1. FISCAL POLICY ECONOMICS What does it mean to me?
READ Krugman Sec 4, Mod 21
Mankiw Ch 34
DO Morton Unit 3

2. READ
Krugman Section 4, Module 21
Mankiw Chapter 33, 34, 35,

3. Module Fiscal Policy and the Multiplier21
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson

4. What you will learn in this Module:
Why fiscal policy has a multiplier effect
How the multiplier effect is influenced by automatic stabilizers
Krugman, Sec 4 Mod 21

6. Fear the Boom and Bust

7. What you will learn in this chapter:
What fiscal policy is and why it is an important tool in managing economic fluctuations
Which policies constitute an expansionary fiscal policy and which constitute a contractionary fiscal policy
Why fiscal policy has a multiplier effect and how this effect is influenced by automatic stabilizers
How to measure the government budget balance and how it is affected by economic fluctuations
Why a large public debt may be a cause for concern
Why implicit liabilities of the government are also a cause for concern
*Krugman

8. MONETARY POLICY
(Federal Reserve)
Expansionary:
Lower discount rate
Lower reserve requirement
Buy T-bills
Contractionary:
Raise discount rate
Raise reserve requirement
Sell T-bills
FISCAL POLICY
(Federal Government)
Expansionary:
Lower taxes
Increase spending
Contractionary:
Raise taxes
Decrease spending

9. Fiscal Policy: The Basics
*Krugman

10. Sources of Tax Revenue in the United States, 2004
*Krugman

11. Government Spending in the United States, 2004
*Krugman

15. The Government Budget and Total Spending
Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve.

16. Unemployment and inflation are forms of economic instability closely tied to long-term economic growth. The INSTABILITY carries an enormous cost--one that can be measured in economic as well as human terms.

17. On one level, unemployment and inflation are simply numbers that are collected, reported in the press, or plotted on a graph.
On another level, they represent enormous economic failures that waste the resources of the nation and its people.

18. In the early 1980s, the U.S. reduced personal income tax rates by some 25 percent, without offsetting decreases in government spending. By expanding the aggregate demand, this tax cut helped end the recession of and promoted growth of output and employment
Earlier, during the Vietnam War, the U.S. placed a 10 percent surcharge--a tax added to taxes otherwise owed--on both corporate and personal income taxes. The idea was to reduce private spending and contain the demand-pull inflation it caused.
In the mid-1990s, Japan instituted a massive government spending program to help move its economy out of recession.

19. Why doesn’t government always match it’s increase in spending with its increase in taxes?
Under what circumstances might government change spending and taxation--or engage in FISCAL POLICY.
Do these policies work?

20. FISCAL POLICY is the manipulation of government spending and taxes to stabilize domestic output, employment, and the price level.

21. When Congressional leaders make changes in the money circulation by adjusting taxes and spending, they shift the aggregate-demand by influencing the spending decisions of businesses and consumers.
For instance, suppose the U.S. Department of Defense places a $25B order for fighter jets from Lockheed Martin. The order raises demand for workers and other resources to produce the jets. This results in an increase in the total quantity of goods and services demanded at each price level. This shifts the aggregate-demand curve to the right.

22. The first emergence of fiscal actions on the economy came during the depression of the 1930s.
The EMPLOYMENT ACT OF 1946 committed the Federal government to the promotion of fiscal responsibility and economic stability by providing efforts to promote employment.
The act also created the COUNCIL OF ECONOMIC ADVISORS to assist the President on economic matters.

23. DISCRETIONARY FISCAL POLICY is the deliberate manipulation of taxes and government spending by Congress to alter real GDP and employment, control inflation, and stimulate economic growth.
“Discretionary” means that the change in taxes and government spending are at the option of the Federal government.
We assume government spending does not in any way affect planned private spending
We assume fiscal policy affects only the aggregate demand side of the macroeconomy; it has no intended or unintended effects on aggregate supply.

24. There are 2 types of Discretionary Fiscal Policy used to control inflation, employment, and stimulate economic growth.
1) Expansionary Fiscal Policy: used to reverse recession.
2) Contractionary Fiscal Policy: used to control demand-pull inflation.

25. MARGINAL PROPENSITY to CONSUME MARGINAL PROPENSITY to SAVE
In order to explain DISCRETIONARY FISCAL POLICY, we must first learn about:
MULTIPLIER EFFECT
CROWDING OUT EFFECT
MARGINAL PROPENSITY to CONSUME
MARGINAL PROPENSITY to SAVE

