ECO ch 13 notes - Summary Macroeconomics PDF

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Professor James D'Angelo...

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ECO 200 Ch 13 – Fiscal Policy, Deficits and Debt 13.1 – Fiscal Policy and the AD-AS Model - Council of Economic Advisers (CEA) – a group of three persons that advises & assists the president of the United States on economic matters (including the preparation of the annual Economic Report of the President) - Expansionary Fiscal Policy – an increase in government purchases of goods & services, a decrease in net taxes, or some combination of the two for the purpose of increasing aggregate demand & expanding real output - Expansionary fiscal policy uses increase in government spending or tax cuts to push the economy out of recession - Budget Deficit – the amount by which expenditures exceed revenues in any year; if the federal budget is balanced at the outset; government spending in excess of tax revenues - 3 fiscal policy options the federal government adopt to try to stimulate the economy: o Increase government spending o Reduce taxes o Use some combination of the two - Contractionary Fiscal Policy – a decrease in government purchases of goods & services, an increase in net taxes, or some combination of the two, for the purpose of decreasing aggregate demand & thus controlling inflation - Using fiscal policy to eliminate the inflationary GDP gap, the government can: o Decrease government spending o Raise taxes o Use some combination of those two policies - Budget Surplus – the amount by which the revenues of the federal government exceed its expenditures in any year 13.1 Review - Discretionary fiscal policy the purposeful change of government expenditures and tax collections by government to promote full employment, price stability & economic growth - Expansionary fiscal policy consists of increases in government spending, reductions in taxes, or both, & is designed to expand real GDP by increasing aggregate demand - Contractionary fiscal policy entails decrease in government spending, increases in taxes, or both & is designed to reduce aggregate demand & slow or halt demand-pull inflation - To be implemented correctly, contractionary fiscal policy must properly account for the ratchet effect & the fact that the price level will not fall as the government shifts the aggregate demand curve leftward 13.2 – Built-In Stability - Unemployment compensation payments & welfare payments decrease during economic expansion & increase during economic contraction - Built-In Stabilizer – a mechanism that increases government’s budget deficit (or reduces its surplus) during a recession & increases government’s budget surplus (or reduces its deficit) during an expansion without any action by policymakers. The tax system is one such mechanism - Tax revenues (T) vary directly with GDP & government spending (G) is independent of GDP o As GDP falls in a recession, deficits occur automatically & help alleviate the recession o As GDP rises in an expansion, surpluses occur automatically & help offset possible inflation - The economic importance of the direct relationship between tax receipts & GDP becomes apparent when we consider that: o Taxes rude spending & aggregate demand o Reductions in spending are desirable when the economy is moving toward inflation, whereas increases in spending are desirable when the economy is slumping - Progressive Tax – at the individual level, a tax whose average tax rate increases as the taxpayer’s income increases. At the national level, a tax for which the average tax rate (= tax revenue/GDP) rises with GDP

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Proportional Tax – at the individual level, a tax whose average tax rate remains constant as the taxpayer’s income increases or decreases. At the national level, a tax for which the average tax rate (= tax revenue/GDP) remains constant as GDP rises or falls Regressive Tax – at the individual level, a tax whose average tax rate decreases as the taxpayer’s income increases. At the national level, a tax for which the average tax rate (= tax revenue/GDP) falls as GDP rises

