Fiscal Policy and Economic Indicators

Inflation

• Inflation is primarily measured using the Consumer Price Index (CPI).
• The CPI indicates how much prices have risen compared to the previous year.
• A 0% CPI means prices are the same as last year.
• A CPI around 2% is generally considered good, and 3% is acceptable.
• During the recession, the CPI rose to almost 6%.
• In February 2022, the CPI was over 9%, which is undesirable as it means goods and services are significantly more expensive.
• Unless wages increase at the same rate as inflation (e.g., a 9% raise with a 9% CPI), purchasing power decreases.
• Inflation, GDP, and unemployment are the three major economic indicators.

Calculating GDP

• The most common method for calculating GDP is the output determination, represented by the equation:

  GDP = C + I + G + (EX - IM)

  • C: Consumption - Spending by consumers on goods and services (e.g., buying a car or a house).
  • I: Investment - Reinvestment of profits back into a business (e.g., buying new equipment or remodeling a store). It does not refer to stock market investments.
  • G: Government spending - Money spent by the government on goods and services.
  • (EX - IM): Net Exports - Exports (goods produced domestically and sold abroad) minus Imports (goods produced abroad and sold domestically).
    • If exports are $100 billion and imports are $75 billion, net exports are +$25 billion.
    • If exports are $75 billion and imports are $100 billion, net exports are -$25 billion, resulting in a trade deficit.

Government Influence on GDP

• To stimulate economic growth and maintain a healthy economy, the government can influence:
  • Consumer spending
  • Business investment
  • Government spending
  • Net exports

Fiscal Policy

• Fiscal policy is implemented by the President and Congress.
• It primarily involves government spending (G) and taxes (T).
• Example: Congress cutting taxes by $400 billion and cutting spending by $800 billion is an example of fiscal policy.

Impact of Taxes on the Economy

• Increasing taxes contracts the economy.
• Decreasing taxes stimulates the economy.
  • Tax cuts leave consumers with more money, encouraging spending.
  • Tax increases leave consumers with less money, decreasing spending.

Impact of Government Spending on the Economy

• Increasing government spending stimulates the economy.
• Decreasing government spending contracts the economy.
• Examples of government spending: health insurance (24% of budget), Social Security retirement (21%), defense spending (13%), interest on debt (13%), veterans' affairs (8%), economic security/welfare (7%), and education (5%).
• The government can adjust spending and taxes on various sectors (e.g., defense, healthcare, wealthy vs. middle class taxes) to influence economic outcomes.

Aggregate Supply and Demand

• Any supply and demand graph must have:
  • Vertical axis: Price
  • Horizontal axis: Quantity
  • Origin: Zero
• Graphs are called aggregate supply and demand graphs.
  • Aggregate means "everything" (supply and demand for everything in the economy).
• Components:
  • Aggregate Demand Curve (D_1)
  • Aggregate Supply Curve (S_1)
  • Equilibrium Point (P_1) - where supply and demand curves intersect.
  • Equilibrium Price
  • Equilibrium Quantity
• Price changes affect inflation.
• Quantity changes affect GDP.
  • More goods and services produced (quantity increases) leads to an increase in GDP.

Example Government Intervention

Lowering taxes for everyone, especially the poorest:

• Impact: Increases aggregate demand because people have more money to spend.
• Graphically: The demand curve shifts to the right.
• Supply does not change.
• A new equilibrium point is established, leading to:
  • Increased price, which means that inflation goes up.
  • Increased quantity, which means that GDP goes up.

Effect on Economic Indicators

• GDP Increase: More goods and services are made, so businesses hire workers, decreasing unemployment.
• Unemployment Decrease: Generally desierable and shows economic growth.
• Inflation Increase: Monitorable and not always desirable unless the increase is insubstantial. (e.g., 2.3% to 2.5% is not significant, but 2.3% to 8.3% is a serious sign of negative effect). There are pluses and minuses of each scenario.

Government Spending vs. Taxes

• Changes in government spending have a greater impact on the economy than changes in taxes.
• Government spending is direct:
  • Example: Building a bridge involves hiring a company, which hires workers, who then spend their wages.
• Tax rebates:
  • People may save the money instead of spending it, reducing the economic impact.
  • About 75-80% of tax rebates do not translate into spending.
• The expenditure multiplier effect: Spending becomes income, which becomes more spending, creating a ripple effect throughout the economy.

Debt and Deficit

• Deficit: A negative balance for one year (spending exceeds taxes).
• Debt: The accumulation of deficits over time.
• Example:
  • If a government brings in $400 billion in taxes but spends $500 billion, the deficit is $100 billion.
  • If the same happens the next year, the deficit is still $100 billion, but the debt is $200 billion.
• In 2023, the US had a deficit of $1.7 trillion.
• The US debt is currently very high (over $30 trillion).

Crowding Out

• Increased government spending can lead to decreased private investment.
  • The government borrows money by selling bonds, increasing interest rates.
  • Higher interest rates make it more expensive for private individuals to get loans, reducing private investment.

Macroeconomic Goals and Fiscal Policy

• Major goals:
  • Full employment (low unemployment)
  • Economic growth (high GDP)
  • Price stability (low inflation)
• Fiscal policy involves changing government spending or taxes to influence economic activity.
• Government spending has a greater impact than taxes due to the expenditure multiplier.
• Excessive spending can lead to deficits and debt.
• Government spending can lead to crowding out (reduced private investment).