26. Multiplier Effects of an Increase in Government Purchases of Goods and Services
Initial increase in spending
Indirect effect of increased spending
Remember the multiplier
Note: remind the students that they have already learned about the spending multiplier.
If C or I increased by $1, eventually that would multiply into more dollars of spending and income and real GDP.
The size of the multiplier depends on the marginal propensity to consume or MPC.
Spending multiplier = 1/(1-MPC)
An injection of government spending (G) works in the same way.
Example 1:
Suppose the government is experiencing a recessionary gap.
Current output is $500 billion below potential GDP (Yp) and unemployment is beginning to rise. Does the government need to inject $500 of new G into the economy to return to full employment? No.
If MPC=.90, the spending multiplier:
M = 1/.10 = 10
So an increase of G=$50 billion will eventually multiply to a 10*$50 billion = $500 billion shift of AD to the right.
Example 2:
Suppose the government is experiencing an inflationary gap.
Current output is $800 billion above potential GDP (Yp) and inflation is starting to hurt the economy.
If MPC = .75, M = 1/.25 = 4.
So a decrease of G=$200 billion will eventually multiply to a 4*$200 billion = $800 billion shift of AD to the left.
Krugman, Sec 4 Mod 21

27. Multiplier = change in real GDP
The MULTIPLIER is a change in a component of aggregate expenditures leading to a larger change in equilibrium GDP.
Stated generally:
Multiplier = change in real GDP
initial change in spending
By rearranging the above equation, we can also say that:
Change in GDP = multiplier X initial change in spending

28. The reduction in AD that results when a fiscal expansion raises the interest rate is called the CROWDING OUT EFFECT.
This happens as a result of rising incomes in households. As incomes rise, people plan to buy more goods and services, resulting in those people holding more of their wealth in liquid form. The combination of fiscal expansion causing the rise in incomes raises the demand for money.

29. When an increase in government purchases increases AD….
The increase in spending increases money demand….
Which increases the equilibrium interest rate……
Which in turn partly offsets the initial increase in AD.
Price Level MS MS r2
AD2
Interest Rates r1
MD2
AD3
MD1
AD1
Quantity of Money
Quantity of Output

30. The sum of MPC and MPS must always equal 1.
The MARGINAL PROPENSITY to CONSUME (MPC) is the change in consumption as related to a change in income.
MPC = change in consumption
change in income
The MARGINAL PROPENSITY to SAVE (MPS) is the ratio of saving as related to a change in income.
MPS = change in saving
change in income
The sum of MPC and MPS must always equal 1.

31. There is also a relationship between Marginal Propensities (MPC and MPS) and the multiplier.20
The initial change in investment spending of $5B creates an equal $5B of new income in the first round.
15.25
13.67
11.56
8.75 5

32. Assume this economy has an MPC = .75.
In the 2nd round, households spend $3.75 (=.75 x 5) 20
15.25
13.67
Round 3, spending increase by $2.81 (=.75 x 3.75)
11.56
8.75
Round 4, by $2.11 (=.75 x 2.81) 5
Round 5, by $1.58 (=.75 x 2.81)

33. Assume this economy has an MPC = .75.
Once the entire process is complete, the cumulation results in total change in income of $20B 20
15.25
13.67
11.56
8.75
Using the equation
Multiplier = MPC we find that the multiplier is 4. 5

34. Three points about the multiplier must be made:
1) “Initial change in spending” is usually associated with investment spending because of its volatility. But changes in consumption, net exports, and government purchases can also lead to the multiplier effect.
2) “Initial change in spending” refers to an upshift or downshift of the aggregate expenditures schedule due to an upshift or downshift of one of its components.
3) The multiplier works in both directions….an increase in initial spending can create a multiple increase in GDP or a decrease in spending can be multiplied into a larger decrease in GDP.

35. Module Economic Policy and the Aggregate Demand-Aggregate Supply Model20
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson

36. What you will learn in this Module:
How the AD-AS model is used to formulate macroeconomic policy
The rationale for stabilization policy
Why fiscal policy is an important tool for managing economic fluctuations
Which policies constitute expansionary fiscal policy and which constitute contractionary fiscal policy

37. Macroeconomic Policy Self-correction? Stabilization Policy
The long-run adjustment back to Yp may take a long time so most economists believe that the government can help expedite the return to full employment and stable prices.
stabilization policy: the use of government policy to reduce the severity of recessions and rein in excessively strong expansions.

38. Policy in the Face of Demand Shocks
Negative Demand Shocks & Positive Demand Shocks
Why are they bad?
Should policymakers counteract?
Negative demand shock causes a recessionary gap. The price level falls, but so does real GDP. Unemployment becomes a problem.
Government policy (both fiscal and monetary) is designed to reverse this decline in AD.
This shortens the duration of a recession.
Positive demand shocks cause an inflationary gap. The price level rises and so does real GDP. Unemployment falls, but inflation is the real problem.
Again, government policy would be geared toward reversing the increase in AD.
This shortens the duration of an inflationary period.

39. Responding to Supply Shocks
Policy dilemma
There is very little policymakers can do to reverse a supply shock. It is much easier to affect spending (through AD) than it is to affect production (through AS).
What if we tackled a negative supply shock by trying to influence AD?
Negative Supply Shock:
Note: show the students what happens when SRAS shifts to the left. Inflation and unemployment.
Suppose policymakers wanted to shift AD to the right to fight unemployment. This would worsen the inflation.
Or suppose policymakers wanted to shift AD to the left to fight the inflation. That would only worsen the unemployment.
There are no good options here.

