Reminder: C, I, GLet’s Look at G now…

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.

Sources of Tax Revenue in the United States, 2007

Fiscal Policy (cont’d)

• Expansionary Fiscal Policy is used by the government to fight a recession or to stimulate an economy in order to prevent recession

• Contractionary Fiscal Policy is used by the government to fight an overheated economy or to prevent an economy from overheating

Expansionary Fiscal Policy

• Increased Government Spending– Higher levels of spending by the

government will stimulate aggregate demand, increasing employment & GDP

– Franklin D. Roosevelt’s “New Deal” programs were an example of expansionary fiscal policy

– Increased government spending can have a “trickle down” effect – ultimately putting more money into the hands of consumers

Expansionary Fiscal Policy (cont’d)

• Reduced Taxation– Allows consumers to keep a higher

percentage of their income, stimulating higher levels of consumption, thereby increasing aggregate demand

– George W. Bush’s tax rebate at the beginning of his first term was an example of expansionary fiscal policy intended to stimulate consumption and increase aggregate demand

Expansionary Fiscal Policy

• Government officials may also choose to utilize a combination of increased government spending and reduced taxation in order to bring about the desired result

Expansionary and Contractionary Fiscal Policy

Expansionary Fiscal Policy Can Close a Recessionary Gap

Expansionary fiscal policy increases

aggregate demand.

Recessionary gap

Potential output

Contractionary Fiscal Policy

• Reduced Government Spending– Reduced levels of government spending

will slow an economy that is facing inflationary pressure

– Reduced government spending will reduce aggregate demand, increase unemployment and lower GDP

Contractionary Fiscal Policy

• Increased Taxation– Increased levels of taxation will reduce

the percentage of income that consumers are able to keep, slowing consumption, shifting the AD curve to the left, reducing GDP and increasing unemployment

Contractionary Fiscal Policy

• The government may choose to enact a combination of reduced spending and increased taxation to bring about a decrease in aggregate demand

Expansionary and Contractionary Fiscal PolicyContractionary Fiscal Policy Can Eliminate an Inflationary Gap

Contractionary fiscal policy reduces

aggregate demand.

Inflationary gap

Potential output

A Cautionary Note: Lags in Fiscal Policy

• In the case of fiscal policy, there is an important reason for caution: there are significant lags in its use.– Realize the recessionary/inflationary gap by

collecting and analyzing economic data takes time

– Government develops a spending plan takes time

– Implementation of the action plan (spending the money takes time

ECONOMICS IN ACTION

What Was in the Recovery Act?

• The answer is: it’s a bit complicated.• The numbers are broken down into four categories, not

three.– “Infrastructure and other spending” means spending on

roads, bridges, and schools, as well as “nontraditional” infrastructure like research and development – all of which fall under government purchases of goods and services.

– Tax cuts are self-explanatory. – Transfer payments to persons mostly took the form of

expanded benefits for the unemployed. – But a fourth category, transfers to state and local

governments, accounted for roughly a quarter of the funds. What’s that about?

ECONOMICS IN ACTION

What Was in the Recovery Act?

• America has multiple levels of government. – One effect of the recession was a sharp drop in revenues at the

state and local level, which in turn forced these lower levels of government to cut spending.

– Federal aid—those transfers to state and local governments—was intended to mitigate these spending cuts.

• Perhaps the most surprising aspect of the Recovery Act was how little direct federal spending on goods and services was involved.

• The great bulk of the program involved giving money to other people, one way or another, in the hope that they would spend it.

Fiscal Policy and the Multiplier

• The size of the shift of the aggregate demand curve depends on the type of fiscal policy.

• The multiplier on changes in government purchases, 1/(1 − MPC), is larger than the multiplier on changes in taxes or transfers, MPC/(1 − MPC), because part of any change in taxes or transfers is absorbed by savings.

• Changes in government purchases have a more powerful effect on the economy than equal-sized changes in taxes or transfers.

The Spending Multiplier

• A change in fiscal policy will have a “magnified” effect on the economy as a result of the spending multiplier

• Each additional dollar spent is assumed to be at least fractionally “re-spent”, resulting in an even more significant boost for the economy

The Spending Multiplier

• Economists assume that if the government decides to spend more money on goods and services, that the additional dollars will “multiply” as they are “re-spent” by firms and consumers

• An increase of $1,000,000 in spending by the national government will result in an increase of more than $1,000,000 in Real GDP

The Spending Multiplier

• For each additional dollar spent, a fraction of that dollar will be “re-spent”

• The fraction of a dollar that is “re-spent” is called the Marginal Propensity to Consume

• The fraction of a dollar that is saved represents the Marginal Propensity to Save.

The Spending Multiplier – An Example

• Assume that you make an annual salary of $100,000

• An analysis of your spending indicates that you spend $90,000 per year and save $10,000 per year

• What happens if you receive a raise of $10,000 per year?

The Spending Multiplier – An Example

• Once you have received that raise of $10,000 per year, we discover that you now spend and additional $5,000 per year – saving the remaining $5,000 of your raise

• Your marginal propensity to consume is .5

• Mathmatically: Δ in C/Δ in Y = MPC

The Spending Multiplier – An Example

• It is also possible to calculate the Marginal Propensity to Save (MPS)

• MPS is the fraction of each additional dollar received that will be saved

• MPS= Δ in savings/Δ in income• Your MPS in this case is also .5

The Spending Multiplier – An Example

• Now that we have calculated your MPC and your MPS, so what?

• We can use these values to determine the impact of an increase (or decrease) in government spending

• The spending multiplier is represented as:

• 1/1 – MPC OR 1/MPS

The Spending Multiplier – An Example

• Let’s assume that you are exactly representative of the average American in terms of your MPS & MPC

• What will happen when the government increases spending by $100 million?

The Spending Multiplier – An Example

• New spending x The Spending Multiplier = Actual impact on RGDP

• 1/1 - .5 = 2 (The spending multiplier)• $100 million x 2 = $200 million increase to

RGDP• In this case, the increase in government

spending of $100 million will actually increase RGDP by $200 million

The Spending Multiplier – An Example

• The higher the MPC, the greater the spending multiplier, and the more significant the impact upon RGDP

• Example:– MPC = .8– Spending Multiplier= 1/1-.8 = 1/.2 = 5– $100 Million x 5 = $500 million impact

on RGDP

The Spending Multiplier

• Key point – for every “new” dollar spent, it can only be saved or spent

• The more of each new dollar that is spent (MPC), the greater the impact of an increase

• Spending by the government on goods and services becomes income for the firms, then income for the workers, then consumption etc.

• This is how expansionary fiscal policy stimulates AD to fight recession

Fiscal Policy and the Multiplier

Multiplier Effects of Changes in Taxes and Government Transfers

Hypothetical Effects of a Fiscal Policy with Multiplier of 2

Differences in the Effect of Expansionary Fiscal Policies