Step 20: Fiscal Policy (End of Unit 3)

Fiscal Policy

• changes in expenditures or tax revenues of the federal government

Two Tools of Fiscal Policy (ONLY TWO OPTIONS)

1. taxes - government can increase or decrease taxes
2. spending - government can increase or decrease spending

Fiscal Policy was enacted to promote our nation's economic goals :

• Full Employment
• Price Stability
• Economic Growth

Deficits, Surpluses, and Debt

• Balanced Budget
• revenues = expenditures
• what you bring out, you bring in
• Balanced Deficit
• revenues < expenditures
• you bring out more than you bring in
• Balanced Surplus
• revenues > expenditures
• you bring in more than you bring out
• Government Debt
• sum of all deficits - sum of all surpluses
• government must borrow money when it runs a budget deficit
• government borrows from :
• individuals
• corporations
• taken from both of these by taxes
• financial institutions
• foreign entities or foreign governments
• taken from both of these by buying land or investing

Fiscal Policy Two Options

1. Discretionary Fiscal Policy (action)
• Expansionary fiscal policy - think deficit (recession)
• Contractionary fiscal policy - think surplus (inflation)
2. Non - Discretionary Fiscal Policy (no action)
• Allow what happens in the economy to fix itself
• Laissez - faire
• invisible hand

Discretionary v.s. Automatic Fiscal Policies

• Discretionary
• increasing or decreasing of government spending and or taxes in order to return economy to Full Employment
• discretionary policy involves policy makers doing fiscal policy in response to an economic problem
• Automatic
• unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation
• automatic fiscal policy takes place without policy makers having to respond to the current economic problem

Contractionary v.s. Expansionary Fiscal Policy

• Contractionary Fiscal Policy -
• a policy designed to decrease AD
• strategy for controlling inflation
• decrease in government spending
• increase in taxes

• Expansionary Fiscal Policy -
• a policy designed to increase AD
• strategy for increasing GDP
• combating recession
• increase in government spending
• decrease in taxes
• reducing unemployment

Automatic / Built - In Stabilizers

• anything that increases government's budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policy makers
• tax reduce spending and AD
• reduction in spending is desirable when the economy is moving towards inflation
• increase in spending is desirable when the economy is moving towards a recession
• President is not in charge of fiscal policy, Congressmen are
• Examples of Built - In Stabilizers :
• food stamps
• social securities
• welfare checks
• unemployment checks
• corporation dividends
• veteran's benefits
• (transfer payments)
• 33 - 50 % are taken out of economy
• When the economy goes down, the President steps in to fix the problem.

Progressive Tax System

• average tax rate (tax revenue / GDP) rises with GDP

Proportional Tax System

• average tax rate remains constant as GDP changes

Regressive Tax System

• average tax rate falls with GDP

Step 19: Multiplication

Disposable Income (DI)

-Income after taxes; "net income"

-Formula: DI = Gross Income - Taxes

You can either:

• Consumer - spend money on goods and services
• Save - not spend money on goods and services

Consumption (household spending)

-The ability to consume is constrained by:

Amount of DI

Propensity to save

-Do households consume if DI = 0?

Autonomous consumption

Dissaving

-APC: C/DI = % DI that is spent

Saving (household not spending)

-The ability to save in constrained by:

Amount of DI

Propensity to consume

-Do household save if DI = 0?

No

-APS: S/DI = % DI that is not spent

APC and APS (Average Propensity to Consume/Save)

-APS+APC = 1

-1-APC = APS

-1-APS = APC

-APC > 1.: Dissaving

-(-APS) .: Dissaving

MPC and MPS (Marginal Propensity to Consume/Save)

-MPC

Change in C/Change in DI

% of every extra dollar earned that is spent

-MPS

Change in S/Change in DI

% of every extra dollar earned that is saved

-MPC+MPS = 1

-1-MPC = MPS

Spending Multiplier Effect

-an initial change in spending (C, Ig, G, and Xn) causes a larger change in AS or AD

-Multiplier = change in AD/change in C, Ig, G, or Xn

WHY?

