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Chapter 11 Fiscal Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Presentation on theme: "Chapter 11 Fiscal Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved."— Presentation transcript:

1 Chapter 11 Fiscal Policy McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2 Learning Objectives Identify key differences between the private sector and government. Describe the short-term impacts of increased government spending and use the multiplier effect to calculate the effect of fiscal stimulus. Summarize the limitations of using increased government spending to stimulate growth. Discuss the ways that changes in tax rates affect the economy. Explain how the budget deficit affects the economy in the short run and in the long run. 11-2

3 Fiscal Policy Fiscal policy is defined as the economic effect of government spending and taxes. Fiscal policy looks at the impact on the economy in both the short-term and long- term. In the short-term, fiscal policy consists of the government’s budget decisions. In the long-term, fiscal policy creates the link between government spending and taxation decisions and the country’s economic growth. 11-3

4 The Government and the Economy Government spending and tax policy have a major impact on the economy. Government spends directly on wages, goods and services. It also shifts money from some people to others in the form of Social Security, Medicare, and other programs. 11-4

5 The Government and the Economy In the private sector, spending occurs through market transactions. –In this case, all transactions are voluntary. The level of government spending is set by the political system rather than the economic system. Spending is funded through a combination of taxation and borrowing. –Unlike the private sector, the government pays back debts by raising taxes. 11-5

6 Short-Term Impact of Government Spending Each year the federal budget is set through a process that begins in February. Through the process, the President and Congress come to an agreement on the level of spending and the tax rules. In the short term, an increase in government spending lowers unemployment and increases GDP, all other things being equal. 11-6

7 Short-Term Impact of Government Spending Demand curve for labor after increase in government spending L1L1 W1W1 Original demand curve for labor Wage L Quantity of labor supplied and demanded Supply curve for labor W A B 11-7

8 Short-Term Impact of Government Spending The use of increases in government spending and tax cuts to stimulate the economy and combat the effects of recession is called the Keynesian approach. This approach was developed by John Maynard Keynes as a solution to the economic problems caused by the Great Depression. Increases in government spending and cuts in taxes are called fiscal stimulus. 11-8

9 The Multiplier Effect The total economic impact of government spending is greater than the initial amount of spending. –A government contract to build a new bridge leads to the hiring of construction workers. However, the economic impact doesn’t end there. These workers spend some of their paychecks in the local economy. –This spending leads to additional hiring by local businesses, and further boosts the economy. 11-9

10 The Multiplier Effect Thus, the first round of spending creates income that generates a second round of spending and this induces a third round. The multiplier effect is the overall boost in economic activity that flows from the increase in government spending. We can state the multiplier as either a job or spending multiplier

11 The Multiplier Effect –If the job multiplier is 2, this means that each new government job creates one new private sector job. –Suppose government spending rises by $100 billion. A spending multiplier of 1.5 means that GDP goes up by $150 billion – including $100 billion from the initial spending and $50 billion due to the follow-up effects. The multiplier process also works in reverse, so cuts in spending lead to job losses and lower GDP

12 Marginal Propensity to Consume The question is, what determines the size of the multiplier? –The main factor is the marginal propensity to consume (MPC), or the portion of each additional dollar of income that consumers spend. –MPC takes on values of 0 to 1. –In general, low income households have a MPC close to 1. –In contrast, the richest households tend to have a low MPC

13 Marginal Propensity to Consume –The multiplier will be higher if government spending goes to people with a high marginal propensity to consume. A government project that hires unemployed workers into long-term jobs will generally have a big multiplier effect because these workers are likely to spend a lot of their wages. But a program that hands out money to rich Americans is likely to have only a small impact on GDP

14 Overseas Leakage Another factor affecting the multiplier is the amount of money spent on U.S.-produced goods versus foreign goods, or imports. In order to boost GDP, government spending must increase production in the United States. But in a world where more products are made overseas, it is possible that fiscal stimulus will lead to increased imports rather than to faster growth at home. –This transfer of domestic economic stimulus to foreign markets is known as overseas leakage

15 The Size of the Multiplier The multiplier depends on the value of MPC and percentage of income consumers spend on imported goods. Given these factors, most economists believe that the values of the job and spending multipliers are between 1 and 2.5. Note: If the multiplier is below 1, it means that higher government spending actually causes the private sector to contract

16 Limitations of Spending Stimulus There are downsides to stimulating the economy through fiscal policy. These limit the extent to which government can use spending to stimulate the economy. The first limitation in attempting to use government spending is inflation. –In the short-term, an increase in government spending raises wages and prices

17 Limitations of Spending Stimulus If real GDP is above potential GDP, then increases in government spending will mostly turn into inflation. But if unemployment is high and real GDP is below potential GDP, then increased government spending is more likely to turn into higher output

18 Limitations of Spending Stimulus A second limitation is due to lags in policy. –It takes time to recognize that the economy is in a recession and then pass the appropriate legislation. –If the spending comes when the economy is already out of a recession, then it actually adds to inflation

19 Taxation The main source of revenues for government spending is taxation. The table on the next slide lists the various taxes used to raise revenues. Compared to the size of the economy, tax collections have not changed much over the last 30 years

20 Taxation Name of taxWhat it Taxes Income taxIndividual income Property taxThe value of commercial and residential real estate Payroll taxWage payments Corporate income taxCorporate profits Sales taxRetail sales Excise taxItems such as gasoline, tobacco, and alcohol 11-20

21 Federal Personal Income Taxes as a Share of GDP,

22 Direct Impact of Taxes Disposable income is defined as the amount of income people have left after paying taxes. Tax cuts increase disposable income, while tax increases lower it. Thus, tax cuts are stimulative, and tax increases are contractionary. If the economy goes into recession, the government can cut taxes as a way of stimulating the economy

23 Impact of a Tax Cut Demand curve for cars after income tax cuts Q1Q1 P1P1 Original demand curve for cars Price of cars Q Quantity of cars supplied and demanded Supply curve for cars P A B 11-23

24 Incentives and Taxes There are incentive effects associated with taxes. Higher taxes will discourage whatever activity is being taxed. This link between taxes and incentives is the essential insight of supply-side economics. Supply-side economics focuses on the marginal tax rate – that is, the tax you pay on the last dollar of income you earn

25 Top Marginal Tax Rates,

26 Borrowing If there is a gap between spending and tax revenues, the government has to borrow. The excess of the federal government’s spending over its revenues is the budget deficit. If revenues exceed spending, we have a budget surplus. To pay for the budget deficit, the government borrows money from investors. The total of all the government’s borrowing is called the public debt

27 Federal Budget Surplus or Deficit,

28 Effect of Borrowing In the short run, an increasing federal budget deficit stimulates the economy. Government borrowing has a negative effect, in that, a rising budget deficit pushes up interest rates and crowds out private investment. This is known as crowding out. Crowding out has a negative impact on long-term growth. It is important to get the long-term budget deficit under control. This requires controlling the cost of Medicare, Medicaid, and Social Security

29 Crowding Out New demand curve for loans, including government borrowing L1L1 r1r1 Demand curve for loans Interest rate L Quantity of money borrowed and lent Supply curve for loans r A B 11-29

30 Summary of the Impacts of Fiscal Policy Fiscal Policy ActionHow It Can HelpHow It Can Hurt Increase government spending. Create jobs and boost GDP Can boost inflation and widen budget deficit Lower taxes.Create jobs and boost GDP, and provide incentives for work and investment Can boost inflation and widen budget deficit Accept wider budget deficit. Create jobs and boost GDP Can lead to higher interest rates and lower private investment; lowers long-term GDP growth 11-30

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