Chapter 11 Notes and Vocabulary
Golden Age to Stagflation
-1960s, Golden Age of fiscal policy -Increase or decrease AD -To smooth economic fluctuations -Federal budget deficit to stimulate an economy experiencing a recessionary gap -Tax cut to stimulate business investment, consumption, and employment -Vietnam War era led to a demand-pull inflation cycle -Increase in war spending and passage of Medicare Act combined with the tax cuts over-stimulated the economy
Golden Age to Stagflation - contunued
-1970s: Stagflation -Higher inflation -Higher unemployment -From decreased AS -Crop failures -Higher OPEC-driven oil prices -Adverse supply shocks -No AD fiscal policy solution - Increase in AD make inflation worse - Decrease in AD make unemployment worse
2007-2009 Recession - 5
-American Recovery and Reinvestment Act -37% for tax benefits -One time reduction for individuals (reduced employee contribution on Social Security employment tax) -28% for entitlements (such as Medicaid and unemployment insurance extensions) -35% for grants, contracts, and loans -Some "shovel ready" infrastructure projects - slow to get underway -Grants backfilled deficits in state's budget to stop the lay-off of state workers -If the spending multiplier >1 (A dollar of government spending produces more than a dollar of new output and income) then real GDP will increase
2007-2009 Recession - 4
-American Recovery and Reinvestment Act (Obama) -Estimated cost of $862 billion -Largest stimulus measure in U.S history -Enacted in February 2009, Projected to last two years -Largest fiscal spending stimulus -Intended that unemployed labor and idle capital would be put to work
Fiscal Policy Tools
-Automatic Stabilizers -Revenue and spending programs in the federal budget that automatically adjust with the ups and downs of the economy to stabilize disposable income and, consequently, consumption and real GDP -Discretionary Fiscal Policy -Requires the deliberate manipulation of government purchases, transfer payments, and taxes to promote macroeconomic goals like full employment, price stability, and economic growth
Automatic Stabilizers continued
-Automatic Stabilizers act as built-in countercyclical Fiscal Policy -Smooth out fluctuations DI -Stimulate AD during recessions -Dampen AD during expansions -Federal income tax -Progressive income tax -The fraction of income paid in taxes increases as a taxpayer's income increases -Unemployment insurance -Welfare payments
Pre-Great Depression and Lassie
-Classical economists -Group of 18th, 19th and early 20th century economists -Economic downturns corrected themselves through natural market forces -Economy: self-correcting and needs no government intervention -Flexible market prices, wages, interest rates clear excess supply -Laissez-faire (Classical approach) -Free markets and Balanced budget -Natural market forces --> the economy to adjusts to potential GDP -No need for government intervention
2007-2009 Recession - 1
-December 2007 - recession -Declining home prices -Rising foreclosure rates -Increase in foreclosures as borrowers failed to pay their mortgages mainly in sub-prime mortgages -Early 2008, $168 billion plan to stimulate the softening economy -Borrowed money - increased federal deficit -$117 billion one-time tax rebate -Disappointing results since most of the tax was saved -2008, Recession - gathered steam -Job losses -31,000 a month - first quarter of 2008 -191,000 a month in the second quarter -Third quarter -Consumer spending fell 3.5% -Real GDP fell by 4.0% -Monthly job losses: 334,000
2007-2009 Recession - 7
-Federal deficit (increased due to automatic stabilizers and discretionary fiscal stimulus and recessionary loss of tax revenue -$161 billion in FY2007 -$459 billion in FY2008 -$1.4 trillion in FY2009 -$1.3 trillion in FY2010 -$1.3 trillion in FY2011 -$1.1 trillion in FY2012 -$679 billion FY2013 -$525 billion FY2014 -$438.4 billion FY2015
Feedback Effects and Supply-Side Economics Fiscal Policy in the 1980s
-Fiscal policy affects Aggregate Supply -Higher unemployment benefits funded with higher taxes on earning -Reduce the opportunity cost of not working -Decrease in labor supply --> Decrease LRAS and reduce potential GDP -Reduce the opportunity cost of leisure -Decrease labor supply --> Decrease LRAS -Higher marginal tax rates might reduce the incentive to work --> decrease LRAS (but allows more efficient matching of skills to job openings) -Supply-side economics: fiscal policy designed to shift LRAS curve rightward (beneficial supply shock) -Reagan marginal tax cuts in the 1980s --> Increase marginal cost of leisure --> rightward shift in LRAS -controversial: caused big deficits which may have reduced LRAS shift by decrease in investment -Tax cut would have also shifted AD rightward (traditional FP) -Deduction of student loan interest (2000s) --> Increase in college education --> rightward shift in LRAS -Government funding of basic research --> Increase in technology --> rightward shift in LRAS