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

-Formula: 1/1-MPC or 1/MPS

-Multipliers are positive where there is an increase in spending and negative when there is a decrease

Tax Multiplier

-when the government taxes, the multiplier works in reverse because money leaves circulation

-is always negative

-Formula: = -MPC/1-MPC or -MPC/MPS

-if there is a tax cut, the tax multiplier is positive because there is more money in circulation

Step 18: Schools of Economics

Three Schools of Economics

Classical

Names to know:

• Adam Smith
• John B. Say
• David Ricardo
• Alfred Marshal

-competition is good

-Smith: invisible hand - market will function by itself

-Say's Law - supply creates its own demand = AS determines output

-In the LR, the economy will balance at full employment

-The economy is always close to or at full employment

-AS = AD at FE equilibrium

-Trickle-Down Effect: Help the rich first, everyone else come after

-Savings (leakage) = Investment (injection)

-Savings increase with interest rate

-Prices and wages are flexible downward

-Laissez-faire: government can't touch the economy

Keynesian

Name to know:

• John Maynard Keynes

-competition is flawed

-AD is key, not AS = AD determines output; demand creates its own supply

-Leaks cause constant recessions; savings cause recessions

-Savers and investors save and invest for different reasons

-Savings = Inverse to Interest Rate

-Ratchet Effects and Sticky wages block Say's Law

-Prices and wages are inflexible downward

-Since no mechanism capable of guaranteeing FE, in the LR, we're all dead

-Economy is not always close to or at FE

-Gov't interventions exist
-Use Fiscal Policy (Expansionary and Contractionary)
-Add stabilizers

Monetary

Names to know:

• Allen Greenspan
• Ben Bernanke

-fine tuning needed

-voters won't allow contractionary options

-Congress can't time policy options

-easy money and tight money
-change required reserves if needed

-buy sell bonds through open market operations

-use interest rate to change the discount and federal fund rate

Step 17: Where's your ID (investment demand curve)?

Investment Demand Curve (ID)

-shape?: downward sloping

-why?: interest rates high = fewer profitable investments, vice versa

Shifts in ID

• Cost of production
  -lower costs shifts ID to the right, vice versa
  
• Business taxes
  -lower business taxes shift ID to the right, vice versa
  
• Technological change
  -new technology shifts ID to the right
  -lack of technology shifts ID to the left
  
• Stock of Capital
  -if an economy is low on capital, ID shifts to the right, vice versa
  
• Expectations
  -positive expectations shifts ID to the right, vice versa

LRAS

• always vertical at FE
• represents a point on an economy's PPC
• doesn't change as PL changes
• What change it? The same things that change PPC outward
  -change in resources, technology, and economic growth

Step 16: Help Wanted

Full Employment (FE)

-FE equilibrium exists where AD intersects

Recessionary Gap

-Exists when equilibrium occurs below FE output
-AD shifts left and decreases

Inflationary Gap

-Exists when equilibrium occurs beyond FE output
-AD shifts right and increases

Interest rate and Investment Demand

Investment - money spent or expenditures on:

• new plants (factories)
• capital equipment (machinery)
• technology (hardware and software)
• new homes
• inventories (goods sold by producers)

Expected Rates of Return

• How does business make investment decisions?
  -cost/benefit analysis
• How does business determine the benefits?
  -interest costs
• How does business determine the amount of investment they undertake?
  -if expected return > interest costs, invest
  -if expected return < interest costs, don't invest

Real (r%) v. Nominal (i%)

• What's the difference?
  -nominal is the observable rate of interest. Real subtracts out inflation (π%) and is only ex post facto
• How do you compute the real interest rate (r%)?
  r%= i%(nominal interest rate) - π%(inflation)
• What determines the cost of an investment decision?
  -the real interest rate (r%)

Step 15: LRAS and SRAS

Aggregate Supply

-The level if Real GDP that firms will produce at a each price level

Long and Short Run

Long Run:
-The period of time where input prices are completely flexible and adjust to changes in price level
-Real GDP level supplies is independent of price level

