Introduction to Economics Fiscal Policy Overview

Transcription

1 Introduction to Economics Fiscal Policy Overview This reading will help introduce you to important concepts central to Fiscal Policy. Some of the material will be review, but it is helpful to make sure you understand all these concepts thoroughly, so please read the entire article carefully. The terms in bold are the identification terms for this reading. The Circular Flow of Expenditure and Income So far two main economic models have been introduced: the production possibilities curve and the supply and demand graph. Now it is time to add a third, one that links together all the factors of a country s production together. It is called the circular flow of expenditure and income, and it describes how aggregate demand forms within our economy. 1 Imagine the diagram above shows giant interconnected pipes with water circulating in a clockwise direction. Start at point 1, with the consumers of the economy. Each household earns a certain amount of disposable income (DI), the take-home pay they are free to spend after they pay their taxes or receive their transfer payments. 2 The members of the household can choose to either save their income, putting it into the bank (a part of the financial system), or to spend it. If they spend it, this creates consumption (C) in the economy. The banking system, meanwhile, has taken the money placed in savings accounts by consumers and loaned it to businesses for investment (I). Add that flow into the economy at point 2 and now the pipes are carrying C and I, soon to be joined by government spending (G) 1 Baumol, William J., and Alan S. Blinder, Macroeconomics: Principles and Policy, Eighth Edition (Fort Worth, Texas: Harcourt College Publishers, 2000): Transfer payments are money given by the government to a household as outright grants and not in exchange for productive activity. Examples would be welfare, unemployment insurance, and social security payments. 1

2 at point 3. This last category can include any government expenditure, from paying for the new stealth bomber planes produced by private defense companies, to buying Ford sedans used by FBI field agents. The government is also a key employer in our economy, with 14% of the civilian workforce receiving a salary from the national, state, or local authorities. 3 The flow now includes C + I + G, which would be enough if our economy was closed to the outside world. Without exports or imports, these would be the only components of aggregate demand. Though the United States is not as open as many might think (it only imports and exports about 12% of its total GDP value 4 ), we cannot discount the role of the world in the American economy. Imports leak out of the economy as American money is exchanged for foreign goods these are items we consume and enjoy, but we cannot count them as a part of our production and therefore they have to be subtracted. On the other hand, foreign money is paid into our economy in exchange for the export of American goods stuff produced by us, but consumed by other countries. We get to count that into our GDP, no matter where the sweater or computer might end up being used. Finally, by the time we reach point 4, we have created the essential equation of C + I + G + (X M). This is not the end of the story, though. This money that consumers, businesses, governments, and foreigners pay has got to be in exchange for some sort of good or service. It is not just thrown into the economy for no good reason. These payments are given to firms who now will produce the domestic product. Just as in a regular demand curve, there are different coordinates to represent this product, depending on the current price level. For example, on the graph below, we can start at P 0 which means that the country demands Y 0 worth of real GDP. At different price levels the quantity demanded will change at a higher price level like P 1 the country would not demand as many goods to be made in a given year (only Y 1 ), but at a lower price level like P 2 the country would demand more (see Y 2 ),. The series of these combinations makes an aggregate demand curve (AD). Therefore the real GDP at this particular moment in time is just one point along the AD curve. What is one group s spending is another s income. Consumers, businesses, the government, and foreigners all agreed to the prices of the goods they demanded, and now that price must be paid and collected by the producing firms as their income. Therefore, it is a rule 5 3 Baumol and Blinder, Baumol and Blinder, Baumol and Blinder,