Feedback Effects
-Fiscal policy maybe ineffective -Higher unemployment benefits funded with higher taxes on earning -Unintended consequences -Unemployed: increase C -Employed: decrease C -No real change in: AD or real GDP -Just a Redistribution of income no net stimulus -However, intertemporal transfer of income from expansion to recession periods injects new spending into AD when economy is in recession
Lags in fiscal policy
-Fiscal policy timing -Takes 6 months to identify the onset of a recession -Approve and implement fiscal legislation takes time -Fiscal stimulus may stimulate the economy after the point the economy begins to recover -Lag in timing could cause a demand-pull inflation cycle -Gridlock in Congress prevented any further fiscal policy stimulus packages which may have more quickly lowered unemployment in Great Recession -Infrastructure stimulus proposed in 2012 by administration was rejected by Congress
2007-2009 Recession - 6
-Government spending in 2009 -First quarter: dropped 3.0% -Second quarter: rose by 6.1% after stimulus bill -During last two quarters of 2009 and first two quarters of 2010, government spending averaged 1.2% (because of the cuts in government spending at the state and local level) -During nine months after stimulus bill, economy began a slow recovery -Probably not enough stimulus and the infrastructure stimulus proposed in 2012 would have produced faster GDP growth -By 2014, gained about 9.5 mil jobs replacing the 8mil jobs lost in the Great Recession -By 2016, (economy is now creating 200K+ jobs per month) and added 12.6 million jobs -Real GDP growth averaged 2.2% since 2010
World War II
-Increase production eliminated the Great Depression recessionary gap and cyclical unemployment -Convinced most economists that fiscal policy could close a recessionary gap -Because the economy failed to self-correct during the Great Depression, most economists reject the classical theory of self-correction -Employment Act of 1946 -Law that assigned to the federal government the responsibility for promoting full employment and price stability -Federal government must know use fiscal policy tools to minimize the business cycle deviation from full-employment
Great Depression
-Keynesian theory and policy -Developed in response to the problem of high unemployment during the Great Depression -Prices and wages: 'Sticky' downward because of -Long term wage contracts -Asymmetric information on decline in cost-of-living -High levels of autonomous consumption due to mortgage and consumer durable contractual payments make workers resist declines in nominal wages -SRAS will not shift rightward to eliminate the recessionary gap -Natural forces would not necessarily close the recessionary gap, I depends of on profit expectations and low interest rates may not I and AD -Government: Must use fiscal policy to increase AD and close the recessionary gap
2007-2009 Recession - 3
-October 2008, TARP (Bush) -$700 billion Troubled Asset Relief Program -To unfreeze financial flows by investing in financial institutions -Helped calm credit markets -Fourth quarter of 2008 -Real GDP fell 6.8% -Job losses - averaged 662,000 per month -Job losses hit 800,000 per month -First quarter of 2009 -Job losses continued to average 800,000 per month -Obama Administration inaugurated in January 2009 (gap in fiscal policy response to recession)
Discretionary Fiscal Policy and Permanent Income
-Permanent income -Income that individuals expect to receive on average over the long term -Temporary tax rate change -less effective since because temporary tax change will only slightly affects permanent income -Small change in personal income -Small change in Consumption -Most of the tax cut might be saved use to reduce debt -2007 tax rebate, only 20% was spent
Problems with Implementation of Fiscal Policy
1) Fiscal Policy and Natural Rate of Unemployment a. Attempt to lower unemployment rate below natural unemployment rate b. Political Business cycle 2) Lags in fiscal policy 3) Discretionary and Permanent Income 4) Fiscal Policy Feedback on Aggregate Supply
Fiscal Policy continued
