1. 1 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy CHAPTER 16 Fiscal Policy The tax laws are complicated because the government changes them repeatedly, trying to achieve sometimes conflicting economic, social, and political goals. Fernando Quijano Prepared by:

2. 2 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy CHAPTER 16 Chapter Outline and Learning Objectives 16.1 What is Fiscal Policy? Define fiscal Policy. 16.2 The Effects of Fiscal Policy on Real GDP and the Price Level Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilize the economy. 16.4 The Government Purchases and Tax Multipliers Explain how the government purchases and tax multipliers work. 16.5 The Limits of Using Fiscal Policy to Stabilize the Economy Discuss the difficulties that can arise in implementing fiscal policy. Appendix : A Closer Look at the Multiplier Apply the multiplier formula. Fiscal Policy

3. 3 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Government spending is a component of real GDP: Y = C + I + G + NX This makes it appear as though increases in government spending increase output—and hence other relevant economic variables like employment. However some economists argue that government spending simply shifts employment from one group to another—it does not increase total employment. This debate was particularly important after the 2007-2009 recession: can the government use discretionary fiscal policy to increase employment? Does government spending create jobs?

4. 4 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 4 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Define fiscal policy. 16.1 LEARNING OBJECTIVE The Effects of Fiscal Policy on Real GDP and the Price Level

5. 5 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. (State taxes and spending are not generally aimed at affecting national-level objectives.) What is Fiscal Policy? What Fiscal Policy Is and What It Isn’t Some forms of government spending and taxes automatically increase or decrease along with the business cycle; these are automatic stabilizers. Example: Discretionary fiscal policy, on the other hand, refers to intentional actions the government takes to change spending or taxes. Automatic Stabilizers versus Discretionary Fiscal Policy Define fiscal policy. 16.1 LEARNING OBJECTIVE

6. 6 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Before the Great Depression of the 1930s, most government spending was at the state or local level; now the federal government’s share is two-thirds to three- quarters. How much government spending is federal? Figure 16.1

7. 7 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy As a percentage of GDP, federal expenditures are now higher than ever—almost 25% of GDP. A smaller proportion of that is now spent on government consumption of goods and services (mostly military spending). Federal expenditures as a percentage of GDP Figure 16.2

8. 8 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Federal purchases: So what does the federal government spend money on? Figure 16.3 Federal Government Expenditures, 2010 Federal expenditures:

9. 9 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Government Expenditures

10. 10 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Highlights of the Budget: Sources of tax revenue: 1) personal income taxes 2) social insurance taxes 3) corporate income taxes 4) indirect business taxes (e.g. excise taxes)

11. 11 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy The majority of federal revenues come from: Where does Federal revenue come from? Taxes on corporate profits: The remainder of federal revenue: Figure 16.4 Federal Government Revenue, 2010

12. 12 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Federal Tax Revenues

13. 13 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy The relationship between expenditures and revenues determines the budget situation. Federal Budget: Taxes – Government Purchases – Transfer Payments – Interest on Debt Determine the relationship that defines a government deficit, surplus, or balanced budget: Are Taxes greater than, less than, or equal to (Government Purchases + Transfer Payments + Interest on Debt) ?

14. 14 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 14 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 16.14 The U.S. federal government does not generally balance its budget. Sometimes its revenues are higher than its expenditure, but usually the reverse is true— especially so during wartime. Deficits and Surpluses, 1901-2011

15. 15 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy What is the difference between a government budget and a government debt? Is federal government debt a problem?

16. 16 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 16 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 16.15 Federal government debt, 1901-2011 The national debt increased dramatically as a percentage of GDP during the two world wars, and the two worst recessions. It is now at its highest level since 1947.

17. 17 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Is Spending on Social Security and Medicare a Fiscal Time Bomb? Making the Connection Will the federal government be able to keep the promises made by the Social Security and Medicare programs? Define fiscal policy. 16.1 LEARNING OBJECTIVE

18. 18 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy

19. 19 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy

20. 20 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Life Expectancy at Birth, 1900-2000 Female Male

21. 21 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy

22. 22 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy

23. 23 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 23 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Is Spending on Social Security and Medicare a Fiscal Time Bomb? Making the Connection How can these programs continue to exist? It is likely that a combination of these measures will eventually need to be adopted: Increasing taxes Decreasing benefits (including slower benefit growth, perhaps differently for different income groups) Decreasing eligibility (SSI age already increasing from 65 to 67) But perhaps the most important element will be finding a way to reduce medical costs.