3 that national income and domestic product must be equal. This means that if a car cost $25,000 to the consumer, it also means $25,000 of income to the producer. All earnings in the US represent services and goods sold, so what we earn must be equal to what someone else spent on us. Looking back at the circular flow, you can see that all the water that flows into stage 5 must flow right out again and into the hands of the households that run these firms. They pay their taxes to the government, receive transfer payments in certain cases, and now we are back to where we started from. Determinants of Aggregate Demand and Aggregate Supply AGGREGATE DEMAND Consumption As studied earlier, the aggregate demand and aggregate supply curves of an economy behave much like regular demand and supply curves they only shift when their determinants change. If there is a change in the price level of an economy, we only witness a move along a curve (see graph above). The determinants of an aggregate demand curve are anything that affects its components C, I, G, X, or M. Consumer spending is primarily affected by disposable income, and this relationship will be expanded in the section called the marginal propensity to consume. Another determinant is consumer wealth. Be careful income is different than wealth. Your income is what you earn as a wage or salary, usually determined by a period of time, such as by the hour or per year. A person s wealth includes any assets or savings he or she owns outright at a given time, including the value of bank accounts, land, or stock. This is one concrete reason why the rise and fall of the stock market does affect the American economy. If the value of a largelyheld stock increases, it could cause an increase of the aggregate demand curve from D 0 to D 1 in the graph below. 6 6 Baumol and Blinder, 96. 3

4 A controversial determinant is the real interest rate. This relationship will be studied in more detail in the section on monetary policy, because certainly the Federal Reserve hopes that when it prompts the lowering of the interest rates of the economy, this will spur both investment and consumer spending. They hope that you will be attracted by low interest rate loans on the bank, and decide to buy a new car or house with that borrowed money. However, statistically it seems that the particular relationship between real interest rates and consumer spending is quite weak, though it may be increasing as more and more Americans decide to buy on credit goods and services they cannot afford. Future income expectations are the final consumer spending determinant. To understand how this works, consider this example: governments use tax cuts to encourage greater spending in the economy, creating growth. However, experience has taught us that temporary tax cuts are not effective. Because the citizens know that taxes will rise again, they tend to not spend the money returned to them by the tax cut, instead saving for future years when they know their burden will be higher. So, price expectations in this case counteract the intention of the temporary tax cut, which was to encourage us all to run to the mall. Investment In contrast to consumption s rather weak response to real interest rates, most small businesses depend on loans to cover start-up costs and help them get started. Moreover, large businesses may wait until they see favorable interest rates before borrowing money to expand. Therefore, a very important determinant of aggregate demand is investment s susceptibility to interest rates. This is the focus for a later unit on monetary policy. Net Exports Real interest rates can also attract or repel capital flows into our country from abroad, and so in a different unit on international finance, we will discuss how the X and M components can be affected as well. The other determinants for exports and imports are relative prices between the two countries and the values of currencies. If the value of the American dollar rises on currency markets, for example, this makes it more difficult for foreigners to buy our exports (because they have to buy the dollars first, then pay the price of the export in those dollars). This would cause our aggregate demand to fall from D 0 to D 1, as shown in the graph to the right. 7 7 Baumol and Blinder, 97. 4

5 To sum up, here is a chart of the various determinants of aggregate demand: Determinants of Aggregate Demand (AD) Consumer Incomes Consumer Wealth Consumer Spending (C) Real Interest Rates Future Income Expectations Investment (I) Real Interest Rates Government Spending (G) Government Budgetary Decisions Real Interest Rates Imports and Exports Relative Prices Between Countries Relative Values of Currencies AGGREGATE SUPPLY Aggregate supply also has its own determinants. These include the price of inputs from production (such as wages and costs of raw materials), technology, labor productivity, and the available supplies of labor and capital. If wages in the economy went up, AS would decrease from S 0 to S 1 below. If the price of oil went up, the same AS decrease would occur. If more factories are built or more workers become educated on how to work computers and machines, however, then AS would increase. 8 Determinants of Aggregate Supply Price of Inputs and Raw Materials Wages Technology Labor Productivity Available Supplies of Labor and Capital Aggregate supply and aggregate demand are used together to measure both the real output and price level of an economy. Instead of simply price on the y-axis, the price level of the 8 Baumol and Blinder,

