Unit 3- Fiscal Policy

Fiscal policy: Changes in the expenditures or tax revenues of the federal government. It is enacted to promote our nation's economic goals: full employment, price stability, and economic growth. 

Two tools of fiscal policy:

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

Deficits, Surpluses, and Debt

• Balanced budget
• Revenues = Expenditures
• Budget deficit
• Revenues < Expenditures
• Budget surplus
• Revenues > Expenditures
• Government debt
• Sum of all deficits - Sum of all surpluses

• The government must borrow money when it runs a budget deficit
• The government borrows from:
• Individuals
• Corporations
• Financial institutions
• Foreign entities or foreign governments

Fiscal Policy Two Options

• Discretionary fiscal policy (action)
• Expansionary fiscal policy- think deficit
• Contractionary fiscal policy- think surplus
• Non-discretionary fiscal policy (no action)

Discretionary vs. Automatic Fiscal Policies 

Discretionary fiscal policies 

• Increase or decreasing government spending and/or taxes in order to return the economy to full employment. 
• It involves policymakers doing fiscal policy in response to an economic problem.

Automatic fiscal policies 

• Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation.
• It takes place without policymakers having to respond to current economic problems.

Expansionary fiscal policy 

• Recession is countered with expansionary policy
• Increase in government spending (G ↑)
• Decrease in taxes (T ↓)
• The price level is increased: this means that expansionary fiscal policy creates some inflation.

Contractionary fiscal policy 

• Inflation is countered with contractionary policy
• Decrease in government spending (G ↓)
• Increase in taxes (T ↑)
• The unemployment rate is increased: this means that contractionary fiscal policy creates some unemployment.

Weaknesses of Fiscal Policy 

• Lags
• Inside lags take time to recognize economic problems and to promote solutions to those problems
• Outside lags take time to implement solutions to problems

Supply Side Economics

• Stimulate production (supply) to spur output. 
• Cut taxes and government regulations to increase incentives for businesses and individuals. Businesses invest and expand, creating jobs; people work, save, and spend more.
•  An increase in investment and productivity lead to an increase in output.

Demand Side Economics

• Stimulate the consumption of goods and services (demand to spur output).
• Cut taxes or increase federal spending to put money into people's hands. 
• With more money, people buy more. 
• Businesses increase output to meet the growing demand.

Automatic or Built-In Stabilizers

• Anything that increases the government's budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policymakers.
• Transfer Payments (a type of automatic stabilizers)
• Welfare checks
• Food stamps
• Unemployment checks
• Corporate dividends
• Social security
• Veteran's benefits

Tax Systems

• Progressive
• When the average tax rate (tax revenue/GDP) rises with GDP
• Proportional
• When the average tax rate remains constant as GDP changes
• Regressive tax systems.
• When the average tax rate falls with GDP

Unit 3- Consumption and Saving

Disposable Income (DI): Income after taxes or net income.

With disposable income, households can either: 

• Consume (spend money on goods and services) 
• Save(not spend money on goods and services) 

Consumption (C) is household spending. Households consume if DI = 0 through autonomous consumption and dissaving. The ability to consume is constrained by:

• The amount of DI
• The propensity to save

Saving (S) is when the household is NOT spending. Households do NOT save if DI = 0. The ability to save is constrained by:

• The amount of DI
• The propensity to consume

Average propensity to consume (APC) and average propensity to save (APS) formulas:

• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 (dissaving)
• -APS (dissaving)

Marginal Propensity to Consume (MPC) 

• It's the percentage of every extra dollar that is spent
• The fraction of any change in disposable income that is consumed
• MPC = Change in consumption/change in disposable income= ΔC/ΔDI
• MPC = 1- MPS

Marginal Propensity to Save (MPS) 

• It's the percentage of every extra dollar that is saved
• The fraction of any change in disposable income that is saved
• MPS = Change in savings/change in disposable income = ΔS/ΔDI
• MPS = 1- MPC

The Spending Multiplier Effect 

• An initial change in spending (C, I, G, and/or X) causes a larger change in aggregate spending, or aggregate demand (AD). 
• This happens because expenditures and income flow continuously which sets off a spending increase in the economy. 
• Multiplier = (Change in AD)/(Change in spending) = ΔAD/ΔC, ΔI, ΔG, or ΔX

Calculating the Spending Multiplier

• Can be calculated from the MPC or the MPS. 
• Multipliers are positive when there is an increase in spending and negative when there is a decrease.
• Spending Multiplier = (1)/(1 - MPC) OR (1)/(MPS)

Calculating the Tax Multiplier

• When the government taxes, the multiplier works in reverse because now money is leaving the circular flow.
• If there is a tax cut, then the multiplier is positive, because there is now more money in the circular flow. 
• Tax Multiplier (note:it's negative)= (-MPC)/(1 - MPC) = (-MPC)/(MPS)

Unit 3- Interest Rates and Investment Demand

Investment

Money spent or expenditures on the following:

• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware and software)
• New homes
• Inventories (goods sold by producers)

Expected Rates of Return

• Businesses make investment decisions using cost/benefit analysis. 
• Businesses determine benefits by determining the expected rate of return. 
• Businesses count the costs by interest costs. 
• Businesses determine the amount of investment they should undertake by comparing the expected rate of return to the interest cost. 
• If the expected return is greater than the interest cost, then they should invest. 
• If the expected rate of return is less than the interest cost, then they shouldn't invest.

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

• The nominal interest rate (i%) is the observable rate of interest.
• Real interest rate (r%) subtracts out the inflation rate (π%) and is only known ex post facto. 
• The real interest rate determines the cost of an investment decision. The equation is as follows: r% = i% - π%

Invest Demand Curve 

• The shape of the investment demand (ID) curve is downward sloping 
• When interest rates are high, fewer investments are profitable
• When interest rates are low, more investments are profitable. 
• Conversely, there are few investments that yield high rates of return and many that yield low rates of return.