40. Fiscal Policy: The Basics
A key to understanding fiscal policy is to understand its origins.
Fiscal policy is all about taxation and government spending.
The President proposes a budget to Congress that includes plans for spending and tax collection. Eventually Congress will amend and approve a budget and it becomes law.
We will see that this fundamentally differs from monetary policy which is created by the Federal Reserve, the central bank of the U.S.

41. Taxes, Government Purchases of Goods and Services, Transfers, and Borrowing
Tax Collection
Like households, the government must collect money in order to pay for this spending. The government collects taxes.
Note: ask the students to start a list of all of the taxes they, or their parents, pay.
Sales tax, income tax, property tax, vehicle registration tax, gas (or liquor or tobacco) excise taxes, tax on corporate profits…
And like households, the government can borrow to make up for a shortfall in tax revenue that does not pay for all of the spending. Government borrowing will be covered future sections of the course.

42. Taxes, Government Purchases of Goods and Services, Transfers, and Borrowing
The government plays a sizeable role in the circular flow diagram.
Government Spending
Like households, the government spends money on goods and services.
Note: can the students provide some examples of goods and services purchased by the government?
Remind the students that government includes all levels of government (local, state, federal).
Local: police cars in your city.
State: a system of State Parks.
Federal: the military
Transfer Payments
The government also provides transfer payments to some households.
Note: can the students provide some examples of transfer payments sent from the government to households?
Social Security, Medicare, Medicaid, VA benefits, food stamps, etc.

43. The Government Budget and Total Spending
GDP = C + I + G + X - M
The effect of taxes and transfers
Effects on Investment
How does the government affect AD? Remind the students that if we add up all of the spending in the economy we get GDP.
GDP = C + I + G + X - IM
G: government purchases of goods and services.
This directly affects GDP and thus AD.
Indirectly, the government can influence consumption spending (C) through taxes and transfers.
To see this, look at what goes into consumption spending.
A person receives income Y from his/her job.
Taxes are paid to the government and sometimes transfer payments are received by the government.
What is left over is disposable income Yd.
Disposable income can now either be consumed or saved.
Yd = Y – taxes + transfers = C + S or
C = Yd – S
As we saw in a previous module, when Yd increases, so does C.
So the government can indirectly increase C if it can increase Yd.
How can it increase Yd?
By cutting taxes or by increasing transfers.
The government can also affect investment spending (I) through tax policy.

44. Expansionary and Contractionary Fiscal Policy
Expansionary Fiscal Policy
increase G
decrease T
increase transfers
Note: the instructor should have the students consider two short-run states of the economy: a recessionary gap and an inflationary gap.
Begin by drawing a short-run equilibrium with a recessionary gap.
Recessionary gap: fiscal policy should try to shift AD to the right.
expansionary fiscal policy, normally takes one of three forms:
An increase in government purchases of goods and services
A cut in taxes
An increase in government transfers
Show how any of these policies would shift the AD curve to the right and GDP closer to Yp.

45. Expansionary and Contractionary Fiscal Policy
decrease G
increase T
decrease transfers
Begin by drawing a short-run equilibrium with an inflationary gap.
Inflationary gap: fiscal policy should try to shift AD to the left.
contractionary fiscal policy, normally takes one of three forms:
A decrease in government purchases of goods and services
An increase in taxes
A decrease in government transfers
Show how any of these policies would shift the AD curve to the left and GDP closer to Yp.

46. A Cautionary Note: Lags in Fiscal Policy
Time lags
Recognition lag
Decision lag
Implementation lag
Lags make decision making more difficult
Fiscal policy looks easy on the chalkboard. In reality it is more difficult because there are important time lags in its use.
Recognition lag: The government has to realize that the recessionary gap exists because economic data take time to collect and analyze, and recessions are often recognized only months after they have begun.
Decision lag: the government has to develop a spending plan, which can itself take months, particularly if politicians take time debating how the money should be spent and passing legislation.
Implementation lag: It takes time to spend money. For example, a road construction project begins with activities such as surveying that don’t involve spending large sums.
It may be quite some time before the big spending begins.
By this time, the economy might have already begun self-correcting back to Yp.

47. When recession occurs, an EXPANSIONARY FISCAL POLICY
may be in order.

48. Suppose that a sharp decline in investment spending has shifted AD from AD1 to AD2.
Perhaps profit expectations on investment projects have dimmed, curtailing much investment spending and reducing AD. AS
PRICE
AD2
AD1
$485 $505 GDPf
REAL GDP (billions)

49. This economy is experiencing recession and cyclical unemployment.
Consequently, real GDP has fallen from $485b from its near full-time level of $505b. Accompanying this $20b decline in real output is an increase in unemployment since fewer workers are needed to produce the diminished output. AS
This economy is experiencing recession and cyclical unemployment.
PRICE
AD2
AD1
$485 $505 GDPf
REAL GDP (billions)

50. What should the government do?
There are 3 main options:
1) increase government spending,
2) reduce taxes,
3) use some combination of the two.
If the Federal budget is balanced at the onset, fiscal policy during a recession or depression should create a government BUDGET DEFICIT--or government spending in excess of revenues.