6 entire economy is used (often the Consumer Price Index, or CPI, is chosen). Instead of merely the quantity of a good, the x-axis now represents the entire sum of goods and services produced in the economy that year, adjusted for inflation (real GDP). When the aggregate demand curve increases, the real GDP increases, but so does the price level. In layman s terms, we would say that the economy has grown, but experienced inflation. When AD falls, the economy contracts and experiences deflation (or, more often in real world terms, a slow down of inflation it really depends on how much AD falls). If AS decreases, the country is really in trouble because the economy has both contracted and the price level has risen the economy stagnates and experiences inflation at the same time, called stagflation (see the graph above). On the other hand, if AS increases, then we get growth with stable or deflating prices (imagine moving from S 1 to S 0 in the above graph). This is a very positive outcome and the government tries to induce this kind of shift all the time; however, by looking at the AS determinants above, one can see that very few of these factors are firmly within the government s control. More often than not, political leaders can only affect AD and must accept an inflationary cost to their expansionary policy. The Business Cycle When the economy grows, businesses expand and need to hire more workers, causing unemployment to fall. People who were looking for jobs can now find them, even if they need to be retrained to perform well. In a growing economy, employers may be willing to take a chance, or at least be less particular in their hiring because, frankly, they need the labor! In contrast, when the economy contracts, businesses lay off workers and unemployment rises. There is a law called Okun s Law that states that our economy needs to grow by 3% a year to keep unemployment levels unchanged. Every time the economy slows down 1% (meaning growth of only 2%), unemployment will rise by 0.5%. This is a part of the larger business cycle. Assume that we begin in an economy with low wages, a situation very favorable for the expansion of business. As the economy begins to grow, more workers are hired and unemployment falls. As more workers are attracted into working, or even being fought for by competing businesses, they can begin to demand higher wages. Wages end up getting so high that they drive the cost of producing goods up, forcing firms to charge a higher price to the consumer. Growth has therefore caused inflation, a trend that is magnified because now workers who face rising prices in the grocery store will demand even higher wages at work to survive. Eventually wages become so high that businesses have to begin to lay off workers. Unemployment begins to increase again until wages have been lowered to a reasonable level and the whole process begins again. Another way to look at it is described in the chart on the next page. In a thriving economy, consumers demand more goods and services, driving up aggregate demand. This increase in AD causes the equilibrium price level to rise, causing inflation. Our growth has created some inevitable inflation. Eventually, though, the price level will get too high and the quantity of goods demanded will decrease, because people just cannot afford to pay so much. People buy less, and businesses feel this slump. They lay off workers, who are now unemployed and can buy even less than before. Eventually the economy hits rock bottom and cars, computers, and food are being sold for bargain prices so low that consumers can begin to afford them again. The cycle starts all over again. This trend has been the pattern of industrialized economies for decades, despite the hope that one day we can break through the 6

7 cycle and find a way to just have steady, smooth recession-less growth. So far that has just proven to be a pipe dream. As you can see in the graph below, our economy has been through many cycles even in just the last 40 or so years Kenneth M. Morris and Alan M. Siegel, The Wall Street Journal Guide to Understanding Money & Investing (Lightbulb Press, 1997): Baumol and Blinder, 36. 7

8 Despite the fact that it may look like the economy never makes progress, it believed that the overall trend of an industrialized or developing country is upwards, as shown in the graph below. The final statistic helpful in our evaluation of the economy is potential GDP, shown in the graph above. Potential GDP is the gross domestic product our economy would produce if it was fully employed. Full employment is not zero unemployment, but instead a measure of acceptable frictional (and sometimes structural) employment levels that economists understand is the sign of a normal, healthy economy. Cyclical unemployment, workers not finding jobs because of a contracting economy, is not the kind of unemployment economists like, and so any amount of it will be considered disequilibrium unemployment. Traditionally, our full employment target has been at about 4-6%, most recently thought somewhere between 5-5.5%. If our country could reach full employment and use all its other resources efficiently, then we could say we were operating near the frontier of our production possibility curve. Potential GDP does more than this, though. By comparing our current equilibrium real GDP to our potential, we can tell if we are in a recession or growth period, and by how much. If our equilibrium is falls below potential, then we are in a recessionary gap. This means that our unemployment is higher than the natural rate targeted above, and therefore resources are wasted in our economy (namely labor). We are not producing what we should and could be producing if we were fully employed. You can see this situation illustrated in graph (a) below. On the other hand, if our real GDP exceeds potential, then we are in an inflationary gap. How can we exceed our potential? Remember that potential GDP is based upon full employment as defined by economists, somewhere around 5 to 5.5% unemployment. Our economy has fallen below that on occasion, and you can imagine how this leads to inflation. If unemployment falls too low, then workers are difficult to find and hire and even the people with jobs may be working overtime. Businesses compete for new workers, raising the average wage level, which is inflationary, as discussed above. Moreover, workers have more disposable income, so they spend more, causing AD to shift up as well. Pretty soon AD has shifted past potential GDP and the economy is experiencing inflation. This situation is illustrated in graph (c) below Baumol and Blinder,

