McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Fiscal Policy Chapter 11

2 Part 4: Fiscal Policy Tools Chapter 11: Fiscal Policy: 1. Background: Some History on Taxes & Spending. 2. Fiscal Stimulus. 3. Fiscal Restraint. 4. Fiscal Guidelines.

3 1. Background: Taxes & Spending. (Brief Overview)

4 Taxes and Spending

5 The federal government: 1902: employed < than 350,000 people, Spending = $650 million. Today, employs > 4 million people, Spending = $3 trillion.

6 Government Revenue granted the power to tax incomes. Today, the federal government collects nearly $3 trillion a year in taxes. All of this government spending directly affects aggregate demand. Government expansion started with the 16th Amendment to the U.S. Constitution (1913):

7 Purchases vs. Transfers Government purchases: part of aggregate demand. Spent on resources to provide services. Income transfers: payments to individuals for which no current goods or services are exchanged. It contributes to consumer income. Not part of AD until spent by consumers.

8 Fiscal Policy Fiscal Policy: The federal government can alter aggregate demand and macro outcomes by changing its own level of: Spending, Taxing, Income transfers.

9 Fiscal Policy Internal market forces External shocks Policy levers: Output Jobs Prices Growth International balances DETERMINANTSOUTCOMES AD AS Fiscal policy

10 2. Fiscal Stimulus. -The naïve Keynesian model. -The AD shortfall. -The multiplier. -The formula for desired fiscal stimulus. -Translating fiscal stimulus into spending, tax, or income transfer changes.

11 Fiscal Stimulus Keynesian Strategy: the way out of recession is to get someone to spend more on goods and services. It can start with the government. Fiscal Stimulus: Tax cuts/spending hikes, intended to increase AD.

12 Keynesian Strategy Two strategic policy questions must be answered: 1. By how much do we want to shift the AD curve to the right? 2. How to induce the desired shift?

13 The Policy Goal AS Q E = 5.6 a AD 1 PEPE Price Level (average price) Real GDP (trillions of dollars per year) 6.0 = Q F GDP Equilibrium Full-employment GDP b GDP gap The goal is to close GDP gaps

14 The Naive Keynesian Model The Naive Keynesian Model: The desired spending (AD) increase = the GDP gap. An increase in AD by $400 billion will achieve full employment. BUT… …This is only possible if the aggregate supply curve is horizontal. AS Q E = 5.6 a AD 1 PEPE Price Level Real GDP (trillions of dollars per year) 6.0 = Q F GDP Equilibrium Full-employment GDP b GDP gap

15 Naïve Keynesian Model AS Q E = 5.6 a AD 1 AD 2 PEPE Price Level (average price) Real GDP (trillions of dollars per year) Q F = 6.0 c b Recessionary GDP gap LO1

16 Price Level Changes When the AD curve shifts to the right, the economy moves up the AS curve, not horizontally to the right. Both real output and prices change. As long as the AS curve slopes upward, AD must increase by more than the size of the recessionary GDP gap to achieve full employment.

17 The AD Shortfall AS Q E = 5.6 a AD 1 AD 2 PEPE Price Level (average price) Real GDP (trillions of dollars per year) Q F = AD 3 c d be Recessionary GDP gap AD shortfall LO1

18 The AD Shortfall AS Q E = 5.6 a AD 1 PEPE Price Level (average price) Real GDP (trillions of dollars per year) Q F = AD 3 d e Recessionary GDP gap AD shortfall LO1

19 The AD Shortfall The “fiscal target” is (=)… …the “AD shortfall:” the amount of additional AD needed to achieve full employment … ***…after allowing for price level changes. * * * * * However… LO1

20 Fiscal Stimulus Three forms of fiscal stimulus that the federal government can use to shift AD are: Spending, Tax cuts, Transfer payment increases.

