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Macroeconomics Unit 11 Fiscal Policy Decisions Top 5 Concepts

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Introduction This unit discusses the use of fiscal policy tools or levers (basically Keynesian ideas) to restore the economy to full employment. Recessions and inflationary periods are examined. Also discussed are some of the problems associated with focusing only on demand. Could our federal government actually reduce spending to control inflation?

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Concept 1: Fiscal Policy When we study fiscal policy we are examining how the federal government can alter macroeconomic outcomes. Fiscal policy uses Keynesian techniques to change aggregate demand. Often these changes are called using fiscal policy levers. Fiscal policy is the use of federal government taxes, spending, and transfer payments to alter macroeconomic outcomes.

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Concept 1: Fiscal Policy The federal government can change aggregate demand by: Purchasing more or fewer goods and services. Raising or lowering individual income and corporate taxes. Changing the level of income transfers. All of these tools are implemented through the federal budget and require congressional and presidential approval.

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Concept 1: Fiscal Policy Fiscal policy tools are designed to shift aggregate demand by increasing aggregate expenditures. Usually we are concerned about achieving a level of output (GDP) where we are at full employment. Often we are confronted with a recessionary GDP gap, which is the amount by which equilibrium GDP falls below full- employment GDP. The intent is to use fiscal policy tools to close the gap.

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Using Fiscal Stimulus The obvious solution to close the recessionary gap is to shift aggregate demand to the right using a fiscal policy tool that stimulates the economy. Tax cuts, increasing government spending, and increasing transfer payments are all viable ways to shift aggregate demand to the right. The problem with this strategy is that shifting AD to the right also causes average prices to increase.

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Closing the recessionary GDP Gap AS Q E = 5.6 a AD 1 PEPE Price Level (average price) Real GDP (in trillions $) 6.0 = Q F GDP Equilibrium Full-employment GDP b GDP gap AD needs to shift right from Q E to Q F, from point a to b – but the supply curve is not horizontal, so prices increase.

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Using Fiscal Stimulus Shifting aggregate demand to the right causes movement up the AS curve. The movement up the AS curve indicates prices are increasing. Since prices are increasing, consumers are required to pay more for goods and services. Even though increased spending is occurring, the increases in price have offset part of the increased spending by consumers. As a result we fail to achieve full employment output.

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Concept 2: The AD Shortfall Because of rising prices, we fail to achieve the demand necessary for full employment. This creates the AD shortfall. The AD shortfall is the amount of additional aggregate demand needed to achieve full employment after allowing for price-level changes. Therefore in order to achieve our full-employment output goal, we need to increase aggregate demand an additional amount which compensates for the increase in average prices as aggregate demand shifts to the right.

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Concept 2: The AD Shortfall AS Q E = 5.6 a AD 1 AD 2 PEPE Price Level (average price) Real GDP (in trillions $) Q F = 6.06.4 AD 3 c d be Recessionary GDP gap AD shortfall

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Concept 2: The AD Shortfall As you examine the previous graph, notice that as we move AD from AD 1 to AD 2, equilibrium does not occur at point b. It occurs at point c which is below our desired output level. Additional fiscal stimulus can shift AD from AD 2 to AD 3 and equilibrium is reached at point d. Unfortunately, higher average prices exist at this level. The AD shortfall, which is the distance between point a and point e, is eliminated and full employment is achieved, although average prices are higher.

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Multiplier Effect The entire amount of the AD shortfall does not require funds directly from the federal government. An initial increase in government spending, decrease in taxes, or an increase in transfer payments, causes a multiplier effect as it moves through the economy. The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditures after an infinite number of spending cycles.

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Multiplier Effect Multiplier = 1/ (1-MPC) We can use the multiplier to help us determine the total change in spending and the amount of fiscal stimulus needed. For example, if the government increases spending by $200 billion, the AD curve will initially shift to the right by $200 billion. If our MPC =.75, then the multiplier is 4. The total change in spending produced by our initial $200 billion spending increase = 4 X $200 billion = $800 billion.

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Concept 3: Multiplier Effect The initial increase in spending by the government of $200 billion shifted AD to the right by $200 billion. The multiplier effect tells us that an additional $600 billion of consumption will occur as the initial spending increase moves through the economy. The total change in spending = $800 billion which includes the initial $200 billion.

