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c h a p t e rc h a p t e r
seventeenseventeen
© 2007 Prentice Hall Business Publishing Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien
Prepared by: Fernando & Yvonn Quijano
Fiscal Policy
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After studying this chapter, you should be able to:
Define fiscal policy.
Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilize the economy.
Explain how the multiplier process works with respect to fiscal policy.
Discuss the difficulties that can arise in implementing fiscal policy.
Explain how the federal budget can serve as an automatic stabilizer.
Discuss the long-run effects of fiscal policy.
A Boon for H&R Block
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5In this chapter, we will explore how the government uses fiscal policy, which involves changes in taxes and changes in government purchases…
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Fiscal Policy
LEARNING OBJECTIVE1
Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth.
What Fiscal Policy Is and What It Isn’t
Automatic Stabilizers versus Discretionary Fiscal Policy
Automatic stabilizers Government spending and taxes that automatically increase or decrease along with the business cycle.
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Fiscal Policy
17 - 1The Federal Government’s Share of Total Government Expenditures, 1929-2004
An Overview of Government Spending and Taxes
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Fiscal Policy
17 - 2Federal Purchases and Federal Expenditures as a Percentage of GDP, 1929-2004
An Overview of Government Spending and Taxes
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Fiscal Policy
An Overview of Government Spending and Taxes
17 - 3Federal Government Expenditures, 2004
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The Federal Budget
Fiscal policy operates within the framework of the Employment Act of 1946, which committed the government to work toward “maximum employment, production, and purchasing power.”
The President’s Council of Economic Advisers monitors the economy and advises the President on economic policy.
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Employment Act of 1946
The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means consistent with its needs and obligations and other essential considerations of national policy, with the assistance and cooperation of industry, agriculture, labor, and State and local governments, ... for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self-employment, for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power.
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Employment Act of 1946
The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means consistent with its needs and obligations and other essential considerations of national policy, with the assistance and cooperation of industry, agriculture, labor, and State and local governments, ... for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self-employment, for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power.
10 of 32© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien
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Employment Act of 1946
The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means consistent with its needs and obligations and other essential considerations of national policy, with the assistance and cooperation of industry, agriculture, labor, and State and local governments, ... for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self-employment,
for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power.
11 of 32© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien
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Employment Act of 1946
The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means consistent with its needs and obligations and other essential considerations of national policy, with the assistance and cooperation of industry, agriculture, labor, and State and local governments, ... for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self-employment, for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power.
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The Federal Budget
The federal budget is the annual statement of the federal government’s expenditures and tax revenues.Fiscal policy is the use of the federal budget to achieve macroeconomic objectives, such as full employment, sustained long-
term economic growth, and price level stability.
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The Federal Budget
Fiscal policy operates within the framework of the Employment Act of 1946, which committed the government to work toward “maximum employment, production, and purchasing power.”
The President’s Council of Economic Advisers monitors the economy and advises the President on economic policy.
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The Federal Budget
The federal government’s budget balance equals tax revenue minus expenditure.If tax revenues exceed expenditures, the government has a budget surplus.If expenditures exceed tax revenues, the government has a budget deficit.If tax revenues equal expenditures, the government has a balanced budget.
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The Federal Budget
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The Federal Budget
Government debt is the total amount that the government has borrowed—that the government owes. It is the accumulation of all past deficits.
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The Federal Budget
Figure below shows the evolution of the debt as a percentage of GDP since 1942.
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The Federal Budget
State and Local BudgetsIn 2002, when the federal government spent $2,000 billion, state and local governments spent almost $1,900 billion, mostly on education, protective services, and roads. State and local budgets are not used for stabilization purposes, and occasionally are destabilizing in recessions.
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National Debt/GDP
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Who Is Debt Owed To?
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National Debt
National Debt – Some Simple Calculations
National Debt January 2007 per capita ($000)
(Pop = 300m)
Publicly-held USA 2674 8.9
Publicly-held-foreign 2240 7.5
US Government held 3794 12.6
Total 8708 29.0
Net Debt
Publicly-held USA 2674 8.9
Foreign-held 2240 7.5
Total 4914 16.4
Foreign debt as % of net debt 45.6%
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The Future of Social Security and Medicare
17 - 1
Will the federal government be able to keep the promises made by the Social Security and Medicare programs?
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Fiscal Policy
17 - 4Federal Government Revenue, 2004
An Overview of Government Spending and Taxes
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Using Fiscal Policy to Influence Aggregate Demand
LEARNING OBJECTIVE2
17 - 5An Expansionary Fiscal Policy
Expansionary Fiscal Policy
25 of 32© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien
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Using Fiscal Policy to Influence Aggregate Demand
17 - 6A Contractionary Fiscal Policy
Contractionary Fiscal Policy
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Using Fiscal Policy to Influence Aggregate Demand
A Summary of How Fiscal Policy Affects Aggregate Demand
PROBLEM TYPE OF POLICYACTIONS BY CONGRESS AND THE PRESIDENT RESULT
Recession Expansionary Increase government spending or cut taxes
Real GDP and the price level rise
Rising Inflation
Contractionary Decrease government spending or raise taxes
Real GDP and the price level fall
Countercyclical Fiscal Policy
17 – 1
Don’t Confuse Fiscal Policy and Monetary Policy
27 of 32© 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien
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The Government Purchases and Tax Multipliers
LEARNING OBJECTIVE3
17 - 7The Multiplier Effect and Aggregate Demand
Multiplier effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures.
