Survey of Economics Irvin B. Tucker Chapter 15 Fiscal Policy Lecture Slides Survey of Economics Irvin B. Tucker © 2016 south-Western, a part of Cengage Learning

What will I learn in this chapter? How the federal government uses discretionary fiscal policy to influence the economy’s performance © 2016 south-Western, a part of Cengage Learning

What is discretionary fiscal policy? The deliberate use of changes in government spending or taxes to alter aggregate demand © 2016 south-Western, a part of Cengage Learning

Expansionary Fiscal Policy Exhibit 15-1 Expansionary Fiscal Policy Increase government spending Decrease taxes Increase government spending and taxes equally © 2016 south-Western, a part of Cengage Learning

Decrease government spending Increase taxes Exhibit 15-1 Contractionary Fiscal Policy Decrease government spending Increase taxes Decrease government spending and taxes equally © 2016 south-Western, a part of Cengage Learning

Increase in price level and real GDP Increase in aggregate demand curve Increase in government spending or decrease in taxes © 2016 south-Western, a part of Cengage Learning

(trillions of dollars per year) Exhibit 15-2 Using Government Spending to Combat a Recession AS E2 215 E1 Price Level (CPI) X 210 AD2 AD1 Full employment 13 14 15 Real GDP © 2016 south-Western, a part of Cengage Learning (trillions of dollars per year)

What is the spending multiplier? Any initial change in spending leads to a chain reaction of more spending which causes a greater change in demand © 2016 south-Western, a part of Cengage Learning

How is the spending multiplier calculated? The ratio of the change in real GDP to an initial change in any component of aggregate expenditures © 2016 south-Western, a part of Cengage Learning

What is the marginal propensity to consume (MPC)? MPC is the change in consumption resulting from a change in income © 2016 south-Western, a part of Cengage Learning

The spending multiplier formula Spending multiplier (SM) = 1/(1-MPC) © 2016 south-Western, a part of Cengage Learning

With an MPC of 0.50, what is the spending multiplier? © 2016 south-Western, a part of Cengage Learning

How much will real GDP increase with an increase in government spending of $1,000 billion? ∆G X SM = ∆Y $1,000Bn x 2 = $2,000Bn © 2016 south-Western, a part of Cengage Learning

Exhibit 15-3 The Spending Multiplier Effect Component of Total Sending New Consumption Spending (billions of dollars) Round 1 Government spending $1,000 2 Consumption 500 3 Consumption 250 . . . 4 Consumption 125 . . . . . . All other rounds Consumption 125 Total spending $2,000 © 2016 south-Western, a part of Cengage Learning

Exhibit 15-4 Relation Between MPC and the Spending Multiplier (1) (2) (3) Marginal Propensity to Consume (MPC) Marginal Propensity to Save (MPS) Spending Multiplier (SM) 0.90 0.10 10 0.80 0.20 5 0.75 0.25 4 0.67 0.33 3 0.50 0.50 2 0.33 0.67 1.5 © 2016 south-Western, a part of Cengage Learning

What is the tax multiplier? The change in aggregate demand (total spending) resulting from an initial change in taxes © 2016 south-Western, a part of Cengage Learning

What is the tax multiplier formula? TM = 1 – spending multiplier © 2016 south-Western, a part of Cengage Learning

With a spending multiplier of 2 what is the tax multiplier (TX)? © 2016 south-Western, a part of Cengage Learning

How much does real GDP increase by with a cut in taxes of $1,000Bn? ∆ T x TM = ∆Y 1 x $1,000B = $1,000Bn © 2016 south-Western, a part of Cengage Learning

What will happen to AD if both government spending (G) and taxes are increased by $1,000 Bn? © 2016 south-Western, a part of Cengage Learning

Exhibit 15-5 Comparison of the Spending and Multipliers Increase in Aggregate Demand from a (1) (2) $1 Trillion increase in Government Spending (x G) $1 Trillion Cut in Taxes (- T) Component of Total Sending ∆ ∆ Round 1 Government spending $1,000 $ 0 2 Consumption 500 500 3 Consumption 250 250 . . . . 4 Consumption 125 125 . . . . . . . . All other rounds Consumption 125 125 Total spending $2,000 $1,000 © 2016 south-Western, a part of Cengage Learning

What is the conclusion? A tax cut has a smaller multiplier effect on aggregate demand than an equal increase in government spending © 2016 south-Western, a part of Cengage Learning

Can we assume that the MPC will remain fixed? No, it can change from one time period to another © 2016 south-Western, a part of Cengage Learning

Can fiscal policy be used to combat inflation? Yes, this would happen when the economy is operating in the intermediate or classical ranges of the aggregate supply curve © 2016 south-Western, a part of Cengage Learning

Decrease in price level and real GDP Decrease in aggregate demand curve Decrease in government spending or increase in taxes © 2016 south-Western, a part of Cengage Learning

Exhibit 15-6 Using Fiscal Policy to Combat Inflation AS E´ E1 220 Price Level (CPI) E2 215 AD1 AD2 Full employment 13 14 Real GDP © 2016 south-Western, a part of Cengage Learning (trillions of dollars per year)

What is an automatic stabilizer? Federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction © 2016 south-Western, a part of Cengage Learning

What are examples of automatic stabilizers? Transfer payments Unemployment compensation Welfare Tax collections © 2016 south-Western, a part of Cengage Learning

Budget surplus offsets inflation Tax collections rise and government transfer payments fall Increase in real GDP © 2016 south-Western, a part of Cengage Learning

What is a budget surplus? A budget in which government revenues exceed government expenditures in a given time period © 2016 south-Western, a part of Cengage Learning

Budget deficit offsets recession Tax collections fall and government transfer payments rise Decrease in real GDP © 2016 south-Western, a part of Cengage Learning

What is a budget deficit? A budget in which government expenditures exceed government revenues in a given time period © 2016 south-Western, a part of Cengage Learning

T G T G 12 Exhibit 15-7 Automatic Stabilizers 2.5 2.0 Budget deficit Budget surplus 1.5 Government Spending and Taxes (trillions of dollars per year) 1.0 T G 0.5 12 14 16 Real GDP © 2016 south-Western, a part of Cengage Learning (trillions of dollars per year)

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