Chapter 11

Fiscal PolicyFiscal Policy

Theory of Fiscal PolicyTheory of Fiscal Policy

What is fiscal policy? Government purchases, transfer payments, taxes,

and borrowing as they affect macroeconomic variables such as real GDP, employment, the price level, and economic growth.

Fiscal Policy ToolsFiscal Policy Tools

Two categories: Automatic stabilizers

Automatic stabilizers are revenue and spending programs in the federal budget that automatically adjust with the ups and downs of the economy to stabilize disposable income and, consequently, consumption and real GDP.

Example: Federal income tax Discretionary fiscal policy

Requires the deliberate manipulation of government purchases, transfer payments, and taxes to promote macroeconomic goals.

Discretionary Fiscal PolicyDiscretionary Fiscal Policy

Increases in government spending or decreases in taxes increases real GDP

Decreases in government spending or increases in taxes decreases real GDP

Changes in Government PurchasesChanges in Government Purchases

MPCG

1

1demanded GDP Real Δ

Increase government purchases– Stimulate the economy– Upward shift of Aggregate

Expenditure line– Increase in GDP

Effect of a $0.1 Trillion Increase in Government Purchases on Aggregate Expenditure and Real GDP

Demanded

C + I + G + (X - M)

a

14.0 14.50 Real GDP(trillions of dollars)

14.0

14.5

Agg

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45°

C + I + G’ + (X - M)

b

As a result of a $0.1 trillion increase in government purchases, the aggregate expenditure line shifts up by $0.1 trillion, increasing the real GDP demanded by $0.5 trillion. This model assumes price level remains unchanged.

0.1

Exhibit 1

Changes in Net TaxesChanges in Net Taxes Decrease in net taxes

Increases Disposable Income by ∆Net Taxes (NT) Increases Consumption by MPC ×∆NT Upward shift of Aggregate Expenditure line Increase in GDP

MPC

MPCΔNT

-MPC

-MPC

1demanded GDP Real Δ

1 multiplier tax Simple

14.0 14.40 Real GDP(trillions of dollars)

Effect of a $0.1 Trillion Decrease in Net Taxes on Aggregate Expenditure and Real GDP Demanded

C + I + G + (X - M)

a14.0

14.4

Agg

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C’ + I + G + (X - M)

c

As a result of a decrease in NT of $0.1 trillion, consumers, who are assumed to have a MPC of 0.8, spend $80 billion more and save $20 billion at every level of GDP. The consumption function shifts up by $80 billion, as does the AE line.

0.08

An $80 billion increase of AE line eventually increases real GDP demanded by $0.4 trillion. Keep in mind that the price level is assumed to remain constant during all this.

LO1 Exhibit 2

Discretionary Fiscal Policy to Close a Discretionary Fiscal Policy to Close a Contractionary GapContractionary Gap

When an economy is operating below its potential output, the Keynesian model suggests that the government should institute expansionary fiscal policy, by: increasing the government’s purchases

of goods & services, and/or, cutting taxes.

Discretionary Fiscal Policy to Close a Contractionary Gap

The aggregate demand curve AD and the short-run aggregate supply curve SRAS130 intersect at point e. Output falls short of the economy’s potential. The resulting contractionary gap is $0.5 trillion. This gap could be closed by discretionary fiscal policy that increases aggregate demand by just the right amount. An increase in government purchases, a decrease in net taxes, or some combination could shift aggregate demand out to AD*, moving the economy out to its

potential output at e*.

LO2 Exhibit 3P

rice

leve

l

125

130

AD

SRAS130

e

Potential outputLRAS

Real GDP

(trillions of dollars)0 14.0 14.513.5

AD*e’

e*

e’’

Discretionary Fiscal Policy to Close a Discretionary Fiscal Policy to Close a Expansionary GapExpansionary Gap

When inflation is a potential problem, Keynesian analysis suggests a shift toward a more contractionary fiscal policy by:

reducing government spending, and/or,

raising taxes.

Discretionary Fiscal Policy to Close an Expansionary Gap

The aggregate demand curve AD’ and the short-run aggregate supply curve SRAS130 intersect at point e’ resulting in an expansionary gap of $0.5 trillion.

Discretionary fiscal policy aimed at reducing aggregate demand by just the right amount could close this gap without inflation. An increase in net taxes, a decrease in government purchases, or some combination could shift aggregate demand back to AD* and move the economy back to its potential output at e*.

