1. Fiscal Policy Chapter 11 McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Fiscal Policy
Government’s tax and spending activities affect not only the level of output and prices but the mix of output as well
Can government spending and tax policies ensure full employment?
What policy actions will help fight inflation?
What are the risks of government intervention?

3. Taxes and Spending Today, the federal government
Employs over 4 million people and spends more than $3.5 trillion a year
Collects nearly $3 trillion a year in taxes, with nearly half that from individual income taxes
Spends all of its tax revenues—and more, borrowing additional funds

4. Government Expenditure
Government purchases are part of aggregate demand, income transfers are not
Income transfers: Payments to individuals for which no current goods or services are exchanged

5. Fiscal Policy The federal government can alter aggregate demand by:
Purchasing more or fewer goods and services
Raising or lowering taxes
Changing the level of income transfers

6. Fiscal Policy
Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes
The federal budget is a tool that can shift aggregate demand and thereby alter macroeconomic outcomes

7. Fiscal Policy DETERMINANTS OUTCOMES Internal market forces AS Output
Jobs
Prices
External shocks
Growth
Policy tools: Fiscal policy AD
International balances

8. Fiscal Stimulus
Suppose the economy is experiencing a recessionary GDP gap of $400 billion
From a Keynesian perspective, the solution is to get someone to spend more on goods and services

9. The Policy Goal AS QE = 5.6 a AD1 PE Price Level Real GDP 6.0 = QF
GDP Equilibrium
Full-employment GDP b
The goal is to close GDP gaps
GDP gap

10. Keynesian Strategy
Fiscal stimulus: Tax cuts or spending hikes intended to increase (shift) aggregate demand
Two strategic policy questions:
By how much do we want to shift the AD curve to the right?
How can we induce the desired shift?

11. The Naive Keynesian Model
An increase in AD by $400 billion will achieve full employment only if AS curve is horizontal
Assumption of a horizontal AS curve seems naïve today
Although not every AD shift will raise prices, inflationary pressures increase as AD expands

12. The AD Shortfall
So long as the AS curve slopes upward, AD must increase by more than the size of the recessionary gap to achieve full employment
AD shortfall: The amount of additional aggregate demand needed to achieve full employment after allowing for price-level changes

13. The AD Shortfall AS
QE = 5.6 a
AD1
AD2 PE
Price Level
Real GDP
QF = 6.0
6.4
AD3 c d b e
Recessionary GDP gap
AD shortfall
The AD shortfall is the fiscal policy target for achieving full employment.

14. More Government Spending
Increased government spending is a form of fiscal stimulus
Every dollar of new government spending has a multiplied impact on aggregate demand
How much of a boost the economy gets depends on the value of the multiplier

15. Multiplier Effects
Impact of fiscal stimulus on aggregate demand includes both the new government spending and all subsequent increases in consumer spending triggered by multiplier effects

16. Multiplier Effects
The second equation is identical to the first but expressed in the terminology of fiscal policy

17. Multiplier Effects Price Level Real GDP
Direct impact of rise in government spending + $200 billion
Indirect impact via increased consumption
+ $600 billion
Price Level a b
Current price level P1
AD2
AD3
AD1
5.6 QE
5.8
6.4
Real GDP

18. The Desired Stimulus
The general formula for computing the desired stimulus is a simple rearrangement of the earlier formula:

19. Tax Cuts
By lowering taxes, the government increases disposable income, which stimulates the consumption component of AD
The amount consumption increases depends on the marginal propensity to consume

20. Multiplier Effects
A dollar of tax cut contains less stimulus than a same size increase in government purchases

21. Cumulative change in saving: = tax cut
The Tax Cut Multiplier
Tax Cut
More consumption
= MPC X tax cut
More saving
= MPS X tax cut
First round of spending:
More income
More saving
Second round of spending:
More consumption
More income
More saving
Third round of spending:
More consumption
Cumulative change in saving: = tax cut

22. Taxes and Investment
A tax cut may also be an effective mechanism for increasing investment spending
If a cut in corporate taxes raises potential after-tax profits, it should encourage investment
Once additional investment spending enters the circular flow, it, too, has a multiplier effect

23. Increased Transfers
Increasing transfer payments stimulates the economy

24. Fiscal Restraint
At times the economy is expanding too fast and fiscal restraint is more appropriate
Inflationary GDP gap: The amount by which equilibrium GDP exceeds full-employment
Fiscal restraint: Tax hikes or spending cuts intended to reduce (shift) aggregate demand

25. The Fiscal Target
AD excess: The amount by which aggregate demand must be reduced to achieve full-employment equilibrium after allowing for price-level changes
The AD excess exceeds the inflationary GDP gap

26. The Fiscal Target First determine the size of the AD excess
Then we compute how much government spending or taxes must be changed to achieve the desired shift, taking into account multiplier effects

27. Excess Aggregate DemandAS
Q2 = 5.8 E2 f
AD1
AD2 PE PF
Price Level
Real Output E1
QF = 6.0
Q1 = 6.2
AD must shift by more
than the GDP gap
Inflationary GDP gap
Excess AD

28. Budget Cuts
Budget cuts reduce government spending and induce cutbacks in consumer spending
Budget cuts should equal the size of the desired fiscal restraint

29. Tax Hikes
Tax hikes can be used to shift the AD curve to the left by reducing disposable income
Taxes must be increased more than a dollar to get a dollar of fiscal restraint

30. Reduced Transfers
A cut in transfer payments works like a tax hike, reducing the disposable income of transfer recipients
The desired reduction in transfers is the same as a desired tax increase

31. Fiscal Guidelines
The essence of fiscal policy is the deliberate shifting of the aggregate demand curve
Steps required to formulate fiscal policy:
Specify the amount of the desired AD shift
Select the policy tools needed to induce the desired shift

32. Weak Economy: Fiscal Stimulus

33. Overheated Economy: Fiscal Restraint

34. A Warning: Crowding Out
Some of the intended fiscal stimulus may be offset by the crowding out of private expenditure
Crowding out: A reduction in private-sector borrowing (and spending) caused by increased government borrowing

35. Time Lags
It takes time to recognize that a problem exists and then formulate policy to address it
The very nature of the macro problems could change if the economy is hit with other internal or external shocks

36. Pork-Barrel Politics
Members of Congress want their constituents to get the biggest tax savings
They don’t want spending cuts in their own districts
They don’t want a tax hike or spending cut before an election

37. Fiscal Policy End of Chapter 11 McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.