CFA Level 1 (2009) - 2

Swdy Session 6

Cross-Reference to CFA Institute Assigned Reading #25 - U.S. Inflation, Unemployment, and Business Cycles

ANSWERS - CONCEPT CHECKERS

1.C Using rhe formula for rhe inflarion rare, we call calculare rhe inflarion rate for years 2 ro

5.

Year 2	7.2%
Year .::;	5.0 0;l>
Year 4	4.1 ')/0
Year 5	2.6%

		lnflarion was deceleraring over rhis period.
")	B To cause more rhan a one-rime increase in rhe price level, wharever caused rhe AD curve
		ro shifr ro rhe righr (demand-pull) or rhe AS curve ro shift to rhe lefr (cosr-push) must
		be susrained over rime .
.1. C		An unexpecred change in inflarion causes rhe unemployment rare ({l move in rhe
		opposite direction. This represenrs 1l100Tmeni along the shon-run Phillips curve .
.;	A	IllJnc'l1If1jovlllCl1l i, ~ll it, natural rate. (;]))' growth i., ,It its	potcntial ratc. Srimularing
		.-\1) ~'rom rhi" Incl incre'lses ourput in rhc shorr run. which	redull:s uncmplo:-'l1clH. bur
		also increases rhe price level.
"i. C		1n rill'long rUI1, uneI1lplo\'ll1ent cannor be held below irs natural rare. The srimulus ro
		AD will resulr in \\';lge fHessures. forcing rhe AS curve [() rhe lef[. reducing ourpur hack
		ro irs porenrial rare. increasing unelllplm'menr back (() irs namral rare, and increasing rhe
		price level further. As rhe verricallong-rull Phillips curve shows, rhe higher inflarion rare
		has no beneficial effect on rhe namral rare of unemploymenr.
().	B	Because rhe nominal inreresr rate was 1()'\'O and rhe expecred rare of inflarion was 70;()
		in rhe firsr year, rhe real rare of inreresr was 3% (10% - 7%). One year larer with rhe

nominal interesr rare ar 8% and inflation expecrarions ar 6%, rhe real rare of inreresr was 2% (8% - GO;o). Therefore, rhe real inreresr rare decreased 11)' 1% berween year 1 and year 2.

AAn economic contracrion is likely to feamre increasing unemploymenr (i.e., decreasing elllploymenr), along wirh declining economic ourpur and decreasing inflarionary pressure.

8.A Under real business cycle rheory, the variarion in rhe rare ar which rechnological change increases labor producriviry leads ro periods of fasrer or slower growrh in porential

(full-employment) CDP. Mainstream business cvcle rheories. including rhe new Keynesian and new classical cycle rheories, arc based on an assumprion thar the rare of growrh in porelHial GDP is srable over rime.

©2008 Kaplan Schweser

Page] 81

budget deficit

The following is a review of the Economics principles designed to address the learning outcome statements set forth by CFA Institute®. This topic is also covered in:

FISCAL POLICY

Study Session 6

EXAM Focus

This topic review focuses on fiscal policy, which refers to the taxing and spending decisions of the governmenr. Understand well how changes in taxing and government spending affect economic growth through theireffectson individuals' consumption and saving decisions and investment spending

by businesses. Be sure to understand the

differenr multiplier effects			and	be able
to	distinguish	between	discretionary
fiscal	policy and	automatic	fiscal	policy

stabilizers. Understand the lags involved in the implementation and eventual effects of discretionary fiscal policy decisions.

FISCAL POLICY, BUDGET DEFICITS, AND BUDGET SURPLUSES

Fiscal polic~' refers to the federal government', usc: of' spending and L.lxation to meet macroeconomic goals. The federal budget is said to be balanced when tax revenues equal federal government expenditures. A budget slIrpLw occurs when government tax revenues

exceed expenditures, and J occurs when government expenditures exeetel rax revenlle~.. The Administration. through aetil)n of the President and Congress, enaCl fiscal poliL.\ designed to stabilize rhe economv.. n order ro smooth economic cycles. raxes are increased and/or government spending reduced during inAationary periods, ancl taxes are decreasd and/or government spending incrused during recessionary periods.

