Fiscal Policy 20

After studying this chapter, you should be able to: Describe the tools that governments use to influence aggregate demand. Describe mandatory and discretionary government spending. Describe the multiplier effect of increased government spending on the equilibrium output of an economy. Explain expansionary and contractionary fiscal policy Describe why tax changes have a smaller impact on the economy than changes in government. Describe the impact of automatic stabilizers, lag effects, and the crowding out effects in fiscal policymaking. Describe the debate over the size of government and economic policy.

Federal Government Budget, 2009

Fiscal Policy Fiscal policy: one way the government tries to manage the economy and tame the business cycle. involves adjusting government spending on: Goods and services Transfer payments Taxes

Discretionary Spending The federal budget contains two types of spending: discretionary and mandatory. Discretionary spending: The part of the budget that works its way through the appropriations process of Congress each year Includes: National defense Transportation Science Environment Income security

Mandatory Spending Mandatory spending: authorized by permanent laws and does not go through the same appropriation process as discretionary spending. To change these entitlements, Congress must change the law. Includes: Social Security Medicare Interest on the national debt

Discretionary and Mandatory Federal Spending Getting harder to maneuver…

Discretionary Fiscal Policy adjusting government spending and tax policies with the express short-run goal of moving the economy toward full employment, encouraging economic growth, or controlling inflation

The Multiplier and Government Spending But when we reach full employment, more spending will only create inflation The Multiplier will boost government spending when the economy is below full employment

The Multiplier Effect When government spending is injected into the economy, the multiplier goes to work… $1 of additional spending in the economy will create new income which will be spent (and re-spent many times by all who receive it as income) Total new spending = Initial injection x Multiplier

Taxes When taxes are increased, money is withdrawn from the economy’s spending stream. When taxes are reduced, consumers and business have more to spend. A tax increase (or decrease) will have less of a direct impact on income, employment, and output than an equivalent change in government spending.

Taxes GDP= C + I + G + (X - M) Let’s simplify for a moment… If GDP = C + I (no government or foreign sector) and we know Y = GDP if there is no taxes… so Y= C + I or Y – C = I and we know that (Y – C) = S so S = I At equilibrium, injections (I) are just equal to withdrawals (S)

Equilibrium I + G + X = S + T + M Add in back in injections (G and X) and subtract withdrawals (T and M) and get I + G + X = S + T + M Fiscal Policy works by changing G or T to change the level of injections or withdrawals in the economy

Expansionary and Contractionary Fiscal Policy Expansionary fiscal policy: increasing government spending or decreasing taxes to increase aggregate demand to expand output.

Expansionary Fiscal Policy If the economy is below full employment, expansionary fiscal policy can be used to boost AD to AD1. LRAS SRAS0 P1 f Aggregate Price Level (P) e P0 AD1 AD0 Q0 Qf Aggregate Output (Q)

Contractionary Fiscal Policy If the economy is beyond the point of full employment, contractionary fiscal policy can be used to dampen inflationary pressures. This requires an increase in taxes or a decrease in government spending.

Contractionary Fiscal Policy A contractionary fiscal policy that shifts AD from AD0 to AD1 will lower the price level as it reduces aggregate output. LRAS SRAS0 P0 e Aggregate Price Level (P) P1 a AD0 AD1 Qf Q0 Aggregate Output (Q)

Supply-Side Fiscal Policies Goal: create growth, reduce unemployment and stabilize prices They are designed to shift the long-run aggregate supply curve to the right Do not always require such tradeoffs between price levels and output Supply-side policies require more time to work than do demand-side policies

Supply-Side Outcomes Current examples of supply-side technology: Spending on infrastructure and education Improvements in technology and communications have increased productivity. These have helped to keep interest rates and inflation low for several decades.

Supply-Side Policy If successful, supply-side policies will create economic growth, lower unemployment and lower prices

President Reagan arguing for a tax cut Supply-Side Policy Supply-side policy ideas: Infrastructure Spending Reducing Tax Rates Expanding Investment and Reducing Regulations President Reagan arguing for a tax cut

The Laffer Curve One recommendation of supply-side economics: lower tax rates to increase productivity. The Laffer Curve argues that tax revenues can sometimes be increased by lowering tax rates Encourages risk-taking by entrepreneurs; lower taxes mean higher after-tax returns on investments Encourages private saving and business investment

Art Laffer: Reduce the tax rate and watch the revenues increase…. The Laffer Curve Art Laffer: Reduce the tax rate and watch the revenues increase….

Encouraging Investment Investment can be increased by: Investment tax credits More rapid depreciation schedules for plant and equipment When a firm can expense its capital equipment over a shorter period of time, it reduces tax payments now rather than later, and so earns a higher net return. Repealing unnecessarily heavy regulation Government grants for basic research

Implementing Fiscal Policy It takes time to recognize economic problems and implement solutions… some times too much time.

Automatic Stabilizers The solution? Automatic Stabilizers Automatic Stabilizers: Tax revenues and transfer payments automatically adjust to economic fluctuations without requiring overt action by Congress. When the economy is growing tax receipts will rise with rising income, and transfer payments will decline because fewer people require welfare or unemployment assistance.

Automatic Stabilizers The income tax is a powerful stabilizer because of its progressivity. When incomes fall, tax revenues fall faster since people pay lower rates as their incomes fall. Disposable income falls more slowly than aggregate income.

Fiscal Policy Timing Lags Information lag Most of the data that policy makers need are not available until at least one quarter after the fact. Recognition lag It may take several quarters to confirm the economic trends. Decision lag The time it takes Congress and the administration to decide on a policy once a problem is recognized. Implementation lag Fiscal policy requires a long and often contentious legislative and implementation process. It also takes time for the policy to affect the economy.

The Crowding-Out Effect The crowding-out effect of fiscal policy: deficit spending requires the government to borrow from a the economy’s pool of funds. This borrowing can drive up interest rates. Higher interest rates: Dampen consumer spending Reduce business investment

How big should the government be? Ponder This How big should the government be?

Key Concepts Discretionary spending Supply-side fiscal policies Mandatory spending Laffer curve Discretionary fiscal policy Automatic stabilizers Information lag Expansionary fiscal policy Recognition lag Decision lag Contractionary fiscal policy Implementation lag Crowding-out effect

In a depressed economy with a lot of excess capacity and a MPC of 0 In a depressed economy with a lot of excess capacity and a MPC of 0.75, what effect will a $100 increase in government spending have on equilibrium GDP? Reduce it by $250 Raise it by $250 Raise it by $400 Raise it by $700

Which of the following is a contractionary fiscal policy? Increasing government spending Expanding transfer payments Subsidizing basic research Raising tax rates

True or false: Supply-side fiscal policy does not require tradeoffs between output and prices and it works faster than demand-side fiscal policy. True False

True or false: Supply-side fiscal policy does not require tradeoffs between output and prices and it works faster than demand-side fiscal policy. True False