AP Macroeconomics Section 6 Lecture January 2016 Mr

AP Macroeconomics Section 6 Lecture January 2016 Mr. Gammie

M 30: Long-Run Implications of Fiscal Policy: Deficits and the Public Debt

$1, 300, 000, 000

$2. 2 Billion

Should the budget be balanced?

Budget Balance Is a budget deficit bad and a budget surplus good?

The Budget Balance as a Measure of Fiscal Policy The Budget Balance Formula: Sgovernment = T- G - TR Where: T is the value of tax revenues G is government purchases of goods and services TR is the value of government transfers

Budget Balance • Surplus = positive budget balance • Deficit = negative budget balance This is affected by fiscal policy.

Budget Balance and Fiscal Policy Recessionary Gap > Run _____ fiscal policy. > 3 options to do so: 1. 2. 3. All else equal this will ____ the budget balance.

Budget Balance and Fiscal Policy Inflationary Gap > Run _____ fiscal policy. > 3 options to do so: 1. 2. 3. All else equal this will ____ the budget balance.

How can we measure fiscal policy? Will changes in the budget balance always reflect changes fiscal policy?

Two Reasons Why it Doesn’t Reason 1: Two different changes in fiscal policy that have equal-sized effects on the budget balance might have unequal effects on the economy. Example: If government spending increases by $1000, it will have a larger impact on real GDP than a tax decrease of $1000. The budget balance would change by $1000 in each case, but the impacts would be different.

Two Reasons Why it Doesn’t Reason 2: Often, changes in the budget balance are themselves the result, not the cause, of fluctuations in the economy.

The Business Cycle and the Cyclically Adjusted Budget Balance • The budget deficit almost always rises when the unemployment rate rises and falls when the unemployment rate falls. Explain why this statement is true.

Automatic Stabilizers These are programs built into our tax and transfer system that work to reduce the swings of the business cycle. When the economy heads into a recession: 1. Tax revenues decline because incomes and profits are declining. 2. Transfer payments rise as more people tend to find themselves unemployed and struggling.

On the reverse side… When the economy is heading into an inflationary period: 1. Tax revenues rise because incomes and profits are rising. 2. Transfer payments fall as fewer people find themselves unemployed and struggling.

If we are going to measure fiscal policy, we need a way to separate out two effects on the budget balance: – The impact due to deliberate changes in fiscal policy. – The impact due to the current state of the business cycle. This is an estimate of what the budget balance would be if there was neither a recessionary or inflationary gap.

The Cyclically Adjusted Budget Balance • An estimate of what the budget balance would be if the real GDP were exactly equal to potential output. • Takes into account extra revenue the gov’t would collect and transfers it would save if recessionary gap were eliminated. And vice versa. • If after this adjustment is made the gov’t is still running a deficit, then we might make the conclusion that their fiscal policy decisions are not sustainable over the long run.

Should the budget be balanced?

Balanced Budgets What would be the result of legislation that required the government to balance the budget on an annual basis?

Balanced Budgets • If this was the case and there was a recessionary gap… – Falling tax revenue and rising transfer payments push the budget toward deficit – How would we balance this deficit? – We would need to increase taxes or decrease G – How would that impact the recession? – It would worsen it!

Balanced Budgets • If there was an inflationary gap… – Rising tax revenue and falling transfer payments push the budget toward surplus – How would we balance this surplus? – We would need to decrease taxes or increase G – How would this impact the inflationary period? – It would worsen it!

So what should the government do?

Homework Assignment Go home over the weekend and “interview” a family member/neighbor/etc. who was of voting age in the last federal election. Ask them the following questions… these will be discussed in class on Tuesday. 1. 2. 3. 4. What is your opinion about the Federal Liberals running a budget deficit? Should Canada have a national debt? Should the government actively work to reduce the national debt? If so what should they do? If not, why not? Any other comments you would like to make regarding this issue?

