fiscal year equals the national debt at the end of the previous fiscal year plus the current budget deficit or minus the current budget surplus. Example: Debt at the end of 2021 is: Debt at the end of 2020 + Budget Deficit in 2021.

What would have a larger effect on aggregate demand: $150 billion of tax cuts or $150 billion of government expenditure? Government expenditure would have a _______ effect on aggregate demand than the tax cuts because _______.

-larger; all government expenditure is spent while some of the tax cut is saved -All of the $150 billion in government expenditure is spent, which increases aggregate demand by $150 billion. -Consumers save some of the tax cut, so only the part of $150 billion is spent. Aggregate demand increases but by less than $150 billion.

What are the effects of an increase in government expenditure on infrastructure capital on the demand for labor the real wage rate, the full employment quantity of labor, and potential GDP?

1) An increase in government expenditure on infrastructure capital increases the demand for labor, which increases the real wage rate. -An increase in government expenditure on infrastructure capital makes labor more productive and increases the real GDP that a given amount of labor can produce. -The demand for labor increases and the real wage rate rises. 2) An increase in government expenditure on infrastructure capital increases the full employment quantity of labor, which increases potential GDP. -An increase in government in government expenditure on infrastructure capital makes labor more productive and increases the demand for labor. -When the demand for labor increases, the full employment quantity of labor increases. -Potential GDP increases because the real GDP that a given amount of labor can produce increases and because the full employment quantity of labor increases.

The government raises the income tax. What is the effect on the supply of labor, demand for labor, equilibrium employment, the real wage rate, and potential GDP?

1) The supply of labor decreases and the demand for labor does not change. -An increase in income tax doesn't change how productive labor is so the demand for labor does not change. 2) Equilibrium employment decreases and the real wage rate rises. -When the supply of labor decreases, the supply of labor curve shifts leftward. -The equilibrium level of employment decreases and the real wage rises. 3) Potential GDP decreases. -The greater the full employment quantity of labor, the greater is potential GDP. -So when the full employment quantity of labor decreases, potential GDP decreases.

In October 2009, real GDP increased by $65 billion when only $160 billion of the $787 billion American Recovery and Reinvestment Act was spent. What was the government expenditure multiplier? The government expenditure multiplier was:

65/160 = 0.4

Discretionary Fiscal Policy

A discretionary fiscal policy action is a policy action initiated by an act of Congress. -If real GDP is below potential GDP, the government might pursue fiscal stimulus by increasing its expenditure on goods and services, increasing transfer payments, cutting taxes, or doing some combination of all three. -For a fiscal stimulus package to be successful, the government needs an accurate estimate of potential GDP, the output gap, and the relevant fiscal policy multipliers. -With these estimates in hand, economists can calculate alternative combinations of changes in government expenditure, transfer payments, and tax cuts that will achieve full employment.

Which of the following is an example of an automatic stablilizer?

A fall in tax revenue when the economy enters a recession. -An automatic stabilizer stabilizes real GDP without any government action. -An example of an automatic stabilizer is the fall in tax revenue that occurs when the economy enters a recession.

How does a tax on interest income influence investment?

A rise in the tax on interest income lowers the after tax interest rate and decreases investment. -A rise in the tax on interest income decreases the supply of loanable funds, which raises the before tax interest rate, lowers the after tax interest rate, and decreases investment.

An example of discretionary fiscal policy is

A tax law that lowers tax rates.

How do income taxes and taxes on consumption expenditure influence the tax wedge?

An increase in income taxes increases the tax wedge, and an increase in taxes on consumption expenditure increases the tax wedge. -The tax wedge is the wedge between the take home wage of workers and the cost of labor firms. -An income tax weakens the incentive to work. An increase in the income tax decreases the supply of labor and increases the tax wedge. -Similarly, taxes on consumption expenditure raise the prices paid for consumption goods and services, which decreases the incentive to work. An increase in tax on consumption expenditure decreases the supply of labor and increases the tax wedge.

How does an increase in infrastructure capital influence the labor market?

An increase in infrastructure capital makes labor more productive, which increases the demand for labor and raises the equilibrium real wage rate.

How does an increase in infrastructure capital influence the production function and potential GDP?