LO2 Exhibit 4P

rice

leve

l

135

130AD’

SRAS130

e’

Potential outputLRAS

Real GDP

(trillions of dollars)0 14.0 14.5

AD*

e*

e’’

Contractionary and Expansionary Contractionary and Expansionary Fiscal PolicyFiscal Policy

Difficult to achieve

Potential output gauged accurately

Spending multiplier predicted accurately

AD shifts by just the right amount

Government entities – coordinate fiscal efforts

Shape of SRAS curve is known, unaffected by the policy

The Multiplier and the Time HorizonThe Multiplier and the Time Horizon

Simple multiplier

Overstates ∆Real GDP

∆Real GDP depends

Steepness of SRAS curve

Production costs increase

The steeper SRAS curve

Less impact of an AD shift on real GDP

More impact on price level

The smaller the spending multiplier

The Evolution of Fiscal PolicyThe Evolution of Fiscal Policy

1. Prior to the Great Depression Classical economists

– Laissez-faire; Free markets– Balanced budget– Natural market forces

• Flexible:• Prices

• Wages

• Interest rates

• NO government intervention needed

Automatic StabilizersAutomatic Stabilizers

• Automatic Stabilizers: Without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom.

• The major advantage of automatic stabilizers is that they institute counter-cyclical fiscal policy without the delays associated with legislative action.

Automatic StabilizersAutomatic Stabilizers

• Examples of automatic stabilizers– Unemployment compensation– Corporate profit tax– A progressive income tax

The Evolution of Fiscal PolicyThe Evolution of Fiscal Policy

2. The Great Depression and World War II– Keynesian theory and policy

• Prices and wages: ‘Sticky’ downward• Increase AD

– WWII• Increase production• No cyclical unemployment

– Employment Act of 1946, Government:• Full employment• Economic stability

The Evolution of Fiscal PolicyThe Evolution of Fiscal Policy

3. From the Golden Age to Stagflation– 1960s: demand-management policy

• Increase or decrease AD– 1970s: Stagflation

• Higher inflation• Higher unemployment• From decreased AD

• Crop failures

• Higher OPEC-driven oil prices

• Adverse supply shocks

Fiscal Policy and the Natural Rate of Fiscal Policy and the Natural Rate of UnemploymentUnemployment

Underestimate natural rate of unemployment– Expansionary fiscal policy

• Increase AD; Short run:• Increase output

• Decrease unemployment

• Expansionary gap; Long run:• Decrease SRAS

• Inflation

• Decrease output

When Discretionary Fiscal Policy Overshoots Potential Output

If public officials underestimate the natural rate of unemployment, they may attempt to stimulate AD even if the economy is already producing at its potential output, a.This expansionary policy yields a short-run equilibrium at b, where the price level and output are higher and unemployment is lower, so the policy appears to succeed.But the resulting expansionary gap will, in the long-run, reduce the SRAS, eventually reducing output to its potential level of $14.0 trillion while increasing the price level to 140.Thus, attempts to increase production beyond its potential GDP lead only to inflation in the long-run

LO3 Exhibit 5P

rice

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l

130

140

AD

SRAS130

Potential outputLRAS

Real GDP

(trillions of dollars)0 14.0 14.2

AD’

b

a

SRAS140

c

Lags in Fiscal PolicyLags in Fiscal Policy Fiscal policy

– Time• Approve • Implement

– Less effective– Too late– More harm than good

Fiscal Policy and Permanent IncomeFiscal Policy and Permanent Income

Permanent income– On average, over long term

Temporary tax rate change– Not effective– Small change in personal income– Small change in consumption– Less saving

The Feedback Effects of Fiscal Policy The Feedback Effects of Fiscal Policy on ASon AS

Fiscal policy– Affects Aggregate Supply – unintentional– Higher unemployment benefits

• Unemployed; increase C• Paid: higher taxes on earnings

• Employed: decrease C• Same MPC for employed and unemployed

• No change in: AD, real GDP• Redistribution of income

• Decrease labor supply• Decrease AS

The Evolution of Fiscal PolicyThe Evolution of Fiscal Policy

4. Since 1990: from deficits to surpluses 1980s – mid-1990s: large deficits 1993 recovery under way

– Increase tax on high-income households 1994: Decreased federal spending 1993 – 1998

– Tax revenues: +8.3% per year– Federal outlays: +3.2% per year

The Evolution of Fiscal PolicyThe Evolution of Fiscal Policy4. Since 1990: from deficits to surpluses back to deficits

– 1998: Federal surplus $70 billion– 2000: Federal surplus $236 billion– Early 2001 – Recession: 10-year tax cut– September 11, 2001: Terrorist attack– 2003 – 2007 Recovery

– Employment: +8 million– Federal deficit (2004) $400 billion– Federal deficit (2007) under $200 billion

– Recession beginning December 2007– Federal deficit increased to $450 billion in 2008; now

forecast between $1 trillion and $2 trillion