21 Government Spending Increased government spending is a form of fiscal stimulus. But… …Every dollar of new government spending has a multiplied impact on aggregate demand. LO3

22 Multiplier Effects How much of a boost the economy gets depends on the value of the multiplier: Multiplier value = 1/(1-MPC) (1/MPS)!!! Example: an MPC of.75 = Multiplier of 4: 1/(1-.75) = LO3 1/.25 =4

23 Multiplier Effects The total spending change equals the multiplier times the new spending injections. LO3 $800 billion Total Change in Spending == $3.2 trillionx 4

24 Multiplier Effects So… …for government spending… …the impact of fiscal stimulus on aggregate demand includes: 1. The amount of new government spending (“first round”), plus… 2. All subsequent increases in consumer spending triggered by multiplier effects. LO3

25 Multiplier Effects fiscal stimulus (new spending injection) multiplierX  induced increase in consumption new spending injection (fiscal stimulus) Cumulative increase (horizontal shift) in AD  LO3

26 The AD Shortfall AS Q E = 5.6 AD 1 AD 2 PEPE Price Level (average price) Real GDP (trillions of dollars per year) Q F = AD 3 AD shortfall LO1

27 Multiplier Effects So… Desired increase in AD (Ad shortfall) fiscal stimulus (new spending injection) multiplierX 

28 The AD Shortfall AS Q E = 5.6 AD 1 AD 2 PEPE Price Level (average price) Real GDP (trillions of dollars per year) Q F = AD 3 AD shortfall LO1 MPC =.75

29 The AD Shortfall AS Q E = 5.6 a AD 1 AD 2 PEPE Price Level (average price) Real GDP (trillions of dollars per year) Q F = AD 3 c d be Recessionary GDP gap AD shortfall LO1 MPC =.75

30 Multiplier Effects 800 billion 4 =200 billion

31 Multiplier Effects Real GDP ($ trillions per year) Price Level (average price) P1P1 5.6 QEQE AD 2 AD 3 Current price level Direct impact of rise in government spending + $200 billion AD 1 a b Indirect impact via increased consumption + $600 billion LO3

32 Tax Cuts

33 Taxes and Consumption The government can also use tax cuts as fiscal stimulus: this increases the disposable income (Y d ) of the private sector. The amount by which consumption will increase still depends on the MPC. tax cut MPC Initial increase in consumption   LO2 200 Billion Billion  

34 Taxes and Consumption Tax cuts: A dollar of tax cut contains less fiscal stimulus than a government spending increase of the same size (money is siphoned off to savings). So, the tax cut must be larger than the desired fiscal stimulus to counterbalance the MPS. LO2

35 Taxes and Consumption

36 The Tax Cut Multiplier First round of spending: Second round of spending: Third round of spending: More incomeMore consumptionMore incomeMore consumption Tax Cut More consumption = MPC X tax cut More saving = MPS X tax cut More saving Cumulative change in saving: = tax cut LO2

37 Taxes and Investment A tax cut may also be an effective mechanism for increasing investment spending. Tax cuts have been used numerous times to stimulate the economy. LO2

38 Increased Transfer Payments Increasing transfer payments works the same way as cutting taxes: LO3

39 Practice 1: If the MPS is.90, what is the initial fiscal impact of the following gov’t actions: $1 billion spending increase? v. $1 billion tax decrease? v. $1 billion transfer payment increase?

40 Practice 2: If the MPS is.90, what is the cumulative fiscal impact of the following gov’t actions: $1 billion spending increase? v. $1 billion tax decrease? v. $1 billion transfer payment increase?

41 Practice 3: If the MPS is.98, the recessionary GDP gap is $200 billion, and the AD shortfall is $600 billion: 1. What is the fiscal target? 2. What size gov’t spending increase is needed to close the GDP gap? 3. What size tax decrease is needed to close the GDP gap? 4. What size transfer payment increase is needed to close the GDP gap?

