1. Principles of Economics:
Macroeconomics - Econ101
Fiscal Policy
Chapter 11
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2. 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

3. 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

4. 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

5. 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

6. 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?

7. 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

8. 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

9. 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.

10. 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

11. 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

12. 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

13. 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

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

15. 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

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

17. 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

18. Weak Economy: Fiscal Stimulus

19. Overheated Economy: Fiscal Restraint

20. 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