Chapter 12 The Fiscal Policy Approach to Stabilization

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-2 Learning Objectives Describe the relationship between an individual’s current disposable income and that individual’s planned consumption. List three non-interest-rate-variables whose changes might influence investment decisions. Describe two ways in which the government can engage in discretionary fiscal policy. Define an automatic stabilizer and give two examples.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-3 Fiscal Policy Fiscal policy involves either changing our tax structure or changing the rate of growth of government spending. A fiscal policy approach to short-run stabilization is often associated with a twentieth-century economist named John Maynard Keynes.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-4 The Life and Times of Mr. Keynes John Maynard Keynes (1883–1946) originated the school of economic thought referred to as Keynesian economics, which supports the use of government spending and taxing to help stabilize the economy. Keynes believed that there was a need for government intervention, in part because an economy may reach an equilibrium level of real GDP per year that generates less than full employment.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-5 The Life and Times of Mr. Keynes (cont.) Keynes developed his fiscal policy theories during The Great Depression in the 1930s. He observed that the forces of aggregate supply and aggregate demand operated too slowly on their own in such a serious recession. His idea was that the government could step in to stimulate aggregate demand.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-6 Inflexible Prices—The Culprit Keynes argued that prices, especially the price of labor (wages) were inflexible downward due to the existence of unions and of long-term contracts between businesses and workers. In such a world, when there are large amounts of excess capacity and unemployment, an increase in aggregate demand would not raise the price level.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-7 Figure 12-1: Changes in Aggregate Demand Do Not Alter the Price Level

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-8 Keynes Sought to Understand Why People Spend Consumer spending, called consumption, is a key aspect of aggregate demand. Keynes focused much of his research on what determines how much you and I decide to spend each year. He focused on the relationship between how much people earn and their willingness to engage in personal consumption expenditures.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.12-9 Relating Consumption to Saving You can only do two things with a dollar of disposable income (income net of taxes): either you can consume it or you can save it. If you consume a dollar in disposable income, it is gone. If you save the entire dollar, however, you will be able to consume it (and perhaps more if it earns interest) at some future time. That is the distinction between consumption and saving.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Relating Consumption to Saving (cont.) A dollar of take-home income can either be consumed or not consumed. Therefore, the relationship between disposal income, saving, and consumption is:

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Planned Consumption and Actual Income Keynes chose to ignore all of the psychological factors that might explain people’s planned consumption and planned saving. Keynes argued that consumption and saving decisions depend primarily on an individual’s current disposable income.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Marginal Propensity to Consume (MPC) Marginal refers to a small incremental change. Propensity is a tendency to do something. So, your marginal propensity to consume is defined as: Marginal Propensity to Consume (MPC)

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Marginal Propensity to Save (MPS) MPC + MPS = 1 The marginal propensities to consume and to save tell you what percentage of a given increase in income will go toward consumption and saving, respectively. Marginal Propensity to Save (MPS)

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Investment Keynes also believed that the equilibrium level of employment depends on the level of investment. He argued that if the level of investment is low, full employment can’t be achieved. In economic analysis, investment is defined as expenditures by firms on new machines and buildings that are expected to yield a future stream of income.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Investment and Interest Rates When the cost of borrowing falls, businesspeople can undertake more investment projects, and vice versa. Therefore, planned investment rises as interest rates fall, all other things held constant. Planned investment falls as interest rates rise, all other things held constant.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Other Factors that Cause Planned Investment to Change Expectations of business people. Any change in productive technology can potentially shift businesspersons’ investment plans. Changes in business taxes can change a businessperson’s investment plans.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Changes in Investment Can Cause a Multiplier Effect When a businessperson decides to spend more on an investment, his spending decision has ramifications throughout the economy. The extra income of the workers who are hired to build a new plant is spent. If the marginal propensity to consume is 80 percent, or 0.8, all those workers who get the extra income will spend 80¢ out of every extra dollar earned.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Changes in Investment Can Cause a Multiplier Effect (cont.) Then there are others who will receive this 80¢ as income. They will in turn spend 80 percent of that additional income. This process goes on and on. It turns out, then, that an increase in investment spending will lead to a multiple increase in the equilibrium level of national income. What is operating here is the multiplier effect of changes in investment spending.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Multiplier Formula There is a relationship between the marginal propensity to consume and the size of the multiplier. The formula is:

Copyright © 2005 Pearson Addison-Wesley. All rights reserved The MPC and the Multiplier The larger the marginal propensity to consume (MPC), the larger the multiplier. This fact has implications for the effectiveness of changes in government spending or taxes—what we call the realm of fiscal policy. The multiplier formula applies to changes in government spending too.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Discretionary Fiscal Policy Fiscal policy can be thought of as a deliberate attempt via changes in government spending or taxes to cause the economy to move to full employment and price level stability more quickly than it otherwise might.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Discretionary Fiscal Policy (cont.) To John Maynard Keynes and his followers, during recessions and especially depressions, the government has to step in to increase aggregate demand. Expansionary fiscal policy—increases in government spending or tax reductions— initiated by the federal government is a way to ward off recessions.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 12-3: The Effects of Tax Cuts on the Equilibrium Level of Real GDP

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Figure 12-4: The Effects of Increased Government Spending on Aggregate Demand

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Financing of Increased Government Spending The effectiveness of increasing government spending (or tax reductions) depends in large part on how such increased spending (or tax reduction) is financed.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Financing of Increased Government Spending (cont.) If the government simultaneously raises taxes to finance the increased spending, there will not be much net impact on the economy. If the government finances the increased spending by borrowing from the private sector, it may crowd out private investment. This is called the crowding out effect.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Automatic Stabilizers Our federal tax system is an automatic stabilizer because when incomes fall, government tax revenues fall, too, thereby softening the reduction in nationwide economic activity. Unemployment compensation and welfare benefits also act as automatic stabilizers. They help people not to experience as dramatic a drop in disposable income as they would otherwise.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Federal Budget Deficit When the federal government spends more than it receives in revenues it has a budget deficit. The reverse situation generates a budget surplus. Since 1960, there have only been a few years of budget surpluses. The rest of the time, the federal government has run a deficit.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Government Borrowing Our governments—federal, state, and local— borrow funds to finance their budget deficits. The federal government typically borrows by selling U.S. Treasury bonds. The sale of these federal government bonds to corporations, private individuals, pension plans, foreign governments, foreign businesses, and foreign individuals add to this nation’s public debt.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved Key Terms and Concepts automatic stabilizers budget surpluses consumption crowding out effect disposable income fiscal policy Investment Keynesian economics marginal propensity to consume (MPC) marginal propensity to save (MPS) multiplier effect saving