Congress The President

BUDGET

Taxes Spending

FiscalPolicy

Fiscal Policy

• A tool of macroeconomic policy that seeks to influence the level of economic activity through control of government expenditure and taxation.

• There are two types of fiscal policy:– Automatic Stabilizers– Discretionary Policies

Fiscal Policy: Automatic Stabilizers

• Automatic stabilizers– Built in, non-discretionary elements in fiscal

policy that serve to reduce the impact of economic events automatically. For example,

• A fall in output and national income reduces government tax liabilities and increases unemployment and welfare payments.

– Lower tax receipts and higher transfer payments increase the government’s budget deficit and restore some of the lost income.

Fiscal Policy: Discretionary Policy

• Discretionary Fiscal Policy– Expansionary Fiscal Policy

• Decreases in taxes and/or increases in spending that tend to increase economic activity.

– Contractionary Fiscal Policy• Increases in taxes and/or decreases in spending that

tend to dampen economic activity.

• Fiscal policy may work on the demand side of the economy or the supply side.

Government Spending Rises

TaxesDecrease

Fiscal Policy: Demand Side Transmission Mechanism

InvestmentSpending isCrowded Out

ExportSpending isCrowded OutAggregate

Spending Increases

Price Level Rises

SpendingDecreases

Interest Rates Rise

DeficitIncreases

Imports RiseExports Fall

Expansionary Fiscal Policy

Government Spending Rises

TaxesDecrease

Fiscal Policy: Demand Side Transmission Mechanism

Export SpendingIs Crowded Out

InvestmentSpending isCrowded Out

Aggregate Spending Increases

Price Level Rises

SpendingDecreases

Interest Rates Rise

DeficitIncreases

Imports RiseExports Fall

Expansionary Fiscal Policy

Demand Side Logic: The Multiplier

• Expansionary fiscal policy causes aggregate demand to rise such that demand exceeds supply.– Government spending affects aggregate demand

directly.– Changing tax rates affects aggregate demand

primarily through changes in consumption spending.

Demand Side Logic: The Multiplier

• Inventories fall unexpectedly, prompting firms to produce more output.

• As output increases, income rises, causing consumption to rise.

• Once again, demand exceeds supply, causing inventories to fall…….etc.

The Multiplier: Summary

/\ Gov’t Spend /\ Inventories /\ Income /\ Consumption

$100 $100 $100 $90 $90 $90 $81

$81 $81 $72.90 $72.90 $72.90 $65.61 $65.61 $65.61 $59.05

$100 $1000 $1000 $900

The Multiplier: An Example

1) Government spending rises by $100.

2) Aggregate demand rises by $100 and now exceeds current aggregate supply by $100.

3) Inventories fall by $100.

4) Firms produce just enough to replace the inventories.

The Multiplier: An Example

5) Production and national income rise by $100.

6) Consumption now rises, but not by $100.– Consumption rises by less than $100 because some

part of the increase in income is saved.

7) Let consumption rise by $90.

8) Repeat from step 2.

Government Spending Rises

TaxesDecrease

Fiscal Policy: Demand Side Transmission Mechanism

InvestmentSpending isCrowded Out

ExportSpending isCrowded OutAggregate

Spending Increases

Price Level Rises

SpendingDecreases

Interest Rates Rise

DeficitIncreases

Imports RiseExports Fall

Expansionary Fiscal Policy

Demand Side Logic: Interest Rates

• As the economy expands, demand for credit increases.

• If the Federal Reserve does not fully accommodate the rise in credit demand, interest rates rise.– Rising interest rates tend to dampen investment

spending.

Demand Side Logic: Interest Rates

• If as interest rates rise, assets in the USA become more attractive than assets in the rest of the world, the dollar rises.– An increase in the value of the dollar tends to

cause exports to fall.

Demand Side Logic: Price Level

• As the economy expands, firms compete with each other for resources.– There is a tendency at some point for factor

payments to rise.

• If monetary policy is accommodative, the price level rises.

• At full employment of resources, further expansion of spending results in pure inflation.

Expansionary Demand Side Fiscal Policy

AD1

SRAS

Y

P

Y1 Y2* Y3

P1

AD2

P2

Expansionary fiscal policyshifts the AD curve from AD1 to AD2.

If prices do not rise, the fiscal stimulus causes Y to rise to Y3.

But as Y rises money demand rises,causing interest rates to rise andinvestment and net exportsto rise by smaller amounts. As Y rises, competition for resources causes other prices to rise.

Equilibrium Y occurs at Y2 and P2.

National income rises from Y1

to Y2*. Prices rise from P1 to P2.

0

LRAS

Contractionary Demand Side Fiscal Policy

AD1

SRAS

Y

P

Y1 Y2* Y3

P1

AD2

P2

Contractionary fiscal policyshifts the AD curve from AD2 to AD1.If prices do not fall, the fiscal contraction causes Y to fall to Y1.

But as Y falls, money demand falls,causing interest rates to fall andinvestment and net exportsto fall by smaller amounts. As Y falls, less competition for resources causes other prices to fall.

Equilibrium Y occurs at Y2 and P1.

National income falls from Y1

to Y2. Prices fall from P2 to P1.

0

LRAS

Demand Side Fiscal Policy and Deficits

• Summary:– Tax cuts and increased government spending lead

to government budget deficits.– But, as output rises, so do tax revenues so

ultimately the revenues lost because of the rate decrease are recovered as the tax base expands.

• Conclusion: The deficit may increase or decrease.

Fiscal Policy: Supply Side

• Expansionary fiscal policy– The federal government decreases taxes.

• People work more: People save more: Firms invest more.

• Aggregate supply increases, unemployment falls, inflation falls.

Fiscal Policy: Supply Side

• Contractionary fiscal policy– The federal government increases taxes.

• People work less: People save less: Firms invest less.

• Aggregate supply decreases, unemployment rises, inflation rises.

Fiscal Policy: Supply Side Fiscal Policy: Supply Side Transmission MechanismTransmission Mechanism

ProductivityRises

After-tax ROR Rises

Investment Rises

Interest RatesFall

After-tax WageHigher

Increase in Labor Supply

Lower BusinessTax Rates

Lower PersonalTax Rates

Savings Rise

Aggregate SupplyRises

Unemployment Falls

Inflation Falls

Tax Cuts: Labor Supply

• The decrease in marginal income tax rates encourages people to work more.– People are willing to work more because they now

keep more of their wages.• More specifically, they get to keep more of the last

dollar earned.

– Therefore, the increased labor supply increases output without putting upward pressure on wages.

Tax Cuts: Saving and Investment

• Business tax cuts increase business profits.– Higher profits encourage investment in new

capital.

• Individual tax cuts stimulate household savings.– Increased savings contribute to lower interest rates

and increased investment in new capital.

• New capital increases productivity, thus, lowering costs and inflationary pressures.

Expansionary Supply Side Fiscal Policy

AD1

SRAS1

Y

P

Y1 Y2*

P1

P2

Expansionary fiscal policyshifts the AS curve from AS1 to AS2.

As productivity rises and costs fall, output increases while prices fall.

Equilibrium Y occurs at Y2 and P2.

National income rises from Y1

to Y2. Prices fall from P1 to P2.

0

SRAS2

LRAS

Supply Side Fiscal Policy and Deficits

• Summary:– Tax cuts lead to increased economic activity.– As output rises, so do tax revenues so ultimately

the revenues lost because of the rate decrease are recovered as the tax base expands.

• Conclusion: The deficit may decrease if government spending does not rise.