Fiscal Cliff – What does it mean?

Nov 26th, 2012 | By | Category: Archive

Special thank you to Dr. Larry Hill for this information regarding the Fiscal Cliff.


The ‘Fiscal Cliff”, named by Ben Bernanke, the chairman of the Federal Reserve, is a big deal. Let’s set the economic background for us to understand what it is and its importance.

I have previously taught you that Aggregate demand in the economy is the sum of all consumer demand + investor or Business demand + government demand + (Exports – Import). Aggregate supply is defined as Gross National Product (Gross domestic product eliminates Export and Imports). So if:

Ct + I + G + (X – N) is less than GNP then we have a deflation or weak economy like today. There are not enough demanders to buy the product so suppliers will lay people off and let supplies dwindle.

Now we can use Fiscal Policy (changing taxation and government spending) or Monetary Policy (Changing the money supply and rate of interest) or both to stimulate the demanders.

  1. We can lower taxes and increase government spending and that will send consumers, businesses, and government to the stores and we will increase demand and put people back to work.
  2. We could lower the interest rate and increase the money supply and stimulate the consumer and businesses as well.

That is exactly what Obama and the Federal Reserve did over the last four years. Let’s just concentrate on the Fiscal side since the cliff does not mandate monetary changes.

  1. Obama and congress keep the Bush-era tax rate reductions; smaller tax cuts that periodically expire for businesses and individuals, and the 2- percentage point cut in payroll taxes that Obama pushed in 2010. The latter is about $2,500 per tax payer in decreased taxes. Another 28 million taxpayers get a tax break form the Alternative Minimum Tax.
  2. The result was net income increased and consumers spent it stimulating the economy. Things started to get turned around and employment rose slowly.

Fiscal Cliff

Automatically on December 31, 2012 the following would expire:

  1. $400 Billion dollars in tax relief from the Bush taxes cuts and other tax cuts
  2.  $26 billion in unemployment compensation programs would expire
  3. Medicare payments to physicians would be reduced 27 percent or $11 Billion
  4.  $65 Billion is cuts across the board in most federal programs (called sequester)
  5. $1 trillion dollars in reduced government spending over 10 years in most government programs especially in defense.

Congress and the President identified $1 trillion dollars in reduced spending over 10 years in most government programs especially in defense which agreed to specify another $1.2 trillion in saving by January 1, 2013.

So the CLIFF is this:

  1. Obama and Congress must agree on $1.2 trillion in cuts by January 1, 2012 or effectively $426 billion dollars in consumer income will go away.
  2. Government spending will automatically cut $65 billion, enacted across the board for most federal programs over the last nine months of fiscal year 2013, from January through September. This cut, known as the sequester, was mandated by an August 2011 budget deal between Mr. Obama and Congress that ended their standoff over raising the nation’s debt limit.

That is the FISCAL CLIFF in a nutshell. Agree to cut spending by another $1.2 over the next 10 years regardless of the state of the economy or Aggregate demand will be reduced by a multiple of roughly half a trillion dollars starting January 1.

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