Fiscal and Monetary Policy Effects

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Fiscal and Monetary Policy Effects
CHAPTER
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C H A P T E R C H E C K L I S T

• When you have completed your study of this
  chapter, you will be able to

Describe the federal budget process and explain
the effects of fiscal policy.
Describe the Federal Reserves monetary policy
process and explain the effects of monetary
policy.
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16.1 THE BUDGET AND FISCAL POLICY

• Fiscal policy is the use of the federal budget to
  sustain economic growth and smooth the business
  cycle.

• The Federal Budget

The federal budget is an annual statement of the
expenditures and tax receipts of the government
of the United States.
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16.1 THE BUDGET AND FISCAL POLICY
The governments surplus or deficit is equal to
tax receipts minus expenditures.
Budget surplus ()/deficit () Tax receipts
Expenditures

• The government has a budget surplus if tax
  receipts exceed expenditures.
• The government has a budget deficit if
  expenditures exceeds tax receipts.
• The government has a balanced budget if tax
  receipts equal expenditures.

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16.1 THE BUDGET AND FISCAL POLICY

• The government borrows to finance a budget
  deficit and repays its debt when it has a budget
  surplus.
• The amount of debt outstanding that arises from
  past budget deficits is called national debt.

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16.1 THE BUDGET AND FISCAL POLICY
Budget Time Line The President and Congress make
the federal budget on the annual time line.

• Figure 16.1 shows the federal budget time line
  for Fiscal year 2007.

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16.1 THE BUDGET AND FISCAL POLICY

• Types of Fiscal Policy
• Fiscal policy can be either
• Discretionary or
• Automatic

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16.1 THE BUDGET AND FISCAL POLICY

• Discretionary fiscal policy
• A fiscal policy action that is initiated by an
  act of Congress.
• Automatic fiscal policy
• A fiscal policy action that is triggered by the
  state of the economy
• For example, an increase in unemployment induces
  an increase in payments to the unemployed or in a
  recession tax receipts decrease as incomes fall.

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16.1 THE BUDGET AND FISCAL POLICY

• Discretionary Fiscal Policy Demand-Side Effects
• The Government Expenditure Multiplier
• The government expenditure multiplier is
  magnification effect of a change in government
  expenditure on goods and services on aggregate
  demand.
• It works like the investment multiplier.

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16.1 THE BUDGET AND FISCAL POLICY

• The Tax Multiplier
• The tax multiplier magnification effect of a
  change in taxes on aggregate demand.
• A decrease in taxes increases disposable income.
  And an increase in disposable income increases
  consumption expenditure.
• With increased consumption expenditure,
  employment and incomes rise and consumption
  expenditure increases yet further.

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16.1 THE BUDGET AND FISCAL POLICY

• So a decrease in taxes works like an increase in
  government expenditure.
• Both actions increase aggregate demand and have a
  multiplier effect.
• The magnitude of the tax multiplier is smaller
  than the government expenditure multiplier.

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16.1 THE BUDGET AND FISCAL POLICY

• The Balanced Budget Multiplier
• The balanced budget multiplier is the
  magnification 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 zeroit is
  positivebecause the government expenditure
  multiplier is larger than the tax multiplier.

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16.1 THE BUDGET AND FISCAL POLICY

• Discretionary Fiscal Stabilization
• If real GDP is below potential GDP, the
  government might use discretionary fiscal policy
  in an attempt to restore full employment.
• Expansionary fiscal policy is a discretionary
  fiscal policy designed to increase aggregate
  demanda discretionary increase in government
  expenditure or a discretionary tax cut.

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16.1 THE BUDGET AND FISCAL POLICY
Figure 16.2 illustrates an expansionary fiscal
policy.
Potential GDP is 10 trillion, real GDP is 9
trillion, and
1. There is a 1 trillion recessionary gap.
2. An increase in government expenditure or a tax
cut increases expenditure by ?E.
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16.1 THE BUDGET AND FISCAL POLICY

• 3. The multiplier increases induced expenditure.
  The AD curve shifts rightward to AD1.

The price level rises to 110, real GDP increases
to 10 trillion, and the recessionary gap is
eliminated.
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16.1 THE BUDGET AND FISCAL POLICY

• Figure 16.3 illustrates contractionary fiscal
  policy.