An increase in infrastructure capital shifts the production function upward and increases potential GDP by more than the production function shifts. -An increase in infrastructure capital makes labor more productive, which shifts the production function upward and increases the demand for labor. -The equilibrium real wage rate and employment increases, which increases potential GDP by more than the production function shifts.

An example of automatic fiscal policy is

An increase in unemployment benefits and a decrease in tax revenues triggered by recession.

An economy with a balanced budget at full employment goes into a recession. How does its budget balance change? When an economy with a balanced budget at full employment goes into a recession, its budget balance becomes a _______.

Cyclical Deficit -When an economy with a balanced budget at full employment goes into a recession, its budget balance becomes a cyclical deficit. Its structural deficit is zero and remains at zero.

What does the fiscal gap expressed as a percentage of GDP tells us?

Expressed as a percentage of GDP, the fiscal gap tells us the percentage of income by which taxes must rise OR spending must be cut.

-OMB submits the proposals to the President, who determines what the administration will support. -Federal agencies send their final requests to the OMB, which forwards them to the President. -The President submits the budget request to Congress on the first Monday in February. -The CBO submits its analysis of the President's budget request to Congressional budget committees. -Congress starts a detailed committee budget review process. -Congress submits the final proposed budget to the President, who must either approve or veto it within 10 days of receiving it. A veto means the process must start again. -Fiscal 2022 begins, with or without a budget. -Without a budget, Congress passes a resolution to ensure federal agencies have the money to operate or it allows the government to close non-essential programs. -The state of the economy influences outlays, tax revenues, and the budget balance. -Fiscal 2022 ends. -Accounts for Fiscal 2022 are prepared. Outlays, tax revenues, and the budget balance are reported.

Federal agencies like the CIA and Homeland Security send budget proposals to the Office of Management and Budget (OMB) for review.

Fiscal 2022 begins on _______.

Fiscal 2022 begins on October 1, 2021

Why does fiscal policy have a multiplier effect?

Fiscal policy has a multiplier effect because a change in an item in the government budget changes disposable income, which induces a change in consumption expenditure. -Aggregate expenditure changes by more than the initial change in the budget.

Limitations of Discretionary Fiscal Policy

Four things hamper the use of discretionary fiscal policy. They are: -Congress can't turn on a dime: Lawmaking takes time and actions might come too late. -Potential GDP is imperfectly estimated. -The multiplier is imperfectly estimated. -Economic forecasting is not an exact science.

Fiscal Policy, Potential GDP, and Economic Growth -Fiscal policy influences potential GDP and the economic growth rate. These influences, called supply side effects, arise for two reasons. (Supply Side Effects: The effects of fiscal policy on potential GDP and economic growth rate.) -First, taxes change the incentives that people face, which change the full employment quantity of labor. -Second, some government expenditure is on social infrastructure capital, such as public Wi-Fi access, which increases labor productivity.

Full Employment and Potential GDP -The quantity of labor demanded and the quantity of labor supplied depend on the real wage rate. Other things remaining the same, a rise in the real wage rate decreases the quantity of labor demanded and increases the quantity of labor supplied. -When the real wage rate has adjusted to make the quantity of labor demanded equal to the quantity of labor supplied, the labor market is in equilibrium and the economy is at full employment. When -When the quantity of labor is the full employment quantity, real GDP equals potential GDP.

Why does a $150 billion increase in government expenditure increase the budget deficit by less than $150 billion? A $150 billion increase in government expenditure increases the budget deficit by less than $150 billion because it increases _______, which ______.

GDP; decreases needs-testing spending and increases tax revenue -A $150 billion increase in government expenditure increases the budget deficit by less than $150 billion because it increases GDP, which decreases needs-testing spending and increases tax revenue.

How does the government expenditure on infrastructure capital influence real GDP?

Government expenditure on infrastructure capital increases the quantity of real GDP that a given amount of labor can produce, which increases the demand for labor and increases potential GDP.

US Federal Budget History

Graph - The US Federal budget since 1946, as a percentage of GDP. -World War II ended in 1945, and government outlays fell from 43% of GDP to 24% in 1946. -From 1950-1970, the budget deficits were small. -During the 1970s, the deficit increased. -In 1983, an increase in defense spending and tax cuts swelled the deficit to 5.9% of GDP. -Clinton spending cuts and tax increases brought a short-lived budget surplus. -Bush tax cuts and increased spending after 9/11 saw a return to deficit. -The Great Recession brought a record peacetime deficit of almost 10% of GDP. -The COVID-19 stimulus brought an increase in the deficit. -The data after 2020 are projections.