Unit 3- The AS/AD Model

The AS/AD Model 
The equilibrium of AS and AD determines current output (GDPᵣ) and the price level.

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

Recessionary Gap 
Exists when equilibrium occurs below full-employment output

Inflationary Gap
Exists when equilibrium occurs beyond full employment output.

Three Ranges of SRAS

1. Keynesian/horizontal range 

• Occurs when we are in a recession or depression, not fully using all of our resources, and    below full employment.

2. Intermediate-range 

• Occurs when resources are getting closer to full employment levels, which creates upward   pressure on wages and prices.

3. Classical or vertical range 

• Occurs when real GDP is at a level below the full employment level, where any increase in demand will result only in an increase in prices.

Demand-pull inflation

• An increase in the average price level resulting from an increase in total spending in the economy
• C, Ig, G, and Xn make the AD in a nation.
• AD is always increasing.

Cost-push inflation

When firms respond to rising costs by increasing their prices to protect profit margins. It can be caused by the following:

• Rising unit labor costs
• Higher prices for important components/raw materials 
• A depreciation in the exchange rate causing a rise in import costs
• An increase in business taxes(e.g. a value-added tax (VAT) or environmental taxes) such as a carbon tax
• Expectations in inflation rate

Some factors affecting inflationary pressures:

• Rising property prices → Increased consumer wealth →Demand-pull inflation risk
• Increasing world oil prices → Higher costs for businesses → Cost-push inflation risk
• Depreciating exchange rate → Increased import prices and rising exports → Cost-push and demand-pull inflation risk
• Rapid expansion of money and credit from banks → Rising consumer spending financed by loans → Demand-pull inflation risk

Unit 3- Aggregate Supply

Aggregate Supply(AS): The level of real GDP (GDPᵣ) that firms will produce

Long Run vs. Short Run

Long Run

• The period of time where input prices are completely flexible and adjust to changes in the price level. 
• In the long run, the level of real GDP supplied is independent of the price level.

Short-run

• The period of time where input prices are sticky and don't adjust to changes in the price level.
• In the short-run, the level of real GDP supplied is directly related to the price level.

Two Types of Aggregate Supply

Long-run aggregate supply (LRAS) 

• Marks the level of full employment in the economy (analogous to PPC)
• Because input prices are completely flexible in the long-run, changes in price level don't change firms' real profits and therefore don't change firms' level of output. 
• This means that the LRAS is vertical at the economy's level of full employment.

Short Run Aggregate Supply (SRAS)

Happens because input prices are sticky in the short-run, the SRAS is upward sloping.

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 shifts in SRAS is the per-unit cost of production.

                         Per unit production cost = (total input cost)/(total output)

Determinants of SRAS

1. Input/resource prices

• Domestic resource prices
• Wages (75% of all business costs)
• Cost of capital
• Raw materials (commodity prices)

• Foreign resource prices
• Strong dollar (appreciation) = lower foreign resource prices
• Weak dollar (depreciation) = higher foreign resource prices

• Market power
• Monopolies and cartels that control resources and control the price of those resources

Increases in resource prices = SRAS ←

Decreases in resource prices = SRAS→

2. Productivity

• Calculate using (Total output)/(total input)

More productivity = lower unit production cost = SRAS→
Lower productivity = higher unit production cost = SRAS ←

3. Legal Institutional Environment:

• Taxes and subsidies
• Taxes (money the government receives) on businesses increase per-unit production cost = SRAS←
• Subsidies (money the government gives) to businesses reduce per-unit production cost = SRAS→
• Government regulation
• Government regulation creates a cost of compliances = SRAS←
• Deregulation reduces compliance costs = SRAS→

Unit 3- Aggregate Demand

Aggregate Demand (AD): The demand by consumers (C), businesses (Ig), government (G), and foreign countries (Xn). 

• Changes in price level (PL) cause a move along the curve, NOT a shift of the curve
• Shows the amount of real GDP(GDPᵣ) that the private, public, and foreign sector collectively desire to purchase at each possible PL.
• The relationship between the PL and the level of GDPᵣ is inverse.
• AD = C + Ig+ G + Xn

3 reasons why AD is downward sloping
1. Wealth Effect

• Higher prices reduce purchasing power of money
• This decreases the quantity of expenditures.
• Lower price levels increase purchasing power and increase expenditures.

2. Interest rate effect

• As price level increases, lenders need to charge higher interest rates to get a REAL return on their loans.
• Higher interest rates discourage 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 demanded to fall (Xn decreases).

Shifts of Aggregate Demand
There are two parts to a shift in AD:

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

Increases in AD = AD→
Decreases in AD = AD←




Determinants of AD
1. Change in Consumer Spending (C)

• Consumer Wealth (Boom in the stock market...)
• Consumer Expectations (People fear a recession...)
• Household Indebtedness (More consumer debt...)
• Taxes (Decrease in income taxes...)

2. Change in Investment Spending (Ig)

• Real Interest Rate (Price of borrowing money)
• (If interest rates increase/decrease...)                             
• Future Business Expectations (High expectations...)      
• Productivity and Technology (New robots...)       
• Business taxes (Higher corporate taxes means...)

3. Change in Government Spending (G)

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

More government spending = AD→
Less government spending = AD←

4. Change in Net Exports (X-m)

• Exchange rates(If the US dollar depreciates relative to the euro...)
• National Income Compared to Abroad 
• (If a major importer has a recession..)
• (If the US has a recession...)
• The phrase "If the US gets a cold, Canada gets pneumonia" is a good way to remember this