Potential GDP is 10 trillion, real GDP is 11
trillion, and
1. There is a 1 trillion inflationary gap.
2. A decrease in government expenditure or a tax
rise decreases expenditure by ?E.
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16.1 THE BUDGET AND FISCAL POLICY

• 3. The multiplier decreases induced expenditure.
  The AD curve shifts leftward to AD1.

The price level falls to 110, real GDP decreases
to10 trillion, and the inflationary gap is
eliminated.
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16.1 THE BUDGET AND FISCAL POLICY

• Discretionary Fiscal Policy Supply-Side Effects
• An increase in government expenditure that
  increase the quantities of productive services
  and capital increases aggregate supply.

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16.1 THE BUDGET AND FISCAL POLICY

• Supply-Side Effects of Taxes
• Taxes decrease the supply of labor and saving.
• A decrease in the supply of labor increases the
  equilibrium real wage rate and decreases the
  equilibrium quantity of labor employed.
• Similarly, a decrease in the supply of saving
  increases the equilibrium real interest rate and
  decreases the equilibrium quantity of investment
  and capital employed.

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16.1 THE BUDGET AND FISCAL POLICY

• With smaller quantities of labor and capital,
  potential GDP decreases, and so does aggregate
  supply.
• So an increase in taxes decreases aggregate
  supply.

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16.1 THE BUDGET AND FISCAL POLICY

• Scale of Government Supply-Side Effects
• If both government expenditure and taxes
  increase, the scale of government increases.
• More productive government expenditure increases
  potential GDP, but higher taxes to pay for the
  expenditure decreases potential GDP.
• Economists disagree on which of these effects is
  stronger.

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16.1 THE BUDGET AND FISCAL POLICY
Figure 16.4 illustrates the effects of fiscal
policy on potential GDP.
1. A tax cut strengthens the incentive to work,
increases the supply of labor, and increases
employment.
2. A tax cut strengthens the incentive to save
and invest, which increases the quantity of
capital and increases labor productivity.
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16.1 THE BUDGET AND FISCAL POLICY
3. The combined effects of a tax cut on
employment and labor productivity increases
potential GDP.
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16.1 THE BUDGET AND FISCAL POLICY

• Combined Demand and Supply Effects
• An increase in government expenditure or a tax
  cut increases equilibrium real GDP but might
  raise, lower, or have no effect on the price
  level.
• Figure 16.5 on the next slides shows the
  supply-side effects of fiscal policy when fiscal
  policy has no effect on the price level.

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16.1 THE BUDGET AND FISCAL POLICY
1. A tax cut increases disposable income, which
increases aggregate demand from AD0 to AD1.
A tax cut also strengthens the incentive to
work, save, and invest, which increases aggregate
supply from AS0 to AS1.
2. Real GDP increases.
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16.1 THE BUDGET AND FISCAL POLICY

• Limitations of Discretionary Fiscal Policy
• The use of discretionary fiscal policy is
  seriously hampered by three factors
• Law-making time lag
• Estimating potential GDP
• Economic forecasting

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16.1 THE BUDGET AND FISCAL POLICY

• Law-Making Time Lag
• 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.

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16.1 THE BUDGET AND FISCAL POLICY

• Estimating Potential GDP
• It is not easy to tell whether real GDP is below,
  above, or at potential GDP.
• So a discretionary fiscal action might move real
  GDP away from potential GDP instead of toward it.
  
• This problem is a serious one because too much
  fiscal stimulation brings inflation and too
  little might bring recession.

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16.1 THE BUDGET AND FISCAL POLICY

• 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 second reason, discretionary fiscal
  action might move real GDP away from potential
  GDP and create the very problems it seeks to
  correct.

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16.1 THE BUDGET AND FISCAL POLICY

• Automatic Fiscal Policy
• A consequence of tax receipts and expenditures
  that fluctuate with real GDP.
• Automatic stabilizers are features of fiscal
  policy that stabilize real GDP without explicit
  action by the government.
• Induced Taxes
• Induced taxes are taxes that vary with real GDP.

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16.1 THE BUDGET AND FISCAL POLICY

• Needs-Tested Spending
• Needs-tested spending is spending on programs
  that entitle suitably qualified people and
  businesses to receive benefits benefits that
  vary with need and with the state of the economy.

