Fiscal Policy Changes in federal taxes and purchases

Where does the government spend its money?

Federal Government Spending, 2010

Fiscal Policy

An Overview of Government Spending and Taxes

The Federal Government’s Share of Total Government Expenditures, 1929–2009

Fiscal Policy An Overview of Government Spending and Taxes

Federal Purchases and Federal Expenditures as a Percentage of GDP, 1950–2010

Where does the government get its money?

Federal Government Revenue, 2010

Laffer Curve (not in the book): there is optimal amount of taxation

Tax

Go

vern

me

nt

reve

nu

e

Government spending/taxes and aggregate demand

The Effects of Fiscal Policy on Real GDP and the Price Level

Expansionary and Contractionary Fiscal Policy: An Initial Look

Using Fiscal Policy to Influence Aggregate Demand: A More Complete Account

An Expansionary Fiscal Policy

Using Fiscal Policy to Influence Aggregate Demand: A More Complete Account

A Contractionary Fiscal Policy

A Summary of How Fiscal Policy Affects Aggregate Demand

Countercyclical Fiscal Policy

PROBLEM TYPE OF POLICY

ACTIONS 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.

Don’t Let This Happen to YOU! Don’t Confuse Fiscal Policy and Monetary Policy

Multiplier (again)

The Government Purchases and Aggregate Demand

The Multiplier Effect and Aggregate Demand

Taking into Account the Effects of Aggregate Supply

The Multiplier Effect and Aggregate Supply

The Government Purchases and Tax Multipliers

The Multiplier Effect of an Increase in Government Purchases

Change in equilibrium real GDPGovernment purchases multiplier

Change in government purchases

Change in equilibrium real GDPTax multiplier

Change in taxes

The Government Purchases and Tax Multipliers

The ratio of the change in equilibrium real GDP to the initial change in government purchases is known as the government purchases multiplier:

The expression for the tax multiplier is:

A cut in tax rates affects equilibrium real GDP through two channels:

(1) A cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending, and

(2) a cut in tax rates increases the size of the multiplier effect.

Decrease and increases in government expenditure are multiplied

Decrease and increase in taxes are multiplied

The Multipliers Work in Both Directions

Solved Problem Fiscal Policy Multipliers

Briefly explain whether you agree or disagree with the following statement: “Real GDP is currently $12.2 trillion, and potential real GDP is $12.5 trillion. If Congress and the president would increase government purchases by $300 billion or cut taxes by $300 billion, the economy could be brought to equilibrium at potential GDP.”

Change in equilibrium real GDPGovernment purchases multiplier

Change in government purchases

Crowding out A decline in private expenditures as a result of

an increase in government purchases.

Crowding out limits Fiscal Policy in the short run.

Crowding Out in the Money Market

An Expansionary Fiscal Policy Increases Interest Rates

In the long run, the economy returns to potential GDP.

Crowding Out in the Aggregate Demand and Aggregate Supply Diagram

Budget Deficit

Budget deficit The situation in which the government’s expenditures are greater than its tax revenue.

Budget surplus The situation in which the government’s expenditures are less than its tax revenue.

Deficits, Surpluses, and Federal Government Debt

The Federal Budget Deficit, 1901–2009

Solved Problem The Effect of Economic Fluctuations on the Budget Deficit

The federal government’s budget deficit was $207.8 billion in 1983 and $185.4 billion in 1984. A student comments, “The government must have acted during 1984 to raise taxes or cut spending or both.” Do you agree? Briefly explain.

Cyclically adjusted budget deficit or surplus: The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

Deficits, Surpluses, and Federal Government Debt

How the Federal Budget Can Serve as an Automatic Stabilizer

Debt can be a problem for a government for the same reasons that debt can be a problem for a household or a business.

Deficits, Surpluses, and Federal Government Debt

Is Government Debt a Problem?

Although many economists believe that it is a good idea for the federal government to have a balanced budget when the economy is at potential GDP, few economists believe that the federal government should attempt to balance its budget every year.

Deficits, Surpluses, and Federal Government Debt

Should the Federal Budget Always Be Balanced?

•Did Fiscal Policy Fail during the Great Depression?

Making the

Connection

Although government spending increased during the Great Depression, the cyclically adjusted budget was in surplus most years.

FEDERAL

GOVERNMENT

EXPENDITURES

(BILLIONS OF

DOLLARS

ACTUALFEDERAL

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

Tax wedge The difference between the pretax and posttax return to an economic activity.

The Effects of Fiscal Policy in the Long Run

The Long-Run Effects of Tax Policy

• Individual income tax.

• Corporate income tax.

• Taxes on dividends and capital gains.

We can look briefly at the effects on aggregate supply of cutting each of the following taxes:

In addition to the potential gains from cutting individual taxes, there are also gains from tax simplification.

Tax Simplification

The Effects of Fiscal Policy in the Long Run

The Economic Effect of Tax Reform The Supply-Side Effects of a Tax Change

Most economists would agree that there are supply-side effects to reducing taxes: Decreasing marginal income tax rates will increase the quantity of labor supplied, cutting the corporate income tax will increase investment spending, and so on.

The magnitude of the effects is subject to considerable debate, however.

The Effects of Fiscal Policy in the Long Run

How Large Are Supply-Side Effects?