Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives

Fiscal Policy: Congress & President (Treasury/OMB)

Monetary Policy—ain’t fiscal policy—The Fed does M-policy

Fiscal automatic stabilizers Government spending and taxes that automatically increase or decrease with the business cycle

•progressive income tax/unemployment benefits/food stamps / other entitlements

.

Tax wedge The difference between the pre-tax and post-tax return to an economic activity.

Disincentive to work??? Supply-side tax cuts

Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

Government Purchase and Tax Multipliers

The Multiplier Effect and Aggregate Demand

Government Purchase Multiplier

The Multiplier Effect of an Increase in Government Purchases

This spending multiplier is analogous but not the same as the deposit multiplier

The Government Tax Multiplier

Cut in tax rates affects equilibrium real GDP in two ways:

(1) disposable income rises consumption spending rises

(2) the rate at which purchasing power leaks from the spending stream declines the spending multiplier increases

The less the marginal propensity to leak, the greater the spending multiplier.

Recall:

Spending Multiplier = 1/[Marginal Propensity to Leak]

= 1/[Propensity Not to Respend Additional Income Domestically]

=1/[Propensity to pay taxes, save and buy things from abroad]

Taking into Account the Effects of Aggregate Supply:

Slowing the Multiplier

The Government Purchases and Tax Multipliers

Because the Price Level rises,

Real GDP does not increase as much

as it otherwise would

The multiplier effect is reduced

An Expansionary Fiscal Policy Increases Interest Rates

Crowding out A decline in private expenditures as a result of an increase in government purchases…slowing the multiplier

Money market

The Limits of Using Fiscal Policyto Stabilize the Economy

Crowding Out in the Short Run

The 1960s: A Policy Menu?

The Phillips Curve

Explaining the Phillips Curve with Aggregate Demand

and Aggregate Supply Curves

Phillips curve A curve showing the short-run relationship between the unemployment rate and the inflation rate.

As long as SRAS is stable, get Phillips Curve relation

Explaining the Phillips Curve with Aggregate Demand

and Aggregate Supply Curves

Phillips curve A curve showing the short-run relationship between the unemployment rate and the inflation rate.

As long as SRAS is stable, get Phillips Curve relationIf people expect high inflation… Phillips curve shifts…

The Short-Run and Long-Run Phillips CurvesThe Inflation Rate and the Natural Rate of Unemployment in the Long Run

Nonaccelerating inflation rate of unemployment (NAIRU) The unemployment rate at which the inflation rate has no tendency to increase or decrease.

Equilibrium unemploy

“Natural” unemploymt

The Balance of Payments of the United States, 2006 (billions of dollars)

CURRENT ACCOUNT

Exports of goods $1,023

Imports of goods −1,861

Balance of trade −838

Exports of services 423

Imports of services −343

Balance of services 80

Income received on investments 650

Income payments on investments −614

Net income on investments −36

Net transfers −90

Balance on current account −812

Don’t forget net

compensation of nationals working

abroad

(= Labor Services)

FINANCIAL ACCOUNT

Increase in foreign holdings of assets in the United States 1,860

Increase in U.S. holdings of assets in foreign countries −1,055

Balance on Financial Account 805

BALANCE ON CAPITAL ACCOUNT -4

Statistical discrepancy 11

Balance of payments 0

The Balance of Payments

balances:

Current Account

+

Financial Account

+Capital Account

+

Statistical Discrepancy

=

ZERO

The Effect of a Government Budget Deficit on Current Account Balance

The Twin Deficits, 1978–2006

Current Account Deficit = Net Capital Inflows = National Borrowing = (I – Sprivate) + (G – T)

= - NFI = Private Borrowing + Public Borrowing

The Foreign Exchange Market and Exchange Rates: The Operation of Supply and Demand for a Currency

Equilibrium in the Market for Foreign Exchange

Foreign demand for US dollar:

•Buy US stuff

•Currently produced goods

and services

•Buy US assets

•Stocks

•Bonds

•Real estate

•Hotels and factories (fdi)

•Hold $ in US banks

•Transactions demand

•Speculative demand