Aggregate Demand and Supply and Fiscal Policy

Aggregate Demand and Supply and Fiscal Policy

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The Collapse of 2008 - Causes

There is no consensus (and we are not economists) but some common

beliefs are:• Deregulation over the past couple of decades was

based on beliefs that markets can correct themselves – the recent collapse suggests that if they can it is only after severe consequences.

• There was a housing bubble prices increased rapidly before retreating to more reasonable levels.

• There was too much debt.


The Collapse of 2008 - Causes

There is no consensus (and we are not economists) but some common

beliefs are:• There was too much debt backed by housing of declining value.

• There was a legacy of subprime lending.

• There was inflation in the commodity markets.

• There was mismanagement at many financial institutions.

• The crisis accelerated as major financial institutions lost massive amounts of money, some became insolvent and credit became very hard to get.


A Perfect Storm

The 2008 Financial Collapse

Credit Crunc

h

Job Loss

Housing

Collapse

Commodity PricesGlobal

Economy

A Very Scary Outlook and Fear of Another Great

Depression


• There has been something of a rebirth in Keynesian economics and the use of fiscal policy.

• The national deficit has skyrocketed.

• Targeted spending did things such as bail out or federalize financial institutions and automakers.

• The federal government bought bad debt.

• The federal government extended unemployment benefits.

The Collapse of 2008 Fiscal Policy Responses


• Job creation programs have been initiated.

• Certain tax rebates have been enacted.

• There have been financial transfers to states.

The Collapse of 2008 Fiscal Policy Responses


How Was the Collapse Limited?

• The collapse was limited by the belief that governments should intervene.

• There were policy options both monetary and fiscal.

• Global institutions were involved and cooperated.


How Successful Were the Interventions?

• The situation did not turn into another “Great Depression.”

• But, the situation is still not healthy.

• It does seem clear that the aggressive use of monetary and fiscal policies limited the impact of the collapse.

The Car AnalogyThe economy is like a car…• You can drive 120mph but it is not sustainable.

(Extremely Low unemployment)• Driving 20mph is too slow. The car can easily go faster.

(High unemployment)• 70mph is sustainable. (Full employment)• Some cars have the capacity to drive faster then others.

(industrial nations vs. 3rd world nations)• If the engine (technology) or the gas mileage

(productivity) increase then the car can drive at even higher speeds. (Increase LRAS)

The government’s job is to brake or speed up when needed as well as promote things that will improve the engine.

(Shift the PPC outward) 10

How does the Government Stabilizes the Economy?

The Government has two different tool boxes it can use:

1. Fiscal Policy-Actions by Congress to

stabilize the economy.OR

2. Monetary Policy-Actions by the

Federal Reserve Bank to stabilize the

economy. 11

For now we will only focus on Fiscal Policy.

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Fiscal Policy

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Two Types of Fiscal PolicyDiscretionary Fiscal Policy-

• Congress creates a new bill that is designed to change AD through government spending or taxation.•Problem is time lags due to bureaucracy. •Takes time for Congress to act. •Ex: In a recession, Congress increase spending.

Non-Discretionary Fiscal Policy•AKA: Automatic Stabilizers•Permanent spending or taxation laws enacted to work counter cyclically to stabilize the economy •Ex: Welfare, Unemployment, Min. Wage, etc.•When there is high unemployment, unemployment benefits to citizens increase consumer spending.

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Laws that reduce inflation, decrease GDP (Close a Inflationary Gap)

• Decrease Government Spending• Tax Increases• Combinations of the Two

Contractionary Fiscal Policy (The BRAKE)

Laws that reduce unemployment and increase GDP (Close a Recessionary Gap)

• Increase Government Spending• Decrease Taxes on consumers• Combinations of the Two

Expansionary Fiscal Policy (The GAS)

How much should the Government Spend? 15

Pri

ce le

vel

Real GDP (billions)

The government should increasing spending which would increase AD

They should NOT spend 100 billion!!!!!!!!!!

If they spend 100 billion, AD would look like this:

AD1

AD2

• What type of gap and what type of policy is best?• What should the government do to spending? Why?• How much should the government spend?

P1

$400 $500

AS

LRAS

FE

WHY?

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The Multiplier EffectWhy do cities want the Superbowl in their stadium? An initial change in spending will set off a spending chain

that is magnified in the economy.Example: • 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 shows how spending is magnified in the economy.

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Pri

ce le

vel

Real GDP (billions)

Fiscal Policy Practice

1. What type of gap?2. Contractionary or

Expansionary needed?3. What are two options

to fix the gap?4. How much initial

government spending is needed to close gap?

AD2 AD1 $100 Billion

Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .8)

P1

$500 $1000FE

ASLRAS

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Pri

ce le

vel

Real GDP (billions)

Fiscal Policy Practice

AD1 AD

P2

$80FE $100

AS



to fix the gap?4. How much needed to

close gap?

LRAS


-$20 Billion

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What about taxing?•The multiplier effect also applies when the government cuts or increases taxes.•But, changing taxes has less of an impact then government spending. Why?

