1. Describe the federal budget process and explain the effects of fiscal policy.
A. The Federal Budget1. Budget Time Line
B. Budget Balance and Debt1. Surplus, Deficit, and Debt2. A Personal Analogy3. Types of Fiscal Policy
a. Discretionary Fiscal Policyb. Automatic Fiscal Policy
C. Discretionary Fiscal Policy: Demand-Side Effects1. The Government Expenditure Multiplier2. The Tax Multiplier3. The Transfer Payments Multiplier4. The Balanced Budget Multiplier
1. Supply-Side Effects of Government Expenditure2. Supply-Side Effects of Taxes3. Scale of Government Supply-Side Effects4. Supply-Side Effects on Potential GDP
F. Limitations of Discretionary Fiscal Policy1. Law-Making Time Lag2. Shrinking Area of Discretion3. Estimating Potential GDP4. Economic Forecasting
G.Automatic Fiscal PolicyH.Cyclical and Structural Budget BalancesI. Schools of Thought and Cracks in Today’s Consensus
2.Describe the Federal Reserve’s monetary policy process and explain the effects of monetary policy.
1. Monitoring Economic Conditions2. Decisions of the Federal Open Market Committee (FOMC)3. Monetary Policy Report to Congress
B. The Federal Funds Rate TargetC. The Ripple Effects of the Fed’s Actions
1. Other Interest Rates Change2. The Exchange Rate Changes3. The Quantity of Money and Bank Loans Change4. The Long-Term Real Interest Rate5. Consumption Expenditure, Investment, and Net Exports Change6. Aggregate Demand Changes
D.Monetary Stabilization in the AS-AD Model1. The Fed Eases to Fight Recession2. The Fed Tightens to Fight Inflation3. The Size of the Multiplier Effect
E. Limitations of Monetary Stabilization Policy
What’s New in this Edition?Chapter 20 contains updated data, slightly revised and updated Eye On applications, a few slightly re-vised subheadings in 20.1. It also removes key terms designation for federal budget, fiscal year, fiscal stimulus, and needs-tested spending and replaces the key terms designations for balanced budget, budget surplus, and budget deficit with budget bal-ance.
Where We AreChapter 20 uses material from the previous chap-ters. We describe fiscal policy, explain the difference between discretionary and automatic fiscal policy, and discuss the institutional details of fiscal policy. We discuss the multiplier effect on aggregate de-mand from changes in government expenditure, taxes, and from simultaneous changes in govern-ment expenditure and taxes. Then we use the AS-AD model from previous chapters to explore the effects of fiscal policy. The limitations of fiscal policy are discussed. A similar exploration of monetary policy is conducted, including using the AS-AD model to il-lustrate the effects of monetary policy.
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The previous chapter discussed business cycles and used the AS-AD model to explore factors that create business cycles and inflation. This chapter uses the same AS-AD model to explore how fiscal and mone-tary policy can be used to combat business cycle fluctuations.
Where We’re GoingThis chapter is the last chapter in the book.
IN THE CLASSROOM
Class Time NeededThis material is challenging and important. You probably can cover it in two class periods, but depending on your class’s ease with manipu-lating the AS-AD model, you might spend two and one half or slightly more periods on it.
An estimate of the time per checklist topic is:
20.1 The Federal Budget and Fiscal Policy—50 to 65 minutes
20.2 The Federal Reserve and Monetary Policy—50 to 65 minutes
Classroom Activity: After you have completed this chapter, ask your students to write down the type of fiscal and monetary policy they would recommend at the present time. Ask them to describe whether they would rely more on fiscal policy or monetary policy to attempt to influence the current position of the economy. For a smaller class, you can assign half the class to argue a fiscal policy re-sponse and half the class to argue a monetary policy response to the current economy and then allow the two sides to debate the issue. For a more extensive discussion, have the students do some basic research on current monetary and fiscal policy proposals reported in the press. Ask students to come to class pre-pared to defend their chosen policy. This could also be conducted as an in-class small-group exercise. Give the students about 20 minutes in small groups to de-cide on the fiscal or monetary policy they would implement–ask them to back this up with a graph of the effects of the chosen policy. Students can then either turn in their policy and graph or one person from each group can report on the chosen policy to the class.
