Business Cycles, Unemployment, Inflation, and Fiscal Policy

Our government has an interest in measuring the performance of our economy, and uses a variety of statistics to provide that information.

An aggregate of that data, presented as a curve showing the irregular growth of our economy over time is called the business cycle.

Business Cycles
The Government measures economic growth using a set of statistics known as the Index of Leading Economic Indicators.

These measures include:

Initial unemployment claims New orders for consumer goods Plant and equipment orders Building permits Stock prices (S&P 500) Real Money Supply Index of consumer expectations Three consecutive quarters of movement in one direction indicates a shift in the business cycle

Business Cycles, Unemployment, Inflation, and Fiscal Policy

The Business Cycle is a measure of the change in the level of business activity over time.

There are four phases in a business cycle.

Business Cycles, Unemployment, Inflation, and Fiscal Policy

The Business Cycle is a measure of the change in the level of business activity over time.
Peak

There are four phases in a business cycle.

Business Cycles, Unemployment, Inflation, and Fiscal Policy

The Business Cycle is a measure of the change in the level of business activity over time.
Peak Boom

There are four phases in a business cycle.

Business Cycles, Unemployment, Inflation, and Fiscal Policy

The Business Cycle is a measure of the change in the level of business activity over time.
Peak Boom

Contraction

Business Cycles, Unemployment, Inflation, and Fiscal Policy

The Business Cycle is a measure of the change in the level of business activity over time.
Peak Boom

Contraction Recession

Business Cycles, Unemployment, Inflation, and Fiscal Policy

The Business Cycle is a measure of the change in the level of business activity over time.
Peak Boom

Contraction Recession

Trough

Business Cycles, Unemployment, Inflation, and Fiscal Policy

The Business Cycle is a measure of the change in the level of business activity over time.
Peak Boom

Contraction Recession

Trough Depression

Business Cycles, Unemployment, Inflation, and Fiscal Policy

The Business Cycle is a measure of the change in the level of business activity over time.
Peak Boom

Contraction Recession

Expansion

Trough Depression

Business Cycles, Unemployment, Inflation, and Fiscal Policy

The Business Cycle is a measure of the change in the level of business activity over time.
Peak Boom

Contraction Recession

Expansion Recovery

Trough Depression

Business Cycles
The Government also measures overall economic growth using a measure known as Gross Domestic Product (GDP). GDP is basically a measure of the value of all goods and services produced in the United States within a year.

GDP for the year 2010 was $14,590,000,000,000.

The basic formula for GDP is:

C + I + G + (x-m)

Business Cycles
The components in the formula:

C + I + G + (x-m) C = Consumption (Consumer Spending) Consumption includes only the final purchase of goods and services by individuals.

Business Cycles
The components in the formula:

C + I + G + (x-m) C = Consumption (Consumer Spending) Consumption includes only the final purchase of goods and services by individuals. Consumption is equal to approximately 50% of GDP.

Business Cycles
The components in the formula:

C + I + G + (x-m)

I = Investment
Investment includes spending on: tools, machinery, software, etc. Land and construction of buildings (factories). Inventory (goods to be resold). Investment accounts for approximately 13% of GDP

Business Cycles
The components in the formula:

C + I + G + (x-m)

G = Government Spending
Government spending is divided into two categories: Government consumption refers to acquisition of goods and services for current use to directly satisfy individual or collective needs of the members of the community Government Investment refers to acquisition of goods and services intended to create future benefits (infrastructure investment or research spending). Transfer Payments to Individuals are not counted as government spending.

Business Cycles
Government spending in the US has increased from less than 10% of GDP in 1900 to almost 40% of GDP by 2010.

Business Cycles
The components in the formula:

C + I + G + (x-m)

(x-m) = Net Exports

X= Exports M = Imports We count the value of goods produced in the US but sold to other countries as part of GDP.

We do not count the value of goods produced in other countries, so those items are subtracted from our GDP calculations.

Business Cycle
There are two main issues associated with changes in the business cycle.

UNEMPLOYMENT

Increasing unemployment is the main symptom associated with a Recession.