Graph explores some real world tax wedges calculated by Edward C. Prescott of the Arizona State University, who shared the 2004 Nobel Prize of Economic Science. -In the US, the consumption taxes are 12% and income taxes (including Social Security taxes) are 30%, which makes the tax wedge 42%. -In France, consumption taxes are 33% and income taxes 49% which makes the tax wedge 82% almost double the US level. -The estimates for the UK fall between those for France and the US.

How big is the US tax wedge? 42%

The effects of Taxes in Capital and Financial Market -Taxes can change incentives in the labor market and influence potential GDP. Taxes also affect the market for loanable funds, which influences real GDP in two ways. -First, a tax on interest-the income from capital-drives a wedge between the interest rate paid by borrowers and the interest rate received by lenders. The after tax interest rate earned by lenders falls, which decreases the amount of saving. -And the before tax interest rate paid by borrowers rises, which decreases the amount of investment. The decreases in saving and investment lowers real GDP and slows the economic growth rate. -Second, if the government has a budget deficit, then government borrowing to finance the deficit competes with firms' borrowing to finance investment and to some degree, government borrowing "crowds out" private investment.

How does a tax on interest income influence the economic growth rate? A tax on interest income drives a wedge between the interest rate paid by borrowers and the interest rate received by lenders, which lowers the amount of saving and investment and slows the economic growth rate. 1) Taxes drive a wedge between the interest rate paid by borrowers and the interest rate received by lenders. This wedge lowers the amount of saving and investment and lowers potential GDP and its growth rate. 2) If the government has a budget deficit, then government borrowing to finance the deficit competes with firms' borrowing to finance investment and to some degree, government borrowing "crowds out" private investment.

The effect on investment of a tax on interest income.

How does a tax on interest income influence the real interest rate and investment? A tax on interest income decreases the supply of loanable funds, which raises the real interest rate and decreases investment. -A tax on interest income is an incentive to save less, which decreases the supply of loanable funds. The real interest rate rises, which decreases the quantity of loanable funds demanded, and investment decreases.

The Effects of Taxes in the Labor Market -Taxes in the labor market create a tax wedge between the cost of an hour of labor to firms and after tax wage received by the workers. -(A tax drives a wedge between the price paid by the buyer and the price received by a seller.) -(In the labor market, an income tax drives a wedge between the before tax wage rate and after tax wage rate. -(The result is a decrease in the full employment quantity of labor and a decrease in potential GDP.) -The tax wedge weakens the incentive to work and decreases the supply of labor. The result is a smaller quantity of labor employed and a smaller potential.

How does a tax on labor income change full employment and potential GDP? -A tax on labor income decreases the supply of labor. -The equilibrium wage rate rises, and full employment decreases. The decrease in full employment decreases potential GDP.

On the graph -Draw a vertical potential GDP line that shows the budget balance is a structural surplus. Label it 1 -Draw a vertical potential GDP line that shows the budget balance is a structural deficit. Label it 2

If tax revenues exceeds outlays when the economy is at potential GDP, the budget balance is a structural surplus. A structural surplus is shown on the graph when potential GDP is greater than $12 trillion. If outlays exceed tax revenues when the economy is at potential GDP, the budget balance is structural deficit. A structural deficit is shown on the graph when potential GDP is less than $12 trillion.

Starting with a structural budget balance of zero, what is the structural budget balance if the government lowers the income tax rate to 10%?

If the government lowers the income tax rate to 10%, the budget goes into a structural? The deficit would be $0.2 trillion.

Graph part 2

In the graph, if the real wage rate is above $55 an hour and employment is 200 billion hours, what can say about real GDP? -Real GDP is less than potential GDP

How do income taxes and needs-tested spending work as automatic fiscal policy to dampen the business cycle? Income taxes and needs-tested spending dampen the business cycle because tax revenues _______ during an expansion, and needs-tested spending _______ during a recession.

Increases; Increases -When real GDP increases in a business cycle expansion, wages and profits rise, so tax revenues increase. -This induced increase in tax revenues is an automatic fiscal policy that slows down the growth of real GDP. -When real GDP decreases in a recession, unemployment increases, which induces an increase in needs-tested spending. This induced increase in needs-tested spending is an automatic fiscal policy that increases real GDP.

