Fiscal and Monetary Policy Effects Outline: 1.What is fiscal and monetary policy and how do they...
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Fiscal and Monetary Policy Effects
Outline:
1. What is fiscal and monetary policy and how do they work?
2. The Federal Budget
3. Principles of taxation
4. The automatic stabilizers
2
4
6
8
10
12
14
16
50 55 60 65 70 75 80 85 90 95 00
State and Local Federal
Federal, State & Local Government Spendingas a Percent of GDP
www.economagic.com
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.
The Federal Budget
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)
The Federal budget is an annual statement of expenditures, tax receipts, and surplus or deficit of the government of the U.S.
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.
www.economagic.com
0
500000
1000000
1500000
2000000
2500000
78 80 82 84 86 88 90 92 94 96 98 00 02
OUTLAYS RECEIPTS
Federal Outlays and Tax Receipts, 1978-2002 (in millions of dollars)
How Fiscal Policy Works
AE
Real GDP0 Y1
AE1
YFE
Full employment GDP
AE2
G
)1(
1
MTRMPIMPCG
Y
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.
Potential GDP
AS
AD1
Real GDP
Price Level
0
AD2
Modeling Expansionary Fiscal Policy
Y1
Question: How is Fed policy “transmitted” to macroeconomic variables such as real GDP, employment, and the general price level?
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 rates—specifically, investment and consumer durable goods
Multiplier Effect
Real GDP
00
AE
Real GDP
450
)()1(
1IC
MTRMPIMPCY
6%
4%
MS1 MS2
Y1 Y2
AE1
AE2
Md
Diagrammatic explanation of the transmission mechanism
IC
Nom
inal
In
tere
st R
ate
(%)
Money
The Fed pulled on the string big time
beginning in 1979—it was an anti-inflation
strategy under Chairman Paul Volcker
Potential GDP AS
AD1
Real GDP
Price Level
0
AD2
Modeling Contractionary Monetary Policy
Y1
8
10
12
14
16
18
20
79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01
Federal Funds
Recessions are shaded
6
8
10
12
14
16
18
20
80 82 84 86 88 90 92
Mortgage Interest Rates
Recessions are shadedConventional 30 year
www.economagic.com
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.
Monthly payments on a $110,000 30 year mortgage note
400
800
1200
1600
2000
2400
80 82 84 86 88 90 92
Monthly Housing Starts
Recessions are shadedData in thousands of units
www.economagic.gov
More recently, the Fed raised the
federal funds rate six times between May 99 and May 2000—from 4.75% to 6.5
%.
The Fed reversed course at the beginning of 2001 and reduced the
federal funds rate 11 times that year!
•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.
Principles of Taxation
•Taxable income: Gross income - income exempt from taxes. Example: For single filers who use the 1040EZ:
Gross Income: $35,000
Minus: Standard deduction
7,050
Equals: Taxable income
$27,950
•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.
•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.
By making the tax structure
“progressive,” governments can
make the after-tax distribution of income
more equitable (or even).
AffluentNeedy
Total TaxableIncome
Marginal TaxRate (%)
$0 0%
0-36,900 1536,901-89,150 28
89,151-140,000 31
140,001-250,000 36
250,000 and up 39.6
Federal personal Income Tax rates Under the 1993 Tax Reform Act (Married couple filing jointly)
Income Tax Ave. Tax Rate Marginal Tax Rate$10,000 $0 0% 0%20,000 272 1.4 1530,000 1,766 5.9 1550,000 4,766 9.5 1575,000 10,315 13.8 28
150,000 32,140 21.4 31250,000 66,802 26.7 36400,000 128,710 32.2 39.6
Average and Marginal Tax Rates under the Tax Reform Act of 1993 (for a couple with 2 children)
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
Tax Brackets for 2003 under the 2001 Tax Reform Act
Source : Wall Street Journal
Quick Facts about President Bush’s 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)
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
Assume a 7.13 percent excise tax on groceries, gasoline, cigarettes, and liquor
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.
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 automatic
stabilizers make sure that disposable income (DI) does
not fall too muchwhen national income
is falling, and vice-versa.
Automatic Stabilizers
Remember that the federaldeficit or surplus is
equal to the differencebetween G and Net Tax Receipts,
where Net Taxes are equal toTX - TR
YTX, for example
YTX, and vice versa
YTR, for example
YTR, and vice versa
Note that claims for unemployment compensation and other assistance surges when unemployment rises.
Real GDP0
G, T Potential GDP
G
T = TX - TR
Y1
DeficitBalanced budget at full-employment
In the case of a federal deficit, the Treasury must borrow. The national debt
is the accumulated borrowing of thefederal government in all previous
fiscal years, minus what has been repaid
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 payments—leaving 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 units—i.e., firms and households.
“[W]e (the U.S.) owe $5.7 trillion in debt and if we don’t 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.
Interest as a Percent of Federal Outlays
www.economagic.com
Year
20001995199019851980197519701965
Perc
ent
16
14
12
10
8
6
4
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.
Growth Rate of Nominal GDP and the Public Debt
-10
-5
0
5
10
15
20
25
30
35
Year
Pe
rce
nt
Ch
an
ge
Growth Rate of theNational Debt
Growth Rate ofNominal GDP
www.economagic.com
Ratio of Gross Federal Debt to GDP in the
U.S.
0
0.2
0.4
0.6
0.8
1
1.2
1.4
Year
De
bt
to G
DP
www.bea.gov
Who Owns the National Debt?
Source: Federal Reserve
3342 / 48%
463 / 7%
1271 / 18%
1814 / 26%
Privately Owned
Fed. Reserve Banks
Foreign Investors
Agencies and Trusts