Fiscal Policy

How much spending does it take?

Introduction

• http://www.youtube.com/watch?v=1qhJPqyJR o8&feature=plcp&context=C49f6c9cVDvjVQa1 PpcFMdkWSNt1EsUKtB5fYByDq14YICcdVaANI %3D

What is FISCAL Policy?

Fiscal Policy Spending – where does it all go?

• http://www.nytimes.com/interactive/2012/ 02/13/us/politics/2013-budget-proposal graphic.html

HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND • •

Fiscal policy

– taxing, spending, and borrowing • influences saving, investment, and growth in the long run.

• In the short run, fiscal policy primarily affects the aggregate demand.

What are challenges to fiscal policy implementation?

Changes in Government Purchases

• There are two macroeconomic effects from the change in government purchases: – The multiplier effect – The crowding-out effect http://www.youtube.com/watch?v=H3nyc8XHrQc

The Multiplier Effect

• Government purchases are said to have a multiplier effect on aggregate demand.

– Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.

Price Level

Figure 4 The Multiplier Effect

2. . . . but the multiplier effect can amplify the shift in aggregate demand.

$20 billion 0

AD

3 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion . . .

AD

2 Aggregate demand,

AD

1

Quantity of Output

A Formula for the Spending Multiplier • The formula for the multiplier is: – Multiplier = 1/(1 – MPC) – An important number in this formula is the marginal propensity to consume (MPC).

• It is the fraction of extra income that a household consumes rather than saves.

A Formula for the Spending Multiplier • • If the MPC = 3/4, then the multiplier will be: Multiplier = 1/(1 – 3/4) = 4 In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

The Crowding-Out Effect

• • • Fiscal policy may not affect the economy as strongly as predicted by the multiplier.

An increase in government purchases causes the interest rate to rise.

What are the consequences of a higer interest rate?

The Crowding-Out Effect

• • This reduction in demand that results when a fiscal expansion raises the interest rate is called the

crowding-out effect

.

The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

Figure 5 The Crowding-Out Effect

Interest Rate

Money supply

(a) The Money Market

2. . . . the increase in spending increases money demand . . .

Price Level (b) The Shift in Aggregate Demand

$20 billion 4. . . . which in turn partly offsets the initial increase in aggregate demand.

r

2 3. . . . which increases the equilibrium interest rate . . .

r

0 Quantity fixed by the Fed

MD

2 Money demand, MD

Quantity of Money

AD

2

AD

3 0 Aggregate demand, AD 1 1. When an increase in government purchases increases aggregate demand . . .

Quantity of Output

http://www.youtube.com/watch?v=RGlt0nEQdRI&feature=plc p&context=C48ec1e6VDvjVQa1PpcFMdkWSNt1EsUByRZ_JiwO oaMf6ZO6WVkJM%3D

Changes in Taxes

• • • • When the government cuts personal income taxes, it increases households’ take-home pay.

Households save some of this additional income.

Households also spend some of it on consumer goods.

Increased household spending shifts the aggregate-demand curve to the right.

Changes in Taxes

• • The size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding-out effects.

It is also determined by the households’ perceptions about the permanency of the tax change.

What are the Types of Taxes?

• • •

Proportional Taxes

•

A tax with a constant % paid regardless of income

•

Flat tax Progressive Taxes

•

A tax where the % paid in taxes increases as income increases

•

U.S. Personal Income Tax Regressive Taxes

•

The lower your income the higher % you pay in taxes

•

Sales Tax

Proportional, regressive, or progressive?

USING POLICY TO STABILIZE THE ECONOMY • Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946, which states that: – “it is the continuing policy and responsibility of the federal government to…promote full employment and production.”

The Case for Active Stabilization Policy • The Employment Act has two implications: – The government should avoid being the cause of economic fluctuations.

– The government should respond to changes in the private economy in order to stabilize aggregate demand.

– What economic school of thought does this follow? Who would be against active stablization?

The Case against Active Stabilization Policy • • • Some economists argue that monetary and fiscal policy destabilizes the economy.

Monetary and fiscal policy affect the economy with a substantial lag – rational expectations!!!

They suggest the economy should be left to deal with the short-run fluctuations on its own.

Automatic Stabilizers

• •

Automatic stabilizers

are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

Automatic stabilizers include the tax system and some forms of government spending.