Short Run:
-The period of time where input prices are sticky and do not adjust to changes in 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 LRAS marks the level of full employment in the economy (analogous to PPC) because input are completely flexible in the Long Run, change in price level do not change firms' real profits and therefore do not change firms' level of output. This means that the LRAS is vertical at the economy's level of full employment (FE)

Short-Run Aggregate Supply (SRAS)

-SRAS is upward sloping because input is sticky. Reflects the fact in the short run, input prices increase
-Change in SRAS: an increase shifts that graph to the right and vice versa.
-The key to understanding shifts in SRAS is per unit cost of production
-Formula for Per-Unit Production Cost= total input cost/total output cost

Determinants of SRAS

1. Input Prices
   -Domestic
   ~Wages - 75% of was employers payout
   ~Raw Materials
   ~Cost of Capital
   -Foreign Resource Prices
   ~Strong Dollar = lower foreign resource prices
   ~Weak Dollar = higher foreign resource prices
   -Market Power
   ~Monopolies and cartels that control resources and control the price of those resources
   ~Increases in resource prices = SRAS shifts to the left
   ~Decreases in resources prices = SRAS shifts to the right
   
2. Productivity
   -More productivity = lower unit production cost = SRAS shifts right
   -Lower productivity = higher unit production cost = SRAS shifts left
   -Formula: total output/ total input
   
3. Legal-Institutional Environment
   -Taxes and Subsidies
   ~taxes (money to government) on business increase per unit production cost = SRAS shifts left
   ~subsidies (money from government) on business reduce per unit production cost = SRAS shifts right
   -Government regulation
   ~Government regulation creates a cost of compliance = SRAS shifts left
   ~Deregulation reduces compliance cost = SRAS shifts right

Step 14: What's Aggregate mean? (Start of Unit 3)

Aggregate Demand

• shows amount of real GDP that the private, public, and foreign sector collectively desire to purchase at each possible price level
• relationship between price level and level of real GDP is inverse, which means as price level goes up, real GDP goes down.

Three reasons why Aggregate Demand AD is downward sloping

1. Real-Balance Effect

• when price level (PL) is high, households and businesses cannot afford to purchase as much output
• when PL is low, households and businesses can afford to purchase as much output

    2.  Interest-Rate Effect 

• higher PL increases interest rate, which tends to discourage investment
• lower PL decreases interest rate, which tends to encourage investment

    3. Foreign Purchases Effect

• higher PL increases demand for relatively cheaper inputs
• lower PL increase foreign demand for relatively cheaper U.S. exports

Shifts in AD

• Two parts to shift in AD
  -change in C, Ig, G, and/or Xn
  -multiplier effect that produces greater change than the original change in the four components
• increase in AD shifts the graph to the right
• decrease in AD shifts the graph to the left

Consumption

• Household spending is affected by:
  
  -Consumer wealth
  More wealth means more spending, which shifts AD to the right
  Less wealth means less spending, which shifts AD to the left
  
  -Consumer expectations
  Positive expectations means more spending, which shifts AD to the right
  Negative expectations means less spending, which shifts AD to the left
  
  -Household indebtedness
  Less debt means more spending, which shifts AD to the right
  More debt means  less spending, which shifts AD to the left
  
  -Taxes
  Less taxes mean more spending, which shifts AD to the right
  More taxes mean less spending, which shifts AD to the left

Gross Private Investment

• Investment Spending is sensitive to:
  
  -Real Interest Rate
  Lower real IR means more investment, which shifts AD to the right
  Higher real IR means less investment, which shifts AD to the left
  
  -Expected Returns
  Higher expected returns mean more investment, which shifts AD to the right
  Lower expected returns means less investment, which shifts AD to the left
  Expected returns are influenced by:
  ~expectations in future profitability
  ~changes in technology
  ~degree of excess capital (Existing Stock of Capital)

Government Spending

• More government spending shifts AD to the right
• Less government spending shifts AD to the left

