Outlays (Spending, Expenditures) Fiscal Policy Actions taken by the government through the federal budget, that are designed to achieve steady growth and full employment. Revenues (Taxes) Outlays (Spending, Expenditures) Deficit= Debt= Debt Clock when spending > revenues (for a specific budget year) the total sum of money owed by the gov’t due to past years of deficit spending

Keynesian vs. Mainstream View Keynesian – Fiscal Stimulus (increased spending and/or a decrease in taxes) boosts RGDP and stabilizes or increases employment levels. (demand-side) AD & multiplier effect Mainstream – Keynesians over-estimate the positive effects, and that they are small, short-lived and take too long to show results. (supply-side) Gov’t stimulus crowds out private consumption & investments Result in bigger gov’ts, lower potential GDP, slower RGDP growth rate and more gov’t debt.

Keynesian View of Fiscal Stimulus Automatic vs. Discretionary Policies Automatic- affect the economy/RGDP without explicit gov’t action. - Induced Taxes (taxes that vary with GDP) income, wages, profits - Needs-Tested Spending (gov’t programs for needy) unemployment, welfare, medicaid etc. - Automatic Stimulus – the changes in the above affect the budgets for those years and automatically affect the economy (Structural vs Cyclical)

Actual budget balance = Structural + Cyclical Automatic Stimulus Structural surplus/deficit – the balance that is built in and voted on for the budget (would occur anyway) Cyclical surplus/deficit – Unplanned changes in actual revenues/taxes that occur due to the economy Actual budget balance = Structural + Cyclical

Discretionary Policy Discretionary policies are actions that are initiated by Congress. -require explicit actions reflected in the budget or tax laws. CETERIS PARIBUS- A change in any aspect of the gov’t budget will have a multiplier effect on Aggregate Demand -Gov’t Expenditure Multiplier -Tax Multiplier -Transfer Payment Multiplier -Balanced Budget Multiplier

Gov’t Expenditure Multiplier AE = C + G + I + NX Gov’t spending increases AD, RGDP increases, so which triggers an increase in consumption, which increases AE and so on… 1/(1-MPC) OR ΔY/ΔI Tax Multiplier A decrease in taxes increases disposable income = AD But because of the MPC/MPS relationship the effect of the tax cuts is less than the effect of the expenditure multiplier -MPC/(1-MPC) = –MPC/MPS

Transfer Payments Multiplier An increase in transfer pymnts = increases disposable income which increases AD This is also affected by the MPC/MPS relationship MPC/MPS Balanced Budget Multiplier When a spending change occurs at the same time as a tax change- The effect of the spending is greater proportionally than the effect of the tax change; spending changes mitigate the tax change (because of the multiplier effect) BBM= 1/(1-MPC) + -MPC/MPS = 1

Fiscal Stimulus in Action Potential GDP Price Level AS AD2 AD1 PL2 PL1 AD RGDP

Limitations of Discretionary Fiscal Policy Time Lag- The budget process takes months and set budgets in motion a year ahead of time – by the time the budget takes effect things might have changed Shrinking Discretionary Budget – 80% of the budget is mandatory spending and the 20% that is left is very hard to cut w/o public outcry and significant political maneuvering Estimating Potential GDP – it is not a perfect science, actions might actually make things worse if the estimates are wrong Economic Forecasting - Congress is basing their budgets on expectations and predictions and there is not guarantee that things will play out as expected

Classify the following items as either automatic or discretionary policy, or not a part of fiscal policy. a. decrease in tax revenues in a recession b. additional gov’t spending to upgrade the highway system c. an increase in public education budget d. a cut in infrastructure expenditures during a boom

Explain how aggregate demand changes when gov’t expenditure on national defense changes by $100 billion. Explain how aggregate demand changes when the gov’t increases taxes by $100 billion. Explain how aggregate demand changes when the gov’t increases both expenditure on goods and services by $100 billion.

Supply-Side (Mainstream View) Keynesian view emphasizes the effects of fiscal policy on AD and consumption Mainstream view focuses on actions that affect potential GDP and the GDP growth rate Wage Rate = Labor Qty Demanded; Qty Labor Supplied Expenditures = public goods & services = productivity Tax Changes = change in work incentive & saving/investment

Tax Wedge -the gap between the price paid by the consumer and the price received by the producer Income tax creates a wedge between gross and net wages, and affects the qty of labor supplied Sales, excise and consumption taxes create a wedge that effectively lowers the real wage rate and lowers the incentive to work Total tax wedge = income tax rate+ expenditure tax rate Potential GDP is a reflection of employment levels, so if there is less incentive to work, the potential GDP shifts left

Effects of Tax Rates on Labor Supply LS + tax Real Wage Rate LS $35 hr Real Wage Rate after tax increase Real Wage Rate $30 hr LD Labor Qty

Income Tax changes and Potential GDP Income Tax cuts increase AD due to increased disposable income, but it also creates a rightward shift in Labor Supply which increases potential GDP Fiscal policy and GDP Growth Rate Tax Wedge also applies to interest rates and can affect investment spending and affect the growth rate Deficit Spending on behalf of the Gov’t crowds out private investment and lowers the growth rate

Tax Wedge and Interest Rates Lenders pay income tax on interest rec’d from borrowers- This has a two-fold effect - taxes on interest lowers qty of saving/investing & slows the growth rate of RGDP (Lucas Wedge) (if the banks have to pay higher taxes they are less likely to loan out money) - True tax rate on interest can be amplified by inflation Interest Tax Rate = 40% of Nominal Interest Rate Nominal = 4%, with no inflation, interest tax =1.6% Real after tax interest rate = 2.4% Nominal = 10%, inflation = 6%, real Interest rate = 4%, interest tax =4% Real after tax interest rate = 0%

Crowding Out Effect -If the government is in deficit spending it must borrow to make up the difference- -this increases the demand for loanable funds, but the supply of loanable funds remains unchanged so…- -the interest rate will go up-which decreases the investment expenditure and slows the growth rate of RGDP Interest Rate SLF DLF1 DLF Qty of Loanable Funds

Laffer Curve Laffer argued that tax cuts employment and output, and tax cuts would tax revenues enough to cover deficit spending (reagan-nomics, voodoo economics) Tax cuts can increase incentives, but must be combined with spending cuts or it will cause greater deficits and add to the crowding out effect.

Combined Demand and Supply Side Effects Price Level AD1 AS AS1 AS1 AS1 AD1 AD1 AD

Long-Run Fiscal Policy Effects Investment Crowded Out = growth rate, and PGDP gets even farther from what it should be (Lucas Wedge) Budget Deficit leads to debt = confidence inflation Different Types of Taxes Progressive Tax – the more you make - the more you pay Proportional Tax (flat tax) – the amount of taxes is the same percentage of income across the board Regressive Tax- the tax is a fixed amount regardless of income, but the tax burden is heaviest on the lowest incomes. (i.e. $5000 tax = 20% of 25,000 a yr; but only 5% of 100,000 a yr)