24. 24 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 24 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilize the economy. 16.2 LEARNING OBJECTIVE The Effects of Fiscal Policy on Real GDP and the Price Level

25. 25 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 25 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Expansionary fiscal policy involves increasing government purchases or decreasing taxes. Increasing government purchases directly increases aggregate demand. Decreasing taxes indirectly affects aggregate demand by increasing disposable income, and hence consumption spending. Expansionary fiscal policy in the static AD-AS model

26. 26 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 26 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Contractionary fiscal policy involves decreasing government purchases or increasing taxes. This works just like expansionary fiscal policy, only in reverse. Contractionary fiscal policy in the static AD-AS model

27. 27 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Table 16-1 Countercyclical Fiscal Policy The Effects of Fiscal Policy on Real GDP and the Price Level PROBLEMTYPE OF POLICY ACTIONS BY CONGRESS AND THE PRESIDENTRESULT RecessionExpansionary Rising inflationContractionary 16.2 LEARNING OBJECTIVE

28. 28 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Figure 16.13 The 2009 Stimulus Package American Recovery and Reinvestment Act of 2009 In 2009, Congress passed the “stimulus package”, a combination of increased government spending (about two-thirds)… … and decreased taxes (about one-third). At $825 billion, the stimulus package was by far the largest fiscal policy action in U.S. history.

29. 29 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 29 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explain how the government purchases and tax multipliers work. 16.4 LEARNING OBJECTIVE The Government Purchases and Tax Multipliers

30. 30 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 30 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall If the government increases its spending on goods and services, then aggregate demand increases immediately. This is the autonomous increase in aggregate demand. Aggregate demand and the multiplier effect. Figure 16.8 But then people receive this increased spending as increased income, and increase their consumption spending accordingly. This is the induced increase in aggregate demand. The series of induced increases in consumption spending that results from the initial increase in autonomous expenditures is known as the multiplier effect.

31. 31 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Multiplier effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures. The Government Purchases and Tax Multipliers Explain how the government purchases and tax multipliers work. 16.4 LEARNING OBJECTIVE

32. 32 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 32 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 16.9 Multiplier effect of an increase in government purchases Suppose each increase in spending induces half again as much consumption spending. Over time, a $100 billion increase in government purchases will result in an additional $100 billion in induced consumption spending.

33. 33 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy The Multipliers Work in Both Directions The Government Purchases and Tax Multipliers Increases in government purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP. Decreases in government purchases and increases in taxes also have a multiplier effect on equilibrium real GDP, but in this case, the effect is negative. Explain how the government purchases and tax multipliers work. 16.4 LEARNING OBJECTIVE

34. 34 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 34 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall We can describe the total effect of a change (increase or decrease) in government purchases or taxes by measuring the change in equilibrium real GDP. The tax multiplier will be a negative number: an increase in taxes will decrease equilibrium real GDP, and vice versa. We expect the tax multiplier to be smaller (in absolute value) than the government purchases multiplier. Why? A $100 billion increase in purchases initially increases spending by $100 billion; but a $100 billion tax cut is partially spent and partially saved. Multipliers for government purchases and taxes

35. 35 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 35 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The tax multiplier applies to changes in the amount of taxes, without changes in tax rates. Example: In 2009 and 2010, the federal government enacted the Making Work Pay Tax Credit: a $400 reduction in taxes for working individuals ($800 for households). Decreases in tax rates have a slightly different effect: 1.Increasing the disposable income of households, leading them to increase their consumption spending 2.Increasing the size of the multiplier effect, since more of any increase in income becomes disposable income. The effect of changes in tax rates

36. 36 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Solved Problem 16-4 Fiscal Policy Multipliers Briefly explain whether you agree or disagree with the following statement: “Real GDP is currently $14.2 trillion, and potential real GDP is $14.4 trillion. If Congress and the president would increase government purchases by $200 billion or cut taxes by $200 billion, the economy could be brought to equilibrium at potential GDP.” YOUR TURN: For more practice, do related problem 4.6 at the end of this chapter. Explain how the government purchases and tax multipliers work. 16.4 LEARNING OBJECTIVE

37. 37 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 37 of 64 © 2013 Pearson Education, Inc. Publishing as Prentice Hall For several reasons, fiscal policy may be less effective than monetary policy at countercyclical stabilization: Timing fiscal policy is harder, due to: Legislative delay: Congress needs to agree on the actions Implementation delay: Large spending projects may take months or even years to begin, even once approved. Government spending might crowd out private spending Crowding out: A decline in private expenditures as a result of an increase in government purchases. Can we use fiscal policy to stabilize the economy?

