Chapter 10: Fiscal Policy Principles of MacroEconomics: Econ101

In this Lecture……………….. What is Fiscal Policy Automatic Discretionary The Multiplier Effect Revisited Government Spending Taxes Expansionary vs. Contractionary Fiscal Policy The Crowding Out Effect Deficits, Surpluses and Federal Government Debt

What is Fiscal Policy? Changes in government expenditures and/or taxes to achieve particular economic goals, such as low unemployment, stable prices, and economic growth. 3

What is Automatic Fiscal Policy Changes in government expenditures and/or taxes that occur automatically without (additional) congressional action…..automatic stabilizers. Entitlements such as: Unemployment benefits Welfare spending Social Security spending Income Taxes Each one percentage point increase in the unemployment rate will increase government spending by about $5 billion and will decrease tax revenues approximately $25 billion for a total budget deficit of $30 billion. 4

The Use of Discretionary Fiscal Policy Deliberate changes of government expenditures and/or taxes to achieve particular economic goals. Government spending Taxation Changing Transfers Not as successful as automatic fiscal policy Tax/transfer Multiplier = Marginal Propensity to Consume 1 – Marginal Propensity to Consume The multiplier is a number that multiplies a change in taxes or transfers in order to calculate the change in real GDP. The tax & transfer multiplier is lower than the government purchases multiplier because if government purchases goods and services, every dollar is spent to buy goods or services. If government reduces taxes, only part of that money is spent to buy goods and services. Therefore, increasing government purchases has a larger effect, dollar for dollar than reducing taxes or increasing transfers. 5

The Government Spending & Taxes Multiplier Effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures.

Official Budget Deficit vs. Structural Budget Deficit Structural Deficit: The part of the budget deficit that would exist even if the economy were operating at full employment. Only reason that structural can change from year to year is that the federal government took some specific action to change government spending or tax revenues. The structural budget deficit or surplus measures the intent of fiscal policy Official Budget Deficit: The part of the budget deficit that is a result of a downturn in economic activity. 7

Expansionary vs. Contractionary Fiscal Policy Expansionary Fiscal Policy: Increases in government expenditures and/or decreases in taxes to achieve particular economic goals. Contractionary Fiscal Policy: Decreases in government expenditures and/or increases in taxes to achieve particular economic goals. PROBLEM TYPE OF POLICY ACTIONS BY CONGRESS AND THE PRESIDENT RESULT Recession Expansionary Increase government spending or cut taxes Real GDP and the price level rise. Rising Inflation Contractionary Decrease government spending or raise taxes Real GDP and the price level fall. Don’t Let This Happen to YOU! Don’t Confuse Fiscal Policy and Monetary Policy 8

Expansionary Policy in a Recessionary Gap Increased government purchases, decreased taxes, or both lead to a rightward shift in the aggregate demand curve from AD1 to AD2, restoring the economy to the natural level of Real GDP, QN 9

Expansionary Fiscal Policy

Contractionary Policy in an Inflationary Gap Decreased government purchases, increased taxes, or both lead to a leftward shift in the aggregate demand curve from AD1 to AD2, restoring the economy to the natural level of Real GDP, QN. 11

Contractionary Fiscal Policy

Fiscal Policy May Destabilize the Economy In this scenario, the SRAS curve is shifting rightward (healing the economy of its recessionary gap), but this information is unknown to policymakers. Policymakers implement expansionary fiscal policy, and the AD curve ends up intersecting SRAS2 at point 2instead of intersecting SRAS1 at point1'. Policymakers thereby move the economy into an inflationary gap, thus destabilizing the economy. 13

Crowding Out The decrease in private expenditures that occurs as a consequence of increased government spending (direct effect) or the financing needs of the Federal budget deficit (indirect effect). 14

Crowding Out in the Short-Run

Crowding Out in the Short-Run

An Overview of Government Spending and Taxes

Deficits, Surpluses and the Federal Government Debt Budget deficit: The situation in which the government’s spending is greater than its tax revenue. Budget Surplus: The situation in which the government’s expenditures are less than its tax revenue.

Is Federal Government Debt a Problem?