Long-Run Implications of Fiscal Policy • Governments that runs persistent deficits end up with substantial debts. • National Debt: the accumulation of all past deficits, minus all past surpluses. • Public debt: Government debt held by individuals and institutions outside the government.

Rising Government Debt Two reasons for concern: 1. When the government borrows funds in the financial markets, it is competing with firms that plan to borrow funds for investment spending. As a result, the government’s borrowing may “crowd out” private investment spending, increasing interest rates and reducing the economy’s long-run rate of growth. 2. Today’s deficits, by increasing the government’s debt, place financial pressure on future budgets. Interest must be paid in the future, and this can take dollars away from other future obligations like education, social services, space exploration, etc.

How can the government pay off debt? • Borrowing more to pay it off? • Print more money? • Increase taxes or cut spending?

Deficits and Debt in Practice • To assess the ability of governments to pay off their debt, we use the debt-GDP ratio • This measures the gov’ts debt as a % of GDP Why? • GDP is a good indicator of the potential taxes the gov’t can collect. If the gov’ts debt grows more slowly than GDP, the burden of paying that debt is actually falling compared with potential tax revenue.

Is the debt-GDP ratio rising, falling, or staying the same?

Canada Debt to GDP Ratio

Implicit Liabilities • Implicit Liabilities are spending promises made by the gov’t that are debt despite the fact they are not included in usual debt statistics. • Examples include social security, Medicare, Medicaid. – How will demographic trends affect future spending on these programs?

Practice Question

Practice Question

Practice Question

M 31: Monetary Policy and the Interest Rate

Money Market: Fed Increases MS

Money Market: Fed Decreases MS

Target Rate

Monetary Policy – Trace Out the Steps Expansionary Monetary Policy Contractionary Monetary Policy

Monetary Policy – Trace Out the Steps Expansionary Monetary Policy Recessionary Gap>Increase MS>Decrease Interest Rate>I and C Increase>AD Shifts Right>RGDP Increases Contractionary Monetary Policy Expansionary Gap>Decrease MS>Increase Interest Rate>I and C Decrease >AD Shifts Left>RGDP Decreases

Monetary Policy in Practice • Taylor Rule • Inflation Targeting – Transparency – Accountability

M 31 Summary • The Fed uses monetary policy to stabilize the economy. • When the Fed wants to lower interest rates, they engage in expansionary monetary policy. As the money supply curve shifts to the right, interest rates fall. As interest rates fall, private investment increase and aggregate demand shifts to the right. • When the Fed wants to raise interest rates, they engage in contractionary monetary policy. As the money supply curve shifts to the left, interest rates rise. As interest rates rise, private investment decreases and aggregate demand shifts to the left.

M 32: Money, Output, and Prices in the Long Run

Money, Output, and Prices 0. 5%

Monetary policy can destabilize the economy.

Key Takeaway In long-run, expansionary monetary policy doesn’t increase RGDP, it only causes inflation.

Money Neutrality • Money Neutrality: changes in the money supply have no real effects on the economy. – In the long run, the only effect of an increase in the money supply is to raise the aggregate price level by an equal percentage. – Economists argue that money is neutral in the long run.

How? All prices in the economy double. Money supply doubles at the same time. What difference does this make in real terms? All variables in the economy – real GDP, real value of the money supply (the amount of goods and services it can buy) – are unchanged. • If this is the case, there is no reason for anyone to behave differently. • •

Money Neutrality Takeaway • If the money supply increases by any given percentage, in the long run, the aggregate price level will rise by the same percentage.

Changes in the Money Supply and the Interest Rate in the Long Run • Fed has power in the short run. • What happens in the long run?

M 32 Summary • Money neutrality asserts that expansionary monetary policy to boost the economy will result in long run equilibrium at potential GDP with a higher price level (and vice versa for contractionary monetary policy). • Monetary policy is an effective tool for shortening the duration of a recession or cooling off a period of inflation in the short run.

M 33: Inflation, Disinflation, and Deflation

Money Supply and the Price Level 1. Draw the long-run equilibrium in the AD/AS model. 2. Show the short-run impact of expansionary monetary policy. 3. Show the long-run adjustment in the graph and explain how it happens.