Automatic Stabilizers -Features of fiscal policy that stabilize real GDP without explicit action by the government (Automatic Stabilizers make the budget balance fluctuate with real GDP over the business cycle.)

Induced taxes and spending are called automatic stabilizers because they work to stabilize the real GDP without government action. (Because government tax revenues fall and outlays increase in a recession, automatic stabilizers provide stimulus that helps to shrink the recessionary gap. Similarly, because tax revenues rise and outlays decrease in an expansion, automatic stabilizers shrink an inflationary gap)

Fiscal Policy and Aggregate Demand

Is a change in government outlays or in tax revenues. -Other things remaining the same, a change in any item in the government budget changes aggregate demand. -These changes might occur as an automatic response to the state of the economy or as a result of new spending tax decisions by Congress.

The Federal Budget

Is an annual statement of tax revenues, outlays, and the budget surplus or deficit of the government of the United States, together with the laws and regulations that authorize these revenues, outlays, and lending or borrowing.

Another fiscal policy that can have an expansionary side effect

Is an income tax cut -passed by President Bush and then extended by President Obama in 2010, because it creates an incentive to work.

The Government Expenditure Multiplier

Is the effect of a change in government expenditure on goods and services on aggregate demand. -Government expenditure is a component of aggregate expenditure, so when government expenditure increases, aggregate demand increases. -Real GDP increases and induces an increase in consumption expenditure, which brings a further increase in aggregate expenditure.

The Balanced Budget Multiplier

Is the effect on aggregate demand of a simultaneous change in government expenditure and taxes that leaves the budget balance unchanged. -The balanced budget multiplier is not zero. It is positive, because the government expenditure multiplier is larger than the tax multiplier. -It is greater than zero because a $1 increase in government expenditure injects a dollar more into aggregate demand while a $1 tax rise. (or decrease in transfer payments) takes less than $1 from aggregate demand. -So when both government expenditure and taxes increase by $1, aggregate demand increases.

Fiscal Policy

Is the use of the federal budget to achieve the macroeconomic objectives of full employment and high and sustained economic growth. -Influences the output gap by changing aggregate demand and real GDP relative to potential GDP. -But fiscal policy also influences potential GDP and the economic growth rate. -The effects of fiscal policy on potential GDP are called supply side effects.

What can we say, as a percentage of GDP, about the size of the US budget deficit relative to other countries?

It is larger than that of most advanced countries. -As a percentage of GDP, in 2020 the US had the largest budget deficit of any advanced country.

Great Recession of 2008-2009. What can we say about the American Recovery and Reinvestment Act?

It was an expansionary discretionary fiscal policy. -Intended to bring the economy out of a recessionary gap by stimulating aggregate demand through, for example $50 billion dollars of government expenditure on infrastructure, an energy efficiency tax credit to encourage consumption expenditure on new appliances, and a bonus depreciation allowance in the tax code to encourage investment expenditure. -Is it possible the government expenditure on infrastructure could also have a supply side effect? Yes, If new roads and highways increase labor productivity, labor demand will increase, the real wage rate and employment will rise, and potential GDP will increase.

Fiscal Policy Multipliers

Other things remaining the same, a change in any item in the government budget changes aggregate demand and has a multiplier effect-aggregate demand changes by a greater amount than the initial change in the item in the government budget.

What are the powers of the President after Congress has passed a budget act? The President may __________

Sign the act into law or veto the entire budget bill.

How does tax revenues and needs test spending change during a recession?

Tax revenues decrease and needs test spending increases during a recession. -In a recession, real GDP decreases and unemployment increases. Wages and profits fall, so tax revenues fall. -As unemployment rises, the number of people experiencing economic hardship increases, so needs tested spending increases.

Which of the following statements is not a reason why discretionary fiscal policy is difficult to conduct?

Tax revenues do change when real GDP changes, but that is not a reason why discretionary fiscal policy is difficult to conduct.

What is the source of the Social Security and Medicare time bomb?

The 77 million baby boomers

What was the name of the legislation signed into law by President Obama to help the economy move out of the Great Recession?

The American Recovery and Reinvestment Act

Which branch of the Federal Government signs legislation into law?