20.1 The Federal BudgetFiscal policy is the use of the federal budget to achieve the macroeconomic objec-tives of high and sustained economic growth and full employment.
The Federal Budget The federal budget is the annual statement of the expenditures and tax rev-
enues of the government of the United States. The President proposes a bud-get to Congress in February. The Congress passes budget acts by September and the President either signs them or vetoes them.
Budget balance = Tax revenues – Outlays If tax revenues exceed outlays, the government has a budget surplus. If outlays exceed tax revenues, the government has a budget deficit. In
recent years the federal government has run a budget deficit. For the 2014 fiscal year, the projected U.S. budget balance is $3,000 billion $3,627 billion = $627 billion, that is, a budget deficit of $627 billion.
If tax revenues equal outlays, the government has a balanced budget.National debt – the amount of government debt outstanding that has arisen
from past budget deficits.
Students often do not know the difference between a deficit and debt. Spend some time describing the national debt and how it is based on the accumulation of deficits over time. Linking this to the individual level as in the chapter can be very useful. Having students go find the current deficit (or projected deficit) and the national debt can be a useful (and eye-opening) exercise.
Automatic and Discretionary Fiscal Stimulus Discretionary fiscal policy is a fiscal action that is initiated by an act of
Congress. Automatic fiscal policy is a fiscal action that is triggered by the state of the
economy.
Discretionary Fiscal Policy: Demand-Side Effects The government expenditure multiplier is the effect of a change in gov-
ernment expenditure on goods and services on aggregate demand. An in-crease in government expenditure on goods and services increases aggre-gate expenditure, which sets in motion the multiplier process.
The tax multiplier is the effect of a change in taxes on aggregate demand. A decrease in taxes increases disposable income and hence consumption ex-penditure, setting in motion the multiplier process. A decrease in taxes in-creases aggregate demand.
The magnitude of the tax multiplier is less than the magnitude of the gov-ernment expenditure multiplier because a $1 tax cut generates less than a $1 increase in consumption expenditure since only a fraction (equal to the MPC ) of the increase in disposable income is spent on consumption expenditure.
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The transfer payments multiplier is the effect of a change in transfer pay-ments on aggregate demand. An increase in transfer payments increases dis-posable income and hence consumption expenditure, which sets in motion the multiplier process. An increase in transfer payments increases aggregate demand.
The balanced budget multiplier is the effect on aggregate demand of a simultaneous change in government expenditures and taxes that leaves the budget balance unchanged. Because the government expenditure multiplier is larger than the tax multiplier, the balanced budget multiplier is positive, so a balanced budget increase in government expenditures and taxes increases aggregate demand.
A Successful Fiscal StimulusFiscal stimulus, a fiscal policy designed to increase aggregate demand (an increase in government expenditure or transfer payments, a decrease in taxes, or combi-nation of all three) seeks to eliminate a re-cessionary gap.
In the figure, the initial equilibrium is at real GDP of $15 trillion and a price level of 100. There is a reces-sionary gap because potential GDP ($16 trillion) exceeds real GDP.
The government can use expan-sionary fiscal policy. The initial in-crease in aggregate demand from the cut in taxes or hike in govern-ment expenditure or transfer pay-ments is reinforced by the multi-plier effect. The aggregate demand curve shifts rightward from AD0 to AD1. Real GDP increases so it equals potential GDP, $16 trillion, and the price level rises, to 110 in the figure.
Discretionary Fiscal Policy: Supply-Side Effects Some government services (law
and order, public education) and some government capital infra-structure (highways, airports) in-crease production possibilities and thus increase potential GDP and aggregate supply. An increase in government expenditures of these types increases potential GDP and aggregate supply.
Taxes create a disincentive to work and save, so taxes decrease em-ployment and capital, thereby de-creasing potential GDP and aggre-gate supply. An increase in taxes decreases potential GDP and ag-gregate supply.
If both government expenditure and taxes increase, the net ef-fect on potential GDP is uncertain. So, a larger government might either increase or decrease potential GDP.