LOS 26.a: Explain supply-side effects on employment, potential CDP, and aggregate supply, including the income tax and taxes on expenditure, and describe the Laffer curve and its relation to supply-side economics.

Supply-side effects refer to the influence that fiscal policy, especially taxation, has on long-run aggregate supply (potential real COP). Income taxes reduce the incenrive to work by creating a tax wedge between pretax and after-tax wages. An increase in income taxes causes after-tax wages to fall. Consequendy, workers will be less likely to work the same number of hours as they did when their after-tax wages were higher. As income taxes rise, the full-employment supply of labor (a key factor of production) falls, which reduces potential CDP. These effects arc illustrated in Figure 1.

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©2008 Kaplan Schweser

Study Session 6

Cross-Reference to CFA Institute Assigned Reading #26 - Fiscal Policy

Figure 1: Taxes and Potential GOP

Wages

l.abor

Rcal	I	ProductiOJl
c:np	.
'.l;	IT· FunctioJl
Q\] r		·. : .)

Figure 1 illustrates the link between tax rates and real GOP. The tax increase causes the labor supply curve (0 shift (0 the left, from the before-tax supply curve SBT to after-tax supply curve SAT' which reflects a decrease in after-tax income from an hour's work.

This results in a drop in the equilibrium (full-employment) quantity of labor from LBT (labor hours before tax) to LAT (labor hours after tax). Real GOP drops as a result of the decrease in the equilibrium quantity of labor. The production function in Figure] shows real GOP (the output of the economy adjusted for price level changes) as a funClion of labor. Potential real GDP supplied decreases from QnT to ~T because the quantity of labor supplied at full employment bas decreased.

An increase in taxes on consumption expenditures (e.g., sales tax) also causes the supply of labor and potelHial real GOP to decrease. Workers "convert" hours of work into purchases of goods and services. An increase in expenditure taxes decreases the amount of goods and services that each hour of labor can buy. This disincentive to work reduces the supply of labor. which causes potential GOP to fall.

The Laffer Curve

Because of the supply-side effect on potential GOP, an increase in tax rates will not always result in an increase in tax revenue. Beyond a certain point, the increase in taxes per dollar earned will be more than offset by the decrease in the total number of dollars earned. Economist Arthur Laffer illustrated this relationship in what is called the Laffer curve.

©2008 Kaplan Schweser

Page 183

Smdy Session 6

Cross-Reference to CFA Institute Assigned Reading #26 - Fisca1 Policy

Figure 2 shows the Laffer curve. When the tax rate is low, increasing the rate increases total tax revenue. But at higher tax rates, the supply-side reduction in potential GOP is greater and the increase in total tax revenue in response to higher tax rates slows. Beyond some ratc of taxation (labeled t M in Figure 2), increasing the tax ratc reduces economic output so much that total tax revenues actually decrease.

Much of the debate about "supply side" fiscal policy recommendations concerns how high the revenue-maximizing tax rate really is, and wheth~r the current tax rate is above or below it.

Professor's Note: A Laffir curl/e begins and ends at zero tax revenues. At a 0% tax rate, potentiaL CDP is maximizal but 110 taxes arc coLLected. At a 100% tax mit. ta).: rellwue is zero bectlllse potO/tial GDP is zero-no olle is wiLLing to supp/-)' Labor.

Figure 2: Laffer Curve

Tax

rcvt:nllL'I

			\
			\
	/ /		\.
			\
	/		\
	/		\
	/
			\	Tax rare
	0%		JOO%

LOS 26.b: Discuss the sources of investment finance, and the influence of fiscal policy on capital markets, including the crowding-ollt effect.

Total investment is one of the major components of GOP (the others are consumption, government spending. and net exports). Investment is defined as expenditures for fixed productive assets and inventory. The sources of financing for investment arc

(l) national savings, (2) borrowing from foreigners, and (.'1)government savings.

The firSt two components are private sources of financing. The third source, government savings, equals the difference between government tax revenues and expenditures. Government budget surpluses (savings) increase the sources of total investment, but government budget deficits (borrowing rather than saving) decrease them.

