20.

1 THE FEDERAL BUDGET AND FISCAL POLICY

BUDGET BALANCE AND DEBT

BALANCES BUDGET = tax revenue = outlay

BUDGET SURPLUS -tax revenue > outlay
budget deficit - OUTLAY > TEX RAVENUE

SURPLUS, DEFICIT, AND DEBT

+ Deficit: government borrows, repays when it has surplus
+ NATIONAL DEBT - amount of debt outstanding from past budget deficits.
National debt at end of one year = Debt at end of previous year + budget deficit or minus budget
surplus.
TYPES OF FISCAL POLICY

+ Requires change in spending program or in tax law.

+ Ex. increase in defense spending/cut in income tax rate.

+ Increase in unemployment induces increase in payments to unemployed.

+ Fall in income induces decrease in tax revenue.

CYCLICAL STRUCTURAL BUDGET BALANCES

+ How to identify government budget deficit that arises from business cycle, we need to figure out
structure/cyclical budget balances.

+ Structural balance = balance that full employment level of real GDP would create given the
spending programs/tax laws Congress creates.

+ Cyclical balance = balance because tax revenues rise and outlays fall in an inflationary gap, or tax
revenues fall and outlays rise in recessionary gap.

TOGETHER:
+ Actual budget balance.= structural balance + cyclical balance.
+ Cyclical deficits will correct itself when full employment returns.
+ Structure deficit requires action by congress.

A FISCAL POLICY CHALLENGE:

+ Oof baby boomers are gonna cause a lot of social security debt!

GENERATIONAL ACCOUNTING
+ To determine scale of government obligations across generations. We need to focus on:
+ Present value = amount of money that (if invested today) will earn interest and grow to equal to
required future amount.
+ Fiscal imbalance measures government's true debt.
+ Measures today's value of the future cost of programs to which the government has committed to
- today's value of the future taxes it will collect.
+ So right now we broke af rip
SOLUTIONS to meeting obligations

+ Delaying a start on tackling programs increase scale of changes needed.

+ Why not keep borrowing by selling government bonds? No, holders would see government's debt
too large and that government cannot pay the interest on it. Then, global economy would collapse.

GENERATIONAL IMBALANCE:

+ Fiscal imbalance must be corrected, when it is- people either pay higher taxes or receive lower
benefits.
+ Generational imbalance tells us who will pay.

DISCRETIONARY FISCAL POLICY: DEMAND-SIDE EFFECTS

+ Influences agg. demand and supply.
+ Changes in government expenditure and changes in taxes have multiplier effect on agg. demand

THE GOVERNMENT EXPENDITURE MULTIPLIER

+ Gov expenditure part of aggregate expenditure, when government expenditure increase, agg.
demand increases.
+ Real GDP increases and induces increase in consumption expenditure, now more increase in agg.
expenditure.
THE TAX MULTIPLIER

+ Decrease in tax increases disposable income, increase consumption expenditure. Works like an
increase in government expenditure, magnitude is smaller than government (1 dollar tax cut
generate less than 1 dollar additional expenditure)
+ Marginal propensity to consume is .75, then initial increase in consumption expenditure of $1 tax
is 75 cents. Tax multiplier .75 times magnitude of government expenditure multiplier.

TRANSFER PAYMENTS MULTIPLIER

+ Works like tax multiplier, in OPPOSITE direction.

+ increase transfer payment = increase disposable income = increase consumption expenditure
+ magnitude of multiplier similar to tax, $1 increase in transfer payment is less than $1 additional
expenditure.
+ marginal propensity to consume determine increase in expenditure from transfer payments.

THE BALANCE BUDGET MULTIPLIER

+ Balanced budget multiplier not zero, greater than zero.

+ $1 increase in government expenditure injects dollar more in to agg. demand, $1 tax rise (or
decrease in transfer payment) takes less than $1 from agg. demand.
+ When both gov. expenditure and tax increase by 1, agg. demand increases.

SUCCESSFUL FISCAL STIMULUS

+

DISCRETIONARY FISCAL POLICY: SUPPLY-SIDE EFFECTS

+ Gov expenditure and tax influence potential GDP and agg. supply, look at side effects of fiscal
policy:

SUPPLY SIDE EFFECTS OF GOVERNMENT EXPENDITURE:

+ Government provides highways, education, health care etc.
+ Increase in government expenditure = increase in quantity of production services, capital
increases potential GDP, increase agg. supply.

SUPPLY SIDE EFFECTS OF TAXES

+ Taxes on labor decrease supply of labor, smaller supply means higher equilibrium real wage rate,
smaller equilibrium quantity of labor employed, potential GDP and agg. supply are smaller.
+ Taxes on income from capital - decrease saving, decrease supply of capital, higher equilibrium
real interest rate, smaller equilibrium quantity of investment and capital employed, potential gdp
and agg. supply smaller.
+ Taxes on incomes of entrepreneurs - weaken incentive to take risks+create new businesses.
Smaller # firms, quantity of labor/capital employed lower, potential GDP and agg. supply are
smaller.
+ Increase in taxes - strengthen disincentive effects, decrease supply of labor, capital,
entrepreneurial services: decrease potential GDP, decrease agg. supply
+ Tax cut opp. effect - increase in incentive to work, save, provide entrepreneurial services, increase
potential gdp and agg. supply.

SCALE OF GOVERNMENT SUPPLY-SIDE EFFECTS

+ Both gov exp + ta increase, scale of government grows.
+ More productive gov. expenditure increases potential GDP, higher taxes
+ Higher paxes to pay for expenditure decreases potential GDP
+ INCREASE IN SCALE OF GOV MUGHT INCREASE/DECREASE POTENTIAL GDP AND
AGG. SUPPLY DEPENDING ON WHICH IS STRONGER.

