Fiscal Policy (03/06/17)

Fiscal Policy  

How does the government stabilize the economy?

The government has 2 different tool boxes it can use:

1. Fiscal Policy

Actions by congress to stabilize the economy.

2.Monetary Policy

Actions by the Federal reserve bank to stabilize the economy.

Fiscal Policy

Changed in expenditures or/and revenues of the federal government

- 2 tools of fiscal policy:

• Taxes- government can increase or decrease taxes.
• Spending- government can increase or decrease spending
• Fiscal Policy is enacted to promote our nation's economic goals: full employment, price stability, economic growth

Deficit, Surpluses, and Debt

• Balanced budget

-Revenues = Expenditures

• Budget Deficit

- Revenues > Expenditures

• 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

- Financial institutions

- Foreign entities of foreign governments

Fiscal Policy

• Discretionary Fiscal Policy(action)

• Expansionary Fiscal Policy - think deficit

• Contractionary Fiscal Policy - think surplus

•  Non- Discretionary Fiscal Policy ( no action)

3 Types of Taxes

1. Progressive Taxes- takes a larger percent of income from high income group (takes more from rich people).

Ex.: Current Federal Income Tax system.

2. Proportional Taxes (flat rate) - takes the same percent of income from all income groups.

Ex.: 20% flat income tax on all income groups.

3. Regressive Tax- takes a larger percentage from low income group (takes more from poor people)

Ex.: Sales Tax; any consumption tax.

Contractionary Fiscal Policy ( The Brakes)

Laws that reduce inflation, decrease GDP (Close a inflationary Gap)

• Decrease Government spending
• Tax Increases
• Combination of the two

If in a Inflation, then G↓.: AD←.: GDPR↓ & PL↓.: u%↑ & π↓ or T↑.: DI↓.: C↓.: AD←.: GDPR↓ & PL↓.: u%↑ & π↓

  Expansionary Fiscal Policy (The Gas)
Laws that reduce unemployment and increase GDP (Close Recessionary Gap)

• Increase Government spending

• Decrease Taxes on consumption

• Combination of the two

If Recession, then G↑.: AD→.: GDPR↑ & PL↑.: u%↓ & π↑ or T↓.: DI↑.: C↑.: AD→.: GDPR↑ & PL↑.: u%↓ & π↑

• Anything that increases the government budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policy makers.

1.    Transfer Payments

Automatic or Built - In Stabilizers

A. Welfare checks

B. Food Stamps

C. Unemployment checks

D. Corporate dividends

E. Social Security 

F. Veteran's benefits

Schools of Economics (02/28/17)

Classical vs Keynesian   

More information:

http://smallbusiness.chron.com/differences-between-classical-keynesian-economics-3897.html

3 Ranges of AS (02/27/17)

3 Ranges of AS 

Reasons why price tend to be inflexible or "sticky" in a downward direction:

1. Fear of Wars

2. Wage Contracts

3. Minimum Wage

4. Menu Cost

5. Moral, effort and productivity

Range 1 (Horizontal range/ Keynesian model)

• Output is low relative to the economies full employment output
• Unemployment increases & GDP decreases.

Range 2 (Intermediate model)

Output expands as savings increases.

Range 3 (Vertical or Classical range)

• In the Long- Run the A.S. curve is vertical, because the only effects of an increase in AD, when we are at full employment  or an increase at the price level.
• Firms can't respond to increase in demand by increasing output

The Spending Multiplier (02/24/17)

The Spending Multiplier Effect 

·         An initial change in spending (C, I_G, G, X_N) causes a larger change in aggregate spending or Aggregate Demand (AD).

·         Multiplier = Change in AD / Change in Spending = ∆ AD / ∆ C, I_G, G or X_N

·         Why does this happen?

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

Calculating the Spending Multiplier

·         The Spending Multiplier can be calculated from the MPS or the MPC.

·         Multiplier = 1 / 1 – MPC or 1 / MPS

Calculating the Tax Multiplier

·         When the government taxes, the multiplier works as reverse.

·         Why?

-          Because now money is leaving the circular flow

·         Tax multiplier (note: it’s negative)

-          = - MPC / 1 – MPC or - MPC / MPS

·         If  there is a tax – CUT, then then the multiplier is +, because there is now more money in the circular flow.

