Fiscal Policy, Deficits, and Debt 30 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Fiscal Policy Recall; AD = C + I + G + X - M Changes in AD will have significant effects on the economy. Economic problems such as inflation and unemployment Changes in AD components leads to changes in AD LO1 30-2

Fiscal Policy Recall that the government sector purchase goods and services (G) and collect taxes (T) The government can use: G and T to affect AD Fiscal policy: deliberate changes in G and/or T to achieve full employment, price stability, and economic growth. LO1 30-3

Fiscal Policy How to use fiscal policy? Performed by the government via its tools: G and/or T Note that G has a direct effect on AD while T has indirect effect (through C and S) Two different fiscal policies: Expansionary Fiscal Policy and Contractionary Fiscal Policy LO1 30-4

Expansionary Fiscal Policy Used to face a recession When: GDP (or Y) < AE Need to increase the level of AE Increase level of G, and / or Reduce level of T Both will increase the level of Y LO1 30-5

Expansionary Fiscal Policy Real GDP (billions) Price level AD 2 AD 1 increase in aggregate demand AS $510 P1P1 LO1 30-6

Expansionary Fiscal Policy Example; Assume we have a sharp decline in I from I 0 to I 1. (show the graph? ) Result: what will happen to AD(show the graph?) This may cause a problem.………. What is the solution? Use …………..fiscal policy. What are the tools of such fiscal Policy to use? LO1 30-7

Expansionary Fiscal Policy Assume that GDP 0 =$505, When I falls, GDP 1 =$485 This is accompanied by an increase unemployment. How much we need ∆G, ∆ T, or both? Recall that MPC=75%, and Gm=4, Tm=3 ∆G: ∆Y = ∆G. M 20 = ∆G. 4 ∆G = $5 ∆T: ∆Y = - ∆T. M 20 = - ∆T. 3 ∆T = - $6.67 LO1 30-8

Expansionary Fiscal Policy Therefore; ∆C = MPC.T=(0.75)(6.67) = +5 ∆S = MPS.T=(0.25)(6.67) = What if we used both? ∆Y= ∆ G m g + ∆T m t 20 = ∆G(4)+ ∆T(3) 20 = 1.25(4)+ 5(3) 20 = 2(4)+ 4(3) 20 = 2.75(4)+ 3(3) LO1 30-9

Contractionary Fiscal Policy Used to face a demand-pull inflation When: GDP (or Y) > AE Need to reduce the level of AE Reduce level of G, or/ and Increase level of T Both will reduce the level of Y LO

Contractionary Fiscal Policy Real GDP (billions) Price level AD 2 AD 1 decrease in aggregate demand AS $ 522 P2P2 a b P1P1 LO

Contractionary Fiscal Policy Example; Assume we have a increase in I from I 0 to I 1. (show the graph? ) Result: what will happen to AD(show the graph?) This may cause a problem.………. What is the solution? Use …………..fiscal policy. What are the tools of such fiscal Policy to use? LO

Contractionary Fiscal Policy Assume that GDP 0 =$505, When I falls, GDP 1 =$515 This is accompanied by an increase prices. How much we need ∆G, ∆ T, or both? Recall that MPC=75%, and Gm=4, Tm=3 ∆G: ∆Y = ∆G. M -10 = ∆G. 4 ∆G = $2.5 ∆T: ∆Y = - ∆T. M -10 = - ∆T. 3 ∆T = - $3.34 LO

Contractionary Fiscal Policy Therefore; ∆C = MPC.T=(0.75)(3.34) = ∆S = MPS.T=(0.25)(6.67) = What if we used both? ∆Y= ∆ G m g + ∆T m t 10 = ∆G(4)+ ∆T(3) 10 = 1 (4)+ 2(3) 10 = 1.75(4)+ 1(3) 10 = 0.25(4)+ 3(3) LO

Policy Options: G or T? To expand the size of government (if they are concerned about unmet social needs or infrastructure) If recession, then increase government spending If inflation, then increase taxes To reduce the size of government (when they think government is too large and inefficient) If recession, then decrease taxes If inflation, then decrease government spending LO

Other Considerations The crowding ‑ out effect  The crowding ‑ out effect may be caused by fiscal policy.  “Crowding ‑ out” may occur with government deficit spending. It may increase the interest rate and reduce private spending (Private Investment Spending) which weakens or cancels the stimulus of fiscal policy. Standardized Budget (Full-Employment Budget)  Public Budget = Total Revenue – Government Spending  Total Revenue is coming usually from Tax Revenue  Total Revenue >Government Spending…Budget Surplus  Total Revenue < Government Spending….Budget Deficit  If the budget was initially balanced, expansionary fiscal policy creates a budget deficit..How?? LO