EC 202 Lecture Notes - Lecture 7: Fiscal Multiplier, George W. Bush, Procyclical And Countercyclical

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31 May 2018

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Week 7

● Midterm Next Thursday, May 24th!

●Deficits, Borrowing, and Debt

○ Debt: accumulated (unpaid) deficit

○Current US debt is around 20 trillion dollars

○Should we be worried about debt?

■Many people worry about the fact that the US debt is huge, and is

growing. Why?

●It can affect ability to borrow/increase interest rate

●If we can’t borrow,we cannot pay for things

●High interest rates → lower investment/GDP

■The main thing that affects our ability to borrow in the future is how able

we are to make the interest payments.

■These interest payments depend on the current interest rates, tax rates,

and GDP growth.

■The debt will start to increase so much that eventually it will become

unsustainable

●Small forecast errors can completely change the predicted path of

debt

●Slightly higher GDP growth/lower interest rates would make the

debt a non-issue

● Fiscal Policy: changes in government spending and taxes

○One of the tools of the government to affect the economy

○Responsibility of the Congress and the President

○AD/AS Model

■Changes in spending/taxes usually affect the AD curve

■Changes in government spending directly affect the aggregate demand

■Changes in taxes change either consumption or investment by changing

disposable income

○Types of Fiscal Policy

■ Expansionary FP

●Increases AD (and hence output) in the short run

●Results from spending increases or tax cuts;

■ Contractionary FP

●Decreases AD (and therefore decreases output in the short run)

●Results from spending cuts or tax increases

○Why/when does the government pursue Expansionary/Contractionary fiscal

policy?

■Expansionary

●Typically used to overcome low economic growth (recession)

●In the past it was used to (or tried to) push output above potential

output → bad idea

■Contractionary

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●Typically used to slow down economic growth when economy is

overheating

●To pay down the debt → higher taxes/lower spending → smaller

deficit (or lower surplus)

○ Countercyclical Policy: Policy that counteracts the business cycle

■Use expansionary fiscal policy when the economy is not doing well and

contractionary when it is

■Helps moderate the business cycle

○Recession, Countercyclical Policy, and the Debt

■If the government pursues countercyclical policy during recession →

increase deficit

■Expansionary policy → more spending/less taxes → larger deficits

■Is this a bad idea?

●Even if we don’t like deficits, pursuing expansionary policy during

a recession is likely a good move

●My spending is someone else’s income -- need someone to spend

to prevent downward spiral

●Pursuing a contractionary policy during recession can make

deficits larger (lower tax revenue)

○ Spending Multiplier: how many times initial spending is multiplied by.

■When government spending increases, AD increases by more than the

increase in government spending because of the ‘multiplier effect’.

■Government spends → people who receive the money spend on x →

people who receive the money for x spend it on y → people who receive

money for y spend it on z → etc

■The money spent by the government initially is spent multiple times

■The size of the multiplier depends on marginal propensity to

consume(MPC)

● MPC: what fraction of each additional dollar of income people

spend on income

MPC = change in consumption / change in income

● MPC is always between 0 and 1

SM = 1 / (1-MPC)

■Total change in spending = SM x initial change in spending

■Large MPC → larger multiplier

■Small MPC → smaller multiplier

■Multiplier also works for decreases in government spending and

increases in taxes

■Also works for changes in private spending

○ Income and MPC

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Document Summary

Current us debt is around 20 trillion dollars. Many people worry about the fact that the us debt is huge, and is growing. It can affect ability to borrow/increase interest rate. If we can"t borrow,we cannot pay for things. The main thing that affects our ability to borrow in the future is how able we are to make the interest payments. These interest payments depend on the current interest rates, tax rates, and gdp growth. The debt will start to increase so much that eventually it will become unsustainable. Small forecast errors can completely change the predicted path of debt. Slightly higher gdp growth/lower interest rates would make the debt a non-issue. Fiscal policy: changes in government spending and taxes. One of the tools of the government to affect the economy. Responsibility of the congress and the president. Changes in spending/taxes usually affect the ad curve. Changes in government spending directly affect the aggregate demand.

Related Questions

Dems, GOP talk up deficit reduction, but don't act

WASHINGTON (AP) â Liberals' loud objections to White House proposals for slowing the growth of huge social programs make it clear that neither political party puts a high priority on reducing the deficit, despite much talk to the contrary.

For years, House Republicans have adamantly refused to raise income taxes, even though U.S. taxes are historically low, and the Bush-era tax cuts were a major cause of the current deficit.

And now, top Democrats are staunchly opposing changes to Medicare and Social Security benefits, despite studies showing the programs' financial paths are unsustainable.

Unless something gives, it's hard to see what will produce the significant compromises needed to tame the federal debt, which is nearing $17 trillion.

"There's not much of an appetite for deficit reduction," said Bob Bixby of the Concord Coalition, which pushes for "responsible fiscal policy."

There might be a few small steps this year, he said, when the government again needs to raise its borrowing limit. But a "grand bargain" involving significant spending cuts and revenue increases seems unlikely, Bixby said.

He added, "It's a little depressing to hear the reactions to the president's budget, from both sides."