13.3 – Evaluating How Expansionary or Contractionary Fiscal Policy is Determined - Cyclically Adjusted Budget – the estimated annual budget deficit or surplus that would occur under existing tax rates & government spending levels if the economy were to operate at its full-employment level of GDP for a year; the full-employment budget deficit or surplus - Cyclical Deficit – federal budget deficit that is caused by a recession & the consequent decline in tax revenues 13.4 – Recent & Projected U.S. Fiscal Policy - In 2000 fiscal policy was contractionary; the economy was fully employed & corporate profits were strong; tax revenues poured into the federal government & exceeded government expenditures - March 2001, the economy slid into a recession; the dot-com stock market bubble burst, slowing the economy; Congress & Bush cut taxes which helped boost the economy & offset the recession - 2002-2007 was expansionary, more tax cuts; the economy strengthened & output grew; full employment has been restored - Major economic trouble began in 2007, severely disrupted the entire financial system; entered a recession by December one of the steepest & longest economic downturns since the 1930’s, the Great Recession - In 2008 Congress acted rapidly to pass an economic stimulus package; the increase in the cyclically adjusted budget reveals that fiscal policy in 2008 was expansionary - Obama & Congress enacted the American Recovery & Reinvestment Act in 2009, aimed at lower & middle level incomes, to flood the economy with additional appending to try to boost aggregate demand & get people back to work; the recession officially ended during the summer of 2009 o In summary: The budget surpluses of 1998-2001 were the first budget surpluses since 1969. Deficits reemerged after the 2001 recession & then ballooned massively with the Great Recession of 2007-2009. Deficits are projected to remain high for many years to come, though not as nearly as high as in the years immediately following the Great Recession 13.5 – Problems, Criticisms & Complications of Implementing Fiscal Policy -

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Several problems of timing may arise in connection with fiscal policy: o Recognition lag – takes 4-6 months into a recession/inflation to be able to clearly identify it as one o Administrative lag – time between recognizing the need for fiscal action & the action taking place o Operational lag – time between when the fiscal action is taken & when the action affects output, employment or the price level Political Business Cycle – fluctuations in the economy caused by the alleged tendency of Congress to destabilize the economy by reducing taxes & increasing government expenditures before elections & to raise taxes & lower expenditures after elections Crowing-Out Effect – a rise in interest rates & a resulting decrease in planned investment caused by the federal government’s increased borrowing to finance budget deficits & refinance debt

13.2 – 13.5 Review - Automatic changes in net taxes (taxes minus transfers) add a degree of built-in stability to the economy

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Cyclical deficits arise from declines in net tax revenues that automatically occur as the economy recedes & incomes & profits fall The cyclically adjusted budget eliminates cyclical effects on net tax revenues; it compares actual levels of government spending to the projected levels of net taxes that would occur if the economy were achieving its full-employment output Time lags, political problems, expectations & state & local finances complicate fiscal policy The crowding-out effect indicates that an expansionary fiscal policy may increase the interest rate & reduce investment spending

13.6 – The U.S. Public Debt

13.6 Review -

The U.S. public debt - $18.2 trillion in 2015 – is essentially the total accumulation of all past federal budget deficits & surpluses; about 34% of the U.S. public debt is held by foreigners The U.S. public debt held by the public (excluding the Federal Reserve) was 75% of GDP in 2015, up from 33% in 2000 The federal government is in no danger of going bankrupt because it needs only to refinance (not retire) the public debt & it can raise revenues, if need, through higher taxes The borrowing & interest payments associated with the public debt may (a) increase income inequality; (b) require higher taxes, which may dampen incentives; and (c) impede the growth of the nation’s stock of capital through crowding out of private investment

Summary: 13.1 – Identify & explain the purposes, tools & limitations of fiscal policy - Fiscal policy consists of deliberate changes in government spending, taxes or some combination of both to promote full employment, price-level stability & economic growth. Fiscal policy requires increases in government spending, decreases in taxes or both – a budget deficit – to increase aggregate demand & push an economy from a recession. Decreases in government spending, increases in taxes, or both – a budget surplus – are appropriate fiscal policy for decreasing aggregate demand to try to slow or halt demand-pull inflation 13.2 – Explain the role of built-in stabilizers in moderating business cycles - Built-in stability arises from net tax revenues, which vary directly with the level of GDP. During recession, the federal budget automatically moves toward a stabilizing deficit; during expansion, the budget automatically moves toward an anti-inflationary surplus. Built-in stability lessens, but does not fully correct, undesired changes in real GDP. 3.3 – Describe how the cyclically adjusted budget reveals the status of U.S. fiscal policy - Actual federal budget deficits can go up or down because of changes in GDP, changes in fiscal policy, or both. Deficits caused by changes in GDP are called cyclical deficits. The cyclically adjusted budget removes cyclical deficits from the budget & therefore measures the budget or surplus that would occur if the economy operated at its full-employment output throughout the year. Changes in the cyclical budget deficit or surplus provide meaningful information as to whether the government’s fiscal policy is expansionary, neutral or contractionary. Changes in the actual budget deficit or surplus do not, since such deficits or surpluses can include cyclical deficits or surpluses. 3.4 – Summarize recent U.S. fiscal policy & the projections for the U.S. fiscal policy over the next few years - In 2001 the Bush administration & Congress chose to reduce marginal tax rates & phase out the federal estate tax. A recession occurred in 2001 & federal spending for the war on terrorism rocketed. The federal budget swung from a surplus of $128 billion in 2001 to a deficit of $158 billion in 2002. In 2003 the Bush administration & Congress accelerated the tax reductions scheduled under the 2001 tax law & cut tax rates on capital gains & dividends. The purposes

