Presentation on theme: "Chapter 13: Fiscal Policy"— Presentation transcript:
1 Chapter 13: Fiscal Policy End of Chapter 10ECON 151 – PRINCIPLES OF MACROECONOMICSChapter 13: Fiscal PolicyMaterials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.1
2 Discretionary Fiscal Policy The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals is the realm of fiscal policy.High employment (low unemployment)Price stabilityEconomic growthImprovement of international payments balance
3 Discretionary Fiscal Policy (cont'd) The discretionary changing of government expenditures or taxes to achieve national economic goals, such as high employment with price stability
4 Discretionary Fiscal Policy (cont'd) An increase in government spending will stimulate economic activityChanges in government spendingMilitary spendingEducation spendingBudgets for government agencies
5 Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (a) If there is a recessionary gap in panel (a), fiscal policy can presumably increase aggregate demand
6 Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (b) If there is an inflationary gap, fiscal policy can presumably decrease aggregate demand
7 Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a) In panel (a), the economy is initially at E1, where real GDP exceeds long-run equilibriumContractionary fiscal policy can move aggregate demand to AD2 via a tax increaseA new equilibrium is at E2 at a lower price levelReal GDP is now consistent with LRAS
8 Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (b) In panel (b) with a recessionary gap (in this case $500 billion) taxes are cutAD1 moves to AD2The economy moves from E1 to E2, and real GDP is now at $12 trillion per yearWe are at the long-run equilibrium level
9 Discretionary Fiscal Policy (cont'd) Change in taxesA rise in taxes causes a reduction in aggregate demand because it can reduce consumption spending, investment expenditures, and net exports.
10 Possible Offsets to Fiscal Policy Fiscal policy does not operate in a vacuum and important questions must be answered.How are expenditures financed and by whom?If taxes are increased what does government do with the taxes?What will happen if individuals worry about increases in future taxes?
11 Possible Offsets to Fiscal Policy (cont'd) Crowding-Out EffectThe tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector; this decrease normally results from the rise of interest rates.
12 Figure 13-3 The Crowding-Out Effect, Step by Step
13 Figure 13-4 The Crowding-Out Effect Expansionary policy causing deficit spending initially shifts from AD1 to AD2Due to crowding out, AD shifts inward to AD3Equilibrium GDPbelow full-employment GDP—recessionary gap
14 Possible Offsets to Fiscal Policy (cont'd) Planning for the future: the Ricardian equivalence theoremRicardian Equivalence TheoremThe proposition that an increase in the government budget deficit has no effect on aggregate demandThe reason for the offsetPeople anticipate that a larger deficit today will mean higher taxes in the future and adjust their spending accordingly.
15 Possible Offsets to Fiscal Policy (cont'd) Direct Expenditure OffsetsActions on the part of the private sector in spending income that offset government fiscal policy actionsAny increase in government spending in an area that competes with the private sector will have some direct expenditure offset.
16 Possible Offsets to Fiscal Policy (cont'd) The supply-side effects of changes in taxesExpansionary fiscal policy could involve reducing marginal tax rates.Advocates argue this increases productivity since individuals will work harder and longer, save more, and invest more.The increased productivity will lead to more economic growth.
17 Possible Offsets to Fiscal Policy (cont'd) Supply-Side EconomicsThe suggestion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward
18 Figure 13-5 Laffer Curve Tax revenues are at a maximum Tax rates and rise togetherTax rates and taxrevenues fall together
19 Discretionary Fiscal Policy in Practice: Coping with Time Lags Recognition Time LagThe time required to gather information about the current state of the economyAction Time LagThe time required between recognizing an economic problem and putting policy into effectEffect Time LagThe time it takes for a fiscal policy to affect the economy
20 Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) Fiscal policy time lags are long and a policy designed to correct a recession may not produce results until the economy is experiencing inflation.Fiscal policy time lags are variable in length (1–3 years), and the timing of the desired effect cannot be predicted.Because fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy.
21 Automatic Stabilizers Automatic or Built-In StabilizersChanges in government spending and taxation that occur automatically without deliberate action of CongressThe tax systemUnemployment compensationWelfare spending
22 Figure 13-6 Automatic Stabilizers The automatic changes tend to drive the economy back toward its full-employment output level
23 What Do We Really Know About Fiscal Policy? Fiscal policy during normal timesCongress ends up doing too little too late to help in a minor recession.Fiscal policy that generates repeated tax changes (as has happened) creates uncertainty.
24 What Do We Really Know About Fiscal Policy? (cont'd) Fiscal policy during abnormal timesFiscal policy can be effectiveThe Great Depression—fiscal policy may be able to stimulate aggregate demand.Wartime—during World War II real GDP increased dramatically.
25 What Do We Really Know About Fiscal Policy? (cont'd) The “soothing” effect of Keynesian fiscal policyShould we encounter a severe downturn, fiscal policy is available.Knowing this may reassure consumers and investors.Stable expectations encourage a smoothing of investment spending.
26 Chapter 13: Fiscal Policy End of Chapter 10ECON 151 – PRINCIPLES OF MACROECONOMICSChapter 13: Fiscal PolicyMaterials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.26