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16. 2 THE FED AND MONETARY POLICY

• The Monetary Policy Process
• The Fed makes monetary policy in a process that
  has three main elements
• Monitoring economic conditions
• Making policy decisions
• Reporting to Congress

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16. 2 THE FED AND MONETARY POLICY

• Monitoring Economic Conditions
• Beige Book
• A report that summarizes current economic
  conditions in each Federal Reserve district and
  each sector of the economy.
• The Beige Book is a good source of current
  information about the state of the economy.

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16. 2 THE FED AND MONETARY POLICY

• Meetings of the Federal Open Market Committee
  (FOMC)
• The FOMC, which meets eight times a year, makes
  the monetary policy decisions.
• After each meeting, the FOMC announces its
  decisions and describes its view of the
  likelihood that its goals of price stability and
  sustainable economic growth will be achieved.

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16. 2 THE FED AND MONETARY POLICY

• The Monetary Policy Report to Congress
• Twice a year, in February and July, the Fed
  prepares a Monetary Policy Report to Congress,
  and the Fed chairman testifies before the House
  of Representatives Committee on Financial
  Services.

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16. 2 THE FED AND MONETARY POLICY

• Influencing the Interest Rate
• When the FOMC announces a policy change, its
  press release talks about the federal funds
  interest rate or the discount rate.
• The press release does not talk about the
  quantity of money or the size of the open market
  operations it plans to conduct.
• This impression that the Fed determines interest
  rates rather than the quantity of money is
  misleading to two reason a long-run reason and a
  short-run reason.

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16. 2 THE FED AND MONETARY POLICY

• In the Long Run
• In the long run, the real interest rate is
  determined in global financial markets and the
  inflation rate is determined by the growth rate
  of the quantity of money.
• So in the long run, the Fed influences the
  nominal interest rate by the effects of its
  policies on the inflation rate.
• The Fed does not directly control the nominal
  interest rate, and it has no control over the
  real interest rate.

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16. 2 THE FED AND MONETARY POLICY

• In the Short Run
• In the short run, the Fed can determine the
  nominal interest rate and take actions to set the
  federal funds rate.
• But to do so, the Fed must undertake open market
  operations that change the quantity of money.
• Also, in the short run, the expected inflation
  rate is determined by recent monetary policy and
  inflation experience.
• So when the Fed changes the nominal interest
  rate, the real interest rate also changes,
  temporarily.

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16. 2 THE FED AND MONETARY POLICY

• The Fed Raises the Interest Rate
• Suppose the Fed fears inflation and decides it
  must take action.
• The FOMC instructs the New York Fed to sell
  securities in the open market.
• This action mops up bank reserves. Some banks are
  short of reserves and they seek to borrow
  reserves from other banks.
• The federal funds interest rate rises.

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16. 2 THE FED AND MONETARY POLICY

• With fewer reserves, the banks make a smaller
  quantity of new loans each day until the quantity
  of loans outstanding has fallen to a level that
  is consistent with the new lower level of
  reserves.
• The quantity of money decreases.
• Figure 16.6(a) on the next slide illustrates
  these events.

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16. 2 THE FED AND MONETARY POLICY
1. The current interest rate is 5 percent a year.
2. The FOMCs target interest rate is 6 percent a
year.
3. To raise the interest rate to the target, the
Fed must sell securities in the open market and
decrease the quantity of money to 0.9 trillion.
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16. 2 THE FED AND MONETARY POLICY

• The Fed Lowers the Interest Rate
• If the Fed fears recession, it acts to increase
  aggregate demand.
• The FOMC announces that it will lower the
  short-term interest rates.
• To achieve this goal, the FOMC instructs the New
  York Fed to buy securities in the open market.

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16. 2 THE FED AND MONETARY POLICY

• This action increases bank reserves.
• Flush with reserves, banks now seek to lend
  reserves to other banks.
• The federal funds rate falls.
• With more reserves, the banks increase their
  lending and the quantity of money increases.
• Figure 16.6(b) on the next slide illustrates
  these events.

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16. 2 THE FED AND MONETARY POLICY

• 1. The current interest rate is 5 percent a year.

2. The FOMCs interest rate target is 4 percent a
year.
3. To lower the interest rate to the target, the
Fed must buy securities in the open market and
increase the quantity of money to 1.1 trillion.
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• The Ripple Effects of the Feds Actions
• Suppose that the Fed increases the interest rate.
  