There was nothing surprising about Republican denunciations of Obama's proposed tax increases, which he wants to combine with spending cuts to reduce the deficit.

The newer wrinkle was the left's sharp criticism of his proposals to slow the growth in Medicare and Social Security benefits, provided Republicans agree to new revenues. Obama has offered Republicans such a deal before. But this month's budget proposal gave it a new imprimatur.

The group MoveOn.org said Wednesday that supporters "who are outraged at President Obama's proposal to cut Social Security benefits will protest and deliver petitions" this week.

Sen. Bernie Sanders, a liberal independent from Vermont, is leading a similar petition drive, opposing "any benefit cuts to Social Security, Medicare or Medicaid." The deficit, his letter says, "was primarily caused during the Bush years by two unpaid-for wars, huge tax breaks for the rich and a prescription drug program" for Medicare, funded through borrowing. He suggests that higher taxes on the wealthy are the fairest way to tackle the deficit.

Democrats cite several reasons to raise taxes on high-income households. Obama campaigned for such tax increases in 2008 and 2012 but accomplished them only partially with the "fiscal cliff" resolution of Jan. 1.

Major tax cuts in 2001 and 2003 played big roles in turning a federal budget surplus into soaring deficits, according to research by the Congressional Budget Office and others. And by many measures, the U.S. tax burden in near historic lows.

Households earning roughly the national median income paid, on average, 11.1 percent of their income in total federal taxes in 2009, the most recent year for such data. That's the lowest level in more than 30 years, the CBO says.

Nonetheless, House Republicans have placed their highest priority on refusing to raise income tax rates, effectively ranking it above all other goals.

"The president got his tax hikes on Jan. 1," House Speaker John Boehner, R-Ohio, is fond of saying. It's a reference to the $620 billion in new revenues, over 10 years, that Republicans were unable to stop because of the "fiscal cliff" law, resolved on New Year's Day.

If it's easy to make a case for higher revenues, the same is true for slowing the growth of Social Security and Medicare benefits. For decades, studies have warned of approaching trouble in these popular but costly programs, as health care costs rise and baby boomers begin to retire.

"Both Medicare and Social Security cannot sustain projected long-run program costs under currently scheduled financing, and legislative modifications are necessary to avoid disruptive consequences for beneficiaries and taxpayers," the Social Security Administration says, summarizing findings by the two programs' trustees.

"The early detection light has been going on for a while, and there has been a failure to act," Social Security trustee Charles P. Blahous recently told a House panel. If lawmakers are to preserve the programs for future retirees, he said, they will have to accept much more "political pain" than officials endured during a 1983 overhaul that included "several extremely controversial measures."

Obama has proposed an often-discussed step, which deals with government accounting in general, not just entitlement programs. If Congress agrees to higher tax revenues, the president said, he would back a slower growth calculation for cost-of-living increases for Social Security benefits, plus higher Medicare premiums for higher-income seniors.

Interest groups have criticized both ideas. AARP calls the slower cost-of-living formula a "harmful change," and urges seniors to oppose it.

American voters can largely blame themselves when Congress is more talk than action on deficit reduction. Americans routinely say they want a smaller federal debt, but not at the cost of programs they hold dear â including Social Security and Medicare.

A CBS News poll in March found that most Americans want to cut spending and raise taxes to reduce the deficit. But 4 in 5 oppose cuts to Social Security or Medicare. And two-thirds are unwilling to have their own taxes raised in the name of deficit reduction.

When Pew Research asked which was more important â reducing the national debt or keeping Social Security and Medicare benefits as they are now â the public sided with safeguarding the benefits programs, 53 percent to 36 percent.

The deficit-spending partisanship continued Wednesday. On a party-line vote, House Ways and Means Committee Republicans passed a bill to protect Social Security recipients and investors in Treasury bonds if the government hits its borrowing limit and can't pay all its bills later this year. Democrats say if the federal government starts reneging on any obligations â even if it pays bondholders â financial markets will lose faith and the economy will tank.

Some Democrats fear a lose-lose situation if they support Obama's proposals. First, they could be attacked from the left for tweaking the programs that many Democrats see as their party's greatest legacy. And second, Republicans might accuse them of "raiding Medicare" in next year's congressional elections. That battle cry proved effective in 2010 after Obama's health care overhaul bill was passed.

Democrats call such tactics shamelessly hypocritical. Republicans, they note, have long called for reining in entitlement spending.

Boehner rebuked a top GOP campaign figure for hinting at a renewal of the "raiding Medicare" attacks. But Reince Priebus, the national Republican Party chairman, seemed eager to revive the question of whether Democratic trims to Medicare's costs amount to an unfair cut in benefits.

9. Read the AP article âDems, GOP talk up deficit reduction, but don't act (Links to an external site.)â by C. Babington (Apr25â13).

a. What are the two basic ways of shrinking a budget deficit?

b. Which of your answers above are Republicans vehemently against? What are the potential negative economic effects of implementing this basic policy?

c. Which of your answers above are Democrats strongly opposed to? What are the potential negative economic effects of implementing this basic policy?

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EC 202 Lecture Notes - Lecture 7: Fiscal Multiplier, George W. Bush, Procyclical And Countercyclical

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