51. All things being equal, an increase in government spending will shift the AD curve to the right.
Suppose that recession prompts government to initiate $5b of new spending on highways, communications, and prisons, represented by the dashed line.
At EACH price level, the amount of real output demanded is now $5b greater than that demanded before the increase.
$5 billion initial increase in spending AS
PRICE
AD2
REAL GDP (billions)

52. But the AD curve shifts rightward to AD1; aggregate demand increases by much more than the $5b in government purchases.
$5 billion initial increase in spending
This occurs because the multiplier process magnifies the initial change in spending into successive rounds of new consumption spending. AS
PRICE
AD2
REAL GDP (billions)

53. Unemployment falls as firms call back laid off workers.
If the economy’s MPC is .75 then the simple multiplier is 4. The AD curve shifts right 4 times the $5b increase.
$5 billion initial increase in spending
Because this particular increase in AD occurs within the horizontal range of AS, real output rises by the full extent of the multiplier.
Unemployment falls as firms call back laid off workers. AS
PRICE
Full $20 billion increase in aggregate demand
AD1
AD2
REAL GDP (billions)

54. Another option for expansionary fiscal policy would be tax reductions to shift the aggregate demand curve rightward.
Suppose government cuts personal income taxes by $6.7 billion, which increases disposable income by the same amount.
Consumption will rise by $5 billion (= MPC of .75 X $6.67 billion), and saving will go up by $1.67 billion (= MPC of .25 X $6.67 billion). In this case the horizontal distance between AD2 and the dashed line represents only the $5 billion initial increase in consumption spending. AS
PRICE
AD2
AD1
REAL GDP (billions)

55. AS PRICE AD2 AD1 REAL GDP (billions)
The aggregate demand curve eventually shifts rightward by four times the $5 billion initial increase in consumption produced by the tax cut. Real GDP rises by $20 billion, implying a multiplier of 4. Employment also increases accordingly.
You may have also noted that a tax cut must be somewhat larger than the proposed government spending increase to achieve the same amount of rightward shift in the aggregate demand curve. This is part because part of a tax reduction boosts SAVINGS, not consumption. AS
PRICE
AD2
AD1
$485b
$505b
REAL GDP (billions)

56. TO INCREASE INITIAL CONSUMPTION BY A SPECIFIC AMOUNT, GOVERNMENT MUST REDUCE TAXES BY MORE THAN THAT AMOUNT.
With an MPC of .75, taxes must fall by $6.67 billion for $5 billion of new consumption to be forthcoming, because $1.67 billion is saved (not consumed).
If the MPC instead had been .6, then an $8.33b reduction in tax collections would have been necessary to increase initial consumption by $5b.
The smaller the MPC, the greater the tax cut needed to accomplish a specific initial increase in consumption and a shift in the AD curve.

57. Expansionary Fiscal Policy may also be initiated by a combination of spending increases and tax reductions.
Government might increase its spending by $1.25 billion while reducing taxes by $5 billion.
Can you ascertain why this combination will produce the targeted $5b initial increase in new spending.

58. If the government increases its spending during recession to assist the economy, the funds for such expenditures must come from some source. What source would have the greatest expansionary effect?
Creating new money

59. Contractionary Fiscal Policy
is used to control demand-pull inflation.

60. AS PRICE AD4 AD3 REAL GDP (billions)
Suppose a shift of from AD3 to AD4 occurs in the vertical range of AS, and boosts the price level from P3 to P4. This increase may have resulted from a sharp increase in investment or net export spending.
Using fiscal policy, the remedy used to control this is opposite those used to control recession. P4
PRICE
AD4 P3
AD3
$515b
REAL GDP (billions)

61. What should the government do?
There are 3 main options:
1) decrease government spending,
2) increase taxes,
3) use some combination of the two.
When the economy faces demand-pull inflation, fiscal policy should move toward a government BUDGET SURPLUS--tax revenues in excess of government spending.

62. Decreased government spending shifts the AD curve leftward in its efforts to control demand-pull inflation. AS P4
The dashed line represents $5 billion reduction in government spending. Once the multiplier effect is complete, the curve will move from AD4 to AD3. Assuming downward price flexibility, the price level will return to P3 and real output will remain constant.
In the real world, prices are “sticky” downward, so stopping inflation is a matter of halting the rise in the price level, not reducing it to a previous level.
PRICE
AD4 P3
AD3
$515b
REAL GDP (billions)

63. Increased taxes also shifts the AD curve leftward in its efforts to control demand-pull inflation by decreasing consumption. AS
If the economy has an MPC of .75, government must raise taxes by $6.67 billion to reduce consumption by $5b. The $6.67 tax reduces saving by $1.67 ( = the MPS of .25 X $6.67b) and this $1.67b reduction in saving is not a spending reduction.
But the $6.67b tax increase also reduces consumption spending by $5b (= the MPC of .75 x $6.67), as shown by the dashed line. After the multiplier process, AD will shift left by $20b (= multiplier of 4 X $5b). P4
PRICE
AD4 P3
AD3
$515b
REAL GDP (billions)

64. Contractionary Fiscal Policy may also be initiated by a combination of spending decreases and tax increases . AS P4
Why does a $2 billion decline in government spending paired with a $4 billion increase in taxes shift the aggregate demand curve from AD4 to AD3.
PRICE
AD4 P3
AD3
$515b
REAL GDP (billions)

65. Financing of Deficits and Disposing of Surpluses
The expansionary effect of deficit spending on the economy depends on the method used to finance the deficit. Similarly, the anti-inflationary impact of the creation of a budget surplus depends on what is done with the surplus.
There are two ways the government can FINANCE THE DEFICIT:
1) Borrowing: When the government borrows money, it competes with private business borrowers for the funds.
2) Money creation: Creation of new money is a more expansionary (but potentially more inflationary) way of financing deficit spending than is borrowing.

