Fiscal Policy

*Changes in the expenditures or tax revenues of the federal government.

-2 tools of fiscal policy: controlled by congress

• Taxes – government can increase or decrease taxes
• Spending – government can increase or decrease spending

Balanced budget

   -Revenues = Expenditures

  Budget deficit

   -Revenues < Expenditures

  Budget Surplus

   -Revenues >Expenditures

  Government Debt: Sum of all deficits – sum of all surpluses

  Government Borrows money when it runs a budget deficit from:

   -Individuals

    -Corporations

   -Financial Institutions

   -Foreign entities or foreign governments

        Discretionary Fiscal Policy (  action )

    Expansionary fiscal policy – think deficit

    Contractionary fiscal policy – think surplus

      

       Non –Discretionary Fiscal Policy ( no action )

Discretionary:	Automatic:
-Increasing or decreasing government spending and/or taxes in order to return economy to full employment. -Involves policy makers doing fiscal policy in response to an economic problem.	-Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate effects of a recession and inflation. -Automatic fiscal policy takes place without policy makers.

   Contractionary Fiscal Policy – policy designed to decrease aggregate demand

• Strategy for controlling inflation

   Expansionary Fiscal policy – to increase aggregate demand

• Strategy for GDP combating recession and reducing unemployment

 Expansionary - Increase government spending (G increases) and decrease Taxes ( T decreases )

 Contractionary - Decrease government spending  (G decreases) and increase taxes  ( T increases )

Automatic or Built in stabilizers occur without government intervention.

1. Transfer Payments

      -Welfare Checks

      -Food Stamps

      -Unemployment Checks

      -Corporate Dividends

      -Social Security

      -Veteran’s benefits

    2. Progressive income taxes

-Automatic stabilizers take 33-50% out

   Progress 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 fall with GDP 

Disposable Income

*Disposable Income*
Is what you bring home
-Income after taxes or net income
DI = Gross income - Taxes
Two choices: with disposable income, households can either...

1. Consume (spend money on goods and services)
2. Save (not spend money on goods and services)

Consumption: 
-Household spending
-the ability to consume is constrained by:
     *the amount of disposable income
     *the propensity to save
-Do households consume if DI = 0?
     -Autonomous consumption
     -Dissaving

Average Propensity to Consume
-APC = C/Di = % of 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

Average Propensity to Save
-APS = S/DI = % of DI that is not spent

APC and APS:
APC + APS = 1    1 - APC = APS    1 - APS = APC
APC > 1  Dissaving          -APS Dissaving

Marginal Propensity to Consume
-MPC = ΔC/ΔDI  % of every dollar earned that is spent

Marginal Propensity to Save
-MPS = ΔS/ΔDI  % of every extra dollar earned that is saved

MPC + MPS = 1     1 - MPC = MPS     1 - MPS = MPC

The Spending Multiplier Effect:
-An initial change in spending causes a larger change in aggregate spending or aggregate demand
-Multiplier = Change in AD (ΔC, Ig, G, Xn) / Change in spending

Why does this happen?
-expenditures and income flow continuously which sets off a spending increase in the economy.

Calculating the Spending Multiplier: 
-Multiplier = 1/1-MPC or 1/MPS
     *Multiplier are positive when there is an increase in spending and negative when there is a decrease.
     *Spending multiplier can be calculated from the MPC or MPS
Calculating the Tax Multiplier:
-The government taxes the multiplier works in reverse. Why?
 Because now money is leaving the circular flow

Tax Multiplier (note: it is negative)
= -MPC/ 1-MPC or –MPC/MPS
-If tax cut, multiplier is positive because now money is in the circular flow.

Aggregate Demand, Aggregate Supply, and the Investment Demand Curve

*Aggregate Demand*

Shifts in aggregate demand:there are two parts to a shift in ad
  - a change in c, Ig, and/or Xn
  - a multiplier effect that produces a greater change than the original change in the 4 components

• increase=shifts to the right
• decrease=shift to the left

Determinants of AD:

Consumption
   - household spending is affect by: 
       - consumer wealth
           . More wealth= more spending (AD shifts ->)
           . Less wealth= less spending (AD shifts <-)
       - consumer expectations
           . Positive expectations = more spending (AD ->)
           . Negative expectation = less spending (AD <-)
       - household indebtedness
           . Less debt = more spending 
           . More debt = less spending 
       - taxes 
           . Less taxes = more spending 
           . More taxes = less spending

Gross private investment 
• investment spending is a sensitive to:
      - the real interest rate 
           . Lower real interest rate = more investment (AD->)
           . Higher real interest rate = less investment (AD<-)
      - expected returns 
           . Higher expected returns = more investment
           . Lower expected returns = less investment
           . Especial returns are influenced by 
                 - expectation of future profitability 
                 - technology 
                 - degree of excess capacity (Existjng stock of capital)

Govt spending
• more govt spending (AD->)
• less govt spending (AD<-)

Net exports 
• nets exports are sensitive to:
    -exchange rate (international value of $)
        . Strong $ = more imports and fewer exports (AD<-)
        . Weak $ = fewer imports and more exports (AD->)
     - relative income 
         . Strong foreign Economies = more exports 
         . Week foreign economies = less exports

*Aggregate Supply*
-Long Run Aggregate Supply (LRAS) - the period of time where input prices are completely flexible and adjust to changes in the price level.
-the level of real GDP supplied is independent of price level.
-It marks the level of full employment in the economy. (FE, Yf, Y' = full employment)
-Analogous to PPC
-Since input prices are flexible in long run, changes in price level do not change firms real profits and therefore don't change firms level of output.
-LRAS is vertical at the economy's level of full employment. 