The Executive Branch (Also called the Presidential Branch)

The US Budget in Global Perpective

The US is not alone in having a government budget deficit. All the major countries share this experience. -To compare the budget deficits across countries, we use the concept of the "general government" deficit, which combines the budget balances of all levels of government, and we express the budget deficit as a percentage of GDP.

In the graph you've just explored, what is the before tax and after tax wage rate if the income tax rises to $55 an hour?

The before tax wage rate is $85 an hour and the after tax wage rate is $30. -The before tax wage rate is the equilibrium wage rate, and it is $85 an hour. -The after tax wage rate is $85 minus 55, which is $30 an hour.

When is the budget balance is structural surplus is deficit?

The budget balance is a structural surplus when tax revenues exceed outlays at potential GDP. -The structural surplus or deficit is the budget balance that would occur if the economy were at full employment. So the budget balance is a structural surplus when tax revenues exceed outlays at potential GDP.

Slider Graph to explore cyclical budget balances In the graph you've just explored, what happens to the cyclical budget balance when you increase real GDP to $22 trillion?

The budget moves into a cyclical surplus of $0.8 trillion

Potential GDP is $12 trillion, and if real GDP equal potential GDP, the budget deficit would be $1 trillion. Real GDP is actually $14 trillion and the budget surplus is $3 trillion. Calculate the structural and cyclical budget balances.

The economy has a structural deficit of $1 trillion and a cyclical surplus of $4 trillion. (See explanation in image)

What can we say about the federal budget of the US the past ten years?

The federal budget was always in deficit.

Tax Revenues

The federal government's receipts of personal income taxes, corporate income taxes, Social Security taxes, and indirect taxes.

Generational Effects of Fiscal Policy -Two measures, fiscal gap and generational gap.

The fiscal gap Is the present value of the government's current and projected future outlays minus the present value of its current and projected future revenues. The present value of a future sum of money is the amount that, if invested today, will grow to be as large as that future sum when the interest that it can earn is considered. (The amount that must be invested today to earn interest and grow to be as large as a given future amount.) -So, the fiscal gap is the amount that the government would need to have invested today earning interest to be able to meet its current and projected future outlays minus its current and projected future revenues. -Expressed as a percentage of GDP, the fiscal gap is the percentage of income by which taxes must rise or spending must be cut to enable the government to meet its current and projected future outlays minus its current and projected future revenues. -The generational gap is division of the fiscal gap between the current and next generation, assuming that the current generation will enjoy the existing levels of taxes and benefits. The generational gap tells us who will pay. When economists examined the fiscal gap and generational gap arising from Social Security and Medicare, they found a time bomb!

How can the government increase the economic growth rate?

The government can increase the economic growth rate by decreasing taxes on financial capital to increase the pace of capital accumulation. -When the government decreases taxes on financial capital, the amount of saving and investment increases. -The increase in investment increases the pace of capital accumulation and the economic growth rate.

At the end of 2019, a country's national debt was $200 billion. In 2020, the government spent $120 billion and ended the year with a debt of $230 billion. How much did the government receive in tax revenues in 2020?

The government received $90 billion in tax revenues in 2020 -The debt increased from $200 billion in 2019 to$230 billion in 2020, so debt increased by $30 billion and the budget deficit in 2020 was $30 billion. -The budget balance equals tax revenues minus outlays, so when the budget is a deficit of$30 billion, then tax revenues must be $30 billion less than outlays. -Outlays are $120 billion, so the government collected $90 billion in tax revenues.

Budget Balance & Debt Balance Surplus Deficit

The government's budget balance is equal to tax revenues minus outlays. That is: Budget Balance = Tax Revenues - Outlays (Tax revenues minus outlays) If tax revenues equal outlays, the government has a balanced budget. The government has a budget surplus if tax revenues exceed outlays. The government has a budget deficit if outlays exceeds tax revenues.

Suppose the government's present value of current and projected future outlay is 75% of GDP and its present value of current and projected future revenues is 50% of GDP. What gap does this describe, and what is the size of the gap?

The information describes the fiscal gap which is 25% of GDP -The fiscal gap is the present value of the government's current and projected future outlays minus the present value of its current and projected future revenues. -The fiscal gap is 75% of GDP minus 50% of GDP, which is 25% of GDP.

The graph shows an economy's labor market. In the graph, draw a point at the labor market equilibrium. Label it 1. Now the government decides to tax labor income. Draw a curve that shows the effect of this tax. Label it. Draw points at the new equilibrium quantity of labor to show: 1) the before-tax wage rate. Label it 2. 2) the after-tax wage rate. Label it 3.