Real Money Supply • A change in the nominal money supply, M. • Leads in the long run to a change in the aggregate price level, P. • That leaves the real quantity of money, M/P, at its original level. • As a result there is no long-run effect on the aggregate demand or real GDP.

1%

100%

The Classical Model of Money and Prices

The Classical Model of Money and Prices • The Classical Model is not representative of how economies react to low levels of inflation. • The Classical Model is a good indication of how the economy reacts to very high levels of inflation. – Workers become sensitized. Adjustments are quicker.

Back to paying off the debt… Does the US print money to pay off it’s debt? Yes.

The Inflation Tax • The Federal Reserve issues money, but works hand in hand with the Treasury. • The Treasury issues debt to finance the gov’ts purchases of goods and services, while the Fed monetizes the debt by creating money and buying the debt back from the public through open market purchases of T-Bills. • The US gov’t can and does raise revenue by printing money.

Printing Money • The Fed creates money as it purchases gov’t securities from the private sector. • The Fed gets interest from these T-Bills, paid by the Treasury. The Fed then hands this interest back over to the Treasury. • The Fed’s actions allow the gov’t to pay off billions in outstanding gov’t debt by printing money (the gov’t owns it’s own debt).

Seignorage: a government’s right to print money

The Inflation Tax • We know this leads to inflation. • When the gov’t prints money, the people who currently hold money pay. • They pay because inflation erodes the purchasing power of their money holdings. • The gov’t, in essence, imposes an inflation tax, by printing money to cover its budget deficit.

How does inflation get so out of control?

Hyperinflation • How does it start? 1. Large budget deficit. 2. Inability or incompetence to eliminate deficit by raising taxes or cutting government spending. 3. Government unable to borrow as lenders refuse to extend loans based on weakness. • Therefore… print money.

Hyperinflation • Suppose the gov’t needs to print enough money to pay for a given quantity of goods and serves each month. • As the gov’t prints money to do so, it causes inflation. • As people hold smaller amounts of money due to higher inflation, the gov’t has to respond by accelerating the rate of growth of the money supply. • This will lead to an even higher rate of inflation. • People respond to this higher rate of inflation by reducing their money holdings yet again. • This sequence spirals out of control as inflation skyrockets.

Types of Inflation

Cost-Push Inflation

Demand-Pull Inflation

Key Terms Disinflation: a decrease in the inflation rate. Deflation: a decreasing aggregate price level.

M 33 Summary • Hyperinflation is almost always the result of a government that is increasing the money supply to cover national debts, while gradual inflation is the result of market forces and the business cycle. • When the government funds deficit spending with newly printed money, the people who currently hold money end up paying an inflation tax. This is not a tax that is explicitly paid like an income tax, it acts as an implicit tax because inflation erodes the purchasing power of their money holdings. • Cost-push inflation is caused by a significant increase in the price of an input with economy-wide importance. This creates a leftward shift in SRAS and an increase in the price level. • Demand-pull inflation is caused by a rightward shift of the AD curve and is the result of too much spending relative to the economy’s capacity for production.

M 34: Inflation and Unemployment: The Phillips Curve

The Three Macroeconomic Goals • Low Rate of Unemployment • Stable price Level • Economic Growth

Inflation Unemployment

The Phillips Curve

Proof?

Supply Shocks

Expected Rate of Inflation • Changes in the expected rate of inflation affect the short-run trade-off between unemployment and inflation. • Changes in expectations result in a shift of the short-run Phillips curve. • Higher expected inflation = shift up. • Lower expected inflation = shift down.

Inflation and the Unemployment Rate in the Long-Run • Draw the long-run equilibrium in the AD-AS model. • Show what happens to the SRPC in the shortrun when AD increases. • Now show what happens to the SRPC in the long run.