66. There are two ways the government can DISPOSE OF THE SURPLUS:
Demand-Pull inflation calls for fiscal action which will result in a budget surplus. But the anti-inflationary effect of this surplus depends on what government does with it.
There are two ways the government can DISPOSE OF THE SURPLUS:
1) Debt Reduction: To retire the National Debt, the government buys back some of its bonds; in doing so, it transfers its surplus tax revenues back into the money market. This causes interest rates to fall and thus private borrowing and spending to rise.
2) Impounding: Impounding the surplus funds and allowing them to stand idle is a way for the government to extract and withhold purchasing power from the economy.
Because there is no chance for the funds to be spent, the impounding of a budget surplus is more anti-inflationary than the use of the surplus to retire the public debt.

67. IS IT PREFERABLE TO USE GOVERNMENT SPENDING OR TAXES TO ELIMINATE RECESSION AND INFLATION?
The answer depends upon one’s view as to whether the public sector is too large or too small.
“Liberal” economists, who think there are many unmet social and infrastructure needs, usually recommend that government spending be increased during recessions. In times of demand-pull inflation, they tend to recommend tax increases.
“Conservative” economists, who think the public sector is too large and inefficient, usually advocate tax cuts during recessions and cuts in government spending during times of demand-pull inflation.

68. KRUGMAN’S Contractionary v Expansionary Policy

69. Expansionary and Contractionary Fiscal Policy
Expansionary Fiscal Policy Can Close a Recessionary Gap
*Krugman

70. Expansionary and Contractionary Fiscal Policy
Contractionary Fiscal Policy Can Eliminate an Inflationary Gap
*Krugman

72. The Multiplier Effect of an Increase in Government Purchases of Goods and Services
*Krugman

73. How Taxes Affect the Multiplier
Automatic Stabilizers
Discretionary Fiscal Policy
The video on the next page is actually a Micro concept but still applies here……….

75. Differences in the Effect of Expansionary Fiscal Policies

76. The Budget Balance as a Measure of Fiscal Policy
The budget balance is equal to government savings and is defined by the following equation:
expansionary fiscal policies
contractionary fiscal policies
T= tax revenues
G=government spending
TR=transfer payments

77. The U.S. Federal Budget Deficit and the Business Cycle
*Krugman

78. The U.S. Federal Budget Deficit and the Unemployment Rate
*Krugman

79. What would the budget balance be if there were neither a recessionary gap nor an inflationary gap?
Cyclically adjusted budget balance is the estimate of what the budget balance would be if real GDP were exactly equal to potential output.
It takes into account the extra tax revenue the government would collect and the transfers it would save if a recessionary gap were eliminated-- or the revenue the government would lose and the extra transfers it would make if an inflationary gap were eliminated.

80. The Actual Budget Deficit Versus the Cyclically Adjusted Budget Deficit
*Krugman

81. Government Debt as a Percentage of GDP
*Krugman

82. U.S. Federal Deficit and the Federal Debt-GDP Ratio since 1939
*Krugman

83. Japanese Deficits and Debt
*Krugman

84. Examples: Medicare & Social Security
IMPLICIT LIABILITIES are spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics.
Examples: Medicare & Social Security

85. The Implicit Liabilities of the U.S. Government
*Krugman

86. Multiplier Effects of Changes in Government Transfers and Taxes
Taxes and Transfers compared to Government Spending
Transfers (payments by the government to households for which no good or service is provided in return)
Tax cuts
Taxes
Lump-sum taxes: (taxes that don’t depend on the taxpayer’s income)
Government can indirectly affect AD through taxes and transfers.
But the impact of tax/transfer policy indirectly affects real GDP because this type of policy first affects consumer disposable income (Yd).
Consumers will save some of every new dollar of Yd.
If dollars of new Yd are saved, they cannot multiply into additional spending and income.
Example 1:
Suppose the government decides to lower income taxes by a lump-sum $1000.
The MPC = .90.
When Americans get $1000 back into their pockets, they will save $100 (10%) and spend $900 (90%).
$900 of new spending will now multiply by a factor of 10 because M=1/.90 = 10.
So $1000 tax cut will eventually multiply into $9000 of additional real GDP.
Example 2:
Suppose the government decides to increase transfer payments by a lump-sum of $500.
The MPC = .80
When Americans receive $500 more disposable income, they will save $100 (20%) and spend $400 (80%).
$400 of new spending will now multiply by a factor of 5 because M = 1/.80 = 5.
So a $500 increase of transfers will eventually multiply into $2000 of additional real GDP.
We can generalize that the tax multiplier Tm is less than the spending multiplier M.
In fact:
Tm = MPC*M = MPC/(1-MPC)
Krugman, Sec 4 Mod 21