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Concept 3: Multiplier Effect If we are fortunate enough to know what our gap is, we can determine how much government spending is necessary to close the gap (desired fiscal stimulus). Desired Fiscal Stimulus = AD shortfall / the multiplier In our previous example, the amount of the AD shortfall was $800 billion, and the multiplier was 4. Therefore our desired fiscal stimulus is $800 billion/4 = $200 billion.

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Concept 3: Multiplier Effect So far we have computed the multiplier effect for increased government spending. We found that any initial increase in government spending causes a direct increase in AD. As the initial increase moves through the economy, the total change in spending is determined by the multiplier effect. But what if we use tax cuts or increased transfer payments instead? Are there any differences?

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Concept 3: Multiplier Effect Tax Cuts – Cutting taxes is another way to shift AD to the right and increase spending. Unlike government spending, the initial amount of spending resulting from a tax cut is dependent upon the MPC. Why? Because a portion of any tax cut will be saved not spent. Therefore it does not provide an immediate economic stimulus and help shift AD to the right.

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Concept 3: Multiplier Effect To determine the effects of a tax cut, we must first calculate the initial increase in consumption. Initial increase = MPC X tax cut amount If taxes are cut by $200 billion, and our MPC =.75, then our initial increase in consumption =.75 X $200 billion = $150 billion. The total or cumulative effect of the tax cut would be = multiplier X initial change in consumption. 4 X $150 billion = $600 billion

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Concept 3: Multiplier Effect Notice that the total effect of a tax cut using the same initial amount of $200 billion is $600 billion. If we used government spending then the total effect would be $800 billion. Why is there a difference? Consumer savings takes a portion of the tax cut – part of the cut does not get immediately spent. The amount saved will vary based upon the MPC. The higher the MPC the less saved by consumers.

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Concept 3: Multiplier Effect Government spending provides more fiscal stimulus than tax cuts, assuming the MPC is less than 1.00. The third option to shift AD is to increase transfer payments (Social Security, Unemployment, etc.). The effect of increasing transfer payments is the same as the effect of tax cuts. A portion of the transfer payment increase gets saved. This amount is determined by the MPC. Therefore both increased transfer payments and tax cuts are less effective than increased government spending at shifting aggregate demand (spending) to the right.

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Multiplier Effect – Summary $100 billion, MPC.75 Increase Gov’t Spending Tax CutsIncrease Transfer Payments Initial Effect $100 billion$100 X.75 = $75 billion Total Effect $100 X 1/1-.75 = $400 billion $75 X 1/1-.75 = $300 billion

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Fiscal Restraint Sometimes we want to decrease aggregate demand. This occurs when we have an inflationary GDP gap. Instead of an AD shortfall we have AD excess. AD excess is the amount by which aggregate demand must be reduced to achieve full-employment equilibrium after allowing for price-level changes. Our equilibrium point is above the level of full-employment output.

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Excess Aggregate Demand AS Q 2 = 5.8 E2E2 f AD 1 AD 2 PEPE PFPF Price Level (average price) Real Output (in trillions $) E1E1 Q F = 6.0Q 1 = 6.2 Inflationary GDP gap Excess AD Target

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Excess Aggregate Demand The previous slide illustrates excessive AD at AD 1. The goal is to shift AD to the left, from the equilibrium point E 1 to E 2. Falling prices will cause demand to increase. Therefore our policy target is to shift AD far enough to the left to compensate for increased demand due to lower prices. Our output target is found at point f on the new demand curve AD 2. We fail to achieve that target because of falling prices, but we reach equilibrium at E 2 which is full employment output.

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Concept 4: Fiscal Restraint/Inflationary GDP Gap When we have AD excess we will need to reduce aggregate demand by an amount greater than the inflationary gap. This is necessary because as we reduce aggregate demand, average prices decline and spending increases (desired fiscal restraint). The desired fiscal restraint = excess AD / the multiplier If our multiplier is 4 (MPC =.75) and our excess AD = $400 billion, then our desired fiscal restraint = $400 billion / 4 = $100 billion.

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Concept 4: Fiscal Restraint/Inflationary GDP Gap Once we have a dollar target for our fiscal restraint, then the federal budget can be reduced to accomplish our goal. Another way to look at fiscal restraint is to take an amount and determine the total effect. If we cut spending by $100 billion, then our cumulative effect = multiplier X initial budget cut. A cut of $100 billion, with an MPC of.75 (multiplier = 4) provides a cumulative effect of 4 X $100 billion = $400 billion.