38. 38 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy The Limits of Using Fiscal Policy to Stabilize the Economy Crowding Out in the Short Run Figure 16-13 The Effect of Crowding Out in the Short Run The economy begins in a recession, with real GDP of $14.2 trillion (point A). In the absence of crowding out, an increase in government purchases will shift aggregate demand to AD2 (no crowding out) and bring the economy to equilibrium at potential real GDP of $14.4 trillion (point B). But the higher interest rate resulting from the increased government purchases will reduce consumption, investment, and net exports, causing aggregate demand to shift to AD 2(crowding out). The result is a new short-run equilibrium at point C, with real GDP of $14.3 trillion, which is $100 billion short of potential real GDP. Discuss the difficulties that can arise in implementing fiscal policy. 16.5 LEARNING OBJECTIVE

39. 39 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 39 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall In early 2008, believing a recession was imminent, Congress authorized a tax cut: a one-time rebate of taxes already paid, totaling $95 billion. This result in a boost to consumers’ current incomes. Changes to current incomes result in smaller increases in spending than changes to permanent incomes, because people seek to “smooth” their consumption over time. Economists estimate that consumers spent about 33-40% of the rebates they received; so the tax cut resulted in about $35 billion in increased spending. Fiscal policy in action: the 2007-2009 recession

40. 40 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 40 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall When the stimulus was passed, Obama administration economists believed that by the end of 2010, it would: Increase real GDP by 3.5% Increase employment by 3.5 million By the end of 2010, real GDP actually rose by 4.4% but employment fell by 3.3 million. Did the stimulus fail? To judge the effect of the stimulus package, we have to measure its effects holding constant all other factors affecting real GDP and employment. Isolating the effects of the stimulus package is very difficult; economists still differ in their views about how effective the stimulus package was. How effective was the stimulus package?

41. 41 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy 41 of 43 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The Congressional Budget Office (CBO) is a non-partisan organization that estimates the effects of government policies. The table shows CBO estimates of the effect of the stimulus package on economic variables, relative to what would have happened without the stimulus package: The CBO’s conclusion: the stimulus package reduced the severity of the recession, but did not come close to bringing the economy back to full employment. CBO estimates of the effects of the stimulus package YearChange in Real GDP Change in the Unemployment Rate Change in Employment (millions of people) 2009 0.9% to 1.9%−0.3% to −0.5%0.5 to 0.9 2010 1.5% to 4.2%−0.7% to −1.8%1.3 to 3.3 2011 0.8% to 2.3%−0.5% to −1.4%0.9 to 2.7 2012 0.3% to 0.8%−0.2% to −0.6%0.4 to 1.1 Table 16.2

42. 42 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Why Was the Recession of 2007–2009 So Severe? Making the Connection The recession of 2007-2009 was the worst recession to hit the United States since the Great Depression of the 1930s. The Great Depression of the 1930s was accompanied by a financial crisis—just like the recession of 2007-2009. Are recessions generally worse when they are accompanied by a financial crisis? DurationDecline in Real GDPPeak Unemployment Rate Average for postwar recessions10.4 months−1.7%7.6% Recession of 2007–200918 months−4.1%10.1%

43. 43 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 16: Fiscal Policy Why Was the Recession of 2007–2009 So Severe? Making the Connection Economic VariableAverage Change Average Duration of ChangeNumber of Countries Unemployment rate+7 percentage points4.8 years14 Real GDP per capita−9.3%1.9 years14 Real stock prices−55.9%3.4 years22 Real house prices−35.5%6 years21 Real government debt+86%3 years13 Note: Data above do not include the U.S. recession of 2007-2009. After studying recessions accompanied by financial crises worldwide, economists Carmen Reinhart and Ken Rogoff say that such recessions are much more severe than average: Most people did not see the financial crisis coming, so they also underestimated how severe the 2007-2009 recession would be.