• Three main events follow
• Investment and consumption expenditure decrease.
• The dollar rises, and net exports decrease.
• A multiplier process induces a further decrease
  in consumption expenditure and aggregate demand.

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16. 2 THE FED AND MONETARY POLICY

• Investment and Consumption Expenditure
• The interest rate influences investment and
  consumption expenditure.
• When the Fed increases the nominal interest rate,
  the real interest rate rises temporarily, and
  investment and expenditure on consumer durables
  decrease.

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16. 2 THE FED AND MONETARY POLICY

• The Dollar and Net Exports
• The higher price of the dollar means that
  foreigners must now pay more for U.S.-made goods
  and services.
• So the quantity demanded and the expenditure on
  U.S.-made items decrease. U.S. exports decrease.

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16. 2 THE FED AND MONETARY POLICY

• Similarly, the higher price of the dollar means
  that Americans now pay less for foreign-made
  goods and services.
• So the quantity demanded and the expenditure on
  foreign-made items increase.
• U.S. imports increase.

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16. 2 THE FED AND MONETARY POLICY

• The Multiplier Process
• Taking these effects together, investment,
  consumption expenditure, and net exports are all
  interest-sensitive components of expenditure.
• So a rise in the interest rate brings a decrease
  in aggregate expenditure.

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16. 2 THE FED AND MONETARY POLICY

• The decrease in expenditure decreases incomes,
  and the decrease in income induces a decrease in
  consumption expenditure.
• The decreased consumption expenditure lowers
  aggregate expenditure.
• Real GDP and disposable income decrease further,
  and so does consumption expenditure.
• Real GDP growth slows, and the inflation rate
  slows.

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16. 2 THE FED AND MONETARY POLICY

• Figure 16.7(a) shows ripple effects of the Feds
  actions when the Fed raises the interest rate.

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16. 2 THE FED AND MONETARY POLICY

• Figure 16.7(a) shows ripple effects of the Feds
  actions when the Fed lowers the interest rate.

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16. 2 THE FED AND MONETARY POLICY

• Monetary Stabilization in the AS-AD Model
• The Fed Tightens to Fight Inflation
• Real GDP exceeds potential GDP and the Fed Fears
  inflation.
• Figure 16.8 illustrates how the Feds policy
  works.

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16. 2 THE FED AND MONETARY POLICY
The curve ID is the investment demand curve.
The interest rate is 5 percent a year and
investment is 2 trillion.
1. The Fed raises the interest rate and the
quantity of investment decreases.
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• 2. Expenditure decreases by ?I.

3. The multiplier induces additional expenditure
cuts. The aggregate demand curve shifts to AD1.
Real GDP decreases to potential GDP, and
inflation is avoided.
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16. 2 THE FED AND MONETARY POLICY

• The Fed Eases to Fight Recession
• Real GDP is below potential GDP and the Fed fears
  recession.
• Figure 16.9 illustrates how the Feds policy
  works.

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16. 2 THE FED AND MONETARY POLICY
The curve ID is the investment demand curve.
The interest rate is 5 percent a year and
investment is 2 trillion.
1. The Fed lowers the interest rate and the
quantity of investment increases.
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• 2. Expenditure increases by ?I.

3. The multiplier induces additional expenditure.
The aggregate demand curve shifts to AD1.
Real GDP increases to potential GDP, and
recession is avoided.
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• The Size of the Multiplier Effect
• The size of the multiplier effect of monetary
  policy depends on the sensitivity of expenditure
  plans to the interest rate.
• The larger the effect of a change in the interest
  rate on aggregate expenditure,
• The greater is the multiplier effect and
• The smaller is the change in the interest rate
  that achieves the Feds objective.

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• Limitations of Monetary Stabilization Policy
• Monetary policy has an advantage over fiscal
  policy because it cuts out the law-making time
  lags.
• But monetary policy shares the other two
  limitations of fiscal policy
• Estimating potential GDP is hard.
• Economic forecasting is error-prone.

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Fiscal Policy and Monetary Policy in YOUR Life

• Consider the U.S. economy right now.
• Is the U.S. economy at full employment or is
  there a recessionary gap or an inflationary gap?
• What type of fiscal policy or monetary policy
  would you recommend?

What do recent changes in policy say about the
governments and the Feds view of the state of
the economy? How do you think recent changes in
fiscal policy and monetary policy will affect you?