UNIT 5: STABILIZATION POLICIES WHAT CAN THE GOVERNMENT AND THE FEDERAL RESERVE DO TO FIX RECESSIONARY AND INFLATIONARY GAPS?

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1 UNIT 5: STABILIZATION POLICIES WHAT CAN THE GOVERNMENT AND THE FEDERAL RESERVE DO TO FIX RECESSIONARY AND INFLATIONARY GAPS?

2 FISCAL POLICY

3 CLASSICAL ECONOMICS Adam Smith Invisible Hand It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages." A free market is self-regulating. There may be periods of inflation and unemployment, but in the long run, the economy will bring itself back to equilibrium.

4 How does the government stabilize the economy? The government has two different tool boxes it can use: 1. Fiscal Policy- Actions by Congress and the president to adjust to the G and C in aggregate demand. 2. Monetary Policy- Actions by the Federal Reserve Bank (our central bank) to adjust the money supply

5 What can the federal gov t do to stabilize the economy? Automatic Stabilizers - policies that are already set in place that automatically reduce the size of fluctuations in the business cycle Unemployment benefits. If the economy goes into a recession and people are laid off, this payment helps to keep aggregate demand from falling to steeply. Marginal tax brackets when incomes increase so do tax payments; when incomes decrease so do tax payments. Welfare and transfer programs transfer payments tend to rise when the economy is contracting and fall when the economy is expanding.

6 Discretionary Stabilizer (Fiscal Policy) When the government deliberately makes changes to its spending and/or taxes to deal with an economic downturn. KEYNESIAN ECONOMICS John Maynard Keynes ( Canes ) In the long run we are all dead. Believed in times of economic distress, the government could jump start the economy by increasing its spending (shift the AD), which would then encourage production, which would increase employment, which would lead to spending and the cycle would continue.

7 DISCRETIONARY FISCAL POLICY Expansionary Fiscal Policy - stimulate growth by increasing consumer and business spending and employment. To increase aggregate demand, the gov t can: increase in government purchases of goods and services cut in taxes increase in government transfer payments

8 DISCRETIONARY FISCAL POLICY Contractionary Fiscal Policy - slow economic growth to fight inflation. To decrease aggregate demand that is too high, the gov t can: reduce government purchases of goods and services increase in taxes reduce government transfers payments

9 Contractionary Expansionary

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11 Objective for Aggregate Demand Action on Taxes Action on Gov t Spending Effect on Budget The national unemployment rate rises to 12% Inflation is strong and its rate is now 14% per year. Survey shows consumers are losing confidence in the economy, retail sales are weak, and business inventories are increasing rapidly. Business sales and investment are expanding rapidly, and economist believe strong inflation lies ahead. Inflation persists while unemployment stays high.

12 STAGFLATION Any policy that shifts the aggregate demand curve helps one problem but makes the other problem worse. If the government acts to increase aggregate demand and limit the rise in unemployment, it reduces the decline in output but causes even more inflation. If it acts to reduce aggregate demand, it curbs inflation but causes a further rise in unemployment. The true solution to stagflation is to get the SRAS to shift back to the right. This can be accomplished by making resources more available or a technological advance.

13 Why do cities want the Super Bowl in their stadium? Bobby spends $100 on Jason s product Jason now has more income so he buys $100 of Nancy s product Nancy now has more income so she buys $100 of Tiffany s product. The result is an $300 increase in consumer spending The Multiplier Effect is when an increase in spending sets off a chain reaction in the economy.

14 Government s purchases start a chain reaction throughout the economy. The firms producing the goods and services purchased by the government will earn revenues that flow to households in the form of wages, profit, interest, and rent. This increase in disposable income will lead to a rise in consumer spending. The rise in consumer spending, in turn, will induce firms to increase output, leading to a further rise in disposable income, which will lead to another round of consumer spending increases, and so on.

15 If the government spends $5 million, how much will AD increase by? It depends on how much of the new income consumers spend and how much they save. The more they spend, the more AD will increase.

