Unit 3 - Fiscal Policy

What is Fiscal Policy
Changes in the expenditures or tax revenues of federal government

Tools of fiscal policy

• Taxes - government can increase or decrease taxes
• Spending- government can increases or decreases spending

 Goal: To promote our nation's economic good: full employment, price stability, economic growth

Deficits, Surplus and Debt

Balance budget: Revenues = Expenditures

Budget deficit: Revenues < Expenditures

Budget surplus: Rvenues > Expenditures

Government debt: sums of all deficits

*Government must borrow money when it runs a budget deficit

Government borrows from
-Individuals
-Corporations
-Financial institutions
-Foreign entities or foreign government

Fiscal Policy Options

• Discretionary Fiscal Policy-think deficit
• Contractionary Fiscal Policy-think surplus
• Non-Discretionary Fiscal Policy (no action)

Discretionary vs. Automatic fiscal policies

Discretionary
-Increasing or decreasing government spending and/or taxes in order to return the economy to full employment
-Discretionary policy involves policy makers doing fiscal policy in response to an economic problem

Automatic
-Unemployment + compensation & marginal tax rates are examples of automatic policies that help mitigate the effect of recession and inflation. Automatic fiscal policy takes places with out policy makers having to respond to current economic problems

Contractionary vs. Expansionary

Contractionary
-Strategy to control inflation
-Decrease AD
-Decrease government spending
-Increase taxes

Expansionary
-Strategy to control recession
-Increase AD
-Increase GDP
-Reduce unemployment
-Increase government spending
-Decrease taxes


Automatic or Built- In stabilizers
Anything that increases the government increases its budget deficit during a recession and increases its budget surplus without requirement explicit action by policy makers.


Example: welfare check, food stamping, unemployment checks, corporate dividends, social security, veteran benefits, etc.

Economic Importance
- Taxes reduces spending and AD
- Reductions in spending are desirable when the economy is moving toward inflation
- Increases in spending are desirable toward recession

Tax System
Progressive: Average tax rate rises with GDP

Proportionary: Average tax rate remains constant as GDP changes

Regressive: Average tax rate falls as GDP changes

*Average tax rate = tax revenues / GDP

Unit 3 - Consumption and Saving

Disposable Income

• Income after taxes or net income
• DI = Gross Income - Taxes

2 choices

With disposable income, household can either

- Consume (spend money on goods, and services )

- Save (not spend money on goods & services)

Consumption

• Household spending 
• The ability to consume is constrained by the amount of disposable income
• The propensity to save

Do households consume if DI = 0 ?

-Autonomous consumption

-Dis-saving

• APC = C/ DI =  % DI that's spent 

Saving

• House hold not spending
• The ability to save is constrained by the amount of disposable income
• The propensity to consume

Do house holds save if DI = 0 ?

- No

• APS = S/DI= % DI that is not spent

APC and APS

• APC+APS = 1
• 1-APC = APS
• 1-APS =APC
• APC > 1.: Dis-saving
• APS.: Dis-saving

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MPS and MPC

-Marginal Propensity to consume (MPC)

• MPC = change in C/ change in DI

-% of every extra dollar earned that is spent

 

-Marginal Propensity to save (MPS)

• MPS = change in S/ change in DI

-% of every extra dollar earned that is saved

 

- MPC + MPS = 1

-1-MPC=MPS

-1-MPS=MPC

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Spending Multiplier Effect

An inital change in spending (C,Ig,G,Xn) causes a larger change in Aggregate Spending or Aggregate demand

• Multiplier =change in AD/ hange in spending (C,Ig,G,Xn)

Why does this happen? 

Expenditures and income flow continuously which sets off a spending increase in the economy 

 

Calculating the Spending Multiplier

Can be calculated from MPC or MPS

• Multiplier = 1/1 -MPC or 1/MPS

*Multipliers are (+) when there is an increase in spending and (-) when there is a decrease in spending

Calculating Tax Multiplier

When the government taxes the multiplier it works inverse because how money is leaving the circular flow
Tax Multiplier (Always going to be negative*)

• Multiplier = MPC/1-MPS or -MPC/MPS

*If there is a tax-cut, then the multiplier is +, because there is now more money in the circular flow

Unit 3 - Three Schools of Economics

I. Classical

John B. Say
Adam Smith
David Ricardo
Alfred Marshall

What Classical Economics believe in

• Competition is good
• Invisible-Hand Market will take care of it's self
• Say's law supplies creates its own demand 
• AS- Determines output
• economy is always close to or always at full employment
• in the long run the economy will balance at full employment
• Trickle down effect will help the rich first then help everyone else later
• savings(leakage)= investment considered an (injection) because we invest
• prices and wages are flexible downward 
• no involuntary unemployment
• no reason you shouldn't be employed 
• what ever output is produced will be demanded no government intervention 

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II. Keynesian

John Mainer Keynes

What Keynesian Economics believe in

• Competition
• AD is key and not AS
• leaks cause constant recession 
• savings cause recessions 
• believed in ratchet effects and sticky wages Block Say's laws
• In the long run we are all dead
• demand creates its own supply there fore
• savers =/ Investment and save for different reasons
• the economy is not always close to or at full employment
• prices and wages are inflexible downward
• mono-plastic competition 
• there is government intervention
• fiscal or monetary policy 

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III. Monetary 

Allen Green's Span
Ben Bernanke

What Monetary believed in

• Congress can time policy options
• government best control the health of the economy, by regulating banks and interest rates
• easy money- recession
• tight money- inflation
• change required reserves if needed
• Use bands through open market operation
• use interest rate to change the discount rate, the discount rate, federal fund rate. 