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Concept 4: Fiscal Restraint/Inflationary GDP Gap Similar to increased spending, decreased government spending has a multiplier effect for each dollar cut. We could also increase taxes to reduce aggregate demand. If we wish to increase taxes, then we must recognize that we will need to increase them more than our target for government spending. Why? Because once again we must contend with the fact that currently a portion of all consumer spending is saved and this savings must also be considered when taxes are increased.

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Concept 4: Fiscal Restraint/Inflationary GDP Gap To determine the amount of a tax increase: Desired Increase/Taxes = desired fiscal restraint / MPC The desired fiscal restraint = excess AD / the multiplier So once we know the amount of excess AD we have, and the multiplier, we can determine the amount of tax increase necessary to reduce AD.

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Concept 4: Fiscal Restraint/Inflationary GDP Gap Let’s figure it out! Desired fiscal restraint = excess AD / the multiplier If our MPC =.75, the multiplier is 4. If our excess AD = $400 billion, then the desired fiscal restraint = $400 billion / 4 = $100 billion. $100 billion is our desired fiscal restraint (spending reduction).

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Concept 4: Fiscal Restraint/Inflationary GDP Gap Now we can take our value for fiscal restraint of $100 billion, and determine our tax increase. Desired Increase/taxes = fiscal restraint / MPC $100 billion /.75 = $133 billion So if we increase taxes by $133 billion, consumption drops by $100 billion initially, and the cumulative effect is $400 billion.

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Concept 4: Fiscal Restraint/Inflationary GDP Gap The third option for fiscal restraint is similar to the third option for increased spending – changing transfer payments. Reducing transfer payments has the same effect as a tax hike. The disposable income of recipients is reduced and spending declines. Reductions in transfer payments target specific groups of people who may not be the proper target for reduced spending. Therefore it is unlikely that this group would be targeted in an effort to reduce spending.

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Concept 4: Fiscal Restraint/Inflationary GDP Gap To determine the amount of a transfer payment decrease: Desired transfer payment decrease = desired fiscal restraint / MPC The desired fiscal restraint = excess AD / the multiplier So once we know the amount of excess AD we have, and the multiplier, we can determine the amount that transfer payments need to be reduced to cause a reduction in AD.

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Concept 4: Fiscal Restraint/Inflationary GDP Gap To determine the reduction in transfer payments we first determine the amount of the desired fiscal restraint. Desired fiscal restraint = excess AD / the multiplier If our MPC =.90, the multiplier is 10. If our excess AD = $400 billion, then the desired fiscal restraint = $400 billion / 10 = $40 billion.

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Concept 4: Fiscal Restraint/Inflationary GDP Gap Now we can take our value for fiscal restraint of $40 billion, and determine the amount that transfer payments need to be reduced. Desired reduction in transfer payments = fiscal restraint / MPC Since our MPC =.90, we solve the equation by: Desired reduction in transfer payments = $40 billion /.90 = $44.44 billion. Therefore if we reduce transfer payments by $44.44 billion, consumer consumption (demand) decreases by $40 billion, and the cumulative effect is $400 billion.

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Concept 5: Problems Several problems can occur with the implementation of fiscal policy decisions. Crowding out – If the government borrows significant funds to finance its spending, the borrowing may “crowd out” some private sector borrowing and cause a further reduction in AD. Businesses may postpone further investment. Time Lags – Implementing changes in fiscal policy requires time, budgetary, and congressional approval. It may take some time to determine the economy is in trouble. In addition it takes time for the multiplier effect to occur. All of these factors limit the effectiveness of fiscal policy decisions.

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Concept 5: Problems One problem that may cause a significant problem is Pork- Barrel Politics. Members of Congress have their own needs and priorities and spending cuts, tax cuts, or tax increases may not be popular. Pork-Barrel politics refers to the situation when elected officials are more interested in spending and programs that help them get reelected than overall fiscal responsibility. Tax cuts may be popular among some politicians but deciding who gets the cuts and how much should they receive could be a problem. If changes in spending are proposed, how is the money going to be spent? Often these decisions require additional debate and time. Finally, no one likes to raise taxes, especially near an election!

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Summary Fiscal policy. Fiscal Stimulus. AD Shortfall. Multiplier effect. Calculating the desired fiscal stimulus. Excess AD. Fiscal Restraint. Crowding out, time lags. Pork Barrel Politics.

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