A tax cut increases saving and investment, thereby increasing capital. As a result, as illustrated in the figure, the production function shifts higher. A tax cut increases labor supply, thereby increasing employment. As a re-sult, there is a movement upward along the higher production function. On both counts, potential GDP and aggregate supply increase.
Limitations of Discretionary Fiscal Policy In practice, discretionary fiscal policy is hampered by four factors:
Law-Making Time Lag: The law-making lag is the amount of time it takes Congress to pass the laws needed to change taxes or spending.
Shrinking Area of Law-Maker Discretion: An increasing large part of the budget (such as Medicare) is effectively off limits for shrinkage.
Estimating Potential GDP: It is not easy to tell whether real GDP is below, above, or at potential GDP so it is not easy tell if a contractionary or ex-pansionary policy is needed.
Economic Forecasting: Fiscal policy must target forecasts of where the economy will be in the future. Economic forecasting has improved enor-mously in recent years, but it remains inexact and subject to error.
Automatic Fiscal Policy Automatic stabilizers are features of fiscal policy that stabilize real GDP
without explicit action by the government. Induced taxes and needs-tested spending are automatic stabilizers.
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Induced taxes are taxes that vary with real GDP. In an expansion, in-duced taxes rise, helping to stabilize the economy and in a recession, in-duced taxes fall, helping to stabilize the economy.
Needs-tested spending is spending on programs that entitle suitably qualified people and businesses to receive benefits—benefits that vary with need and with the state of the economy.
Induced taxes and needs-tested spending decrease the multiplier effects of changes in expenditure so they moderate both expansions and recessions and make real GDP more stable.
Land Mine: The concept of automatic stabilizers is often diffi-cult for students to grasp. For many students the possibility that something like an automatic stabilizer could exist appears to be incongruent with what they know to be true. To combat this con-fusion, I like to use the term “stability” as it is used in a physics class. In physics, stability is equated with maintaining an equilib-rium position or resuming its original position after displacement. A simple analogy is in order. Ships are built in a way so as to pro-vide for some measure of automatic stability. The shape of the hull is designed in such a way so that as wind pummels it from one side to the other, the ship will tip back in the opposite direc-tion. In fact, the ballast in the ship assists in this way as well. Bal-last is the heavy material that is placed in the hold of a ship to en-hance stability. After giving this explanation, you can ask your students if the existence of the ballast and the shape of the hull guarantee that the ship will remain in an upright position. The answer is “no.” Heavy rains or gale force winds could tip the ship over with virtually no hope of righting itself! What the stability-enhancing characteristic of the shape of the hull and ballast pro-vide is that the ship will not tip over in less than catastrophic con-ditions. This analogy holds true for the economy as well. Auto-matic stabilizers are not insulators from recession or depression but serve as devices that help the economy from reeling out of control when it is hit with less than catastrophic shocks
By their nature, automatic stabilizers imply federal budget deficits in recessions as tax revenues fall and spending increases. By contrast, balanced budget rules for state and local governments mean that these governments do not conduct stabiliz-ing fiscal policy. In the 2008-2009 recession, the sharp decline in state and local tax revenues meant that state spending programs had to be cut and, in some states, taxes raised. Such policies are the opposite of the policies that can be used to help stabilize the business cycle.
Cyclical and Structural Budget Balances The structural surplus or deficit is the budget balance that would occur if
the economy were at full employment and reflects the spending program and tax laws that Congress has created (the discretionary fiscal policy)
The cyclical surplus or deficit is the budget balance that arises because revenues and outlays are not at their full-employment levels (the automatic fiscal policy)
The actual budget balance equals the sum of the structural balance and cycli-cal balance.
Schools of Thought and Cracks in Today’s Consensus The Keynesian view is that fiscal stimulus – an increase in government out-
lays or a decrease in tax revenues – boosts real GDP and creates or saves jobs by increasing aggregate demand with a multiplier effect.
The mainstream view is that Keynesians over-estimate the multiplier effects of fiscal stimulus and that these effects are small, short-lived, and incapable of working fast enough to be useful. Government stimulus “crowds out” private consumption expenditure and investment and ultimately leads to a bigger government, lower potential GDP, a slower real GDP growth rate, and a greater burden of government debt on future generations.
20.2 The Federal Reserve and Monetary Policy
The Monetary Policy Process The Beige Book is a report that summarizes current economic conditions in
each Federal Reserve district and each sector of the economy. It serves as a background document for the members of the Federal Open Market Commit-tee.
The FOMC meets eight times a year and makes the monetary policy deci-sions.
The Federal Funds Rate TargetThe Federal Reserve targets the federal funds rate. The federal funds rate is the in-terest rate in the federal funds market, that is, the market in which banks borrow and loan reserves. The Fed (the New York Fed actually carries out the actions) uses open market operations to influence the quantity of funds available.
If the Fed buys government securities, there are fewer funds (fewer re-serves) available and so the federal funds rate rises.
If the Fed sells government securities, there are more funds (more reserves) available and so the federal funds rate falls.
The Fed can adjust the federal funds rate to equal its target.
The Ripple Effects of the Fed’s Actions Suppose the Fed uses an open market operations purchase of government se-
curities to lower the federal funds rate. The transmission mechanism is then: Other interest rates rise. The effect on short-term interest rates is larger
than the effect on long-term interest rates, but, in general, interest rates rise.
The exchange rate rises: When interest rates in the United States rise, foreigners will want to buy U.S. dollars in order to earn the higher inter-est rate. The demand for the dollar on the foreign exchange rate market increases and the exchange rate rises.
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The quantity of money and bank loans: When the Fed raises the interest rate, it does so by decreasing banks’ reserves. As a result, banks can make fewer loans, so loans and deposits both decrease. The decrease in deposits decreases the quantity of money.
The long-term real interest rate: The change in bank loans affects the long-term real interest rate. The decrease in loans raises the long-term real interest rate.
Consumption expenditure and investment: The higher real interest rate decreases consumption expenditure and investment.
Net exports: With the higher price of the dollar in the foreign exchange market, foreigners must now pay more for U.S.-made goods and services. So, U.S. exports decrease. Additionally, the higher exchange rate means that U.S. residents must pay less for imports. So, U.S. imports increase. As a result, U.S. net exports decrease.
Aggregate demand: The decrease in consumption expenditure, invest-ment, and net exports all decrease aggregate demand.
If the Fed lowers the interest rate, the effects are reversed and aggregate de-mand increases.
Spend some time working through the steps of a Federal Reserve policy change. The chapter does a nice job explaining a change in the interest rate target and walks through the impacts in clearly, but students still have a hard time grasping the steps. Try to emphasize the intuition behind the effects. I often present only one of the policy directions in lecture (e.g., only a Fed loosening) and then break stu-dents into groups to have them try to work through the steps of the other direction (e.g., a Fed tightening). I then follow up and present that direction at the beginning of the next lecture.
Monetary Stabilization in the AS-AD Model The Fed tightens to fight inflation:
If the Fed conducts an open market operation that in-creases the interest rate, there is a decrease in aggre-gate demand, which produces a decrease in real GDP and a fall in the price level.
The figure illustrates this case. The interest rate rises, which decreases consumption, investment, and net exports. The multiplier effect de-creases aggregate demand and shifts the aggregate de-mand curve from AD0 to AD1. The price level falls, from 110
to 100 in the figure, and real GDP decreases, from $17 trillion to $16 tril-lion in the figure.
The Fed eases to fight recession: If the Fed conducts an open market operation that decreases the interest
rate, there is an increase in aggregate demand, which produces an in-crease in real GDP and a rise in the price level.
Limitations of Monetary Stabilization PolicyMonetary policy does not suffer from the law-making time lags. But monetary policy still has the problems of estimating potential GDP and forecasting economic activity in the future. And it suffers an additional limitation because its effects are indirect and depend on how private decisions respond to a change in the interest rate.
Class Activity: Students can be left with the impression that policy is simple to implement. Be sure to give proper emphasis to the real-world difficulties mentioned in the text. It is dangerous to leave your students thinking that policy is trivial because we all know that policy is very difficult. Indeed, you might ask your students what they think is the proper policy for the Fed and/or the federal government to be pursuing. Assuming that the economy is not mired in the depths of a depression or inflation soaring out of sight, you likely will get a variety of answers, which you can use to point out to the students the non-trivial difficulty of determining the proper macroeconomic policy!
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USING EYE ON THE PAST
Federal Tax Revenues, Outlays, Deficits, and DebtStudents are often surprised by the sheer magnitude of the govern-ment’s presence in the overall economy. This eye is a good opportu-nity to demonstrate that what is important is not the mere size of gov-ernment expenditures and debt but its relation to the size of the econ-omy in percentage terms. You might begin with a simple analogy. Ask your class who is likely to incur more debt: a rich person or a poor person. They should respond that the rich person will incur more debt. Just in case you have a reluctant student or two who is not con-vinced, it is worth settling this issue before proceeding forward. For instance, point out that the size of the house and the size of the mort-gage is quite likely different between a rich and a poor person. The next question is to ask which person has a greater ability to pay or service the debt. Again the answer is the rich person. Explain that this set of questions and answers is not that much different than for the economy as a whole. When a nation’s economy is small in size, its abil-ity to incur and pay back large amounts of debt is limited. However, when an economy matures and grows in size, the economy is better able to incur debt and pay it back.It is also worth pointing out to your students that the dramatic reduc-tion of the debt to GDP ratio in the 1950s and 1960s was not really the result of paying down the debt, but of alternating between budget deficits and surpluses such that the budget was balanced on average and of having real GDP basically outgrow the debt. This can be useful to connect to our current debt, as the focus doesn’t necessarily need to be on paying down the debt, but on restoring the federal budget back towards a balance over time and having real GDP grow, thereby again reducing the debt to GDP ratio.
USING EYE ON THE U.S. ECONOMY
A Social Security and Medicare Time BombMost of your students will not appreciate the depth of the problems revolving around Social Security and Medicare. The Eye points out the four alternatives that can be used to “solve” these time bombs but it also points out the magnitude of the changes that these solutions re-quire. Clearly there is no easy answer to these problems. However, they can make for an excellent class discussion focusing on what your students think would be the best answer(s). Make sure that the stu-dents are aware of the magnitude of the problems so that a simple “raise taxes on the rich” answer is not considered complete.
The U.S. Structural and Cyclical Budget BalancesThis Eye can be used to “scare” your students…or, perhaps more posi-tively, it can serve as a springboard to some very interesting discus-sions. Ask your students what, if anything, they should do about the deficit? Would they increase revenue? If so, what taxes would they ad-just? Make certain that the suggestions are specific. For instance, the suggestion to “raise taxes on the rich” needs to be fleshed out. Who are the rich? By how much should their taxes be raised? How much revenue will this change collect? Or if the student thinks expenditures should be slashed, what should be decreased? By how much? You could even have them get into groups and ask them to discuss their proposals and see if they can get a majority of their classmates to agree to support their proposal. They should be able to quickly see why Congress struggles to get deficit reform passed, especially given that changes have to be passed through the House, the Senate (often with a filibuster-proof majority), and the President – and they would also have to worry about the response from their constituents and the media response in a 24-hour news cycle. This sort of discussion can really help demonstrate to the students the difficulty of some of the economic problems we face.
USING EYE ON FISCAL STIMULUS
Can Fiscal Stimulus End a Recession?This Eye can be used to emphasize how even seemingly enormous dis-cretionary fiscal policy actions may only have small impacts on macroeconomic performance in the United State. For all of the politi-cal debate, assignment of blame, and claims of credit for success, it may be that discretionary fiscal policy takes a very distant back seat to automatic stabilizers when it comes to addressing the business cy-cle. However, make sure to discuss not only the short-term, but also the long-term effects of discretionary fiscal policy. This should help students distinguish between demand-side and supply-side effects of fiscal policy. While the demand-side impact of this discretionary stim-ulus is highlighted in the Eye, ask your students to think about the possible long-term supply-side effects of this stimulus package. If your students are unfamiliar with some of the particulars, inform them that this stimulus package consisted of a mixture of tax cuts and expan-sions of government expenditures on things like education, health care, infrastructure, energy efficiency, unemployment benefits, and other social welfare provisions. What are the demand-side and supply-side effects of these policies? Why are the demand-side effects felt sooner in an economy than the supply-side effects?
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USING EYE ON THE FED IN A CRISIS
Did the Fed Save Us From Another Great Depres-sion?This Eye can serve as an excellent reminder of how far monetary pol-icy has come since the Great Depression and how natural experiments and historical analysis have helped improve monetary policy. Un-doubtedly, the Fed will continue to receive some blame for contribut-ing to slipping into the 2008-2009 recession, but it should also receive credit for limiting the depth and duration of the recession in their re-sponse. It is important to emphasize to students that while monetary policy is not (and will likely never be) perfect, as economics as an aca-demic discipline continues to advance, our policymakers will continue to get better at their jobs. The Fed’s response (or lack-there-of) to the money contraction that contributed to the Great Depression served as an excellent learning experience for economists and the Federal Re-serve. Point out to your students that Ben Bernanke’s main area of ex-pertise as an academic was the Great Depression – a study that he was able to bring with him in response to the threat of a similar situa-tion in 2008. As the Eye explains, the Fed’s behavior in 2008 was drastically different than its behavior during the Great Depression. In the recent episode, the Fed accommodated banks’ vastly increased demand for (safe) reserves so that even though the money multiplier fell by more than in the Depression, the quantity of money actually in-creased! The 2008-2009 recession (like all recessions) will also serve as a learning experience for economists and policymakers. Perhaps our learning from this recent recession will lead to advances in eco-nomics and policy that will make future recessions milder and shorter, as has been the trend since the Great Depression.
USING EYE ON YOUR LIFE
Fiscal Policy and Monetary Policy and How They Affect YouIn motivating this “Eye on Your Life” it might be useful to talk about how and why people are likely to view inflation and recession differ-ently in terms of their seriousness. President Truman was once asked what the difference is between a recession and a depression and his quick-witted answer was “a recession is when your neighbor doesn’t have a job, a depression is when you don’t have a job”. He meant this jokingly but the statement resonates at some level if you reflect on the simple fact that we are more likely to be concerned about economic is-sues that directly affect us personally even though other economic is-sues may be affecting other people even more acutely and are no less important. Individual assessments about the relative importance of economic issues are deeply influenced by personal circumstances.
Questions Checkpoint 20.1 The Federal Budget and Fiscal Policy1. It is often fashionable to blame Congress for large deficits and
congratulate it when there are large surpluses. In what way is this blaming and congratulating somewhat unfounded?
Checkpoint 20.2 The Federal Reserve and Monetary Policy2. In September, 2006 the overall CPI fell by 0.5 percent but the
core CPI edged higher just enough to make inflation a concern. What is the Fed’s most likely response to a situation like this one? Will the Fed tighten or ease? Explain the Fed’s action and its con-sequences for real GDP and the inflation rate.
3. If the inflation rate rises, what effect will the Fed’s decision to not change the federal funds rate have on the U.S. economy? If the economy slips into recession, what effect will the Fed’s no-change decision have on the economy?
Answers Checkpoint 20.1 The Federal Budget and Fiscal Policy1. It is somewhat unfounded because Congress does not have direct
control over the entire size of the deficit or surplus. The reason is that even though Congress can control government spending and tax rates, it does not have direct control over the state of the economy. So as the economy moves into recession, the govern-ment will incur larger deficits (smaller surpluses) even with no action of its own. The reason is that tax revenue will fall because income decreases. The same is true during an economic expan-sion. As the economy expands, tax revenue rises.
Checkpoint 20.2 The Federal Reserve and Monetary Policy2. The Fed is more concerned with the core inflation rate than the
overall inflation rate. The core inflation rate edged up enough to make inflation a concern. This result suggests that the Fed might be concerned about inflation increasing. If the Fed is concerned that inflation will rise, the Fed will respond by raising the federal funds rate. In this case, aggregate demand decreases. Real GDP decreases and the price level as well as the inflation rate fall.
3. If the inflation rate increases, then the Fed’s decision to not cut the federal funds rate looks good. If the Fed had cut the federal funds rate, eventually the price level would have responded by rising more than otherwise, which would have aggravated the problem with inflation. However, if the economy slips into a re-cession, then the Fed’s decision looks bad. By not cutting the fed-eral funds rate, the Fed will not have taken action that could have helped offset the problem of rising unemployment.