Investment directly affects the growth rate in real GOP. As investment declines, less capital is created, causing the growth rate in real GDP to fall. Conversely, as investment rises, more capital is created, causing the growth rate in real GDP to rise. This is analogous to capital expenditures of a corporation. Corporations invest in capital to increase output.

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©2008 Kaplan Schweser

Srudy Session (1

Cross-Reference to CFA Institute Assigned Reading #26 - Fiscal P~licy

FiiiCal policy dccisions (government taxing and spending decisions) have significant impacts on markets for investment capital. 'L1Xes on capital income affect the quanrit)' of savings and investment, leading to changes in reaJ GDP growth. The incenrive to save falls as taxes imposed on capital income rise (aftcr-tax returns on savings fall). Therefore, as taxes on capital income rise, private savings likely will fall.

Fiscal polic)' also affects the supply of government savings. Just as budgct surpluses represent government saving, budget deficits rcquire governmenr borrowing (negative saving or dissaving). Larger budget deficits decrease the quantity of savings, which increases the real interest rate, leading firms to reduce their borrowing of financial capital and their investment in physical capital. This adverse effect of a budget deficit on private investment in capital is referred to as the crowding out effect. The decrease in the growth rate of capital will reduce potential GDP.

It may be, however, that increascs in the fiscal dcficit indirectly causc the amount of privatc savings to inCrGlse. The Ricardo-Barro effect refers to tht' fact that increases in rill' current ddlclt mean grc;ller taxes in the future. It is claimed rhat, in order 10 l11;lintain tht'ir prefcrrnl Il;Htcrn of COIEUl1ll'tion (1I'l'r time. r',ltional taXpa\'l'rS lI'i11 indeaSt' L'lIITenl s;l\'ings (and re'duct' Lurrent consumption) in orJer to ofl~"ct rhe effect

01 higher futurc taxes. Ricardo-Sarro ('qui/lalellcc goes further and asserts that tax pavers ",ill reduce currcnt consumption and increaSe' current saving by just enough to huy the bonds rhe go\'ernl1lelH issues to fund the increased ddlcir. In rhis case, funding an inuLast' in gOlcrIlI1lcnr spending lw increasing taxes or b,' borrowing (increasing the deflcit) arc equiv:llenr actions, If Ricardo-Barro equivalence holds, a fiscal deficit has no crowding-our effect because pn\'ate savings increase in an amount that offsets the

increase in governmcnt borrowing. In realiry, increased private savings likely reduce the impact offlscal crO\vding OUt somewhat, bur do not offser ir fully,

LOS 26.c: Discuss the generational effects of fiscal policy, including generational accounting and generational imbalance.

Generational effects of fiscal policy refer 1'0 the effects of postponing fiscal imbalances, Jefined as the prese11l value of future ex peered governme11l deflcits. Eve11lually, (he fiscal imbalance mllst be corrected by increasing taxes or decreasing governme11l spcnding. Studies that use generational accounting to measure the taxes owed by, and the benefits owed to, each generation show that over half of the fiscal imbalance will be paid by

Future generations.

The major source of the fiscal imbalance in the U.S. is payments for Medicare. Since the costs of funding Medicare expenditllres arc nor Sllpporred bv curre11l federal taxes, the burden of these expenditures will f:lll on taxpayers in the future, This is a generational imbalance: the present value of government benefits to the current gellerarion is nor

Fully paid by the taxes levied on the current generation. In effect, current policy is to postpone the payment of taxes so the burden of government expenditures (to pay for current promises) falls on a future generation (one that isn't able to vote yet!).

©2008 Kaplan Schweser

Page 185

Study Session 6

Cross-Reference to CFA Institute Assigned Reading #26 - Fiscal Policy

LOS 26.d: Discuss the use of fiscaJ policy to stabilize the economy, including the effects of the government expenditure multiplier, the tax multiplier, and the balanced budget multiplier.