9 Recessionary and Inflationary Gaps 12 If all this is true, how can the political powers control this series of ups and downs? When the Congress or president is involved, they have fiscal policy decisions they can make taxing and spending. To expand the economy expansionary fiscal policy Congress can increase government spending, increase transfer payments, or cut taxes. Here Congress could raise GDP directly through the G component buying more bomber planes or just hiring more government clerks. Or they could increase consumption (C) by increasing the disposable income families have left over after taxes or the addition of transfer payments. Congress might choose one or several of these policies during a recessionary period. In contrast, someday they may want to contract the economy because they are worried about an inflationary gap. Remember that too much inflation is very harmful to an economy, and a government may want to cool the economy down before it overheats. They would do this through contractionary fiscal policy, which means that Congress could decrease government spending, decrease transfer payments, or raise taxes. This is shown in the table below: Expansionary Fiscal Policy Contractionary Fiscal Policy Raise Government Spending Raise Transfer Payments Lower Taxes Lower Government Spending Lower Transfer Payments Raise Taxes The goal is to find the right target (see graph b) and stabilize the economy there, but this is a very difficult mission. It is like trying to swat gnats with a baseball bat the tool is heavy and clumsy, and by the time you ve gotten it in motion, the fly is probably already gone. 12 Baumol and Blinder,

10 The Marginal Propensity to Consume and the Multiplier If the government could put $100 in everyone s pockets (all 270 million of us), it still would not create $27 billion worth of spending. At first it may only create $24 billion, but eventually it might create over ten times that! Every individual has a marginal propensity to consume (MPC) an amount of each additional dollar of disposable income (DI) he or she gets that he or she will turn around and spend. So, if John Doe received an extra dollar of income, and he spent $.75 of it, then.75 would be his MPC (and.25 would be his MPS, or marginal propensity to save). This figure can be determined by the ratio: MPC = Change in C Change in DI that produces the change in C Everyone may have a different personal MPC, but when you look at national averages it is clear that countries tend to have their own specific spending habits. In 1963, the US government assumed that this country had an overall MPC of.90, meaning that Americans spent about ninety cents of every dollar of additional income. Though this may seem high, it has proven to be accurate. The Japanese, on the other hand, tend to be better savers, and their MPC may only be.60 or.75. If you remember back to the study of the production possibility frontier, this is a reason why Japan may have seen such explosive growth over the past fifty years since World War II savings creates money in the financial system that can be used to loan to businesses and create investment and capital growth. This means Japan s production possibility frontier moved out faster than America s, even though America s was larger to start with. Why do we care about our MPC? Well, it has a lot to do with the correct use of fiscal policy. If John Doe receives an extra $100 from a job with the government, he will probably spend $90 and save $10. Let s say he spent that $90 in a splurge at a local store buying DVDs. The owner of that store has now $90 of additional income that has come his way. He may decide to take his family out to a fancy Japanese sushi dinner in Boston for $81 (keeping with the same MPC of.90), and save $9 under his mattress. The owners of the restaurant now have $81 of additional income, and they can go spend $72.90 somewhere else. Ultimately, if you followed this money throughout the economy, you would have to add $90 + $81 + $ $65.61 and so on until you added it all up to $1000 of total spending added to the economy. So John Doe s $100 of income has actually created $1000 of spending in the economy. This is called the multiplier effect. The easy way to figure out these values is to plug the MPC into the equation for the sum of infinite geometric progression: 1/(1-r). Therefore, the formula for the multiplier is: 1 1-MPC In this case, the MPC is.90, so the equation would read: or