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were to stimulate a sluggish economy. By 2007 the economy had reached its full employment level of output. The federal government responded to the deep recession of 2007-2009 by implementing highly expansionary fiscal policy. In 2008 the federal government passes a tax rebate program that sent $600 checks to qualified individuals. Later that year, it created a $700 billion emergency fund to keep key financial institutions from failing. These & other programs increases the cyclically adjusted budget deficit from -1.3% of potential GDP in 2007 – to -2.9% in 2008. When the economy continued to plunge, the Obama administration & Congress enacted a massive $787 billion surplus program to be implements over 2½ years. The cyclically adjusted budget deficit shot up from -2.9% of potential GDP in 2008 to -7.1% in 2009, but then decreases to -1.6% in 2015

3.5 – Discuss the problems that governments may encounter in enacting & applying fiscal policy - Certain problems complicate the enactment & implementation of fiscal policy. They include (a) timing problems associated with recognition, administrative & operational lags; (b) the potential for misuse of fiscal policy for political rather than economic purposes; (c) the fact that state & local finances tend to be pro-cyclical; (d) potential ineffectiveness if households expect future policy reversals; & € the possibility of fiscal policy crowding out private investment. - Most economists believe that fiscal policy can help move the economy in a desired direction but cannot reliably be used to fine-tune the economy to a position of price stability & full employment. Nevertheless, fiscal policy is a valuable backup tool for aiding monetary policy in fighting significant recession or inflation 13.6 – Discuss the size, composition & consequences of the U.S. public debt - The public debt is the total accumulation of all past federal government deficits & surpluses & consist of Treasury bills, Treasury notes, Treasury bonds & U.S. savings bonds. In 2015 the U.S. public debt was $18.2 trillion, or $56,368 per person. The public (which here includes banks & state & local governments) holds 59% of that federal debt; the Federal Reserve & federal agencies hold the other 41%. Foreigners hold 34% of the federal debt. Interest payments as a percentage of GDP were about 2.2% in 2015 - Because of large deficits during the Great Recession & in subsequent years, the total U.S. public debt more than doubled between 2005 & 2015. - The concern that a large public debt may bankrupt the U.S. government is generally a false worry because (a) the debt needs only to be refinanced rather than refunded & (b) the federal government has the power to increase taxes to make interest payments on the debt. - In general, the public debt is not a vehicle for shifting economic burdens to future generations. Americans inherit not only most of the public debt (a liability) but also most of the U.S. government securities (an asset) that finance the debt. - More substantive problems associated with public debt include the following: (a) Payment of interest on the debt may increase income inequality. (b) Interest payments on the debt require higher taxes, which may impair incentives. (c) Paying interest or principal on the portion of the debt held by foreigners means a transfer of real output abroad. (d) government borrowing to refinance or pau interest on the debt may increase interest rates & crowd out private investment spending, leaving future generations with a smaller stock of capital than they would have had otherwise. - The increase in investment in public capital that may result from debt financing may partly or wholly offset the crowding-out effect of the public debt on private investment. Also, the added public investment may stimulate private investment, where the two are complements....