SUPPLY-SIDE EFFECTS ON POTENTIAL GDP

+ increase potential gdp and agg. supply, increase actual real gdp.
LIMITATIONS OF DISCRETIONARY FISCAL POLICY
(from congress)

TIME LAG: - economy might benefit from fiscal stimulus today, but by time congress acts, might
need different fiscal medicine.

SHRINKING AREA OF DISCRETION -

+ Right now, government spends a lot on entitlement programs (social security/Medicare), but
growth of this spending reduces areas in which Congress can change in either taxes or outlays.
About 80% of budget off limits for discretionary fiscal policy.
+ Room to maneuver is limited.

ESTIMATING POTENTIAL GDP:

+ Difficult to estimate, is real GDP above, below, or at potential GDP? discretionary fiscal action
might move real GDP away from potential GDP instead of toward

ECONOMIC FORECASTING
+ fiscal policy changes take long time to be effective
+ so we must look at economic forecasts.
+ inexact and subject to error, might mislead congress.

+ THESE FOUR LIMITATIONS DO NOT AFFECT AUTOMATIC FISCAL POLICY!!!!!!

(triggered by state of economy)

AUTOMATIC FISCAL POLICY:

Automatic fiscal policy - consequence of tax revenues/outlays that fluctuate with real GDP.
+ These features of fiscal policy are
ON REVENUE SIDE OF BUDGET: tax laws define tax rates, not dollars.
+ tax dollars depend on tax rates and income, incomes vary with real GDP and are called:

+ when real GDP increase with expansion, wages, profits rise, induced taxis rise. Vice versa.

ON EXPENDITURE SIDE OF BUDGET:

+ Government creates benefit programs.
+ NEEDS TESTED SPENDING - spending on such programs - results in transfer payments that
depend on economic state of person/business.
+ recession: number of people in need increase, spending goes up (needs-tested spending on
unemployment benefits and foot stamps increase) vice versa with expansion.
+ Automatic stabilizers give rise to cyclical fluctuations in the budget balance that we can
distinguish from structural changes in the budget.

20.2
THE FEDERAL RESERVE AND MONETARY POLICY

MONITORING ECONOMIC CONDITIONS

+ Each fed. reserve bank monitors district by talking to business leaders/economists/etc. Fed
summarizes state of economy in Beige Book.

DECISIONS OF THE FEDERAL OPEN MARKET COMMITTEE (FOMC)

+ Meets 8 times a year, makes monetary policy decisions. Asses long-term outlook and current
period open-market operations.
+ Assess likelihood of goal of price stability and full employment achievement.
+ Transcripts posted after five years for ease of speech.

MONETARY POLICY REPORT TO CONGRESS

+ Fed prepares monetary policy report to congress, fed chairman testified before House of rep on
financial services. Review monetary policy/economy developments of past year/economic outlook

THE RIPPLE EFFECTS OF THE FED'S ACTIONS

+ When fed changes fed fund rate, ripple effect to real GDP and price level.

1. OTHER INTEREST RATES CHANGE

+ Change in short-term interest rate. Overnight loan to another bank is close substitute for short-
term security such as treasury bill.

2. EXCHANGE RATE CHANGES

+ Rise in u.s interest rate relative to interest rate in other countries brings funds in to u.s from
outside to take advantage of higher interest rate. Move funds to u.s, buy u.s dollars, demand for
dollar rises, exchange rate rises.

3. THE QUANTITY OF MONEY AND BANK LOANS CHANGE

+ Fed fund change, fed has changed quantity of bank reserves in op. direction. Change in reserves
in banks means banks change volume of loans, changes deposits and quantity of money.
+ Fed cut fed. fund rate, quantity of money/loans increase.

4. LONG TERM REAL INTEREST RATE CHANGES

+ Fall in fed fund rate increase supply of interbank loans, increase supply of funds, lowers
equilibrium real interest rate. (vice versa)

5. CONSUMPTION EXPENDITURE, INVESTMENT, AND NET EXPORTS CHANGE

+ interest rate influences spending decision.
+ lower int. rate, more spending, less saving, greater amount of investment ??????????? vice versa.
+ fall in interest rate lowers exchange rate, lowers price of dollar, foreigners pay less for u.s goods/
services, u.s export increase.

6. AGGREGATE DEMAND CHANGES

+ Consumption expenditure, investment and next exports are all components of agg. demand.
+ When these items change, agg. demand changes in same direction.
+ Agg demand changes more than change in items because of multiplier effect.
+ change in expenditure changes income, change in income induces change in consumption
expenditure.
MONETARY STABILIZATION IN THE AS-AD MODEL
+ How can monetary policy stabilize real GDP?

FED EASES FIGHT TO RECESSION

+
FED TIGHTENS TO FIGHT INFLATION

SIZE OF MULTIPLIER EFFECT

+ on monetary policy depends on sensitivity of expenditure plans on interest rate.
+ larger effect of change in interest rate on agg. expenditure, greater the multiplier effect and the
smaller is the change in interest rate that achieves fed objective.

LIMITATIONS OF MONETARY STABILIZATION POLICY

+ Monetary policy has advantage over fiscal because it cuts out law-making time lags.
+ FOMC MEATS EIGHT TIMES A YEAR WHEN NEED ARISES
+ Actual actions taken by new york fed work as well (operating under fomc)
+ monetary policy IS A CONTINUOUS POLICY PROCESS, NOT SUBJECT TO LONG
DECISION LAG/BROAD POLITICAL CONSENSUS
+ Weakness: estimating potential GDP, economic forecasting is error-prone.
+ Another one: effects are indirect, depend on n how private decisions respond to a change interest
rate. Difficult to forecast.
+ time lags in operation of monetary policy are longer than fiscal policy, so forecasting horizon
must be longer??????