16 Marginal Propensity to Consume (MPC) How much people consume rather than save when there is a change in income. Examples: 1. Your income increases by $100 and spend $ Your income increases by $100 and spent $ Your income increases by $100 and spent $100.

17 Marginal Propensity to Save (MPS) How much people save rather than consume when there is a change in income. 1. Your income increases by $100 and save $ Your income increases by $100 your MPC is.7 what is your MPS?

18 Because people can either save or consume MPC + MPS = 1 MPC = 1 MPS MPS = 1 MPC 19

19 FEDERAL RESERVE BANK OF SAN FRANCISCO JUNE 29, 2015 Households at the lower end of the income distribution spend more than twice what they make. At the upper end, households spend about two-thirds of what they make. The survey ranks households by income from low to high and divides them into 10 groups called deciles, with the 1 decile showing households in the bottom 10% of the income distribution, and the 10 decile showing households in the top 10%.

20 March 1, 2013

21 THE MULTIPLIER PROCESS

22 Calculating the Spending Multiplier If the MPC is.5 how much is the multiplier? If the multiplier is 4, how much will an initial increase of $5 in government spending increase the GDP by? 5(4) = $20 How much will a decrease of $3 in spending decrease GDP by? -3(4) =

23 Practice 1. If MPC is.9, what is multiplier? 2. If MPC is.8, what is multiplier? 3. If MPC is.5, and consumption increased by $2M. How much will GDP increase by? 4. If MPC is 0 and investment increased by $2M. How much will GDP increase by? Conclusion: As the MPC falls, the multiplier effect decreases

24 SPENDING MULTIPLIER PRACTICE.80 5 If the MPS =.20 the MPC = M =.25 If the MPC =.75 the MPS = M = 4.10 If the MPC =.90 the MPS = M = If the change in GDP = $20 billion and the change in GS = $5 billion, then the multiplier = 4 and the MPC =.75 and the MPS =

25 Spending Multiplier = 1/MPS MPC 1/MPS = M.90 1/.10 = /.20 = /.25 = /.40 = /.50 = 2

26 Price level Fiscal Policy Practice Congress uses discretionary fiscal policy to the manipulate the following economy (MPC =.8) P 1 $500 $1000FE LRAS AS Real GDP (billions) 1. What type of gap? 2. Contractionary or Expansionary needed? 3. How much initial government spending is needed to close gap? 500 = 5x x=100 AD 2 AD 1 $100 Billion

27 Congress uses discretionary fiscal policy to the manipulate the following economy (MPC =.5) Price level P 2 LRAS AS 1. What type of gap? 2. Contractionary or Expansionary needed? 3. How much needed to close gap? -$20b = 2x -10 = x AD 1 AD -$10 Billion $80FE $100 Real GDP (billions)

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29 What about cutting taxes? Expansionary Policy (Cutting Taxes) MPC is.75 If the government cuts taxes by $4 million, how much will consumer spending increase by? When they get the tax cut, consumers will save $1 million and spend $3 million. The $3 million is the amount that get multiplied in the economy. $3m x 4 = $12 million increase in consumer spending What if the government had increased their spending by $4 million, how much will consumer spending increase by? The gov t will spend $4 million. $4m x 4 = $16 million increase in consumer spending

30 Simple Tax Multiplier Calculating the Tax Multiplier = - MPC MPS A negative Number! taxes and output move in opposite directions If the MPC is.75 how much is the tax multiplier? The tax multiplier is -3 (spending multiplier = 4) Total change in GDP = Tax Multiplier x Initial Change in Taxes If the recessionary gap is $30 = - 3 x decrease in taxes 31

31 MPC =.5 Price level P 1 $80 $100FE LRAS AS 1. How much should the gov t increase spending by? $20b = 2x 10 = x $10 Billion 2. How much should they cut taxes by? $20b = -1x -20 = x AD 1 AD 2 -$20 Billion Real GDP (billions) 32