Isues in economics today 6th by guell chapter09

Chapter 09 Fiscal Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc All rights reserved Chapter Outline • Nondiscretionary And Discretionary Fiscal Policy • Using Fiscal Policy To Counteract “Shocks” • Evaluating Fiscal Policy • Obama Stimulus Plan • Kick It Up a Notch: Aggregate Supply Shocks McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-2 1-2 Fiscal Policy • Fiscal Policy is the purposeful movement in government spending or tax policy designed to direct an economy • Discretionary Fiscal Policy: government spending and tax changes enacted at the time of the problem to alter the economy • Nondiscretionary Fiscal Policy: that set of policies that are built into the system to stabilize the economy McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-3 1-3 How Nondiscretionary Fiscal Policy Works • Nondiscretionary fiscal policy consists of policies that are built into the system so that an expansionary or contractionary stimulus can be given automatically • The welfare state and the progressive income tax serve as the built-in policies • If the economy is in recession, those who lose their jobs are granted unemployment and welfare benefits and they owe less in taxes • If the economy is growing at an unsustainable rate, people are making a lot of money and are faced with higher tax rates and there are fewer people eligible for government benefits McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-4 1-4 How Discretionary Fiscal Policy Works • If we are in a recession the fiscal policy to stimulate the economy would consist of • Increases in government spending • Decreases in taxes • If we are in an inflationary period the fiscal policy to contract the economy would consist of • Decreases in government spending • Increases in taxes McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-5 1-5 Expansionary Fiscal Policy PI AS PI’ PI* AD’ AD RGDP* McGraw-Hill/Irwin RGDP’ RGDP ©2012 The McGraw-Hill Companies, All Rights Reserved 9-6 1-6 Contractionary Fiscal Policy PI AS PI* PI’ AD AD’ RGDP’ McGraw-Hill/Irwin RGDP* RGDP ©2012 The McGraw-Hill Companies, All Rights Reserved 9-7 1-7 Shocks • A Shock is any unanticipated economic event • Aggregate Demand Shock: an unexpected event which causes aggregate demand to increase or decrease, e.g the Sept 11, 2001 terrorist attacks • Aggregate Supply Shock: an unexpected event which causes aggregate supply to increase or decrease, e.g Iraq’s 1990 invasion of Kuwait and threat to Saudi Arabia McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-8 1-8 Nondiscretionary and Discretionary Fiscal Policy Combats a Recession PI AS Shock NDFP PI* AD3 DFP AD1 AD2 RGDP* McGraw-Hill/Irwin RGDP ©2012 The McGraw-Hill Companies, All Rights Reserved 9-9 1-9 Nondiscretionary and Discretionary Fiscal Policy Combats an Overheated Economy PI AS Shock NDFP DFP PI* AD2 AD3 AD1 RGDP* McGraw-Hill/Irwin RGDP ©2012 The McGraw-Hill Companies, All Rights Reserved 9-10 1-10 Evaluating Nondiscretionary Fiscal Policy • Most economists believe that the built-in stabilizers have had a modestly positive effect on diminishing the severity of modern recessions McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-11 1-11 The Mistiming of Discretionary Fiscal Policy • Recognition Lag: the time it takes to measure the state of the economy • Administrative Lag: the time it takes for Congress to agree on a course of action with the president • Operational Lag: the time it takes for the full impact of a government program or tax change to have its effect on the economy McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-12 1-12 Political Problems with Fiscal Policy • Expansionary bias is the problem where politicians are more willing to deal with recessions with tax cuts and spending increases than they are to deal with inflationary pressures with tax increases and spending cuts • The Political Business Cycle suggests that politically motivated fiscal policy is used for short term gain just prior to elections McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-13 1-13 The Rise, Fall and Rebirth of Discretionary Fiscal Policy • Between 1975 and 2001 fiscal policy was pretty much abandoned as a mechanism for controlling the economy • Monetary policy was used to expand or contract prices and GDP • In 2001, the impending recession motivated tax rebates and the Sept 11 attacks motivated a variety of tax cut and spending increase ideas in Congress • In 2003, the continuing slow growth motivated a renewal of the tax credit rebate idea McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-14 1-14 Growth Rates by Presidential Terms First Truman Second Third Fourth -0.5% 8.7% 7.7% 3.8% Eisenhower I 4.6% -0.7% 7.1% 1.9% Eisenhower II 2.0% -1.0% 7.1% 2.5% Kennedy/Johnson 2.3% 6.1% 4.4% 5.8% Johnson 6.4% 6.5% 2.5% 4.8% Nixon I 3.1% 0.2% 3.4% 5.3% Nixon II/ Ford 5.8% -0.5% -0.2% 5.3% Carter 4.6% 5.6% 3.2% 0.2% Reagan I 2.5% -1.9% 4.5% 7.2% Reagan II 4.1% 3.5% 3.4% 4.1% Bush GHW 3.5% 1.9% -0.2% 3.3% Clinton I 2.7% 4.0% 2.5% 3.7% Clinton II 4.5% 4.2% 4.4% 3.7% Bush GW I 0.8% 1.9% 3.0% 4.0% Bush GW II 3.2% 3.3% 2.2% -2.8% Obama 0.2% 2.8% Average 3.1% 2.8% 3.7% 3.5% McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-15 1-15 The 2003 Rebate McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-16 1-16 Obama Stimulus Plan Stimulus Plan Element Non-Discretionary Fiscal Policy: Unemployment, Welfare, Medicaid Aid to States Amount in Millions $135,832 $53,600 Discretionary Fiscal Policy: Tax Cuts $301,135 Discretionary Fiscal Policy: Spending Increases $300,047 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-17 1-17 Kick it Up a Notch Aggregate Supply Shocks McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 9-18 1-18 Nondiscretionary and Discretionary Fiscal in the Wake of a Negative Aggregate Supply Shock AS PI Shock AS1 NDFP DFP AD3 PI* AD1 RGDP* McGraw-Hill/Irwin AD2 RGDP ©2012 The McGraw-Hill Companies, All Rights Reserved 9-19 1-19 Nondiscretionary and Discretionary Fiscal in the Wake of a Positive Aggregate Supply Shock PI AS1 Shock AS2 PI* NDFP AD2 RGDP* McGraw-Hill/Irwin AD1 RGDP ©2012 The McGraw-Hill Companies, All Rights Reserved 9-20 1-20 ... Policy Works • If we are in a recession the fiscal policy to stimulate the economy would consist of • Increases in government spending • Decreases in taxes • If we are in an inflationary period the... variety of tax cut and spending increase ideas in Congress • In 2003, the continuing slow growth motivated a renewal of the tax credit rebate idea McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies,... with recessions with tax cuts and spending increases than they are to deal with inflationary pressures with tax increases and spending cuts • The Political Business Cycle suggests that politically