87. How Taxes Affect the Multiplier
The reliance of taxes on real GDP (ie IncTax Rev increases w/RGDP b/c depends on indiv income….Sales tax Rev increases w/RGDP b/c people w/more money buy more stuff…..Corp profit taxes increase w/RGDP b/c profits increase w/people buying more stuff)
Effect on the multiplier (effect= reduce the size of the multiplier)
Automatic stabilizers (affects RGDP as a consequence of how tax laws are written)
Discretionary Fiscal Policy
In reality, the eventual impact of discretionary fiscal policy is lessened by the progressive tax system.
Assume the economy is in recession and the government has increased G to boost employment and real GDP.
As some consumers find jobs and increased income, they start paying more taxes and disposable income falls.
As Yd falls, it slows down the multiplier process. This may avoid a situation where the big shift in AD creates inflation.
The progressive tax system is a form of automatic stabilizer.
Automatic stabilizers are: government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands, without requiring any deliberate action by policy makers.
This is also called “non-discretionary” fiscal policy.

88. NONDISCRETIONARY FISCAL POLICY:
BUILT-IN STABILIZERS

89. Net tax revenues vary directly with GDP because virtually any tax will yield more tax revenue as GDP rises.
When GDP expands and more goods and services are purchased, revenues from corporate income taxes and sales and excise taxes also increase.
Conversely, when GDP declines, tax receipts from all those sources also decline.

90. Transfer payments (or “negative taxes”) behave in the opposite way from tax revenues.
Unemployment compensation payments, welfare payments, and subsidies to farmers all DECREASE during economic expansion and INCREASE during a contraction.

91. This graph shows how the U. S. tax system creates built-in stability
This graph shows how the U.S. tax system creates built-in stability. Tax revenues vary directly with GDP, and government spending is assumed to be independent of GDP. As GDP falls in a recession, deficits will occur automatically and will help alleviate that recession. As GDP rise during expansion, surpluses will occur automatically and will offset inflation.
Tax Revenues
Surplus
Government Spending
Deficit
Real Domestic Output

92. 1) Taxes reduce spending and aggregate demand.
The economic importance of this direct relationship between tax receipts and GDP is:
1) Taxes reduce spending and aggregate demand.
2) It is desirable from the standpoint of stability to reduce spending when the economy is moving toward inflation and to increase spending when the economy is slumping.
A built-in stabilizer is anything which increases the government’s budget deficit (or reduces its budget surplus) during a recession and increases its budget surplus (or reduces its budget deficit) during inflation without requiring explicit action by policymakers.

93. As GDP rises during prosperity, tax revenues automatically increase and, because they reduce spending, they restrain the economic expansion. Put another way, as the economy moves toward a higher GDP, tax revenues automatically rise and move the budget from deficit toward surplus.
Tax Revenues
Surplus
Government Spending
Deficit
Real Domestic Output

94. T Surplus G Deficit Real Domestic Output
The steepness of T depends on the tax system itself. In a PROGRESSIVE TAX SYSTEM, the average tax rate (=tax revenue/GDP) rises with GDP.
In a PROPORTIONAL TAX SYSTEM, the average tax rate remains constant as GDP rises.
In a REGRESSIVE TAX SYSTEM, the average tax rates falls as GDP rises.
Tax
Revenues
(Tax Revenues)
THE MORE PROGRESSIVE THE TAX SYSTEM, THE GREATER THE ECONOMY’S BUILT-IN STABILITY. T
Surplus G
(Government Spending)
Deficit
Real Domestic Output

95. Changes in public policies or laws which alter the progressivity of the tax system affect the degree of built-in stability.
For example: In 1993, the Clinton administration increased the highest marginal tax rate on personal income from 31 to 39.6 percent and boosted the corporate income tax 1 percentage point to 35 percent.
These increases in tax rates raise the overall progressivity of the tax system, slightly bolstering the economy’s built-in stability.

96. However, built-in stabilizers can only diminish, NOT correct, major changes in equilibrium GDP.
DISCRETIONARY FISCAL POLICY (changes in tax rates and spending) may be needed to correct inflation or recession of any appreciable magnitude.

97. SO………………..
We have built-in stability because tax revenues vary directly with GDP.
But those automatic increases or decreases in tax revenues mean that the ACTUAL BUDGET in any particular year does not tell us whether government’s current discretionary fiscal policy is expansionary, neutral, or contractionary.
Here’s why…………….