-Short Run Aggregate Supply (SRAS) - Period of time where input prices are sticky and don't adjust to changes in the price level
-the level o real GDP supplied is directly related to the price level.
-because input prices are sticky in the short run, the SRAS is upward slopping. 
-an increase in SRAS is seen as a shit to the right ---> and decrease to the left <---
-the key to understanding shifts in SRAS is per unit cost production
-per unit cost production = total input cost

Determinants of SRAS: (affect unit production cost)

1. Input Prices
2. Productivity
3. Legal - Institutional Environment: taxes and subsidies

• Taxes (money to government) on business increase per unit production cost, shits SRAS <----
• Subsidies (money from government) to business reduce per unit production cost, shifts SRAS ---->

Domestic Resource Prices:

-wages (75% of all business costs)

-cost of capital 

-raw materials (commodity prices)

Foreign Resource Prices:

-Strong money: lower foreign resource prices

-Weak money: higher foreign resource prices

Market Power: Monopolies and cartels that control the price of those resources.

-Increase in resource prices: SRAS <----

-Decrease in resource prices: SRAS ---->

Productivity = total output/total inputs

More productivity = lower unit production cost ---->

Lower productivity = higher unit production cost <----

Government Regulation: creates a cost o compliance = SRAS <----

Deregulation: reduces compliance cost = SRAS ---->

Full Employment – Equilibrium exists where AD interests 

SRAS and LRAS at the same point.

Recessionary Gap - exists when equilibrium occurs below full employment output.

-AD decrease shifts to the left 

Inflationary Gap- exists when equilibrium occurs                    beyond full employment output.

-AD increases shifts to the right

Interest Rates and Investments Demand

Money spent on expenditures on:

o   New plants ( factories )

o   Capital equipment ( machinery )

o   Technology ( hardware and software )

o   New homes

o   Inventories ( goods sold by producers )

·         How do a business make investment decisions?

o   Cost / Benefits Analysis

·         How does a business determine benefits?

o   Expected rate of return

·         How does a business count the cost?

o   Interest Cost

·         How does a business determine the amount of investment they undertake?

o   Compare expected rate of return to interest cost

§  If expected return > interest cost, then invest

§  If expected return < interest cost, do not invest

Real ( r% ) vs. Nominal ( i% )  (pie)inflation

What’s the difference?

·         Nominal is observable rate of interest. Real subtracts out inflation (pie%) and only known ex post facto.

How to compute the real interest rate

r%= i% - pie%

What determines cost of an investment decision?

·         Real interest rate ( r%)

What is the shape of investment demand slope?

·         Downward sloping

Why?

·         When interest rates are high, few investments are profitable. When interest rate are low, more investments are profitable.

*The Investment Demand Curve*

Cost of production 

- lower cost shifts ID ---->

-Higher cost shifts ID <----

Business Taxes

-lower business taxes shift ID ---->

-higher business taxes shift ID <----

Technological Change

• New technology ---->
• Lack of technology <----

Stock of Capital

• If an economy is low on capital then ID shifts ---->
• If it has much capital then ID shifts <----

Expectations 

• positive expectations shift ID ---->
• negative expectations shift ID <----

LRAS: represents a point on an economics production possibilities curve and it is a vertical line at an output level that represents the quantity of goods and services a nation can produce over a sustained period using all of its productive resources as efficiently as possible.

-always at full employment

-does not change as price level changes

-shifts outward if there is a change in technology, resource, or there is economic growth. 

Unemployment

Unemployment - Percentage of people who do not have a job but are part of the labor force

Labor force - the number of people in a country that are classified as either employed or unemployed 

Unemployment rate: equals (the number of unemployed / number of employed + number of unemployed ) x 100

The ideal rate is 4-5 %

Not in the labor force-

1.      Kids

2.      Retired people

3.      Military personnel 

4.      Mentally insane

5.      Incarcerated 

6.      Full time student 

7.      Stay at home parent

8.      Discouraged workers  

Types of unemployment:

Frictional - Between jobs because you choose new opportunities new choices new lifestyles or educational levels 

Structural - Lack of skills or a decline in industry or change in technology 

Seasonal - People are waiting for the right season to go to work 

Ex. Santa Claus; Lifeguards 

Cyclical – Occurs due to a swing in the economy; downturns in business cycle

Full employment - Occurs when there is no cyclical unemployment present in the economy 

Natural rate of unemployment(NRU) –When the economy is producing at its best.

Why is unemployment good?

1.      Less pressure to raise wages 

2.      More workers available for future expansions 

Why is unemployment bad?