Unemployment The Government reports unemployment weekly. These figures are calculated by the US Bureau of Labor Statistics.

In order to be unemployed, one must be eligible to be employed. The labor force in the US includes everyone 16 or over, employed or actively seeking employment. It does not include: Full time students Retired people Stay-at-home parents People in prisons or similar institutions People employed in jobs with unreported income Discouraged workers

Unemployment Full Employment is one of the goals of the government, but full employment is not 100% employment. Although Full Employment is usually described as everyone who wants a job has a job, in reality full employment is 4% to 6% unemployment. There are five different types of unemployment, and in its quest for full employment, the government can implement policies that help to relieve some forms of unemployment. Two of these are considered unavoidable, but three forms can be affected by government action.

Unemployment 5 types of unemployment

Seasonal Unemployment
Unemployment due to changes in seasons.

Unemployment 5 types of unemployment

Seasonal Unemployment Frictional Unemployment

Unemployment caused by normal movement within the economy.

Unemployment 5 types of unemployment Seasonal Unemployment Frictional Unemployment Cyclical Unemployment Unemployment due to fluctuations in the business cycle.

Unemployment 5 types of unemployment Seasonal Unemployment Frictional Unemployment Cyclical Unemployment Structural Unemployment Unemployment caused by flaws in the structure of the economy.

Unemployment 5 types of unemployment Seasonal Unemployment Frictional Unemployment Cyclical Unemployment Structural Unemployment Technological Unemployment There are two forms of technological unemployment 1. When changing technology makes your job unnecessary. 2. When you do not have the technological skills for the job.

Unemployment 5 types of unemployment

Seasonal Unemployment Frictional Unemployment

Cyclical Unemployment Structural Unemployment Technological Unemployment

Business Cycle
There are two main issues associated with changes in the business cycle.

INFLATION

If an expansion (recovery) occurs faster than corresponding growth, inflation can result.

Inflation
Inflation refers to an increase in price without a corresponding increase in value.

The Government reports inflation rates monthly. There main measures are calculated by the US Bureau of Labor Statistics and the US Bureau of Economic Analysis.
The BEA calculates inflation using the GDP Deflator formula, which essentially calculates the value of GDP, compares it to previous years and adjusts it to determine which part is due to new production (growth) and which part is due to inflation. The GDP Deflator is considered to be more accurate, but is highly complex and takes a long time to calculate and report.

Inflation
The more commonly used measure of inflation is the Consumer Price Index (CPI), which is calculated by the US Bureau of Labor Statistics. The BLS describes CPI as "a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. It involves actually checking the current prices for a variety of goods, comparing them to past prices, and indexing the average prices. The first time prices were checked, the average (100%) was given an index value of 1. If the average of all prices went up 2% the next month, then the index would be 1.02. The CPI is not as accurate as the GDP deflator, but is more easily understood, and more widely used.

Inflation
There are two types of inflation. The simpler type is known as Cost-Push Inflation. Cost-Push Inflation results when the cost of producing an item rises, thus pushing the price up. An example would be when the rising price of crude oil causes gasoline prices to rise, even though most other prices remain stable. Cost-Push inflation is usually limited in the number of goods affected, thus it is limited in its impact on the economy.

Inflation
The second type of inflation, which is more widespread and thus more damaging to an economy, is Demand-Pull inflation. Demand-Pull inflation results when consumers wish to buy more products than the economy can currently provide, thus bidding (pulling) prices up. It is sometimes described as too much money chasing too few goods.

Inflation Demand-Pull inflation can be explained using the Equation of Exchange.

MV = PQ

Inflation Demand-Pull inflation can be explained using the Equation of Exchange.

MV = PQ
where M = the current money supply (M1). The Treasury department measures the money supply and reports changes monthly. M1 consists of all cash in circulation, plus deposits in checking accounts.

For Oct. 2012, M1 is approximately 2,418 Trillion Dollars.

Inflation Demand-Pull inflation can be explained using the Equation of Exchange.

MV = PQ
where M = the current money supply (M1).

For Oct. 2012, M1 is approximately 2,418 Trillion Dollars.