Long-Run Phillips Curve

Key Takeaways • As aggregate demand shifts to the right or left in the short-run, eventually the economy returns to long-run equilibrium, but at a higher, or lower rate of inflation. • To avoid accelerating inflation over time, the unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation.

NAIRU • The unemployment rate at which inflation does not change over time is referred to as the non-accelerating inflation rate of unemployment. • Keeping the unemployment rate below NAIRU leads to ever accelerating inflation and cannot be maintained.

NAIRU = Natural Rate of Unemployment

Disinflation

Debt and Deflation • Isn’t a falling price level a good thing for consumers?

The Liquidity Trap • A situation in which conventional monetary policy is ineffective because nominal interest rates are up against the zero bound. Nominal rate = real rate + expected inflation rr = 2% ei = 3% nr = ? What if expected inflation = -2%?

The Liquidity Trap • Interest rates cannot fall below 0%, so deflation creates a situation where lenders receive nominal interest rates that approach zero. • If this happens, lending will stop.

The Liquidity Trap

M 34 Summary • The Phillips curve depicts the nature of the short-run trade-off between inflation and unemployment. • A shift of the AD curve is represented by a movement along the SRPC. • The SRPC will shift right if the SRAS shifts left or inflationary expectations increase. The SRPC will shift left if SRAS shifts right or inflationary expectations decrease. • There is not long-run trade off between inflation and unemployment due to the effect of expectations of inflation. • Even moderate levels of inflation can be hard and painful for an economy to reduce through increased unemployment. • Deflation is a problem for economic policy (namely monetary policy). This leads policy makers to prefer a low but positive inflation rate.

M 35: History and Alternative Views of Macroeconomics

Classical Economics According to the classical model: – Prices are flexible. – The aggregate supply curve is vertical… even in the short run. – An increase in the money supply, other things equal, lead to a proportional rise in the aggregate price level. – An increase in the money supply does not increase aggregate output. – Key result: Increases in the money supply lead to inflation. That is all.

Really?

The Business Cycle

In the long run, we are all dead.

Keynesian Economics 1. Short-run shifts in aggregate demand do affect aggregate output and the price level because there is an upward sloping aggregate supply curve. Rather than minor and temporary shifts, these short-run shifts are important.

Keynesian Economics 2. The AD curve can shift because several factors including business confidence, and that these were the main cause of business cycles. Classical economists emphasized the role of changes in the money supply in shifting the aggregate demand curve, paying little attention to other factors.

Consequence of Keynes work legitimized macroeconomic policy activism – the use of monetary and fiscal policy to smooth out the business cycle.

The End of the Great Depression

The Revival of Monetary Policy • Milton Friedman and Anna Schwartz published “A Monetary History of the United States, 1867 -1960” – Showed that business cycles had historically been associated with fluctuations in the money supply. – Money supply fell sharply during the Great Depression. – Persuaded most economists that monetary policy should play a key role in economic management.

Monetarism • Eliminate macroeconomic activism. Maintain the importance of monetary policy. • Monetarism asserted that GDP will grow steadily if the money supply grows steadily. • Solution? Constant rate of growth of the money supply, maintain that target regardless of fluctuations in the economy.

Quantity Theory of Money supply x Velocity = Price Level x Real GDP M*V = P*Y If V is constant, then a slow increase in M will increase PY (nominal GDP) Monetarists believed that V was stable, so they believed that if the Federal Reserve kept M on a steady growth path, nominal GDP would also grow steadily.

Inflation and the Natural Rate of Unemployment • 1968: Milton Friedman and Edmund Phelps propose the natural rate of unemployment. • Important result is that if the unemployment rate is kept below NAIRU inflation will start to rise. • This hypothesis has been validated with empirical testing.

The Political Business Cycle

Rational Expectations • The view that individuals and firms make decisions optimally, using all information available to them. …So what?

Rational Expectations • According to the original natural rate hypothesis, a government attempt to trade off higher inflation for lower unemployment would work in the short run. – This would eventually fail because inflation would get built into expectations.