Consumption and Saving (2/23/17)

• Disposable Income (DI)

- Income after taxes or net income

- DI = Gross Income - Taxes

2 Choices

• With disposable income, households can either:

- Consume (spend money on goods & services)

- Save (not spend money on goods & services)

Consumption

• Household spending
• The amount to consume is constrained by:

- The amount of disposable income

- The 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 is constrained by:

- The amount of disposable income

- The propensity to consume

• Do households save if DI = 0

- NO

• APS = S / DI = % DI that is not spent

APC & APS

• ·         APC + APS = 1
• ·         1  –  APS = APS
• ·         1  – APS = APC
• ·         APC > 1 .: Dissaving
• ·          - APS.: Dissaving

MPC & MPS

• ·         Marginal Propensity to Consume

- ∆C / ∆DI

- % of every extra dollar earned that is spent

• ·         Marginal Propensity to Save

- ∆S / ∆DI

- % of every extra dollar earned that is saved

• ·         MPC + MPS = 1
• ·         1 – MPC = MPS
• ·         1 – MPS = MPC

Determinants of C & S 

• Wealth
• Expectation
• Household Debt
• Taxes

      Practice at:
    http://teachersites.schoolworld.com/webpages/KKrejnik/files/day%2020%20practice%20problems%20multiplier%20effect.pdf

The AS/AD Model (2/22/17)

• The equilibrium of AS & AD determines the current output (GDP_R) and the price level (PL)

Full employment 

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

Inflationary Gap

Output is high and unemployment is less than NRU

Note: An inflationary gap caused by a rightward shift in AD is also known as 'demand pull inflation'

Recessionary Gap 

Output is low and unemployment is more than NRU.

Lower GDP = More Unemployment & Lower Income!

Changes (∆) in AD
↑↓→←∆

• ∆ Consumption (C)

- C↑ .: AD→ .: GDP_R↑ &PL↑ .: u%↓ & π%↑

- C↓ .: AD← .: GDP_R ↓ & PL↓ .: u%↑ & π%↓

• ∆ Gross Private Investment (I_G)

- I_G↑ .: AD→ .: GDP_R↑ & PL↑ .: u%↓ & π%↑

- I_G↓ .: AD← .: GDP_R ↓ & PL↓ .: u%↑ & π%↓

• ∆ Government Spending (G)

- G↑ .: AD→ .: GDP_R↑ & PL↑ .: u%↓ & π%↑

- G↓ .: AD← .: GDP_R ↓ & PL↓ .: u%↑ & π%↓

• ∆ Net Exports (X_N)

- X_N↑ .: AD→ .: GDP_R↑ & PL↑ .: u%↓ & π%↑

- X_N↓ .: AD← .: GDP_R ↓ & PL↓ .: u%↑ & π%↓

Decrease in AD

Increase in AD

Change (∆) in SRAS

• ∆ Input Prices

- Input Prices↓  .: SRAS → .: GDP_R↑ & PL↓ .: u%↓ & π%↓

- Input Prices↑  .: SRAS ← .: GDP_R ↓ & PL↑ .: u%↑ & π%↑

• ∆ Productivity

- Productivity↑  .: SRAS → .: GDP_R↑ & PL↓ .: u%↓ & π%↓

- Productivity↓  .: SRAS ← .: GDP_R ↓ & PL↑ .: u%↑ & π%↑

• ∆ Legal-Institutional Environment

- Deregulation .: SRAS → .: GDP_R↑ & PL↓ .: u%↓ & π%↓

- Regulation .: SRAS ← .: GDP_R ↓ & PL↑ .: u%↑ & π%↑

Increase in SRAS

Decrease in SRAS

Interest rates & Investment Demand & LRAS V SRAS (2/21/17)

Interest rates & Investment Demand

What is Investment

• Money spent on expenditures on:

- New plants (factories)

- Capital equipment (machinery)

- Technology (hardware &software)

- New homes

- Investment (goods sold by producers)

Expected Rates of Return

• How does business make investment decisions?

- Cost / Benefit Analysis

• How does business determine the benifits?

- Expected rate of return

• How does business count the cost?

- Interest costs

• How does business determine the amount of investment they undertake

- Compare expected rate of return to interest cost

- If expected rate of return > I.C., then invest

- If expected rate of return < I.C., then do not investment

Real (r%) v Nominal (i%)

• How do you compute the real interest rate ( r%)

r% = i% -  π% 

• What there determines the cost of an investment decision?

