Fiscal Policy Chapter 12 Part I CHAPTER 1

Countercyclical Fiscal Policy A change in government spending or net taxes (taxes or transfer payments) designed to reverse or prevent a recession or a boom Fiscal policy affects AE and has in the short run demand-side effects on output and employment We will discuss supply-side effects later 2

Initially, equilibrium is at full-employment output of $10,000 billion (Point A). Then a decrease in private investment spending (I P ) or consumption spending (C) shifts the aggregate expenditure line down to AE 2, and the economy starts heading toward point B - a recession. 3 Real GDP ($ billions) Consumption Function Real AE ($ billions) AE 1 45° A AE 2 B $9,000 (Recession Output) $10,000 (Full-Employment Output) Short-run Countercyclical Fiscal Policy

4 Real GDP ($ billions) Consumption Function Real AE ($ billions) AE 1 45° A AE 2 B $9,000 (Recession Output) $10,000 (Full-Employment Output) Recessionary Gap: Distance B to C = $1,000 C Recessionary Gap:

Countercyclical Fiscal Policy Policy Option: Increase Government Spending Direct way to address a recession – increase G and shift the aggregate expenditure line upward – ΔGDP = (Multiplier) ˣ ΔG – where the simple multiplier = 1/(1-MPC) If the MPC is 0.75, how much should G increase to close the recessionary gap of $1,000? 5

Countercyclical Fiscal Policy Policy Option: Cut Net Taxes Increase disposable income – increase consumption spending (less direct than increasing G) – aggregate expenditure line shifts upward – ΔGDP = (tax multiplier) ˣ Δ Net taxes – tax multiplier = - MPC/(1-MPC) 6

Policy Option: Cut Net Taxes Increase disposable income – increase consumption spending (less direct than increasing G) – aggregate expenditure line shifts upward – ΔGDP = (tax multiplier) ˣ Δ Net taxes – tax multiplier = - MPC/(1-MPC) 7 Another multiplier!

Policy Option: Cut Net Taxes Increase disposable income – increase consumption spending (less direct than increasing G) – aggregate expenditure line shifts upward – ΔGDP = (tax multiplier) ˣ Δ Net taxes – tax multiplier = - MPC/(1-MPC) 8 If the MPC is 0.75, how much should taxes decrease or transfers increase to close the recessionary gap of $1,000?

The government could shift the AE line back to its original position by increasing spending (G), or by decreasing net taxes (T) with a change in tax or transfer policies. If the change were enacted quickly enough, the government could prevent the recession. Countercyclical Fiscal Policy Close the Recessionary Gap 9 Real GDP ($ billions) Consumption Function Real AE ($ billions) AE 1 45° A AE 2 B $9,000 (Recession Output) $10,000 (Full-Employment Output) C ΔY ΔG ↑ or ΔT ↓

Short-run Countercyclical Fiscal Policy Combining fiscal changes – Government might decide to increase government purchases, cut taxes, and increase transfer payments all at the same time ! – The final impact on equilibrium GDP add up the separate multiplier effects of each policy change 10

Combining Different Types of Fiscal Stimulus 11 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Short-run Countercyclical Fiscal Policy Another policy option would be to increase government purchases and net taxes by equal amounts Why? No increase in the budget deficit – GDP rises by the same amount Balanced budget multiplier –The multiplier for a change in government purchases that is matched by an equal change in taxes 12

Case Study: American Reinvestment and Recovery Act (ARRA) –A roughly two-year fiscal stimulus Originally estimated at $787 billion, and later revised to $862 billion –One-third was tax cuts - T ↓ –One-third was increased government purchases - G ↑ –One-third was increased transfer payments - T ↓ 13

Range of Estimates for Multipliers in the ARRA 14 Spending multiplier estimates larger than tax and transfer payment multiplier estimates. One-time payments and one-year tax cuts the lowest estimates.

Problems with Countercyclical Fiscal Policy Timing problems –Recognition lag –Implementation lag –Response lag Irreversibility –Spending should be temporary offsetting temporary reduction in private spending Taxes and forward looking behavior –Temporary vs. permanent! The reaction of the Federal Reserve 15

The Multiplier 16 All of the multipliers we derive are a sub-set of a general macro model for an open economy with taxes and imports that depend on the level of income (Y). The process described on the following slides is to first define the model and then through a series of substitutions, solve for the equilibrium level of income (Y).

The Multiplier 17 The model for an open economy when taxes and imports depend on the level of income (Y) is described by the following eight equations:

The Multiplier 18 (1) Y = C + I + G + (X – M), equilibrium condition from chapter 11. (2) C = a + b (Yd), consumption equation from chapter 11. (3) Yd = Y – T, disposable income as defined in chapter 11. (4) T = T 0 + t(Y), tax equation, this is new. (5) I = I P, planned investment from chapter 11. (6) G = G 0, government spending from chapter 11. (7) X = X 0, exports from chapter 11. (8) M = mY, import equation, this is new.

Equations (4) and (8) are new formulas 19

The Multiplier 20 Substitute equations (2) through (8) into the equilibrium condition, equation (1): (9) Y = a + b(Y - T) + I P + G o + X 0 - mY (10) Y = a + b(Y - (T 0 + tY)) +I P + G 0 +X 0 – mY (11) Y = a + b(Y-T 0 - tY) +I P +G 0 +X 0 – mY (12) Y = a + bY- bT 0 - btY+I P +G 0 +X 0 - mY

The Multiplier 21 Now solve Equation (12) for Y: (13) Y- bY+ btY+ mY = a - bT 0 + I P + G 0 + X 0

From Equation (15), the government spending and lump-sum tax multipliers in an open economy with an income tax system are: 22

23 What happens if there is no foreign sector (a closed economy) and taxes are lump-sum. This is the model presented in chapters 11 and 12 of Hall and Lieberman. Equations (7) and (8) listed on the previous slide disappear and the tax rate (t) in Equation (4) equals zero. X, t and m in Equations (14) are equal to zero:

24 We get the investment spending, government spending, and tax multipliers presented in Chapters 11 and 12: