Fiscal and Monetary Policy Effects

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Fiscal and Monetary Policy Effects

• Outline
• What is fiscal and monetary policy and how do
  they work?
• The Federal Budget
• Principles of taxation
• The automatic stabilizers

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Federal, State Local Government Spendingas a
Percent of GDP
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Fiscal Policy
Fiscal policy is the use of the federal
budget to smooth the business cycle and encourage
economic growth.
The Employment Act of 1946 establishes a
responsibility for the Federal government to
promote maximum employment, production, and
purchasing power.
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The Federal Budget
The Federal budget is an annual statement of
expenditures, tax receipts, and surplus or
deficit of the government of the U.S.

• Let
• G denote federal spending for goods and services
  in a fiscal year (Oct. 1 thru Sept. 30).
• TX is federal tax receipts.
• TR is federal transfer payments.
• T is federal net taxes (TX - TR)

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If G exceeds T in a fiscal year, then we have a
federal deficit.If, however, T exceeds G, then
we have a federal surplus.
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Federal Outlays and Tax Receipts, 1978-2002 (in
millions of dollars)
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How Fiscal Policy Works
AE
AE2
AE1
?G
Full employment GDP
Real GDP
0
Y1
YFE
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The preceding slide illustrates the type of
expansionary fiscal policy that Keynesians
recommend for recession. We will now use the
AS-AD framework to illustrate contractionary
fiscal policy.
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Modeling Expansionary Fiscal Policy
Price Level
Potential GDP
AS
AD2
AD1
0
Y1
Real GDP
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The transmission mechanism
Question How is Fed policy transmitted to
macroeconomic variables such as real GDP,
employment, and the general price level?
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Fed Open Market Purchase of Securities
Increase in the Money Supply
Decrease in the interest rate
Increase in components of spending that are
sensitive to interest ratesspecifically,
investment and consumer durable goods
Multiplier Effect
Real GDP
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Diagrammatic explanation of the transmission
mechanism
MS1
MS2
AE
AE2
AE1
Nominal Interest Rate ()
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4
Md
450
0
0
Real GDP
Y1
Y2
Money
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The Fed pulled on the string big time beginning
in 1979it was an anti-inflation strategy under
Chairman Paul Volcker
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Modeling Contractionary Monetary Policy
Price Level
Potential GDP
AS
AD2
AD1
0
Y1
Real GDP
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Conventional 30 year
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Monthly payments on a 110,000 30 year mortgage
note
Mortgage rate Monthly Payment1
8 807.14
10 965.33
12 1,131.47
14 1,303.36
16 1,479.23
1 Does not include prorated insurance or property
taxes.
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Data in thousands of units
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More recently, the Fed raised the federal funds
rate six times between May 99 and May 2000from
4.75 to 6.5 .
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The Fed reversed course at the beginning of 2001
and reduced the federal funds rate 11 times that
year!
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Principles of Taxation

• Horizontal equity Tax code should be written so
  that those in the same economic circumstances pay
  the same amount in taxes.
• Vertical equity Tax code should be written so
  that those in different economic circumstances
  should pay an unequal amount in taxes.
• Benefits received principle Those who derive
  more benefits from government programs should pay
  more taxes.

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Definitions

• Taxable income Gross income - income exempt from
  taxes. Example For single filers who use the
  1040EZ

• Average tax rate (ATR) Tax payments as a percent
  of taxable income.
• Marginal tax rate (MTR) The tax rate applied to
  the last dollar of taxable income.

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Definitions, continued

• Progressive tax The proportion of taxable income
  taken in taxes increases as taxable income
  increases.
• Regressive tax The proportion of taxable income
  taken in taxes decreases as taxable income
  increases.
• Proportional tax The proportion of taxable
  income taken in taxes remains constant as
  taxable income increases.

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Affluent
Needy
The tax code is a tool for income redistribution
By making the tax structure progressive,
governments can make the after-tax distribution
of income more equitable (or even).
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Federal personal Income Tax rates Under the 1993
Tax Reform Act (Married couple filing jointly)
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Average and Marginal Tax Rates under the Tax
Reform Act of 1993 (for a couple with 2 children)
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Tax Brackets for 2003 under the 2001 Tax Reform
Act
2003 Taxable Income Marginal Tax Rate
0-12,000 10.0
12,000-47,500 15.0
47,500-114,650 27.0
114,650-174,700 30.0
174,700-311,950 35.0
Over 311,950 38.6
Source Wall Street Journal
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Quick Facts about President Bushs Tax Bill

• The current 39.6 tax rate drops to 33
• The current 36 tax rate drops to 33
• The current 31 rate drops to 25
• The current 28 rate drops to 25
• The current 15 bracket is retained over most of
  its range
• A new 10 bracket applies to the lowest ¼ of the
  current 15 range.

President Bush comments (wav)
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Why a sales tax is regressive
Assume a 7.13 percent excise tax on groceries,
gasoline, cigarettes, and liquor
Family (1)Income (2)Spending for items subject to excise tax (3) (2)/(1) (4) Excise Tax Paid (5)(4)/(1)ATR
Greens 27,000 16,200 .60 1,188 4.4
Jones 64,000 25,600 .40 1,871 2.9
Lemons 270,000 40,500 .15 2,961 1.0
Moral of the story Low income families tend to
spend a greater proportion of their income on
items subject to excise taxes. Hence excise taxes
tend to be regressive.
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Automatic Stabilizers
Taxes (TX) and Transfer Payments (TR) are
called automatic stabilizers because they react
to changes in national income in a way that
increases the federal deficit (or reduces the
surplus) in the event of an economic contraction
or reduces the deficit (increases the surplus)
when the economy is expanding.
The automaticstabilizers make sure that
disposable income (DI) does not fall too
muchwhen national incomeis falling, and
vice-versa.
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Remember that the federaldeficit or surplus
isequal to the differencebetween G and Net Tax
Receipts,where Net Taxes are equal toTX - TR

• ?Y??TX, for example
• ?Y??TX, and vice versa
• ?Y??TR, for example
• ?Y??TR, and vice versa

Note that claims for unemployment
compensation and other assistance surges when
unemployment rises.
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How the Automatic Stabilizers Work
G, T
Potential GDP
T TX - TR
G
Deficit
Balanced budget at full-employment
0
Y1
Real GDP
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In the case of a federal deficit, the Treasury
must borrow. The national debt is the accumulated
borrowing of the federal government in all
previous fiscal years, minus what has been repaid
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Is a large national debt a bad thing?

• Arguments against a large national debt include
• The burden on future generations argument.
• A large national debt means that a significant
  share of federal spending must be allocated for
  interest paymentsleaving less for other
  priorities.
• A large national debt makes the U.S. too
  dependent on foreign financial inflows.
• Federal borrowing crowds out private sector
  borrowing unitsi.e., firms and households.

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We (the U.S.) owe 5.7 trillion in debt
and if we dont pay it off, our children and our
grandchildren are going to have to.
Congressman Marion Berry, in a speech to the
Jonesboro Lions Club on April 16, 2001.
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Hall Liberman Rule-of-Thumb
As long as the debt grows by the same
percentage as nominal GDP, the ratios of debt to
GDP will remain constant. In this case, the
government can continue to pay interest on its
rising debt without increasing the average tax
rate in the economy.
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www.bea.gov
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