Discretionary fiscal policy refers to the spending and taxing decisions of a national governmeIH that are intended to stabilize the economy. (By contrast, automatic fiscal policy refers to government spending changes that occur when economic growth slows or accelerates, but do not require action by policy makers.) During recessions, actions can be taken to increase government spending and/or decrease taxes. Either change tends to strengthen the economy by increasing aggregate demand, putting more money in the hands of corporations and consumers to invest and spend. During inflationary economic expansions, actions can be taken to decrease government spending and/or increase

taxes. Either change tends to slow the economy by decreasing aggregate demand. taking money out of the hands of corpor:ltions :ll1d consumers. causing both investmeIH and consumption spending to fall.

Chanf.:L's in government spending. raxation. or h(lch havL' magnified effL'cL, on ~lggrq.:a[l· demand. If government spending i., increased. aggregate demand increases hI' a greater amounL This is because the increase in governmenr spending generates additional income, which leads to increases in consumption and investment. which in rurn further increases aggregate demand and incomes. The government expenditure multiplier reLrs to the magnitude of the eventlIal impact on aggregate demand per dollar of change ill governmenr spending. The mulriplier effect applies equalJ~' to increases and decreases in govcrnmcIH spending.

Changes in taxes also have a magnified effect on aggregate demand. A decrease in taxes that is not offset by a change in government spending will increase consumption expenditures and thereby increase aggregate demand. This increases incomes. which further increases aggregate demand. which leads to higher incomes. just as an increase in government spending would. Since some of the initial increase in incomes from the tax cut will be saved. and only a percentage spent on increased consumption, the

autonomous tax multiplier is smaller than the government expenditure multiplier. An increase in taxes will decrease both consumption and savings and will have a magnified effect on aggregate demand as well.

Since the government expenditure multiplier is greater than the tax multiplier, the balanced budget multiplier is positive. For an increase in governmeIH spending that is accompanied by all equal increase in taxes, the increase in aggregate demand from the spending increase is greater than the decrease in aggregate demand from the tax increase. once their different multiplier effects are considered. The result is that an increase in government spending coupled with an equal increase in taxes will tend to increase aggregate demand.

LOS 26.e: Explain the limitations of discretionary fiscal policy, and differentiate between discretionary fiscal policy and automatic stabilizers.

Discretionary fiscal policy is not an exact science. Fitst, economic forecasts might be wrong, leading to incorrect policy decisions. Second, complications arise in practice that

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©2008 Kaplan Schweser

Scudy Session 6

Cross-Reference to CFA Institute Assigned Reading #26 - Fiscal Policy

Figure I: Taxes and Potential GOP

Wages

D

LabDr

Real
(:rw	Prod union
	Functiu/l

::r:::::::::·]······

Figure 1 illustrates the link between CL, rates and real GOP. The tax increase causes the labor supply curve to shift to the left, from the before-tax supply curve SBT to after-tax supply curve SAT' which reflects a decrease in after-tax income from an hour's work.

This results in a drop in the equilibrium (full-employment) quantity of labor from L BT

(labor hours before tax) to L AT (labor hours after tax). Real GDP drops as a result of the decrease in the equilibrium quantity of labor. The production function in Figure 1 shows real GDP (the output of the economy adjusted for price level changes) as a function of bbor. Potential real GDP supplied decreases from QUT to Qu because the quantity of labor supplied at full employment bas decreased.

An increase in taxes on consumption expenditures (e.g., sales tax) also causes the supply of labor and potential real GOP to decrease. Workers "convert" hours of work into purchases of goods and services. An increase in expenditure taxes decreases the amount of goods and services that each hour of labor can buy. This disincentive to work reduces the supply of laboL which causes potential GOP to fall.

The Laffer Curve

Because of the supply-side effect on potential GDP, an increase in tax rates will not always result in an increase in tax revenue. Beyond a certain point, the increase in taxes per dollar earned will be more than offset by the decrease in the total number of dollars earned. Economist Arthur Laffer illustrated this relationship in what is called the Laffer curve.

©2008 Kaplan Schweser

Page 183

Study Session 6

Cross-Reference to CFA Institute Assigned Reading #26 - Fiscal Policy

Figure 2 shows the Laffer curve. When the tax rate is low, increasing the rate increases total tax revenue. But at higher tax rates, the supply-side reduction in potential GOP is greater and the increase in total tax revenue in response to higher tax rates slows. Beyond some rate of taxation (labeled t M in Figure 2), increasing the tax rate reduces economic Output so much that total tax revenues actually decrease.