Inflation Demand-Pull inflation can be explained using the Equation of Exchange.

MV = PQ
where M = the current money supply (M2).

V = the Velocity of money.

Inflation Demand-Pull inflation can be explained using the Equation of Exchange.

MV = PQ
where M = the current money supply (M2). V = the Velocity of money.
Velocity is the average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time In other words, how many times is a dollar spent (within one year) before another dollars worth of goods are created. Velocity ranges widely, but is currently around 7.7.

Inflation Demand-Pull inflation can be explained using the Equation of Exchange.

MV = PQ
where M = the current money supply (M2). V = the Velocity of money.

P = the general price level (CPI)

Inflation Demand-Pull inflation can be explained using the Equation of Exchange.

MV = PQ
where M = the current money supply (M2). V = the Velocity of money.

P = the general price level (CPI)

CPI presents the current price level as an indexed average from the previous year. The current CPI rate is approximately 3%, so the value of this variable would be approximately 1.03.

Inflation Demand-Pull inflation can be explained using the Equation of Exchange.

MV = PQ
where M = the current money supply (M2). V = the Velocity of money. P = the general price level (CPI). Q = the Quantity of Goods and Services available (GDP).

Inflation Demand-Pull inflation can be explained using the Equation of Exchange.

MV = PQ
where M = the current money supply (M2). V = the Velocity of money. P = the general price level (CPI). Q = the Quantity of Goods and Services available (GDP). GDP (Gross Domestic Product) is a measure of the value of all goods and services produced in the US in one year. Current GDP is approximately $15.77 trillion.

Inflation Demand-Pull inflation can be explained using the Equation of Exchange.

MV = PQ
where M = the current money supply (M2). V = the Velocity of money. P = the general price level (CPI). Q = the Quantity of Goods and Services available (GDP). V and Q are relatively stable, so change is going to occur in either M or P.

Inflation Demand-Pull inflation can be explained using the Equation of Exchange.

MV = PQ
where M = the current money supply (M2). V = the Velocity of money. P = the general price level (CPI). Q = the Quantity of Goods and Services available (GDP). V and Q are relatively stable, so change is going to occur in either M or P. If the MV side of the equation is greater, then the Price level will rise to keep both sides in balance. If MV is lower, then prices will fall, resulting in Deflation.

Inflation Why do we care?

Inflation affects everyone in an economy. Some people benefit, while others suffer. Who Suffers from Inflation? 1. Those on Fixed Incomes

Inflation Why do we care?

Inflation affects everyone in an economy. Some people benefit, while others suffer. Who Suffers from Inflation?

Inflation Why do we care?

Inflation affects everyone in an economy. Some people benefit, while others suffer. Who Suffers from Inflation? 1. Those on Fixed Incomes 2. Those who Save

Inflation Why do we care?

Inflation affects everyone in an economy. Some people benefit, while others suffer. Who Suffers from Inflation? 1. Those on Fixed Incomes 2. Those who Save 3. Those who Lend

Inflation Why do we care?

Inflation affects everyone in an economy. Some people benefit, while others suffer. Who Suffers from Inflation? 1. Those on Fixed Incomes 2. Those who Save 3. Those who Lend Who Benefits from Inflation? 1. Borrowers

Inflation Why do we care?

Inflation affects everyone in an economy. Some people benefit, while others suffer. Who Suffers from Inflation? 1. Those on Fixed Incomes 2. Those who Save 3. Those who Lend Who Benefits from Inflation? 1. Borrowers 2. Some Investors in Real Property

Inflation Why do we care?

Inflation affects everyone in an economy. Some people benefit, while others suffer. Who Suffers from Inflation? 1. Those on Fixed Incomes 2. Those who Save 3. Those who Lend Who Benefits from Inflation? 1. Borrowers 2. Some Investors in Real Property 3. The Government

Fiscal Policy
Now that we have identified two problems resulting from changes in the business cycle, what can the government do? Fiscal Policy: The intentional use of the governments powers to tax and spend in an attempt to influence the level of economic activity.