98. Suppose and economy is achieving full-employment at GDPf.
Notice between spending line G and tax line T, there is an actual budget deficit shown by vertical distance ab.
Assume that investment spending plummets, swamping the expansionary effect of this budget deficit and causing a recession to GDPr.
Full-employment or structural deficit T
Assuming the government takes no new discretionary action, line G and T remain.
Expenditures
&
Tax
Revenues a
Government G
With the economy at GDPr, tax revenues are lower than before, while government spending remains unaltered. b
GDPr GDPf (year 2) (year 1)
GDPr
GDPf

99. The budget deficit therefore rises to ec,
expanding from ab (=ed)
by amount dc.
The added deficit of dc is called CYCLICAL DEFICIT because it relates to the business cycle.
Full-employment or structural deficit T
It is NOT the result of discretionary fiscal actions by government; rather, it is the by-product of the economy’s slide into recession.
Expenditures
&
Tax
Revenues e a
Government G d b c
Cyclical Deficit
GDPr GDPf (year 2) (year 1)
GDPr
GDPf

100. Thus, we cannot evaluate the government’s fiscal policy---the extent to which it is expansionary, neutral, or contractionary--by looking ONLY at the size of a current budget or surplus.

101. So……
How do we resolve the problem?
Economists do this by using the FULL-EMPLOYMENT BUDGET.
Also called the STANDARDIZED BUDGET, it measures what the Federal budget deficit or surplus would be with existing tax and government spending structures if the economy were at full employment throughout the year.

102. Specifically, the cyclical part of the deficit dc
Consider the graph once again. In full-employment year 1, the full-employment deficit is ab, the amount of actual deficit.
In year 2, however, the actual budget deficit of ec overstates the full-employment deficit.
Specifically, the cyclical part of the deficit dc
Full-employment or structural deficit
must be subtracted from the actual deficit ec T
Expenditures
&
Tax
Revenues e a
to obtain the full-employment deficit, ed.
Government G =
We note, then, that the full-employment deficit for year 2 is the same as year 1 (ed=ab). d b c
Cyclical Deficit
By comparing these two full-employment deficits, we see that government did not change its fiscal policy between years 1 and 2.
GDPr GDPf (year 2) (year 1)
GDPr
GDPf

103. Proposed BALANCED BUDGET REQUIREMENT
The large annual budget deficits in the U.S. during the past two decades have led many Congressional leaders to support a constitutional amendment requiring the Federal government to balance its budget each year.
Such a mandate would virtually eliminate discretionary fiscal policy as a tool for stabilization, as it would force the government to reduce spending or increase taxes during recession.
Let’s chart the effects of a requirement to balance the budget……..

104. Suppose that in year 1, the economy is operating at full-employment level of GDPf. At this point, the budget is balanced. T
In year 2, the economy slides into recession with real output decreasing to GDPr…automatically decreasing tax revenues, creating a budget deficit of ab. a G
deficit b
GDPr GDPf (year 2) (year 1)

105. To comply with the balanced budget requirement, the government must eliminate this defict in one of three ways: T2 T1
1) Increasing tax revenues so that the tax line shifts upward to T2, intersecting the G1 line at point a. a G1 b
GDPr GDPf (year 2) (year 1)

106. OR
2) Reducing government spending so that the government spending line shifts downward to G2 intersecting with T1 at point b. T1 a G1 G2 b
GDPr GDPf (year 2) (year 1)

107. OR
3) Increasing taxes and reducing government spending in some combination to eliminate the budget deficit. T2 T1 a G1 G2 b
GDPr GDPf (year 2) (year 1)

108. The problem with all three options is that they are aspects of CONTRACTIONARY FISCAL POLICY. They all reduce aggregate demand, which decreases GDP. These actions further reduce real GDP and tax revenues decline once again.
Rather than stabilizing the economy, a strict balanced-budget requirement may force government to take action which worsen the economy.

110. PROBLEMS, CRITICISMS, COMPLICATIONS
1) Recognition Lag: time between beginning of recession or inflation and the certain awareness it is actually happening.
2) Administrative Lag: time that elapses between recognition of need for fiscal action and time action is taken.
3) Operational Lag: time between the action taken and the time that action affects output, employment, or price level.

111. POLITICAL PROBLEMS
1) Governmental goals also include concern with providing public goods and services and redistributing income, not just economic stability.
2) Fiscal policies of State and Local governments are frequently pro-cyclical---they worsen, rather than correct recession or inflation.
3) Deficits may be politically attractive and surpluses politically painful.
4) Some economists contend that the goal of politicians is not to act in the interests of the national economy but, rather, to get reelected. Politicians might manipulate fiscal policy to maximize voter support, even though their fiscal decisions destabilize the economy.

112. The CROWDING-OUT Effect
An expansionary fiscal policy (deficit spending) will increase the interest rate and reduce private spending, weakening or canceling the stimulus of the fiscal policy.
(i.e.) If the economy is in recession and government enacts discretionary fiscal policy in the form of increased government spending, it will borrow the needed funds from the money market.
This results in increased demand for money
The interest rate rises
Investment spending diminishes, as well as some consumption spending (autos, boats on credit)

113. FISCAL POLICY and the NET EXPORT EFFECT
The net export effect may also work through international trade to reduce the effectiveness of fiscal policy.
If the crowding-out effect, during a period of expansionary fiscal policy, boosts interest rates, reduces investment, and weakens fiscal policy, then what effect would these increased interest rates have on a nation’s net exports?

