Principle 8: Fiscal and monetary policies influence people’s decisions.
Objectives:
List the four components of total expenditures.
Define fiscal policy.
Explain the connection between an initial change in spending and the final result of that spending.
Identify the appropriate fiscal actions during times of recession and inflation.
Why do you want to learn this?
If not now, at some point you will be a taxpayer. You will want to know how your money is being used.
Four categories of spending
In 1936, the world economy was in chaos. During the Great Depression US unemployment was greater than 20% (one of every five workers in the labor force was out of work). Real GDP fell 30%. Prices fell (deflation) 33%. Businesses were not investing because people who were out of work were unable to buy much of anything. It was expected that deflation would continue so any goods that were produced were likely to sell for less than the costs of production. People weren’t buying so businesses weren’t producing, so businesses weren’t hiring so people weren’t buying so …. it was a vicious cycle.
According to British economist John Maynard Keynes, the only way out of the mess was to “prime the pump.” If households and businesses weren’t buying, the government should step in and start buying. There are four types of spending (expenditures (E)) in the economy,
E = C + I + G + (X-M)
Total expenditures (E) are made up of consumption (spending by households (C)) Investment (spending by businesses on plant, capital equipment and change in inventories (I)), government spending (G), and net purchases by foreigners (Exports minus imports (X-M)).
Keynes argued that stimulation of any of the four components of spending would generate production and employment. The easiest way to get the economy moving would be for the government to stimulate the economy by working on the G component of the equation above. The government could directly hire people to do desirable public works such as building bridges, working on roads, building post offices, and doing other projects that would not compete with private projects. Once the newly employed workers began spending their new income, businesses would react to the improved business conditions with new production, which would, eventually, send the economy on an upward spiral, reducing the unemployment and underutilization of industrial capacity.
The Expenditure Multiplier
It wouldn’t take a huge commitment on the part of government, and they wouldn’t have to continually increase government spending because of a process called the expenditure multiplier. An initial change in any of the components of spending (C, I, G, or X-M) will be multiplied thorough the economy as income to households causes additional spending by households which increases demand for other goods and services, which causes increased production and employment and spending, etc.
Assume a large new transportation facility is being built in your community. Investment spending increases. The firm buys a piece of land, it builds its offices and factories, it purchases its machines, it hires workers, and starts production. As production starts, more people have jobs and receive income to spend in the community, but the expansion does not stop with the workers hired by the tech company. The plant workers are also consumers who spend much of their income in the local community. The initial investment spending when the new plant was built and started production has caused new consumption spending.
Firms in the community that supply consumer goods expand, and they hire more workers. Those workers will have more income, and they will spend some of that income in the community causing even more hiring. The new tech plant has led to some expanded sales in groceries, automobiles, clothes, and other items. It's an upward spiral as the initial investment spending by the tech plant caused much more spending in the community.
The multiplier effect is the process by which an original change in spending causes a greater change in income and output, as the new income generated is spent and “respent” as it works its way through the economy. Another way to look at this is that the new investment supports many more workers than those it directly employs. The income that the tech firm pays its workers causes them to consume, which creates income for others, which induces them to consume. This effect continues to multiply, so that the original investment increases total spending by several times the original increase in income.
It's important to recognize that this change can go either way. A new tech plant can cause the development of other new businesses, but the shut-down of a Long Beach automotive plant can cause the closing of many other businesses also. As workers are laid off, they spend less on groceries, clothes, vacations, and many other things. This causes decreased demand and layoffs in those markets. The grocer, clothing clerk, and travel agent then spend less and the downward spiral continues.
That's why we have ghost towns. In the old West, the gold or the silver in the mines petered out and the town died. The town depended on the spending of the Mineworkers to stay in business. When the miners stopped spending, the saloon, the general store, the hotel, and the blacksmith all lost their businesses. The power of the multiplier can work for both increases and decreases in aggregate demand.
It's also important to recognize that the multiplier effect occurs, not only with changes in investment spending, but with any change in spending. If consumption spending or government spending or taxes increase or decrease, total spending in the economy will change by a greater amount than the initial increase or decrease. If government spending changes, or consumption changes through a change in taxes, the final effect on spending will be greater than the original change in government spending and taxes.