Fiscal Policy as a theory developed during the early 20th century, and was first implemented as a response to the Great Depression.

Fiscal Policy
From the inception of the US, our government followed a laissez faire economic policy. In 1929, a stock market crash marks the beginning of the Great Depression.
President Herbert Hoover resists efforts to begin government relief programs, and signs into law the Smoot Hawley Tariff, which starts an international trade war.
In 1932, Franklin Roosevelt is elected President, campaigning on the promise of a New Deal for Americans. He proposes drastic increases in direct Federal intervention in the economy.

Fiscal Policy

After his election in 1932, FDR stated the Governments goals in intervening in the economy. 1. Stable Prices 2. Full Employment 3. Economic Growth Stating these goals as a policy justified the first use of Fiscal Policy measures by the US Government. FDR would turn to an Englishman for help in designing the fiscal policy plans he intended to help us end the depression.

Fiscal Policy
John Maynard Keynes (1883-1946) The Father of Fiscal Policy

Studied at Eton and Cambridge Worked in Civil Service from 1906-1909 Began teaching at Cambridge in 1909 Recalled for Government Service in 1914 Appointed to Versailles Treaty Commission in 1918 Resigns and publishes the critique Economic Consequences of the Peace in 1919 Returns to Cambridge and private life, gains international attention as he publishes Treatise on Money in 1930, and in response to the Great Depression, The Means to Prosperity in 1933. In 1936 he publishes his greatest work, The General Theory of Employment, Interest and Money.

Fiscal Policy
Keynes main contribution to economics was the theory of aggregate demand, stating that government spending could be used to offset falling consumer demand, thus ending a recession or depression. During WW2, Keynes worked on plans to finance the war for the Allies, and in 1944 he presented the Bretton Woods plan, that called for international economic cooperation, to help prevent future depressions and wars. The results of his work, the International Monetary Fund and the World Bank are still important institutions in worldwide finance and economics.

Keynes died in 1946, largely due to stress from his work.

Fiscal Policy
The implementation of Fiscal policy depends upon the problem that the government is trying to address.

In the Depression, aggregate demand theory called for additional government spending to offset the missing consumer and business spending. During inflationary periods, government spending can be cut or taxes can be raised to reduce the money supply and to discourage consumer spending. So the two tools for fiscal policy implementation are taxation or government spending.

Taxation Taxation is a primary function of government, and as soon as governments had the power to impose order, they began to levy taxes.
Many of the earliest written records from the Mesopotamian civilizations are tax receipts.
Cuneiform Tax Receipt, ca. 1600BC

In modern government, the imposition of taxes is politically sensitive, but from an economic perspective we can define the qualities necessary to make taxes more acceptable.

Taxation
Taxation can be based upon one of two principles.

Two Principles of Taxation

1. Benefits Received Principle

Taxes are based upon the benefit received by the taxpayer.

Taxation
Taxation can be based upon one of two principles.

Two Principals of Taxation

1. Benefits Received Principle

Taxes are based upon the benefit received by the taxpayer. Examples include license fees, toll bridges, etc.

Taxation
Taxation can be based upon one of two principles.

Two Principles of Taxation

1. Benefits Received Principle

2. Ability to Pay Principle Taxes are based upon the taxpayers ability to pay.

Taxation
Taxation can be based upon one of two principles.

Two Principals of Taxation

1. Benefits Received Principle

2. Ability to Pay Principle Taxes are based upon the taxpayers ability to pay. Examples include Income Tax, Property Tax.

Taxation
Instituting a Successful Tax A successful tax is one that the government can implement in such a way that it raises more revenue than it costs to collect. It also should not cause more political resentment than the income it generates is worth.

Some taxes may be easy to collect, but are politically unpopular. Capitation, a type of tax used from Roman times was such a tax.
There are three characteristics of a successful tax.

Taxation
Three characteristics of a successful tax. 1. Easy to Collect A successful tax should be easy to collect so that the effort of collection does not outweigh the income generated by the tax. Examples include excise taxes incorporated into sales cost, sales taxes, license fees.

