Unit V: Economics of the Government

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By Alan J. CarperBob Jones University Press. 1998
ECONOMICS for Christian Schools

• Unit V Economics of the Government

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Fiscal Policy

• A.P. Macroeconomics Chapter 12
• Economics/Honor Econ Chapter 14

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Biblical Integration

• We need to remember God is the power behind a
  nation, state, county, township, or individual
  who makes them wealthy or poor. (I Sam. 27)

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Objectives

• Define fiscal policy
• Explain Keynes' solution to the business cycle
• Describe the marginal propensity to consume and
  its effect on the money supply
• List and explain the problems of using government
  spending as a tool of fiscal policy
• List the major source of the government's tax
  revenue
• Contrast proportional taxes.
• Progressive taxes and regressive taxes
• List and explain the problems with using taxation
  
• as a tool of fiscal policy
• Explain the Keynesian concept of "pump priming"
• List and explain the problems with using
  government borrowing as a tool of fiscal policy

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A.P. Objectives

• What fiscal policy is and why it is an important
  tool in managing economic fluctuations.
• Which policies constitute expansionary fiscal
  policy and which constitute a contractionary
  fiscal policy.
• Why fiscal policy has a multiplier effect and how
  this effect is influenced by automatic
  stabilizers.
• Why tax and transfer multipliers are less than
  the government purchases multiplier.
• Why government calculate the cyclically adjusted
  budget balance.
• Why a large public debt may be a cause for
  concern.
• Why implicit liabilities of the government are
  also a cause for concern.

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Sources of Tax Revenue in theUnited States, 2004
Personal income taxes, taxes on corporate
profits, and social insurance taxes account for
most government tax revenue. The rest is a mix of
property taxes, sales taxes, and other sources of
revenue. Source Bureau of Economic Analysis.
(Erbil)
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Government Spending in theUnited States, 2004
Social insurance programs are government programs
intended to protect families against economic
hardship.
The two types of government spending are
purchases of goods and services and government
transfers. The big items in government purchases
are national defense and education. The big items
in government transfers are Social Security and
health care programs.
(Erbil)
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Expansionary and Contractionary Fiscal Policy
Expansionary Fiscal Policy Can Close a
Recessionary Gap
At E1 the economy is in short-run equilibrium
where the aggregate demand curve AD1 intersects
the SRAS curve. At E1, there is a recessionary
gap of YE - Y1. An expansionary fiscal
policyan increase in government purchases, a
reduction in taxes, or an increase in government
transfersshifts the aggregate demand curve
rightward. It can close the recessionary gap by
shifting AD1 to AD2, moving the economy to a new
short-run equilibrium, E2, which is also a
long-run equilibrium.
Expansionary fiscal policy increases aggregate
demand.
Recessionary gap
(Erbil)
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Expansionary and Contractionary Fiscal Policy
Contractionary Fiscal Policy Can Eliminate an
Inflationary Gap
At E1 the economy is in short-run equilibrium
where the aggregate demand curve AD1 intersects
the SRAS curve. At E1, there is an inflationary
gap of Y1 - YE .
A contractionary fiscal policyreduced government
purchases, an increase in taxes, or a reduction
in government transfersshifts the aggregate
demand curve leftward.
Contractionary fiscal policy decreases aggregate
demand.
It can close the inflationary gap by shifting AD1
to AD2, moving the economy to a new short-run
equilibrium, E2, which is also a long-run
equilibrium.
Inflationary gap
(Erbil)
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Lags in Fiscal Policy

• In the case of fiscal policy, there is an
  important reason for caution there are
  significant lags in its use.
• Realize the recessionary/inflationary gap by
  collecting and analyzing economic data ? takes
  time
• Government develops an action plan? takes time
• Implementation of the action plan ? takes time

(Erbil)
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Fiscal Policy and the Multiplier

• Fiscal policy has a multiplier effect on the
  economy.
• Expansionary fiscal policy leads to an increase
  in real GDP larger than the initial rise in
  aggregate spending caused by the policy.
• Conversely, contractionary fiscal policy leads
  to a fall in real GDP larger than the initial
  reduction in aggregate spending caused by the
  policy.

(Erbil)
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The Multiplier Effect of an Increase in
Government Purchases of Goods and Services
A 50 billion increase in government purchases of
goods and services has the direct effect of
shifting the aggregate demand curve to the right
by 50 billion. However, this is not the end of
the story. The rise in GDP causes a rise in
disposable income, which leads to an increase in
consumer spending, which leads to a further rise
in GDP, which leads to a further rise in consumer
spending, and so on. The eventual shift, from
AD1 to AD2, is a multiple of the rise in
GDP. What happens if government purchases of
goods and services are instead reduced? The
math is exactly the same, except that theres
a minus sign in front if government purchases
fall by 50 billion and the marginal propensity
to consume is 0.6, the AD curve shifts leftward
by 125 billion.
(Erbil)
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Multiplier Effects of Changes in Taxes and
Government Transfers

• Ex The government hands out 50 billion in the
  form of tax cuts.
• There is no direct effect on aggregate demand by
  government purchases of goods and services GDP
  goes up only because households spend some of
  that 50 billion.
• How much will they spend?
• MPC 50 billion. For example, if MPC 0.6, the
  first-round increase in consumer spending will be
  30 billion (0.6 50 billion 30 billion).
• This initial rise in consumer spending will lead
  to a series of subsequent rounds in which real
  GDP, disposable income, and consumer spending
  rise further.