114. Problem: RECESSION, SLOW GROWTH Problem: INFLATION
Expansionary Fiscal Policy
Contractionary Fiscal Policy
Lower domestic interest rate
Higher domestic interest rate
Increased foreign demand for dollars
Decreased foreign demand for dollars
Dollar appreciates
Dollar depreciates
Net exports decline (aggregate demand decreases, partially offsetting the expansionary fiscal policy)
Net exports increase (aggregate demand increases, partially offsetting the contractionary fiscal policy)

115. SUPPLY-SIDE FISCAL POLICY
“Supply-siders” contend that changes in aggregate supply must be recognized as active forces in determining levels of inflation and unemployment.
Supply-side economists argue that the huge growth of the US tax-transfer system (welfare, subsidies, unemployment compensation) negatively affects incentives to work, invest, innovate, and assume entrepreneurial risk.
They believe that high taxes reduce the after-tax rewards of workers and producers , making work, innovation, investing, and risk bearing less financially attractive.

116. To induce aggregate inputs of labor
Reduce taxes on incomes
Work is more attractive because of the increasing opportunity cost of leisure
Individuals choose to substitute work for leisure by:
Making people willing to work harder
More hours worked per day
More people in labor force
Discouraging long periods of unemployment
Postpone retirement

117. Labor productivity rises Expanding aggregate supply
The rewards for saving and investing are also reduced by high tax rates.
A critical determinant of investment spending is the expected after-tax return of that spending. (High taxes on investment income will discourage investment spending)
Therefore, if lower marginal tax rates encourage saving and investing, workers will find themselves with more technologically superior machinery and equipment.
Labor productivity rises
Expanding aggregate supply
Unemployment and inflation low

118. Ten men go out to dinner and the bill for all ten equals $100.
TAX CUTS FOR THE RICH?? A different perspective….
Ten men go out to dinner and the bill for all ten equals $100.
If they paid their bill the way we pay our taxes:
FIRST FOUR pay nothing
FIFTH pays $1
SIXTH pays $3
SEVENTH pays $7
EIGHTH pays $12
NINTH pays $18
TENTH pays $59

119. TAX CUTS FOR THE RICH?? A different perspective….
They eat their dinner there every day until one day the owner comes to them and says, “You are such good customers, I’m going to reduce the daily cost of your meal by $20.
The group still wanted to pay their bill the way we pay our taxes do the first four men were unaffected. Should the other 6 men divide the $20 savings between them?
$20 divided by 6 is $3.33, but if they subtracted that from everyone’s share, the fifth and sixth men would each end up being paid to eat their meal.

120. So, the restaurant owner suggested:
TAX CUTS FOR THE RICH?? A different perspective….
So, the restaurant owner suggested:
Paying their bill the way we pay our taxes:
FIRST FOUR pay nothing pay nothing
FIFTH pay $1 pay nothing
SIXTH pays $3 $2
SEVENTH pays $7 $5
EIGHTH pays $12 $9
NINTH pays $18 $14
TENTH pays $59 $49

121. The first 9 men surrounded the TENTH and beat him up.
TAX CUTS FOR THE RICH?? A different perspective….
“I only got a dollar out of the $20” declared the SIXTH man. He pointed to the TENTH man, “but he got $10.”
“Yeah, that’s right,” exclaimed the FIFTH man, “I only saved a dollar, too. The wealthy get all the breaks!”
“Wait a minute,” yelled the first FOUR MEN, “We didn’t get anything at all. The system exploits the poor.”
The first 9 men surrounded the TENTH and beat him up.

122. TAX CUTS FOR THE RICH?? A different perspective….
The next night, the TENTH man didn’t show up for dinner, so the nine sat down and ate without him.
But when it came to pay the bill, they didn’t have enough money between them for even half the bill.
THE PEOPLE WHO PAY THE HIGHEST TAXES GET THE MOST BENEFIT FROM A TAX REDUCTION.
Tax them too much and they just might start eating overseas where the atmosphere is somewhat friendlier.

123. n
THE LAFFER CURVE
100 m
Arthur Laffer suggested that up to point m, higher tax rates will result in larger tax revenues.
Tax revenues decline beyond some point (m) because higher tax rates discourage economic activity which diminishes the tax base. m l
Tax Revenue (dollars)

124. Supply-siders also claim that government’s regulatory involvement in the economy has adversely affected productivity and long-run aggregate supply. They claim that government regulation:
1) creates monopolies and cartels, especially in transportation and communications, and
2) increases the cost of doing business when imposing industry response to pollution, product safety, worker health and safety, and equal access to job opportunities.

125. The Laffer Curve

127. Coral Springs High School Sources:
Compiled by:
Virginia H. Meachum
Coral Springs High School
Sources:
Principles, Problems, and Policies, by Campbell McConnell & Stanley Brue
Economics, by Krugman, Wells
Principles of Economics, by N. Gregory Mankiw
Notes by Florida Council on Economic Education and FAU Center for Economic Education
Notes by Foundation for Teaching Economics