Expansionary Policy (Cutting Taxes)•Assume the MPC is .75 so the multiplier is 4•If the government cuts taxes by $4 million how much will consumer spending increase?•NOT 16 Million!! •When they get the tax cut, consumers will save $1 million and spend $3 million.•The $3 million is the amount magnified in the economy. •$3 x 4 = $12 Million increase in consumer spending

.20

Pri

ce le

vel

Real GDP (billions)

Cutting Tax Practice

1. What two options does the government have?

2. How much should they increase government spending?

$10 Billion3. How much should they

cut taxes?

AD2 AD1 -$20 Billion


P1

$80 $100FE

ASLRAS

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Multiplier Effect

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Non-Discretionary Fiscal Policy

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Non-Discretionary Fiscal PolicyLegislation that act counter cyclically without

explicit action by policy makers.AKA: Automatic Stabilizers

The U.S. Progressive Income Tax System acts counter cyclically to stabilize the economy.

1. When GDP is down, the tax burden on consumers is low, promoting consumption, increasing AD.

2. When GDP is up, more tax burden on consumers, discouraging consumption, decreasing AD.

The more progressive the tax system, the greater the economy’s built-in stability. 24

1. Identify the two types of tool boxes the government has to fix the economy

2. Explain and give examples of Expansionary Fiscal Policy

3. Explain and give examples of Contractionary Fiscal Policy

4. Explain the Multiplier Effect5. Explain how to calculate the spending

multiplier

Review

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Pri

ce le

vel

Real GDP (billions)

Draw and Practice

AD1 AD

P2

$50FE $100

AS



to fix the gap?4. How much needed to

close gap?

LRAS


-$5 Billion

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Pri

ce le

vel

Real GDP (billions)

Draw and Practice



to fix the gap?4. How much initial

government spending is needed to close gap?

AD2 AD1 +$40 Billion


P1

$800 $1000FE

ASLRAS

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Problems With Fiscal Policy

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Problems With Fiscal Policy•When there is a recessionary gap what two options does Congress have to fix it?•What’s wrong with combining both?

Deficit Spending!!!!•A Budget Deficit is when the government’s expenditures exceeds its revenue. •The National Debt is the accumulation of all the budget deficits over time. •If the Government increases spending without increasing taxes they will increase the annual deficit and the national debt.

Most economists agree that budget deficits are a necessary evil because forcing a balanced budget would

not allow Congress to stimulate the economy. 29

Explain this cartoon

200330

Who ultimately pays for excessive government spending?

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Additional Problems with Fiscal Policy1. Problems of Timing

• Recognition Lag- Congress must react to economic indicators before it’s too late

• Administrative Lag- Congress takes time to pass legislation

• Operational Lag- Spending/planning takes time to organize and execute ( changing taxing is quicker)

2. Politically Motivated Policies• Politicians may use economically inappropriate

policies to get reelected. • Ex: A senator promises more welfare and public

works programs when there is already an inflationary gap.

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3. Crowding-Out Effect• In basketball, what is “Boxing Out”?• Government spending might cause unintended

effects that weaken the impact of the policy.Example:• We have a recessionary gap• Government creates new public library. (AD increases)• Now consumers spend less on books (AD decreases)Another Example:• The government increases spending but must borrow

the money (AD increases) • This increases the price for money (the interest rate).• Interest rates rise so Investments fall. (AD decrease)

The government “crowds out” consumers and/or investors 35

Additional Problems with Fiscal Policy

4. Net Export EffectInternational trade reduces the effectiveness

of fiscal policies. Example:

• We have a recessionary gap so the government spends to increase AD.

• The increase in AD causes an increase in price level and interest rates.

• U.S. goods are now more expensive and the US dollar appreciates…

• Foreign countries buy less. (Exports fall)• Net Exports (Exports-Imports) falls, decreasing

AD. 36

Additional Problems with Fiscal Policy

Explain this cartoon

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Activity

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Congressional CommitteesAs a group, analyze the situation, identify the

problem, and identify your solution

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Unemployment Inflation GDP Growth

Good 6% or less 1%-4% 2.5%-5%

Worry 6.5%-8% 5%-8% 1%-2%

Bad 8.5 % or more 9% or more .5% or less

The Good, the Bad, and the Ugly

1.) 1933Situation:

• GDP fell -1.2%

• Inflation rate= -.5%

• Unemployment Rate=25%

Your Solution:

What actually happened:

• FDR increased public works via the New Deal programs.

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2.) 1944Situation:

• GDP grew 8%

• Inflation rate= 3.7%

• Unemployment Rate=1.2%

Your Solution: What actually happened: • War ended the next year and government

orders for war materials decreased.• Many public works programs were

discontinued41

3.) 1980Situation:

• GDP fell -0.3%



Your Solution:


• The next year, President Reagan and congress lowered taxes on individuals and corporations by about 30%. (Supply-side Economics)

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4.) 2003Situation:

• GDP fell 0.5%



Your Solution:


• Congress voted to give tax cuts to citizens. (Bush Tax Cuts)

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Aggregate Demand and Supply and Fiscal Policy

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