-Precisely calculated fiscal policy difficult to achieve - proper execution assumes: -Potential output gap gauged accurately (otherwise the recessionary or expansionary gap isn't known) -Spending multiplier predicted accurately (multiplier changes with economy over time—must know the mult. to determine the amount of the in fiscal policy and shift AD by just the right amount -Government entities (federal, state, local)- must coordinate fiscal efforts -Shape of SRAS curve is unknown effective multiplier is unknown and policymakers will not know the actual effect on real GDP *SLIDE 5*
Discretionary Fiscal Policy to Close Expansionary Gap
1) Leftward Shift in AD curve 2) Decrease in output and decrease in price level -Reducing aggregate demand by just the right amount could close this gap without inflation
2007-2009 Recession - 2
-September 2008, Lehman Brothers -Nation's fourth-largest investment bank (Assets of over $600 billion, 25,000 employees) -Largest bankruptcy in U.S. history -Merrill Lynch bought out by Bank of America -Bear Sterns bought out by JP Morgan Chase -Goldman-Sachs cash infusion from Warren Buffet -Morgan-Stanley need a cash infusion from a Japanese bank -Financial crisis -Mortgage backed securities became worthless -Assets of B of A, Well Fargo, Chase, Citi highly risky -Froze credit markets around the world
The Multiplier and Time Horizon
-Simple multiplier -Overstates ∆Real GDP -∆Real GDP depends -Steepness of SRAS curve --> increase in production costs -The steeper SRAS curve -Less impact of an AD shift on real GDP -More impact on price level -The smaller the spending multiplier -If the economy is at full-employment, then expansionary fiscal policy will result in higher price level w/o any change in output
Fiscal Policy and Natural Rate of Unemployment
-Underestimate the natural rate of unemployment -Actual natural rate of unemployment might be 5% but policymaker may think it is 4% -Expansionary fiscal policy -Increase AD; Short run: Increase output and decrease unemployment -Expansionary gap; Long run adjustment: Leftward shift SRAS and Inflation --> decreased output, higher unemployment -Policymakers might react to increase in unemployment by accelerating the fiscal stimulus --> continuously accelerating inflation -Political business cycle: deliberate economic stimulus before election for political gain (Nixon in 1972)
Evolution of Fiscal Policy
1) Pre-Great Depression and Lassie-faire 2) Great Depression and Post-WWII a. Rise of Keynesian Economics b. Employment Act of 1946 3) Golden Era to Stagflation a. Fine-tuning b. Discretionary Fiscal policy and Aggregate Demand management: no solution to supply shock
Discretionary Fiscal Policy to Close Recessionary Gap
1) Rightward Shift in AD curve 2) Increase in output and price level -Increases aggregate demand by just the right amount
Recent Fiscal Policies
1) 1990-2007: Deficits to Surplus to Deficit 2) 2007-Present: Great Recession a. Financial Crisis and TARP b. Stimulus Package and American Recovery and Reinvestment Act c. Fluctuations in real GDP and government spending
Change in Autonomous Net Taxes
1) Shift in AE curve 2) Simple multiplier -Decrease (increase) in net taxes (NT) --> Economic stimulus (contraction) -Decrease (Increase) NT (T-TR) = Increase (Decrease) transfers or Decrease (Increase) tax revenues Increases (decrease) DI by ∆NT --> DI = -∆NT (DI and NT are negatively related) -Increases (decrease) C by MPC x (-∆NT) Decrease(Increase) NT --> Upward (downward) shift of AE by -(MPC x Delta NT) --> Increase (decrease) in real GDP = 1/[1-MPC] x -(MPC x Delta NT) = -MPC/[1-MPC] x Delta NT -Assume MPC =.8, net tax mult.= -MPC/[1-MPC] = -.8/[1-.8]=-4 -*Simple tax multiplier = -(MPC) / (1-MPC) -*Change in Real GDP demanded = (Delta NT) x -(MPC) / (1-MPC)
Change in Government Purchases
1) Shift in AE curve 2) Simple multiplier -Increase (decrease) government purchases Economic stimulus (contraction) - Change in G --> positive relationship to change in real GDP ( Delta G has a positive impact on AE) -Upward (downward) shift of AE = C + I + G + NX by change in G --> Increase (decrease) in real GDP = multiplier x Delta G -Assume the MPC = .8, the government purchases mult.= 1/[1-MPC] = 1/[1-.8] = 5 -*Change in Real GDP demanded = Change in G x (1/ (1-MPC))*
Contractionary fiscal policy
A *decrease in government purchases* (or transfer payments), *increase in net taxes*, or some combination of the two aimed at reducing (shifting leftward) aggregate demand enough to return the economy to potential output without worsening inflation; fiscal policy *used to close an expansionary gap* -Decrease deficit and borrowing or increase surplus (lending to capital markets) -Used to close an expansionary gap -Price level > expected -Output > potential or natural GDP -Unemployment < natural rate -Long-run self-correction solution: Leftward shift in SRAS curve --> Increase in P and Decrease in Y until Y=YN -Decrease G or increase NT --> Leftward shift in AD by delta real GDP = multiplier x delta fiscal policy tool --> decrease real output and decrease price level (due to movement down SRAS) -Effective multiplier is less than simple multiplier because decrease in P reduces potential decrease in Y (the steeper the SRAS the smaller the effective mult.) *SLIDES 3 & 4*