(Erbil)
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How Taxes Affect the Multiplier
Rules governing taxes and some transfers act as
automatic stabilizers, reducing the size of the
multiplier and automatically reducing the size of
fluctuations in the business cycle. In contrast,
discretionary fiscal policy arises from
deliberate actions by policy makers rather than
from the business cycle.
(Erbil)
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Differences in the Effect of Expansionary Fiscal
Policies
(Source economy.com)
(Erbil)
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The Budget Balance as a Measure of Fiscal Policy

• Other things equal, discretionary expansionary
  fiscal policies increased government purchases
  of goods and services, higher government
  transfers, or lower taxesreduce the budget
  balance for that year.
• That is, expansionary fiscal policies make a
  budget surplus smaller or a budget deficit
  bigger.
• Conversely, contractionary fiscal
  policiessmaller government purchases of goods
  and services, smaller government transfers, or
  higher taxesincrease the budget balance for
  that year, making a budget surplus bigger or a
  budget deficit smaller.

(Erbil)
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The Business Cycle and the Cyclically Adjusted
Budget Balance

• Some of the fluctuations in the budget balance
  are due to the effects of the business cycle.
• In order to separate the effects of the business
  cycle from the effects of discretionary fiscal
  policy, governments estimate the cyclically
  adjusted budget balance, an estimate of the
  budget balance if the economy were at potential
  output.

(Erbil)
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The U.S. Federal Budget Deficit and the Business
Cycle
The budget deficit as a percentage of GDP tends
to rise during recessions (indicated by shaded
areas) and fall during expansions.
Source Congressional Budget Office, National
Bureau of Economic Research. (Erbil)
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The U.S. Federal Budget Deficit and the
Unemployment Rate
Here, the unemployment rate serves as an
indicator of the budget cycle, and we should
expect to see a higher unemployment rate
associated with a higher budget deficit. This
is confirmed by the figure The budget deficit as
a percentage of GDP moves closely in tandem with
the unemployment rate.
There is a close relationship between the budget
balance and the business cycle A recession moves
the budget balance toward deficit, but an
expansion moves it toward surplus.
(Erbil)
Source Congressional Budget Office, Bureau of
Labor Statistics
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Long-Run Implications of Fiscal Policy

• U.S. government budget accounting is calculated
  on the basis of fiscal years.
• Persistent budget deficits have long-run
  consequences because they lead to an increase in
  public debt.

(Erbil)
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Government Debt as a Percentage of GDP
Public debt as a percentage of GDP is a widely
used measure of how deeply in debt a government
is. The United States lies in the middle range
among wealthy countries. Governments of countries
with high public debtGDP ratios, like Italy and
Belgium, pay large sums in interest each year to
service their debt.
(Source OECD.)
(Erbil)
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Problems Posed by Rising Government Debt

• This can be a problem for two reasons
• Public debt may crowd out investment spending,
  which reduces long-run economic growth.
• And in extreme cases, rising debt may lead to
  government default, resulting in economic and
  financial turmoil.

(Erbil)
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Deficits and Debt in Practice
A widely used measure of fiscal health is the
debtGDP ratio. This number can remain stable or
fall even in the face of moderate budget deficits
if GDP rises over time.
(Erbil)
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U.S. Federal Deficit since 1939
The debtGDP ratio is government debt as a
percentage of GDP.
The federal budget deficit as a percentage of GDP
since 1939. The federal government ran huge
deficits during World War II and has usually run
smaller deficits ever since.
(Erbil)
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The Federal DebtGDP Ratio Since 1939
Comparing with the previous slide, one can see
that many years the debt-GDP ratio has declined
in spite of government deficits. This seeming
paradox reflects the fact that the debtGDP ratio
can fall, even when debt is rising, as long as
GDP grows faster than debt.
Source Economic Report of the President (2005).
(Erbil)
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Implicit Liabilities
Implicit liabilities are spending promises made
by governments that are effectively a debt
despite the fact that they are not included in
the usual debt statistics.
(Erbil)
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The Implicit Liabilities of the U.S. Government
This figure shows current spending on Social
Security, Medicare, and Medicaid as percentages
of GDP, together with Congressional Budget Office
projections of spending in 2010, 2030, and 2050.
Due to the combined effects of the aging of the
population and rising health care spending, these
programs represent large implicit liabilities of
the federal government.
Source Congressional Budget Office.
(Erbil)