The initial equilibrium real wage rate and equilibrium quantity of labor are determined at the intersection of the LS curve and the LD curve. When the government imposes a tax on labor income, the supply of labor curve shifts leftward. The before-tax wage rate rises and is determined at the intersection of the LS + tax curve and the LD curve. The after-tax wage rate, which is the real wage rate on the LS curve at the new quantity of labor, falls.

In the data you've just explored, which event generated the largest government budget deficit and which generated the largest government surplus?

The largest deficit was during the Great Recession stimulus and tax cuts; and the largest surplus was during President Clinton's spending cuts and tax increases.

How was the majority of the CARES Act relief distributed?

The majority of the cares act relief was distributed as transfer payments and loans.

When was the government debt as a percentage of GDP at its lowest?

The mid 1970s

What is the role of the President of the US in creating in federal budget?

The president submits the budget request to Congress and approves or vetoes Congress proposed budget.

Income tax on employment and potential GDP graph part 2

The tax on labor income increases the equilibrium real wage rate and decreases potential GDP.

Does this time bomb caused by Social Security and Medicare create a fiscal gap or a generational gap?

The time bomb caused by Social Security and Medicare creates a fiscal gap and a generational gap. -It is estimated that the time bomb caused by Social Security and Medicare creates a fiscal gap that stands at $82 trillion in 2021. The fiscal gap created because the present value of the government's current and projected future outlays on Social Security and Medicare far exceed the present value of the current and projected future revenues from these programs. -There is also a generational gap because future generations will be paying for some of the benefits received by the current generation.

Why is the total impact of the CARES ACT unknown?

There are numerous and uncertain multipliers and time lags.

Table to see projected magnitudes of all these items in the federal budget in Fiscal 2021.

This shows a budget deficit as it is in the negative

Cyclical and Structural Automatic stabilizers - automatic changes in tax revenues and government outlays-make the budget balance fluctuate with real GDP over the business cycle.

To identify the government budget balance that arises from the business cycle, we distinguish between the budget's structural balance and its cyclical balance.

Does an increase in transfer payment or an equal increase in government expenditures change real GDP by the same amount?

Transfer payments increase real GDP by a smaller amount because a portion of the transfer payments are saved or used to pay down debt. -Government expenditure is autonomous expenditure, and a change in autonomous expenditure immediately increases real GDP by the amount of the expenditure, and then gets multiplied by an amount determined by the marginal propensity to consume. -Some transfer payments are saved and some are used to pay down debt, so only the portion of the transfer payments that is spent on goods and services increases real GDP.

The Social Security and Medicare Time Bomb

When Social Security was introduced in the New Deal of the 1930s, today's demographic situation was not foreseen. The age distribution of the US population today is dominated by the surge in the birth rate after World War II that created what is called the "baby boom generation." The first of the baby boomers started collecting Social Security pensions in 2008 and in 2011 they became eligible for Medicare benefits. By 2030, all the baby boomers will have reached retirement age and the population supported by Social Security and Medicare benefits will have doubled. Under the existing laws, the federal government has an obligation to this increasing number of citizens to pay Social Security and Medicare benefits on an already declared scale. These obligations rae a debt owed by the government and are just as real as the bonds that the government issues to finance its current budget deficit and create a fiscal gap. University of Pennsylvania economist Jagadeesh Gokhale estimated that in 2014 the Social Security and Medicare fiscal gap was $68 trillion and was growing every year by $2 trillion. These estimates put the fiscal gap at $82 trillion in 2021. To put the $82 trillion in perspective, note that the US GDP in 2021 was $23 trillion. So the fiscal gap was 3.6 times the value of one year's production. These are enormous numbers and point to a catastrophic future if unaddressed. How can the federal government meet its Social Security and Medicare obligations? There are four ways: -Raise income taxes -Raise Social Security taxes -Cut Social Security and Medicare Benefits -Cut federal government discretionary spending Gokhale and his colleague Kent Smetters estimate that if we had started in 2003 and made only one of these changes, income taxes would need to be raised by 69%, or Social Security taxes raised by 95%, or benefits cut by 56%. Even if the government stopped all its discretionary spending, including that on national defense, it would not be able to pay its bills. By combining the four measures, the pain from each could be lessened, but the pain would still be severe.