11 1.1 which equals 10. So 10 is the multiplier, and you multiply the multiplier by the amount of the original injection into the economy ($100) to get $1000 total spending. The multiplier can also work in reverse. If John Doe were to lose $100 from his income, he would spend $90 less than otherwise, causing someone else to lose $90 from their income, and so on. In the end, $1000 in spending would be lost in the economy. The higher the MPC, the higher the multiplier. If you think about that, it makes sense. The more of each dollar a person spends, the more money they will give to others for them to eventually spend, and the more money is floating around in the economy. A high MPC means a small policy change can have swift and massive results. Take the initial example of a $100 tax rebate for every one of the 270 million US citizens: if we each spent $90 of our original $100, the original injection into the economy would be $24,300 million (270 million people x $90 for each person). Now, that sum enters the rippling effect throughout the economy in which it is multiplied. We multiply $24,300 million by 10 and get a total $243,000 million ($243 billion) worth of new spending in the economy. A tax cut of $27 billion created $243 billion worth of spending. It all works great in theory, but like in the rest of economics our theory is a bit too convenient. We call this tool the oversimplified multiplier, actually, because there are some reasons why it does not always create as much spending as it would seem. 13 For the purposes of this course, though, we will not dwell on these technicalities. Fiscal Policy Options to Correct Gaps Now the objective is to find out how much of a spending injection or tax cut is necessary to correct a recessionary economy, or vice versa for an inflationary one. First, it is necessary to find out how much AD needs to be shifted to reach potential GDP. Notice in the figure below that $800 billion is needed to shift D 0 to D 1 so that the new equilibrium will rest at $6600 billion. Assume that we learn that $6600 is our potential GDP. We were at E 0 at $6000 billion, and are $600 billion short of this goal. If we just increased AD by that $600 billion, it would not get our equilibrium all the way over, because in fact equilibrium is not just decided by the AD curve, but by the intersection of AD and AS curves. In this way, the slope of the AS curve helps reduce the multiplier because the inflationary effect of raising AD cuts out $200 billion of an injection into the economy. (An increase in the price level reduces quantity demanded, causing us to move along the D 1 line from point A to E 1.) 13 One explanation for the oversimplification is taxation. John Doe got paid an additional $100 of his salary from the government, but we didn t take into account that he would have to actually pay taxes on that income. The definition of MPC includes the idea that it is only disposable income that counts, yet we often forget this and directly plug increases in government spending (G) into the multiplier to correct gaps. Thus in reality the multiplier would be slightly less than we are supposing here. Moreover, when we plug the American economy into that of the rest of the world, more reductions of the multiplier occur. If American incomes increase and our economy becomes stronger, we demand not only more of our own goods, but of imported goods as well. Since imports (M) are actually subtracted from GDP, our increased income can actually slightly reduce the otherwise skyrocketing GDP due to this leakage out of our country. One final reason why the multiplier is exaggerated has to do with the supply curve and the inflation effect of AD increases, a topic that will be discussed in a moment. Though we acknowledge these flaws of the oversimplified multiplier, we still use it. 11