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The Government Purchases and Tax Multipliers
27 - 8The Multiplier Effect of an Increase in Government Purchases
17 - 8
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The Government Purchases and Tax Multipliers
Changeinequilibrium real GDPGovernment purchases multiplier
Changein government purchases
Changeinequilibrium real GDPTax multiplier
Changein taxes
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The Government Purchases and Tax Multipliers
The Effect of Changes in Tax Rates
Taking Into Account the Effects of Aggregate Supply
17 - 9The Multiplier Effect and Aggregate Supply
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The Government Purchases and Tax Multipliers
The Multipliers Work in Both Directions
Fiscal Policy Multipliers
17-1
LEARNING OBJECTIVE3
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The Limits of Using Fiscal Policy to Stabilize the Economy
LEARNING OBJECTIVE4
17 - 10How a Bill Becomes Law
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The Limits of Using Fiscal Policy to Stabilize the Economy
Does Government Spending Reduce Private Spending?
Crowding out A decline in private expenditures as a result of an increase in government purchases.
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The Limits of Using Fiscal Policy to Stabilize the Economy
17 - 11An Expansionary Fiscal Policy Increases Interest Rates
Crowding Out in the Short Run
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The Limits of Using Fiscal Policy to Stabilize the Economy
17 - 12The Effect of Crowding Out in the Short Run
Crowding Out in the Short Run
Crowding Out in the Long Run
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Limits to Fiscal Policy: Japan in the Late 1990s
17 - 2
Fiscal policy in Japan has not been effective in expanding real GDP and reducing unemployment.
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Deficits, Surpluses, and Federal Government Debt
LEARNING OBJECTIVE5
Budget deficit The situation in which the government’s spending is greater than its tax revenue.
Budget Surplus The situation in which the government’s expenditures are less than its tax revenue.
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Deficits, Surpluses, and Federal Government Debt
17 - 13The Federal Budget Deficit, 1901-2004
How the Federal Budget Can Serve as an Automatic Stabilizer
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Deficits, Surpluses, and Federal Government Debt
Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP.
17 – 14How the Level of GDP Affects the Cyclically Adjusted Budget Deficit
How the Federal Budget Can Serve as an Automatic Stabilizer
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Did Fiscal Policy Fail During the Great Depression?
17 - 3
Although government spending increased during the Great Depression, the cyclically adjusted budget was in surplus most years.
FEDERAL GOVERNMENT
EXPENDITURES (BILLIONS OF
DOLLARS
ACTUAL FEDERAL BUDGET
DEFICIT OR SURPLUS
(BILLIONS OF DOLLARS)
CYCLICALLY ADJUSTED
BUDGET DEFICIT OR SURPLUS
(BILLIONS OF DOLLARS)
CYCLICALLY ADJUSTED
BUDGET DEFICIT OR
SURPLUS AS A PERCENTAGE
OF GDP
1929 $2.6 $1.0 $1.24 1.20%
1930 2.7 0.2 0.81 0.89
1931 4.0 -2.1 -0.41 -0.54
1932 3.0 -1.3 0.50 0.85
1933 3.4 -0.9 1.06 1.88
1934 5.5 -2.2 0.09 0.14
1935 5.6 -1.9 0.54 0.74
1936 7.8 -3.2 0.47 0.56
1937 6.4 0.2 2.55 2.77
1938 7.3 -1.3 2.47 2.87
1939 8.4 -2.1 2.00 2.17
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Deficits, Surpluses, and Federal Government Debt
Should the Federal Budget Always Be Balanced?
The Effect of Economic Fluctuations on the Budget Deficit
17-2
LEARNING OBJECTIVE5
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Deficits, Surpluses, and Federal Government Debt
The Federal Government Debt
Is the Government Debt a Problem?
17 - 15The Federal Government Debt,1901-2004
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The Effects of Fiscal Policy in the Long Run
LEARNING OBJECTIVE6
Tax wedge The difference between the pre-tax and post-tax return to an economic activity.
The Long-Run Effects of Tax Policy
We can briefly look at the effects on aggregate supply of cutting each of the following taxes:
Individual income tax.
Corporate income tax.
Taxes on dividends and capital gains.
Tax Simplification
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Should the United States Adopt the “Flat Tax”?
17 - 4
Should the United States simplify the tax code by moving to a flat tax?
COUNTRYFLAT TAX
RATE
YEAR FLAT TAX WAS
INTRODUCED
Estonia 26% 1994
Lithuania 33 1994
Latvia 25 1995
Russia 13 2001
Serbia 14 2003
Ukraine 13 2004
Slovakia 19 2004
Georgia 12 2005
Romania 16 2005
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The Effects of Fiscal Policy in the Long Run
The Economic Effect of Tax Reform17 - 15
The Supply-Side Effectsof a Tax Change
How Large Are Supply-Side Effects?
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The Not-So-Incredible Shrinking Deficit
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Automatic stabilizersBudget deficitBudget surplusCrowding outCyclically adjusted budget
deficit or surplusFiscal policyMultiplier effectTax wedge
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National Debt/GDP
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Who Is Debt Owed To?
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National Debt
National Debt – Some Simple Calculations
National Debt January 2007 per capita ($000)
(Pop = 300m)
Publicly-held USA 2674 8.9
Publicly-held-foreign 2240 7.5
US Government held 3794 12.6
Total 8708 29.0
Net Debt
Publicly-held USA 2674 8.9
Foreign-held 2240 7.5
Total 4914 16.4
Foreign debt as % of net debt 45.6%