Fiscal Policy
Keynes suggested that the government should attempt to stimulate the economy with fiscal policy. Fiscal policy involves the use of changes in government spending and taxes for the purpose of influencing economic activity. When Congress and the President increase or decrease government spending or taxes, those changes influence economic growth, employment, and the price level.
In his book, The General Theory of Employment, Interest and Money, he noted that hiring workers for public works projects will directly and immediately increase “G” thereby increasing spending. Likewise, by manipulating taxes, allowing households to keep more or less of their income, consumption (C) can be influenced. A decrease in peoples’ income taxes will give them greater disposable income and will likely increase their consumption. An increase in taxes will give people less disposable income and decrease their spending.
To stimulate the economy, the government should either increase G or decrease T. Remember, this was a time of underutilized resources. As long as people spent more, producers would be able to respond to the increased demand by producing more and hiring additional resources with no fear of wage increases; supply would follow demand. If, however, aggregate demand grew too rapidly, i.e. if people were trying to buy more than producers could supply, inflation would occur. In this case, discretionary fiscal policy could be used in reverse: decreased government spending and increased taxes would reduce the “C” and “G” components, and total spending would tend to decrease, slowing or stopping price increases (inflation).
The multiplier makes the government's fiscal policy somewhat easier. If G increases or T decreases, as the initial impact of expansionary fiscal policy takes hold, governments and households will begin to spend more and their spending will generate jobs for others who will increase their spending, etc.
Critics of fiscal policy question the effectiveness of increased government spending or lower taxes, recognizing that the money must come from somewhere. If government borrows the money, that puts upward pressure on interest rates which lowers consumption and private investment.
There are also political obstacles. Increasing government spending that benefits certain groups with high voting rates is politically advantageous but that is not the case for groups with low voting rates such as the poor. During inflationary periods when prices are increasing, cutting into the purchasing power of all voters, the appropriate policy would be to cut government spending to decrease demand, but that is politically very dangerous. So the “appropriate” inflation reduction policy might be the politically inappropriate policy. In the meantime, folks are paying more for basic items like food and gasoline.
Bottom Line:
There are four types of spending: Consumption, Investment, Government and Net Exports.
E = C+I+G+(X-M)
Fiscal Policy is the attempt by the government to use changes in government spending and taxes to influence the level of economic activity.
The multiplier effect is the process by which an original change in spending causes a greater change in income and output, as the new income generated is spent and “respent” as it works its way through the economy.
According to Keynesian theory appropriate policies during times of significant unemployment are to increase government spending and decrease taxes. It follows that the opposite is true during inflationary times…decrease government spending and increase taxes.
There are economic and political issues with Keynesian fiscal policy.
Which of the following is NOT one of the four expenditure categories?
Consumption
Investment
Government spending
Imports
Define fiscal policy
The process by which an initial change in spending generates higher employment, greater income, and additional spending is called
The accelerator effect.
The multiplier effect.
The generator effect.
The dynamic effect.
During times of high unemployment, appropriate fiscal policy would be to:
Increase government spending and increase taxes.
Increase government spending and decrease taxes.
Decrease government spending and increase taxes.
Decrease government spending and decrease taxes.
During times of high inflation, appropriate fiscal policy would be to:
Increase government spending and increase taxes.
Increase government spending and decrease taxes.
Decrease government spending and increase taxes.
Decrease government spending and decrease taxes.
Which of the following is NOT a challenge to fiscal policy? FRED – Often, to provide public goods and services and to fund expansionary fiscal policies, the government borrows from the public and from the Federal Reserve Bank. This leads to a government budget deficit (spending is greater than the taxes raised to support the spending). Open Fred and type “federal surplus or deficit”. The graph will display the data from 1981 to the most recent year. Tap the red “Edit Graph” on the top right hand side of the graph. Hit the “modify frequency” tab and change the frequency to “annual”.
If the money for increased government spending is borrowed, that may raise interest rates.
Governments may compete with private investors for funds.
Voters may be too likely to spend money that results from expansionary fiscal policy.
Politicians are likely to resent increased taxes.
What is the only year that the federal government surplus? ________
There are five recessions depicted on the graph. Does the graph illustrate the increase in budget deficits during recessions? ______
Which of the recessions shows the greatest budget deficit? _________ Returning to previous summaries, what was happening to employment and economic growth during that period? What does that tell you about the relationship between economic growth, employment, and federal government budgets?