12 Therefore, $800 billion of spending is needed in the economy. But how much government spending or how much of a tax increase is needed to move the AD this far? Let s start with government spending because it is more straightforward. The next question you would need to ask is: What is the MPC for this economy? Assume it is.75. Therefore our oversimplified multiplier would be 4 (plug it into the equation yourself to check). So, any increase in government spending would be multiplied by four times in the economy. So a $200 billion increase of G would create a shift of $800 billion in AD. Taxes are slightly more complicated because you have to assume that instead of a straight injection of spending, people are not going to spend their entire tax rebate. If we know that the multiplier is still 4, and that a $200 billion increase in spending is needed to enter the economy, we then add just one more step. If citizens will spend 75% of their tax rebate, that 75% must equal $200. (The other 25% given to the taxpayers they squirreled that away in their savings.) Let x equal the total amount of the tax cut, and we know that: If.75 x = 200, then solve for x and you get x = 250. Therefore, Congress needed to vote on a total tax break of $250 billion. You can easily see that government spending is a more direct injection into the economy, because all of that spending goes through the multiplier, while a tax cut allows people to shave off some for their savings. The multiplier can only multiply spending if the money is spent to begin with it cannot multiply savings (that will happen later in the monetary policy unit!). Both government spending (G) and taxation (affecting C) can be effective tools of fiscal policy, though, depending on the situation. Tax rebates are generally encouraging to the economy, as long as they are perceived as long-term (and not temporary), and as long as they affect a wide strata of the population (not just the rich who might not need more ample cash to spend anyway). By the way, if you could divide the population into income classes, one might find that the MPC decreases as you work your way up the income scale. It makes sense the poor have to spend more of their everyday income just to survive. The wealthy may always find a way to spend more, but they are less pressured to spend every new dollar in their pocket because they have had the luxury of spending quite a bit for basic necessities already. In conclusion, using the MPC and the multiplier, economists can determine exactly how the elected government can affect the growth and employment levels in the economy. Through Baumol and Blinder,

13 the correct amounts of additional spending/spending cuts or tax raises/tax cuts, the Congress and the president can try to keep our real GDP close to potential. The Self-Correcting Mechanism What if our elected officials do not want to apply fiscal policy? What if they do not know what to do? Can the economy get back on its feet by itself? The short answer is yes, but it does so slowly and painfully. Let s start with an inflationary gap. In this situation, prices and wages have risen due to the tight economy and low unemployment rate. (See the discussion of the business cycle above.) Since wages and input costs are both determinants of aggregate supply, this rapidly growing economy will eventually overheat if no policy action is taken. The high wage increases and rising prices on other inputs causes the AS to decrease and shift back (see graph below). This process causes stagflation decreased output, higher unemployment, and inflation. It is a painful way to contract the economy. It will work, but you would probably be voted out of office before it did. 15 In a recessionary gap, the outcome is favorable but also very slow. In a recession, unemployment is high and wages fall as a result. Workers will accept lower wages just to get a job and earn a living. As wages fall, the cost of production is significantly eroded, and more can be produced for less money. This is a very long term change, one that would only be seen without any intervention in the economy. The AS curve shifts out (see graph below), causing growth with deflation and decreased unemployment. This sounds like a terrific solution, and it might be if it did not take so long. In practice, though, workers are very reluctant to accept wage cuts in their current employment. They may accept putting off raises, but actually decreasing the real value of their income is fought by labor unions and employees. It takes a very deep recession, or even a depression, for workers to give in on this point, maybe taking even years. This is one of the reasons why we rarely see deflation in our economy (not such a bad thing if 15 Baumol and Blinder,

14 you remember from the last unit, deflation can be a drag). Often politicians are not willing to wait this long before acting, so the self-correcting mechanism may work in theory but is impractical in reality. The Keynesians certainly did not like waiting. In our next reading, we will learn that John Maynard Keynes rejected the idea that economies would always correct themselves and instead maintained that it was the duty of the government to help nudge them in the right direction through active fiscal policy. Other economists believe that our economy does have good automatic stabilizers that protect us from falling into another Great Depression. One of those stabilizers is unemployment insurance, preventing disposable income from falling by allowing the newly unemployed workers to collect transfer payments until they find another source of income at a new job. This system works without requiring a policy decision to be made, and therefore is automatic. Many people who like to focus on the self-correcting mechanism and the automatic stabilizers as freemarket, laissez-faire ways to influence the economy may also follow a school of thought called Monetarism (called Monetarists). They believe that fiscal policy is at best ineffective, and at worst inflationary and counterproductive. But that will be a story for another day Baumol and Blinder,