Rational Expectations • According to rational expectations… – remove the word eventually – If it is clear that the gov’t intends to trade off higher inflation for lower unemployment, the public will understand this, and expected inflation will immediately rise. Current View: Price Stickiness does exist in the economy. Inflation is not always quick to rise, even if expectations are higher for prices.

Real Business Cycles 1980 s… Main cause of a recession is a pause in technological progress. Real Business Cycle Theory: fluctuations in the rate of growth of total factor productivity cause the business cycle.

Real Business Cycle Theory • Aggregate supply is vertical. • Source of business cycle fluctuations is a shift of the aggregate supply curve. • Recession = shift left of AS curve. • Recovery occurs when a pickup in productivity growth shifts the aggregate supply curve rightward.

Real Business Cycle Theorists Today • Acknowledge that an upward sloping AD curve is needed to fit with economic models based on past data.

To Summarize 4 Schools of Thought: 1. 2. 3. 4. Classical (and new classical) Keynesian (and new Keynesian) Monetarism Rational Expectations

So what. . ? Macroeconomic theories, like all economic theories are constantly evolving. Much of the debate centres upon whether the business cycle is self-correcting or whether economic policies can be used to smooth out cycle. If economists agree that polices can be used to influence the business cycle, the debate moves to which policy option, fiscal or monetary, is the best option. Most macroeconomists agree that there are useful pieces of most macroeconomic schools of thought that can be used to study the modern economy.

M 35 Summary • Classical macroeconomics asserted that monetary policy affected only the aggregate price level, not aggregate output, and that the short run was unimportant. • Keynesian economics attributed the business cycle to shifts of the aggregate demand curve, often the result of changes in business confidence. Keynesian economics also offered a rationale for macroeconomic policy activism. • Monetarism is a doctrine that called for a monetary policy rule as opposed to discretionary monetary policy, and which argued that GDP would grow steadily if the money supply grew steadily.

M 35 Summary Cont’d • The natural rate hypothesis says that the unemployment rate must be high enough to keep expected inflation and actual inflation equal. • Fears of a political business cycle led to a consensus that monetary policy should be insulated from politics. • Rational expectations suggests that even in the short run there might not be a trade-off between inflation and unemployment because expected inflation would change immediately in the face of expected changes in policy. • Real business cycle theory claims that changes in the rate of growth of total factor productivity are the main cause of business cycles. • New Keynesian economics argues that market imperfections can lead to price stickiness, so that changes in aggregate demand have effects on aggregate output after all.

M 36: Consensus and Conflict in Modern Macroeconomics

The 5 Questions 1. Is expansionary monetary policy helpful in fighting recessions? 2. Is expansionary fiscal policy effective in fighting recessions? 3. Can monetary fiscal policy reduce unemployment in the long-run? 4. Should fiscal policy be used in a discretionary way? 5. Should monetary policy be used in a discretionary way?

The 5 Questions Classical macroeconomics Is expansionary monetary policy helpful in fighting recessions? Is expansionary fiscal policy effective in fighting recessions? Can monetary and/or fiscal policy reduce unemployment in the long run? Keynesian Monetarism macroeconomics Modern consensus No Not very Yes, except in special circumstances No Yes No No Should fiscal policy be used in a discretionary way? No Yes No No, except in special circumstances Should monetary policy be used in a discretionary way? No Yes No Still in dispute

What are Donald J. Trumps views toward regulation of business?

Supply-Side Economics

There is broad consensus on this… • Monetary policy should play the main role in stabilization policy. • The central bank should be independent. • Discretionary fiscal policy should be used sparingly.

There is still much debate over this… • Should the central bank be given a defined target or the discretion to manage the economy? • Should the central bank manage asset prices? • What should the central bank do when conventional policy has reached it limits?

M 36 Summary • The modern consensus is that monetary and fiscal policy are both effective in the short run but that neither can reduce the unemployment rate in the long run. • Discretionary fiscal policy is considered generally unadvisable, except in special circumstances. • There are continuing debates about the appropriate role of monetary policy.