1. Fiscal Policy 20

2. After studying this chapter, you should be able to:
Describe the tools that governments use to influence aggregate demand.
Describe mandatory and discretionary government spending.
Describe the multiplier effect of increased government spending on the equilibrium output of an economy.
Explain expansionary and contractionary fiscal policy
Describe why tax changes have a smaller impact on the economy than changes in government.
Describe the impact of automatic stabilizers, lag effects, and the crowding out effects in fiscal policymaking.
Describe the debate over the size of government and economic policy.

4. Federal Government Budget, 2009

5. Fiscal Policy
Fiscal policy: one way the government tries to manage the economy and tame the business cycle.
involves adjusting government spending on:
Goods and services
Transfer payments
Taxes

6. Discretionary Spending
The federal budget contains two types of spending: discretionary and mandatory.
Discretionary spending:
The part of the budget that works its way through the appropriations process of Congress each year
Includes:
National defense
Transportation
Science
Environment
Income security

7. Mandatory Spending Mandatory spending:
authorized by permanent laws and does not go through the same appropriation process as discretionary spending. To change these entitlements, Congress must change the law.
Includes:
Social Security
Medicare
Interest on the national debt

8. Discretionary and Mandatory Federal Spending
Getting harder to maneuver…

9. Discretionary Fiscal Policy
adjusting government spending and tax policies
with the express short-run goal of moving the economy toward full employment, encouraging economic growth, or controlling inflation

10. The Multiplier and Government Spending
But when we reach full employment, more spending will only create inflation
The Multiplier will boost government spending when the economy is below full employment

11. The Multiplier Effect
When government spending is injected into the economy, the multiplier goes to work…
$1 of additional spending in the economy will create new income which will be spent (and re-spent many times by all who receive it as income)
Total new spending = Initial injection x Multiplier

12. Taxes
When taxes are increased, money is withdrawn from the economy’s spending stream.
When taxes are reduced, consumers and business have more to spend.
A tax increase (or decrease) will have less of a direct impact on income, employment, and output than an equivalent change in government spending.

13. Taxes GDP= C + I + G + (X - M) Let’s simplify for a moment…
If GDP = C + I (no government or foreign sector) and we know Y = GDP if there is no taxes… so
Y= C + I or
Y – C = I and we know that (Y – C) = S so
S = I
At equilibrium, injections (I) are just equal to withdrawals (S)

14. Equilibrium I + G + X = S + T + M
Add in back in injections (G and X) and subtract withdrawals (T and M) and get
I + G + X = S + T + M
Fiscal Policy works by changing G or T to change the level of injections or withdrawals in the economy

15. Expansionary and Contractionary Fiscal Policy
Expansionary fiscal policy: increasing government spending or decreasing taxes to increase aggregate demand to expand output.

16. Expansionary Fiscal Policy
If the economy is below full employment, expansionary fiscal policy can be used to boost AD to AD1.
LRAS
SRAS0 P1 f
Aggregate Price Level (P) e P0
AD1
AD0 Q0 Qf
Aggregate Output (Q)

17. Contractionary Fiscal Policy
If the economy is beyond the point of full employment, contractionary fiscal policy can be used to dampen inflationary pressures.
This requires an increase in taxes or a decrease in government spending.

18. Contractionary Fiscal Policy
A contractionary fiscal policy that shifts AD from AD0 to AD1 will lower the price level as it reduces aggregate output.
LRAS
SRAS0 P0 e
Aggregate Price Level (P) P1 a
AD0
AD1 Qf Q0
Aggregate Output (Q)

19. Supply-Side Fiscal Policies
Goal: create growth, reduce unemployment and stabilize prices
They are designed to shift the long-run aggregate supply curve to the right
Do not always require such tradeoffs between price levels and output
Supply-side policies require more time to work than do demand-side policies

20. Supply-Side Outcomes Current examples of supply-side technology:
Spending on infrastructure and education
Improvements in technology and communications have increased productivity.
These have helped to keep interest rates and inflation low for several decades.

21. Supply-Side Policy
If successful, supply-side policies will create economic growth, lower unemployment and lower prices

22. President Reagan arguing for a tax cut
Supply-Side Policy
Supply-side policy ideas:
Infrastructure Spending
Reducing Tax Rates
Expanding Investment and Reducing Regulations
President Reagan arguing for a tax cut

23. The Laffer Curve
One recommendation of supply-side economics: lower tax rates to increase productivity.
The Laffer Curve argues that tax revenues can sometimes be increased by lowering tax rates
Encourages risk-taking by entrepreneurs; lower taxes mean higher after-tax returns on investments
Encourages private saving and business investment

24. Art Laffer: Reduce the tax rate and watch the revenues increase….
The Laffer Curve
Art Laffer: Reduce the tax rate and watch the revenues increase….

25. Encouraging Investment
Investment can be increased by:
Investment tax credits
More rapid depreciation schedules for plant and equipment
When a firm can expense its capital equipment over a shorter period of time, it reduces tax payments now rather than later, and so earns a higher net return.
Repealing unnecessarily heavy regulation
Government grants for basic research

26. Implementing Fiscal Policy
It takes time to recognize economic problems and implement solutions… some times too much time.

27. Automatic Stabilizers
The solution? Automatic Stabilizers
Automatic Stabilizers: Tax revenues and transfer payments automatically adjust to economic fluctuations without requiring overt action by Congress.
When the economy is growing tax receipts will rise with rising income, and transfer payments will decline because fewer people require welfare or unemployment assistance.

28. Automatic Stabilizers
The income tax is a powerful stabilizer because of its progressivity.
When incomes fall, tax revenues fall faster since people pay lower rates as their incomes fall.
Disposable income falls more slowly than aggregate income.

29. Fiscal Policy Timing Lags
Information lag
Most of the data that policy makers need are not available until at least one quarter after the fact.
Recognition lag
It may take several quarters to confirm the economic trends.
Decision lag
The time it takes Congress and the administration to decide on a policy once a problem is recognized.
Implementation lag
Fiscal policy requires a long and often contentious legislative and implementation process.
It also takes time for the policy to affect the economy.

30. The Crowding-Out Effect
The crowding-out effect of fiscal policy: deficit spending requires the government to borrow from a the economy’s pool of funds.
This borrowing can drive up interest rates.
Higher interest rates:
Dampen consumer spending
Reduce business investment

31. How big should the government be?
Ponder This
How big should the government be?

32. Key Concepts Discretionary spending Supply-side fiscal policies
Mandatory spending
Laffer curve
Discretionary fiscal policy
Automatic stabilizers
Information lag
Expansionary fiscal policy
Recognition lag
Decision lag
Contractionary fiscal policy
Implementation lag
Crowding-out effect

33. In a depressed economy with a lot of excess capacity and a MPC of 0
In a depressed economy with a lot of excess capacity and a MPC of 0.75, what effect will a $100 increase in government spending have on equilibrium GDP?
Reduce it by $250
Raise it by $250
Raise it by $400
Raise it by $700

34. Which of the following is a contractionary fiscal policy?
Increasing government spending
Expanding transfer payments
Subsidizing basic research
Raising tax rates

35. True or false: Supply-side fiscal policy does not require tradeoffs between output and prices and it works faster than demand-side fiscal policy.
True
False

36. True or false: Supply-side fiscal policy does not require tradeoffs between output and prices and it works faster than demand-side fiscal policy.
True
False