Unit 3 - Investment Demand

What is investment

Money spent of expenditures on:

• New plant (factories)
• Capital equipment (machinery)
• Technology (hardware software)
• New homes
• Inventories (goods sold by produces

Expected Rate of Return


How does business make investment decision?
-Cost/benefit analysis


How does business determine the benefits?
-Expected rate of Return

How does business count the cost?
- Interest Cost

How does business determine the amount of investment may undertake?
-Compare expected rate of return to interest cost

*If expected return> interest cost , invest
*If expected return< interest cost then do not invest

Real (r%) v. Nominal (I%) Interest Rate

Nominal is the observable rate of interest. real subtract out inflation (pie%) and is only known ex post factor

Real interest rate (r%)

• r%= I%- pie% 

 *Cost of an investment decision = the real interest rate (r%)

Unit 3 - Full Employment

Full employment equilibrium exists where AD intersects SRAS & LRAS at the same point

Recessionary Gap

• A recessionary gap exists when equilibrium occurs below full employment out put

Recessionary gap <- AD decreased

Inflationary Gap

•  An inflationary gap exists when equilibrium occurs beyond full employment output

Inflationary gap  -> AD increased

Unit 3 - Aggregate Supply

What is Aggregate Supply
The level of real GDP (GDPr) that firms will produce at each price level (PL)
Real GDP= Out put

Long run v Short run AS

Long Run

• period of time where input prices are completely flexible and adjustments to change in the price level
• in the Long run, the level of real GDP supplied is independent of the price level

Short Run

• period of time when input prices are sticky and do not adjust to changes in the price level
• in the Short-run, the level of real GDP supplied is directly related to the price level

Long Run Aggregate Supply (LRAS)

• the long run aggregate supply or in the economy (analogous to ppc)
• Because input prices are completly flexible in the long-run changes in the price level do not change firm's real profits and therefore. do NOT Change firms level of full employment

 

 

Short Run Aggregate Supply (SRAS) 

• Because input prices are sticky in the short run, in the SRAS is upward sloping
• an increase in  GDPr, a decrease goes to the right and left
• The key to understand shifts in SRAS is per unit cost of production.

Per unit cost of production
total input/ total output = per unit cost of production

Changes in SRAS (decreases)
Determinants of SRAS (all following affect production cost)

• input prices
• productivity
• legal-institution environment

Input Prices

Domestic Resource Prices

• Wages (75% of all business cost)
• Cost of capital
• Raw material (commodity prices)

Foreign Resource Prices

• Strong $ = lower foreign resources prices
• Weak $ = higher foreign resources pries

Market Power

• -Monopoly and cartels that control resources
• Increases in resource prices in= SRAS shifts <-
• Decreases in resource prices= SRAS shifts ->

Productivity
productivity = total out put/ total input

• more productivity= lower unit production cost = SRAS shifts ->
• lower productivity = higher unit production cost= SRAS shifts <-

Legal- Institutional Enviornment

• Taxes ($ to gov't) on business increase per unit production cost = SRAS shifts <-
• Subsides ($ form gov't) to business reduce per unit productivity cost = SRAS shifts ->

Government Regulation

• Government regulation creates a cost of compliance = SRAS shifts <-
• Deregulation reduces compliance cost = SRAS shifts ->

Unit 3 - Consumption

What affects household spending

Consumer wealth

• more wealth = more spending (AD shifts ->)
• less wealth = less spending (AD shifts <-)

Consumer expectations

• Positive expectations = more spending (AD shifts ->)
• Negative expectations = less spending (AD shifts <-)

Household Indebtedness

• Less debt= more spending (AD shifts ->)
• more debt= less spending (AD shifts <-)

Taxes

• less taxed = more spending (AD shifts ->)
• more taxes= less spending (AD shifts <-)

Gross Private Investment spending is sensitive to

The Real Interest Rate

• Lower Real Interest Rate =more investment (AD shifts ->)
• Higher Real Interest Rate = less investment (AD shifts <-)

Expected Returns

• High Expected returns =more investment (AD shifts ->)
• Lower expected returns = less investment (AD shifts <-)
• 
  

  Expected returns are influenced by

• Expectations of future profitability
•  Technology
• Degree of excess capacity (existing stock of capital)

Government Spending

• More spending (AD shifts ->)
• Less spending (AD shifts <-)

Net Exports

• Net exports are sensitive to:
• - exchange rates (international value of a $)
• strong $ = more imports and fewer exports (AD shifts <-)
• Weak $= fewer imports and more exports=(AD shifts ->)

Relative income

• Strong foreign economies= more exports =(AD shifts ->)
• Weak foreign economies = less exports= (AD shifts <-)

Unit 3 - Aggregate Demand

What is Aggregate Demand (AD)?
-Shows the amount of real GDP that the private public and foreign sector collectively desire to purchase at each possible price level

-The relationship between the price level and the level of real GDP is inverse

Three Reasons AD is downward sloping

Real-Balance Effect
-When the Price-level is high household and businesses cannot afford to purchase as much out put.

-When the price-level is low households and businesses can afford to purchase more output
Interest Rate Effect

-A higher price level increases that interest rate which tends to discourage investment

-A lower price level decreases the interest rate which tends to encourage investment

Foreign-Purchase Effect
-A higher price level increases the demand for relatively cheaper imports

-A lower price level increases the foreign demand for relatively cheaper U.S exports

Shifts in Aggregate Demand (AD)
It happens when:
- Change in C, Ig, G, and/or Xn
- Multiplier effect that produces a greater change than the 4 components

*increases in AD= AD ->
*decreases in AD= AD <-

 

Aggregate Demand Curve

AD increased

AD decreased