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Fiscal Policy Chapter 11 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Principles of Economics: Macroeconomics.

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Presentation on theme: "Fiscal Policy Chapter 11 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Principles of Economics: Macroeconomics."— Presentation transcript:

1 Fiscal Policy Chapter 11 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Principles of Economics: Macroeconomics - Econ101

2 11-2 Fiscal Policy The federal government can alter aggregate demand by: –Purchasing more or fewer goods and services –Raising or lowering taxes –Changing the level of income transfers

3 11-3 Fiscal Policy Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes The federal budget is a tool that can shift aggregate demand and thereby alter macroeconomic outcomes

4 11-4 Fiscal Stimulus Suppose the economy is experiencing a recessionary GDP gap of $400 billion From a Keynesian perspective, the solution is to get someone to spend more on goods and services

5 11-5 The Policy Goal AS Q E = 5.6 a AD 1 PEPE Price Level Real GDP 6.0 = Q F GDP Equilibrium Full-employment GDP b GDP gap The goal is to close GDP gaps

6 11-6 Keynesian Strategy Fiscal stimulus: Tax cuts or spending hikes intended to increase (shift) aggregate demand Two strategic policy questions: –By how much do we want to shift the AD curve to the right? –How can we induce the desired shift?

7 11-7 The Naive Keynesian Model An increase in AD by $400 billion will achieve full employment only if AS curve is horizontal Assumption of a horizontal AS curve seems naïve today Although not every AD shift will raise prices, inflationary pressures increase as AD expands

8 11-8 The AD Shortfall So long as the AS curve slopes upward, AD must increase by more than the size of the recessionary gap to achieve full employment AD shortfall: The amount of additional aggregate demand needed to achieve full employment after allowing for price-level changes

9 11-9 The AD Shortfall AS Q E = 5.6 a AD 1 AD 2 PEPE Price Level Real GDP Q F = AD 3 c d be Recessionary GDP gap AD shortfall The AD shortfall is the fiscal policy target for achieving full employment.

10 11-10 More Government Spending Increased government spending is a form of fiscal stimulus Every dollar of new government spending has a multiplied impact on aggregate demand How much of a boost the economy gets depends on the value of the multiplier

11 11-11 Fiscal Restraint At times the economy is expanding too fast and fiscal restraint is more appropriate Inflationary GDP gap: The amount by which equilibrium GDP exceeds full-employment Fiscal restraint: Tax hikes or spending cuts intended to reduce (shift) aggregate demand

12 11-12 The Fiscal Target AD excess: The amount by which aggregate demand must be reduced to achieve full- employment equilibrium after allowing for price-level changes The AD excess exceeds the inflationary GDP gap

13 11-13 Multiplier Effects Impact of fiscal stimulus on aggregate demand includes both the new government spending and all subsequent increases in consumer spending triggered by multiplier effects

14 11-14 Multiplier Effects The second equation is identical to the first but expressed in the terminology of fiscal policy

15 11-15 Multiplier Effects Real GDP Price Level P1P1 5.6 QEQE AD 2 AD 3 Current price level Direct impact of rise in government spending + $200 billion AD 1 a b Indirect impact via increased consumption + $600 billion

16 11-16 The Desired Stimulus The general formula for computing the desired stimulus is a simple rearrangement of the earlier formula:

17 11-17 Fiscal Guidelines The essence of fiscal policy is the deliberate shifting of the aggregate demand curve Steps required to formulate fiscal policy: –Specify the amount of the desired AD shift –Select the policy tools needed to induce the desired shift

18 11-18 Weak Economy: Fiscal Stimulus

19 11-19 Overheated Economy: Fiscal Restraint

20 11-20 A Warning: Crowding Out Some of the intended fiscal stimulus may be offset by the crowding out of private expenditure Crowding out: A reduction in private-sector borrowing (and spending) caused by increased government borrowing


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