Taxation
Three characteristics of a successful tax. 1. Easy to Collect 2. Difficult to Avoid In addition to being easy to collect, taxes should be difficult to avoid. Examples would include property tax, inheritance tax.

Taxation
Three characteristics of a successful tax. 1. Easy to Collect 2. Difficult to Avoid 3. Perceived as Fair

Taxpayers are more willing to support taxes that they believe to be fair in both rates and in application.
We can assess the perceived fairness of a tax using the concept of Tax Incidence.

Taxation Tax Incidence

Tax Incidence is a way of measuring where the burden of a tax falls. Taxes are generally considered more fair if they do not place too much of the burden on poorer taxpayers. Taxes may be proportional, progressive or regressive in Incidence.

Taxation Tax Incidence

Proportional Taxes Take a constant proportion of income as income rises.

Taxation Tax Incidence

Proportional Taxes Take a constant proportion of income as income rises. In our system, the closest example to a proportional tax would be Social Security/Medicare, which charges all taxpayers 7.65% (matched by 7.65% from the employer) up to a cut-off wage of $110,100.

Taxation Tax Incidence

Proportional Taxes Take a constant proportion of income as income rises. Progressive Taxes Take an increasing proportion of income as income rises.

Taxation Tax Incidence

Proportional Taxes Take a constant proportion of income as income rises. Progressive Taxes Take an increasing proportion of income as income rises.

The classic example of a progressive tax is our Individual Income Tax, which has rates that increase as income increases. 10% on taxable income from $0 to $8,700, plus 15% on taxable income over $8,700 to $35,350, plus 25% on taxable income over $35,350 to $85,650, plus 28% on taxable income over $85,650 to $178,650, plus 33% on taxable income over $178,650 to $388,350, plus 35% on taxable income over $388,350.

Taxation Tax Incidence

Proportional Taxes Take a constant proportion of income as income rises. Progressive Taxes Take an increasing proportion of income as income rises.

Regressive Taxes- Take a decreasing proportion of income as income rises.

Taxation Tax Incidence

Proportional Taxes Take a constant proportion of income as income rises. Progressive Taxes Take an increasing proportion of income as income rises.

Regressive Taxes- Take a decreasing proportion of income as income rises.

The best example (in our system) of a regressive tax is a general sales tax, where a person pays the same tax rate on all purchases.

Regressive Incidence of a General Sales Tax

Income Sales Tax Rate 8% 8% % of income spent 100% 50% Amount Spent $12,000 $50,000 Tax Paid Tax as % of income. 8% 4%

$12,000 $100,000

$960 $4,000

$1,000,000
$10,000,000 $100,000,000

8%
8% 8%

36.5%
20% 12%

$365,000
$2,000,000 $12,000,000

$29,200
$160,000 $960,000

2.92%
1.6% .96%

$1,000,000,000

8%

7.2%

$72,000,000

$5,760,000

.57%

Taxation Sources of Tax Revenue for the Federal Government

Personal Income Tax . 42% Payroll Taxes (FICA). 40% Corporate Income Tax.. 9% Federal Excise Taxes 3% Tariffs and Duties. 3% Gifts and Winnings Taxes 1% Estate Taxes.. 1% Miscellaneous Fees. 2%

Taxation Sources of Tax Revenue for State & Local Government

Property Taxes.. 42% Sales and Gross Receipt Taxes 40% Personal Income Tax 9% Corporate Income Tax. 3% State Excise Taxes (sin taxes). 3% Estate Taxes... 1% Miscellaneous Fees.. 2%

Government Spending Federal Government Expenditures

Federal Budget for 2011 Overall 2011 Spending: $3.834 trillion. 2011 Discretionary Spending: $1.415 trillion. 2011 Projected Deficit: $1.267 trillion (8.3 percent of GDP)
Largest area of spending: Social Programs Largest single department allocation: Defense

Government Spending

Government Spending
State and Local government spending Education is the largest area of expenditure in each of the 50 states. The Insurance Trust category is the fastest growing for most states. The other category includes parks and recreation, public health, basic functions of government, prisons, outreach and support services.