- The real interest rate (r%)

Investment Demand Curve (ID)

• What is the shape of the investment?

-Downward slopping

• Why?

When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable.

Shifts in Investment Demand

- Cost of Production

- Business taxes

- Stock of Capital

- expectations

Long-Run v. Short-Run

Long-Run Aggregate Supply (LRAS)

• The Long-Run aggregate supply marks the level of full employment in the economy (analogous to the PPC)

only thing that shifts will be the determinants

Y_f – full employment

Short-Run Aggregate Supply (SRAS)

• Because input prices are sticky in the shhort-run, the SRAS is upward slopping

Changes in SRAS

•  An increase in SRAS is seen as a shift to the right. SRAS ->
• A decrease in SRAS is seen as a shift to the left. SRAS <-
•  The key to understanding shift in SRAS is per unit cost of production.

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

Changes in SRAS

(increases/ decreases) 

Determinants of SRAS

• Input Prices
• Productivity
• legal Institutional Environment

Input Prices

• Domestic Resource Prices

- Wages (75% of all business costs)

- Cost of capital

- Raw materials (commodity prices)

• Market Power

- Monopolies and cartels that control resources control the price of those resources

 Increase in Resource Prices = SRAS <-

 Decrease in Resource Prices = SRAS ->

Productivity

• Productivity = total output / total  input
• More productivity =  lower unit production cost = SRAS ->
• Less productivity =  higher unit production cost = SRAS <-

Legal Institutional Environment

• Taxes and Subsidies

- Taxes ($ to gov't) on business increase per unit of production cost = SRAS <-

- Subsidies ($ from gov't) to  business reduce per unit of production cost = SRAS ->

• Government Regulation

- Government regulation creates a cost of compliance = SRAS <-

- Deregulation reduces compliance costs = SRAS ->

Aggregate Demand Curve (02/16/17)

Aggregate Demand Curve

Is the demand by consumer business, governmental, and foreign countries.

Changes in price level cause a move along the curve not a shift of the curve.

AD

Shows the amount of Real GDP that the private, public and foreign sector collectives desire to purchase at each possible price level.
- the relationship between the price level and the level of Real GDP is inverse.

3 reasons of Downward slopping

1. Wealth Effect

• High prices reduce purchasing power of $
•  Lowering the price level increases the purchasing power and increases expenditure.

2. Interest-Rate Effect

• As price level increase, lender needs to charge higher interest rates to get a real return in their loans.
•  Higher interest rate discourages consumer spending and business investment.

3. Foreign trade effect

• When U. S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods.
• Exports fall and imports rise causing Real GDP demand to fall.(Xn decreases)

Ex.: If prices triples in the U.S., Canada will no longer buy U.S. goods causing quantity demanded of

 U.S. products to fall.

Shifts in Aggregate Demand

There are two types to a shift in AD:

• A change in C, Ig, G and/or Xn
• A multiplier effect that produces a greater change than the original change in the 4  components.

Increases in AD = AD =>

Decreases in AD = AD =>

Determinants of AD

•  Consumption (C)
• Gross Private Domestic Investment (Ig)
• Government Spending (G)
• Net Exports (Xn) = Exports - Imports (X-M)

1. Change in consumer spending

- Consumer Wealth (Boom on the Stock Market)

- Consumer Expectations ( People fear a recession)

- Households Indebtedness ( More consumers debt)

- Taxes ( Decreases in income taxes)

2. Change in Investment Spending

- Real Interest Rate (Price of borrowing $)

(If interest rate increases ... )

(If interest rate decreases ... )
- Future Business expectations (High expectations...)
- Productivityand Technology (New Robots...)
- Business taxes (Higher corporate taxes mean...)

3. Change in Government Spending

(War...) (Nationalized Health Care...)
(Decrease in defense spending)

4. Change in Net Exports (X-M)

- Exchange rates. Ex.: If the U.S. dollar depreciates relative to the euro.

National Income Compared to Abroad

(If a major importer has a recession)

( If the U.S. has a recession )

Ex.:  "If the U.S. gets a Cold, Canada gets Pneumonia"

AD = GDP = C + I + G + Xn

Government Spending

• More government spending (AD =>)
• Less government spending (AD <=)

Further understanding:

https://www.tutor2u.net/economics/reference/aggregate-demand-ad