Classical economists
A group of 18th- and 19th-century economists who believed that economic downturns corrected themselves through natural market forces; thus, they believed the economy was self-correcting and needed no government intervention
Expansionary fiscal policy
An *increase in government purchases* (or transfer payments), *decrease in net taxes*, or some combination of the two aimed at increasing (shifting rightward) aggregate demand enough to reduce unemployment and return the economy to its potential output; fiscal policy *used to close a recessionary gap* -Increase deficit and borrowing from capital markets -Used to close a recessionary gap -Price level < expected -Output < potential or natural GDP -Unemployment > natural rate -Long-run self-correction solution: Rightward shift in SRAS curve --> Decrease in P and Increase in Y until Y=YN -Increase G or decrease NT --> Rightward shift in AD by delta real GDP = multiplier x delta fiscal policy tool --> increase real output and increase price level (due to movement along SRAS) -Effective multiplier is less than simple multiplier because increase in P reduces potential increase in Y (the steeper the SRAS the smaller the effective mult.) *SLIDES 1 & 2*
American Recovery and Reinvestment Act
At an estimated cost of $862 billion, the largest stimulus measure in U.S history; enacted in February 2009 and projected to last two years
d. Increase government purchases by $0.25 trillion if about half of the stimulus is absorbed by an increase in the price level
Clicker Question: If policymakers estimate a $0.5 trillion recessionary gap, which of the following fiscal policy will restore full-employment output if the MPC is .75 (assume upward sloping SRAS) a. Increase government purchases by $0.125 trillion b. Increase net taxes by $0.125 trillion c. Decrease net taxes by $0.25 trillion d. Increase government purchases by $0.25 trillion if about half of the stimulus is absorbed by an increase in the price level
Political business cycles
Economic fluctuations that occur when discretionary policy is manipulated for political gain
Permanent income
Income that individuals expect to receive on average over the long term
Employment Act of 1946
Law that assigned to the federal government the responsibility for promoting full employment and price stability
Fiscal policy
Refers to government purchases (G), transfer payments (TP), taxes (T), and borrowing as they affect macroeconomic variables such as real gross domestic product (GDP), employment the price level, and economic growth.
Automatic Stabilizers
Structural features of government spending and taxation that occur automatically under current law -Reduces fluctuations in disposable income and consumption over the business cycle -Adjust automatically to stimulate the economy in a recessionary gap/contract the economy in an expansionary gap -Federal Income Tax -Unemployment tax and benefits -Welfare subsides -Food Stamps
Discretionary fiscal policy
The deliberate manipulation of government purchases, taxation, and transfer payments to promote macroeconomic goals, such as full employment, price stability (inflation rate), and economic growth -Usually requires executive and legislative action to *change current law* -Some are temporary, such as one-time tax cuts or government spending increases to fight a recession EX- President Obama's 2009 stimulus plan; President Bush's 2001 and 2008 one-time tax rebates -Increase in G or TP shifts AE upward, shifts AD rightward and increases real GDP demanded -Decrease in G or TP shifts AE downward, shifts AD leftward and decreases real GDP demanded -Decrease in net taxes shifts AE upward, shifts AD rightward and increases real GDP demanded -Increase in net taxes shifts AE downward, shifts AD leftward and decreases real GDP demanded
Simple multiplier
The ratio of a change in real GDP demanded to the initial change in autonomous government purchases that brought it about; the numerical value of the simple multiplier is 1/(1 − MPC)
Simple tax multiplier
The ratio of a change in real GDP demanded to the initial change in autonomous net taxes that brought it about; the numerical value of the simple tax multiplier is −MPC/(1 − MPC)