Net Exports

• Net Exports are sensitive to:
  Exchange Rates (internet value of money)
  -Strong money = more imports and lower exports, which shifts AD to the left
  -Weak money = fewer imports and more exports, which shifts AD to the right
  Relative Income
  -Strong foreign economy = more exports = AD shifts right
  -Weak foreign economy = less exports = AD shifts left

Step 13: Who's broke? (End of Unit 2)

Unemployment

-% of people who don't have a job but are part of the labor force

Labor Force

-# of people classified as either employed or unemployed

Unemployment Rate

-Calculated by:

[# of Unemployed/(# of Unemployed  +  # of Employed)]  x  100

-Not in the labor force:

• kids
• retired people
• military personnel
• mentally insane
• incarcerated
• stay @ home parents
• full-time students
• discouraged workers: anyone looking for work but has no job

Full Employment (FE)

-Occurs when there's no cyclical unemployment present in the economy
-Natural rate of Unemployment (NRU)  =  4-5%
-Achieved when labor markets are balanced

Pros and Cons to unemplyment

Pros:
-There is less pressure to raise wages
-More workers are available for expansion

Cons:
-Not enough consumption (GDP)
-Too much poverty
-Too much governmental assistance

Okun's Law

-for every 1% of unemployment above the natural rate of unemployment, causes a 2% decline in GDP

Structural Unemployment  +  Frictional Unemployment

Types of Unemployment

-Good/Okay

• Frictional: Voluntary; b/t jobs b/c you choose a new lifestyle, opportunity, and/or education level
• Seasonal: People wait for the right season to conduct their trade

-Bad

• Cyclical: Associated w/ downturns in business cycles; bad for society and the individual
• Structural: Associated w/ lack of skills or decline in industry or change in technology

Official Employment Statistics

Start with total population of the U.S.

-subtract those under 16

-subtract those in the armed forces

-subtract those that are institutionalized

This leaves the "Non Institutional Adult" population

-subtract those that are already retired

-subtract homemakers

-subtract full-time students over 16

-subtract the discouraged

This leaves the "Civilian Labor Force"

-count employed full or part-time

-count employed unpaid workers in the family business

-count those on sick leave, on strike, or on vacation

-count unemployed, but are actively looking for work

This becomes the "Unemployment Rate" in %

0 - 3% : overextended economy, war economy

4 - 5% : "Full Employment" Unemployment Rate (Efficient)

6 +% : "Weak" Economy or "Recession" Economy

25 % : Highest official unemployment rate in 1933

Step 12: Inflation of Prices

Inflation

• rise in general level of prices
• standard rate: 2% to 3%

Measuring Inflation 

• Inflation Rate
• measures percentage increase of price level over time
• key indicator of economy's health
  
• Deflation
• decline in general price level
• Disinflation
• occurs when inflation rate itself declines
• Consumer Price Index (CPI)
• measures inflation by tracking the yearly price of a fixed basket of goods and services
• indicates changes of cost of living and price level

Solving Inflation Problems

• Finding inflation rate using market basket data

((current year market basket data - base year market basket data) / base year market basket data) x 100

• Finding inflation rate using price indexes

((current year price index - base year price index) / base year price index) x 100

• Estimating inflation rate using the rule of 70
• used to calculate number of years it takes for price level to double at any given rate

years needed to double inflation = 70 / annual inflation rate

• Determining real wages

(nominal GDP / price level) x 100

• Finding real interest rate

 nominal interest rate - inflation premium

• Real interest rate
• cost of borrowing or lending money adjusted (expressed as %) for expected inflation
• Nominal interest rate
• unadjusted cost of borrowing or lending money

Causes of Inflation

• Demand - pull inflation
• caused by excess of demand over output that pulls prices upward
• Cost - push inflation
• caused by rise in per unit production cost due to increase of resource cost

Effects of Inflation

Anticipated v.s. Unanticipated inflation

Hurt by Inflation

• fixed income
• savers
• lenders/creditors

Helped by Inflation

• borrowers
• debt will be repaid with cheaper dollars than that which was loaned out*
• fixed contract