What is the relationship between full employment and potential GDP?

When the quantity of labor is the full employment quantity, real GDP equals potential GDP.

In the graph, can a tax cut alone restore full employment?

Yes, a tax cut of $0.6 trillion with no change in outlays would restore full employment. -When the government expenditures and transfer payments sliders are set to zero and the tax slider to -$0.6 trillion, the increase in aggregate demand makes real GDP equal potential GDP.

Is discretionary fiscal policy difficult to conduct when the economy is in a recession?

Yes, because Congress takes time to act, so the law making time lag occurs. -The law making lag is the time that it takes Congress to pass the laws needed to change taxes or spending. -The result is that by the time Congress acts, a different fiscal policy might be needed.

Covid 19 - When workers lost their jobs did some fiscal policy automatically occur?

Yes, it induced an automatic change in the federal budget. -Revenues declined as fewer income taxes were collected and outlays rose as needs tested spending, such as unemployment benefits, increased, helping to stabilize the collapse in real GDP. -When consumption expenditure increased, it put the transfer payment multiplier to work.

The fiscal gap created by Social Security and Medicare _______.

could be eliminated by raising all taxes, cutting benefits, and cutting discretionary spending -The fiscal gap could be eliminated by taxes, cutting benefits, and cutting government discretionary spending.

How does the tax on labor income influence potential GDP? When the government decides to tax labor income, potential GDP?

decreases because the full-employment quantity of labor decreases -A tax on labor income decreases the supply of labor and the full-employment quantity of labor decreases. -With a decrease in the full-employment quantity of labor, potential GDP decreases.

What would be the effects of a tax on labor income? An income tax _______.

decreases the full-employment quantity of labor and potential GDP -An income tax decreases the supply of labor and decreases the full-employment quantity of labor. -When the full-employment quantity of labor decreases, potential GDP decreases.

Cyclical Surplus or Deficit

is the budget balance that arises purely because tax revenues and outlays are not at their full employment levels. -That is, the cyclical balance is the balance that arises because tax revenues rise and outlays fall in an inflationary gap, or tax revenues fall and outlays rise in a recessionary gap.

Tax Multiplier

is the effect of a change in taxes on aggregate demand. A decrease in taxes increases disposable income, which increases consumption expenditure. -The increase in disposable income increases consumption expenditure and aggregate demand. With increased aggregate demand, employment and real GDP increase and consumption expenditure increases yet further. -A decrease in taxes works like an increase in government expenditure. But the magnitude of the tax multiplier is smaller than the government expenditure multiplier because $1 tax cut generates less than $1 of additional expenditure. -The marginal propensity to consume determines the initial increase in expenditure induced by a tax cut and the magnitude of the tax multiplier. -For example, if the marginal propensity to consume is 0.75, then the initial increase in consumption expenditure induced by $1 tax cut is only 75 cents. In this case, the tax multiplier is 0.75 times the magnitude of the government expenditure multiplier.

The Transfer Payments Multiplier

is the effect of a change in transfer payments on aggregate demand. -This multiplier works like the tax multiplier but in the opposite direction. An increase in transfer payments increases disposable income, which increases consumption expenditure. With increased consumption expenditure, employment and real GDP increase and consumption expenditure increases yet further. -The magnitude of the transfer payments multiplier is similar to that of the tax multiplier. Just as $1 tax cut generates less than $1 of additional expenditure, so also does a $1 increase in transfer payments. -Again, it is the marginal propensity to consume that determines that increase in expenditure induced by an increase in transfer payments.

Why does government expenditure on infrastructure capital increase potential GDP? Government expenditure on infrastructure capital increases potential GDP because _______.

labor productivity increases and employment increases -Government expenditure on infrastructure capital increases potential GDP because it increases the real GDP that a given amount of labor can produce labor productivity. -Potential GDP also increases because the increase in labor productivity increases the demand for labor, which increases the equilibrium quantity of labor.

Why do Social Security and Medicare create a fiscal gap, and can anything be done to eliminate it? Social Security and Medicare create a fiscal gap because _______.

the present value of current and projected future outlays exceeds those of future tax revenues -Social Security and Medicare create a fiscal gap because the present value of the current and future outlays exceeds the present value of current and future tax revenues.