Much of the debate about "supply side" fiscal policy recommendations concerns how high the revenue-maximizing tax rate really is, and whether the current tax rate is above or below it . '

Professors Note: A Laffer curve begins and ends at zero tax revenues. At a 0% tax rate, potential GDP is maximized but no taxes are collected. At a 100% tax rate tax revenlle is zero bect/lise potclltial GDP is zero-llo 0111' i.r willing to sUPP!:)' labOl:

Figure 2: Laffer Curve

TJ;: revenuc i

		\
		\
,(		\\
//		\
ICL-I_/_/	- ' -	\L-,- Tax rate
0%		100%

LOS 26.b: Discuss the sources of investment finance, and the influence of fiscal policy on capital markets, including the crowding-out effect.

Total investment is one of the major components of GOP (the others are consumption, government spending, and net exports). Investment is defined as expenditures for fixed productive assets and inventory. The sources of financing for investment arc

(1) national savings, (2) horrowing from foreigners, and (.1) government savings.

The first twO components are private sources of financing. The third source, government savings, equals the difference between government tax revenues and expenditures. Government budget surpluses (savings) increase the sources of total investment, but government budget deficits (borrowing rather than saving) decrease them.

Investment directly affects the growth rate in real GOP. As investment declines, less capital is created, causing the growth rate in real GOP ro fall. Conversely, as investmenr rises, more capital is created, causing the growth rate in real GOP to rise. This is analogous to capital expenditures of a corporation. Corporations invest in capital to lllcrease output.

Page 184

©2008 Kaplan Schweser

Srudv Session 6

Cross-Reference to CFA Institute Assigned Reading #26 - fiscal P()licy

Fiscal policy decisions (governmenr raxing and spending decisions) have significanr impacrs on markers for invesrmenr capiral. Taxes on capiral income affecr rhe quanriry of savings and invesrmenr, leading ro changes in real GDP growrh. The incenrive ro save falls as raxes imposed on capiral income rise (afrer-rax rerurns on savings fall). Therefore, as raxes on capiral income rise, privare savings likely will fall.

fiscal policy also affecrs rhe supply of governmenr savings. Jusr as budger surpluses represenr governmenr saving, budger deficirs require governmenr borrowing (negarive saving or dissaving). Larger budger defici rs decrease rhe q uanri ry of savings, which increases rhe real inreresr rare, leading firms ro reduce rheir harrowing of financial capiral and rheir invesrmenr in physical capital. This adverse effecr of a budger deficir on privare invesrmenr in capiral is referred ro as rhe crowding out effect. The decrease in rhe growrh rare of capiral will reduce porenrial GOP.

Ir may he, however. rhar increases in rhe fiscal deficir indirecdy ClUse rhe amount of pri\'atc savings ro incrl:ase. The Ricardo-Barra effect refers t(1 the fact that increases in t!ll' CUrrl'nl ddicit mean grealcr taxes in rill' future. It is cl~timed thar. in order lei Ill;\in[~lin thclr prl'fcrrl'd p~\[lcrn ur'Lonsumption (Wei lime. r;llioll~t! LlXpa\'ers ",ill incre~lsl' dllTcnl savinp land reduce l'UITl'nt consumption) in orun ro off'ct rill' d}~'Cl

0/'higher fururc raxes. RiCflrr!o-Bl1rro {'quill{z/nlce goes further and asserrs rhar taxpavers will reduce currellt cOllSumprion and increase currel1t s.1\'ing b\' just enough to buy' rill'honds rhl' government issues ((J fund rhe incrcased dcficit. In this case, funding ;In inuease in gm'c:rnl11clH spending h:-' increasing t:!Xe, or I)\' borrowing (increasing the deficit) arc equivalenr aerions, If Ricardo-Sarru equivalence holck a fiscal deficir has no crowding-out effeer because private savings increase in an amounr rhar offscrs rhe

increase in governmenr borrowing. In n:a!ity, increased private savings likely reduce rhe imp:lc[ ofnsca! crowding ollr somC\vhar. hur do not offset it fuJly,

LOS 26.c: Discuss the generational effects of fiscal policy, including generational accounting and generational imbalance.