42 3. Fiscal Restraint

43 The Fiscal Target Fiscal restraint: the use of tax hikes or spending cuts to reduce (shift) aggregate demand. The AD excess: the amount by which aggregate demand must be reduced to achieve price stability… …after allowing for price-level changes. LO1

44 Excess Aggregate Demand AS Q 2 = 5.8 E2E2 f AD 1 AD 2 PEPE PFPF Price Level (average price) Real Output (trillions of dollars per year) E1E1 Q F = 6.0Q 1 = 6.2 Inflationary GDP gap Excess AD LO1

45 The Fiscal Target The AD excess and the multiplier are used to calculate the desired fiscal restraint. LO1

46 Delivering Fiscal Restraint There are three choices for implementing the fiscal restraint: Spending (budget) cuts, Tax increases, Transfer payment cuts.

47 Budget Cuts Budget cuts: Spending cuts (like spending increases) work one-to-one in regards to the amount of fiscal restraint needed. Initial budget cut Xmultiplier Cumulative reduction in spending  LO3

48 Tax Hikes Tax increases: The tax cut must be larger than the desired fiscal restraint to counterbalance the effects of the MPS & MPC. LO2 Desired tax increase = Desired fiscal restraint MPC

49 Reduced Transfers A cut in transfer payments works like a tax hike, reducing the disposable income of transfer recipients. LO3

50 Practice – Fiscal Stimulus 1. Recessionary GDP gap = 2. AD shortfall = 3. Naïve Keynesian policy suggests the value of increased demand needed to achieve Q F = 4. The gov’t spending increase needed to achieve full employment equilibrium = 5. What size tax cut would achieve full employment equilibrium? LO1 AS Q E = 12.6 a AD 1 AD 2 PEPE Price Level Real GDP (trillions of dollars per year) Q F = AD 3 c d be MPC = billion 1,800 billion 600 billion 180 billion 200 billion

51 Practice – Fiscal Restraint 1. AD excess = 2. Inflationary GDP gap = 3. The gov’t spending decrease that would achieve full employment equilibrium = 4. What size transfer payment cut would achieve full employment equilibrium? LO1 AS Q 2 = 5.6 E2E2 f AD 1 AD 2 PEPE PFPF Price Real Output (trillions of dollars per year) E1E1 Q F = 6.0Q 1 = 6.3 MPC = billion 300 billion 14 billion billion

52 Practice Given: C = 400 billion +.95Yd 1. What would be the total impact of a $10 billion spending decrease by the gov’t? 2. What would be the total impact of a $20 billion tax decrease by the gov’t? 3. Would a transfer payment cut be used to close an AD shortfall or excess? 4. What size transfer payment cut would be used to eliminate a $700 billion AD excess. LO1 -$200 billion AD decrease $380 billion AD increase Excess $36.84 billion

53 Fiscal Responsibility “Balanced budget politics:” Spending increases can be paid for with equal tax increases (and vice versa) and still stimulate the economy: Why? A dollar of spending change has more power than a dollar of tax change.

54 4. Fiscal Guidelines

55 Fiscal Guidelines The essence of fiscal policy is the deliberate shifting of the aggregate demand curve. LO3

56 A Primer: Simple Rules The steps required to formulate fiscal policy are: Specify the amount of the desired AD shift. Select the policy tools needed to induce the desired shift. LO3

57 Weak Economy: Fiscal Stimulus LO3

58 Overheated Economy: Fiscal Restraint LO3

59 Problems with the Implementation of Fiscal Policy

60 Crowding Out Some of the intended fiscal stimulus may be offset by the crowding out of private expenditure. Crowding out: the reduction in private-sector borrowing (and therefor spending) caused by increased government borrowing. the government’s new borrowing “crowds out” others from the credit market.

61 Time Lags It takes time to recognize that a problem exists and then formulate policy to address the problem. The very nature of the macro problems could change if the economy is hit with other internal or external shocks.

62 “Pork-Barrel” Politics Members of Congress want their constituents to get the biggest tax savings. They don’t want spending cuts in their own districts. They don’t want a tax hike or spending cut before the election.

McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Fiscal Policy End of Chapter 11