1. Chapter 10: Fiscal Policy
Principles of MacroEconomics: Econ101

2. In this Lecture……………….. What is Fiscal Policy Automatic Discretionary
The Multiplier Effect Revisited
Government Spending
Taxes
Expansionary vs. Contractionary Fiscal Policy
The Crowding Out Effect
Deficits, Surpluses and Federal Government Debt

3. What is Fiscal Policy?
Changes in government expenditures and/or taxes to achieve particular economic goals, such as low unemployment, stable prices, and economic growth. 3

4. What is Automatic Fiscal Policy
Changes in government expenditures and/or taxes that occur automatically without (additional) congressional action…..automatic stabilizers.
Entitlements such as:
Unemployment benefits
Welfare spending
Social Security spending
Income Taxes
Each one percentage point increase in the unemployment rate will increase government spending by about $5 billion and will decrease tax revenues approximately $25 billion for a total budget deficit of $30 billion. 4

5. The Use of Discretionary Fiscal Policy
Deliberate changes of government expenditures and/or taxes to achieve particular economic goals.
Government spending
Taxation
Changing Transfers
Not as successful as automatic fiscal policy
Tax/transfer Multiplier = Marginal Propensity to Consume
1 – Marginal Propensity to Consume
The multiplier is a number that multiplies a change in taxes or transfers in order to calculate the change in real GDP.
The tax & transfer multiplier is lower than the government purchases multiplier because if government purchases goods and services, every dollar is spent to buy goods or services. If government reduces taxes, only part of that money is spent to buy goods and services.
Therefore, increasing government purchases has a larger effect, dollar for dollar than reducing taxes or increasing transfers. 5

6. The Government Spending & Taxes Multiplier Effect
The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures.

7. Official Budget Deficit vs. Structural Budget Deficit
Structural Deficit:
The part of the budget deficit that would exist even if the economy were operating at full employment.
Only reason that structural can change from year to year is that the federal government took some specific action to change government spending or tax revenues.
The structural budget deficit or surplus measures the intent of fiscal policy
Official Budget Deficit:
The part of the budget deficit that is a result of a downturn in economic activity. 7

8. Expansionary vs. Contractionary Fiscal Policy
Expansionary Fiscal Policy:
Increases in government expenditures and/or decreases in taxes to achieve particular economic goals.
Contractionary Fiscal Policy:
Decreases in government expenditures and/or increases in taxes to achieve particular economic goals.
PROBLEM
TYPE OF POLICY
ACTIONS BY CONGRESS AND THE PRESIDENT
RESULT
Recession
Expansionary
Increase government spending or cut taxes
Real GDP and the price level rise.
Rising Inflation
Contractionary
Decrease government spending or raise taxes
Real GDP and the price level fall.
Don’t Let This Happen to YOU! Don’t Confuse Fiscal Policy and Monetary Policy 8

9. Expansionary Policy in a Recessionary Gap
Increased government purchases, decreased taxes, or both lead to a rightward shift in the aggregate demand curve from AD1 to AD2, restoring the economy to the natural level of Real GDP, QN 9

10. Expansionary Fiscal Policy

11. Contractionary Policy in an Inflationary Gap
Decreased government purchases, increased taxes, or both lead to a leftward shift in the aggregate demand curve from AD1 to AD2, restoring the economy to the natural level of Real GDP, QN. 11

12. Contractionary Fiscal Policy

13. Fiscal Policy May Destabilize the Economy
In this scenario, the SRAS curve is shifting rightward (healing the economy of its recessionary gap), but this information is unknown to policymakers.
Policymakers implement expansionary fiscal policy, and the AD curve ends up intersecting SRAS2 at point 2instead of intersecting SRAS1 at point1'.
Policymakers thereby move the economy into an inflationary gap, thus destabilizing the economy. 13

14. Crowding Out
The decrease in private expenditures that occurs as a consequence of increased government spending (direct effect) or the financing needs of the Federal budget deficit (indirect effect). 14

15. Crowding Out in the Short-Run

16. Crowding Out in the Short-Run

17. An Overview of Government Spending and Taxes

18. Deficits, Surpluses and the Federal Government Debt
Budget deficit:
The situation in which the government’s spending is greater than its tax revenue.
Budget Surplus:
The situation in which the government’s expenditures are less than its tax revenue.

19. Is Federal Government Debt a Problem?