Generational effects of fiscal policy refer ro the effecrs of posrponing fiscal imbalances, defined as rhe presenr value of furure expecrcd governmenr deficits. Evenrually, rhe fiscal imbalance must be correcred by increJsing raxes or decreasing governmenr spending. Srudies rhar usc generational accounting ro measure rhe raxes owed by, and rhe benefirs owed ro, each generarion show rbar over half of rhe fiscal imhalance will he paid by future generarions.

The major source of rhe fiscal imbalance in rhe U.S. is paymenrs for Medicare. Since rhe cosrs of funding Medicare expendirures arc nor supporred Lw currenr federal raxes, rhe burden of rhese expendirures will fallon raxp:lyers in rhe furure, This is a generational imbalance: rhe presenr value of governmenr henefirs to [he current generarion is not fuJly paid by rhe raxes levied on the current generarion. In effeer, currenr policy is ro posrpone rhe paymenr of taxes so rhe burden of government expendirures (ro pay for currenr promises) falls on a future generarion (one rhar isn't ahle ro vore yer!).

©2008 Kaplan Schweser

Page 185

Study Session 6

Cross-Reference to CFA Institute Assigned Reading #26 - Fiscal Policy

LOS 26.d: Discuss the use of fiscal policy to stabilize the economy, including the effects of the government expenditure multiplier, the tax multiplier, and the balanced budget multiplier.

Discretionary fiscal policy refers to the spending and taxing decisions of a national government that are intended to stabilize the economy. (By contrast, automatic fiscal policy refers to government spending changes that occur when economic growth slows or accelerates, but do not require action by policy makers.) During recessions, actions can be taken to increase government spending and/or decrease taxes. Either change tends to strengthen the economy by increasing aggregate demand, putting more money in the hands of corporations and consumers to invest and spend. During inflationary economic expansions, actions can be taken to decrease government spending and/or increase

taxes. Either change tends to slow the economy by decreasing aggregate demand, taking money out of the hands of corporations and consumers, causing both investment and consumption spending to hll.

Chan~cs in gOH'l"I1l11cnr spending. t~lX;\(ion. or hoth ha\'c magni11cd cffl,Lt, on ,lggrq:.Hl demand, If g0\'(:rnlllenr spcnding is increased, aggregate demand increases h\ a greater amount. This is because the increase in go\'ernment spending generates additional income, which leads to increases in consumption and investment, which in turn further increases aggregate demand and incomes. The government expendirure multiplier reL:rs to the magnitude of the: eventual impacr on aggregate demand per dollar of change in government spending. The mul1iplier effect applies equall}' to increases and decreases in govern ment spending.

Changes in taxes also have a ma~nified effect on aggregate demand. A decrease in taxes that is not offset by a change in government spending will increase consumption expenditures and thereby increase aggregate demand. This increases incomes, which further increases aggregate demand, which leads to higher incomes, just as an increase in government spending would. Since some of the initial increase in incomes from the tax cur will be saved, and only a percentage spent on increased consumption, the

autonomous tax: multiplier is smaller than the government expenditure multiplier. An increase in taxes will decrease both consumption and savings and VI!ill have a magnified effect on aggregate demand as well.

Since the government expenditure multiplier is greater than the tax multiplier, the balanced budget multiplier is positive. For an increase in government spending that is accompanied b}! an equal increase in taxes, the increase in aggregate demand from the spending increase is greater than the decrease in aggregate demand from the tax increase, once their different multiplier effeers are considered. The result is that an increase in government spending coupled with an equal increase in taxes will tend to increase aggregate demand.

LOS 26.e: Explain the limitations of discretionary fiscal policy, and differentiate between discretionary fiscal policy and automatic stabilizers.

Discretionary fiscal policy is not an exact science. First, economic forecasts might be wrong, leading to incorrect policy decisions. Second, complications arise in practice that

age 186

©2008 Kaplan Schweser