1.      There is not enough consumption  (GDP)

2.      Too much poverty 

3.      Too much government assistance is needed

Okun’s law - For every 1 % of unemployment above the NRU causes a 2 % decline in real GDP  

Inflation - rise in the general level of prices 

Measuring Inflation:

Inflation rate - measures the percentage increase in the price level over time  (offers key indicator of economies health)

a)       Deflation - A decline in the general price level

b)       Disinflation - It occurs when the inflation rate itself declines  

Consumer price index - measures inflation by tracking the yearly price of a fixed basket of consumer goods and services ; indicates changes in the price level and cost of living  

Solving inflation Problems 

A)    finding inflation rate by using market basket data 

(Current year market basket value - base year market basket value / base year market basket value ) x 100  

B)    Finding inflation rate using Price indexes 

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

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

Years needed to double inflation = 70/ annual inflation rate  

Determining real wages = nominal wages / price level ) ×100  

Finding real interest rates = nominal interest rate - inflation premium  

Standard for inflation:

Real interest rates - Cost of borrowing or lending money that is adjusted for expected inflation (expressed as a percentage)

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 upwards 

Cost pushed inflation - Caused by a rise in per unit production cost due to increasing resource cost 

Effects of inflation: Anticipated  vs. Unanticipated  

Inflation Helps: Borrowers because debt will be repaid with cheaper dollars than those that were loaned out; Fixed Contract 

Inflation Hurts: Fixed income; Savers; Lenders / creditors  

Nominal GDP vs. Real GDP

Nominal GDP - Value of output produced in current prices

- Can increase from year to year if either output or price increase 
NGDP = Price x Quantity

Real GDP - Value of output produced in base year or constant prices

-Can increase from year to year only if output increases  

RGDP = Base Price x Quantity   

Price index - A measure of inflation by tracking changes in the price of a market basket of goods compared to the base year.

 Formula: price of market basket of goods in current year / price of market basket of goods in base year  x 100

GDP Deflator - Is a price index that is used to adjust from nominal to real GDP 

• In the base year the GDP deflator = 100  
• For years before the base year it is less than 100
• For years after the base year it is greater than 100

Formula - (Nominal GDP/ Real GDP)  ×100 

Inflation formula - (New GDP deflator - Old GDP deflator / Old GDP deflator ) ×100 

Budget Formula: Government purchases of good + services + government transfer payments - government tax and fee collection 

• Positive number = deficit  

• Negative number =surplus 

Trade Formula: Exports- Imports 

• Positive number = surplus 
• Negative number = deficit

GNP Formula: GDP(expenditure) + net foreign factor payment 

Net national product (NNP) formula: GNP- depreciation 


Net domestic product (NDP) formula: GDP - depreciation 

National income formula: 

1. GDP- Inderect business taxes - depreciation - net foreign factor payment  
2. Compensation of employees + properitares income + rental income + interest income  + corporate profits  

Disposable personal income formula: national income - personal household taxes + government transfer payments  

Gross Domestic Product & Gross National Product

Gross Domestic Product (GDP) - The total money value of all final goods and services produced within a countries borders within a given year.

- Economist collect statistics on production, income, investment, and savings (national income accounting)

Gross National Product (GNP) - A measure of what its citizens produced and whether they produced these items within its borders.

What is included in GDP?
C + IG + G + Xn

1. Consumption - takes up 67% of economy; final goods and services
2. Gross Private Domestic Investment - Factory equipment maintenance; new factory equipment; construction of housing; unsold inventory of products built in a year.
3. Government spending - Military buying weapons; school districts buying buses or other equipment.
4. Net export - (Export - Imports)

Whats not included in GDP?

1. Used or second hand goods.
2. Intermediate goods - goods and services that are purchased for resale or for further processing or manufacturing.
3. Non market activities - Volunteer work, babysit, illegal drug sales, bartering and trading.
4. Financial transactions - stocks, bonds, real-estate.
5. Gifts or transfer payments - Public payments: recipients contribute nothing to the current production. ex. social security, welfare payments. Private payments: produces no output and is simply transferring funds from one individual to another. ex. scholarships, christmas gifts.

Expenditure approach - adding up the market value of all domestic expenditures made on final goods and services in a single year.
          C + IG + G + Xn = GDP

Income approach - adding up all the income earned by households and firms in a single year.
          W + R + I + P + Statistical adjustments = GDP
Wages Rents Interest Profit
Wages - compensation of employees and salaries.
Rent - From tenants to landlord; lease payments that corporations pay for the use of space.
Interests - Money paid by private businesses to the suppliers of loans used to purchase capital.
Profit - Corporate income taxes, dividends, undistributed corporate profits.

Circular Flow Model

The Circular flow model - represents the transactions within an economy

• Goods and Services flow clockwise

Two Markets

      1. Resource or Factor Market- The place where households sell resources and the businesses buy resources

      2. Product Market- The place where goods and services are produced by businesses and are bought and sold to the households

3 Economic Factors: 

     1. Household- Person or group of people that share income

     2. Government

     3. Firm- An organization that produces goods and services for sale