Transcript Chapter 11

Macroeconomics
Unit 11
Fiscal Policy Decisions
Top 5 Concepts
Introduction
This unit discusses the use of fiscal policy tools or levers
(basically Keynesian ideas) to restore the economy to full
employment.
Recessions and inflationary periods are examined. Also
discussed are some of the problems associated with focusing
only on demand.
Could our federal government actually reduce spending to
control inflation?
Concept 1: Fiscal Policy
When we study fiscal policy we are examining how the federal
government can alter macroeconomic outcomes.
Fiscal policy uses Keynesian techniques to change aggregate
demand. Often these changes are called using fiscal policy
levers.
Fiscal policy is the use of federal government taxes, spending,
and transfer payments to alter macroeconomic outcomes.
Concept 1: Fiscal Policy
The federal government can change aggregate demand by:
• Purchasing more or fewer goods and services.
• Raising or lowering individual income and corporate taxes.
• Changing the level of income transfers.
All of these tools are implemented through the federal budget
and require congressional and presidential approval.
Concept 1: Fiscal Policy
Fiscal policy tools are designed to shift aggregate demand by
increasing aggregate expenditures.
Usually we are concerned about achieving a level of output
(GDP) where we are at full employment.
Often we are confronted with a recessionary GDP gap, which is
the amount by which equilibrium GDP falls below fullemployment GDP.
The intent is to use fiscal policy tools to close the gap.
Using Fiscal Stimulus
The obvious solution to close the recessionary gap is to shift
aggregate demand to the right using a fiscal policy tool that
stimulates the economy.
Tax cuts, increasing government spending, and increasing
transfer payments are all viable ways to shift aggregate
demand to the right.
The problem with this strategy is that shifting AD to the right
also causes average prices to increase.
Price Level (average price)
Closing the recessionary GDP Gap
AD needs to shift right from QE to QF, from point a to b –
but the supply curve is not horizontal, so prices increase.
AS
Full-employment GDP
AD1
a
PE
GDP Equilibrium
b
GDP gap
QE = 5.6
6.0 = QF
Real GDP (in trillions $)
Using Fiscal Stimulus
Shifting aggregate demand to the right causes movement up
the AS curve.
The movement up the AS curve indicates prices are increasing.
Since prices are increasing, consumers are required to pay
more for goods and services. Even though increased spending
is occurring, the increases in price have offset part of the
increased spending by consumers.
As a result we fail to achieve full employment output.
Concept 2: The AD Shortfall
Because of rising prices, we fail to achieve the demand
necessary for full employment. This creates the AD shortfall.
The AD shortfall is the amount of additional aggregate
demand needed to achieve full employment after allowing for
price-level changes.
Therefore in order to achieve our full-employment output goal,
we need to increase aggregate demand an additional amount
which compensates for the increase in average prices as
aggregate demand shifts to the right.
Price Level (average price)
Concept 2: The AD Shortfall
AS
AD3
AD2
d
AD1
c
a
PE
b
e
Recessionary
GDP gap
AD shortfall
QE = 5.6
QF = 6.0
Real GDP (in trillions $)
6.4
Concept 2: The AD Shortfall
As you examine the previous graph, notice that as we move AD
from AD1 to AD2, equilibrium does not occur at point b. It
occurs at point c which is below our desired output level.
Additional fiscal stimulus can shift AD from AD2 to AD3 and
equilibrium is reached at point d. Unfortunately, higher average
prices exist at this level.
The AD shortfall, which is the distance between point a and
point e, is eliminated and full employment is achieved, although
average prices are higher.
Multiplier Effect
The entire amount of the AD shortfall does not require funds
directly from the federal government.
An initial increase in government spending, decrease in taxes,
or an increase in transfer payments, causes a multiplier effect
as it moves through the economy.
The multiplier is the multiple by which an initial change in
aggregate spending will alter total expenditures after an infinite
number of spending cycles.
Multiplier Effect
Multiplier = 1/ (1-MPC)
We can use the multiplier to help us determine the total change
in spending and the amount of fiscal stimulus needed.
For example, if the government increases spending by $200
billion, the AD curve will initially shift to the right by $200 billion.
If our MPC = .75, then the multiplier is 4.
The total change in spending produced by our initial $200
billion spending increase = 4 X $200 billion = $800 billion.
Concept 3: Multiplier Effect
The initial increase in spending by the government of $200
billion shifted AD to the right by $200 billion.
The multiplier effect tells us that an additional $600 billion of
consumption will occur as the initial spending increase moves
through the economy.
The total change in spending = $800 billion which includes the
initial $200 billion.
Concept 3: Multiplier Effect
If we are fortunate enough to know what our gap is, we can
determine how much government spending is necessary to
close the gap (desired fiscal stimulus).
Desired Fiscal Stimulus = AD shortfall / the multiplier
In our previous example, the amount of the AD shortfall was
$800 billion, and the multiplier was 4.
Therefore our desired fiscal stimulus is $800 billion/4 = $200
billion.
Concept 3: Multiplier Effect
So far we have computed the multiplier effect for increased
government spending.
We found that any initial increase in government spending
causes a direct increase in AD.
As the initial increase moves through the economy, the total
change in spending is determined by the multiplier effect.
But what if we use tax cuts or increased transfer payments
instead? Are there any differences?
Concept 3: Multiplier Effect
Tax Cuts – Cutting taxes is another way to shift AD to the right
and increase spending.
Unlike government spending, the initial amount of spending
resulting from a tax cut is dependent upon the MPC.
Why? Because a portion of any tax cut will be saved not spent.
Therefore it does not provide an immediate economic stimulus
and help shift AD to the right.
Concept 3: Multiplier Effect
To determine the effects of a tax cut, we must first calculate the
initial increase in consumption.
Initial increase = MPC X tax cut amount
If taxes are cut by $200 billion, and our MPC = .75, then our
initial increase in consumption = .75 X $200 billion = $150
billion. The total or cumulative effect of the tax cut would be =
multiplier X initial change in consumption.
4 X $150 billion = $600 billion
Concept 3: Multiplier Effect
Notice that the total effect of a tax cut using the same initial
amount of $200 billion is $600 billion.
If we used government spending then the total effect would be
$800 billion. Why is there a difference?
Consumer savings takes a portion of the tax cut – part of the
cut does not get immediately spent.
The amount saved will vary based upon the MPC. The higher
the MPC the less saved by consumers.
Concept 3: Multiplier Effect
Government spending provides more fiscal stimulus than tax
cuts, assuming the MPC is less than 1.00.
The third option to shift AD is to increase transfer payments
(Social Security, Unemployment, etc.).
The effect of increasing transfer payments is the same as the
effect of tax cuts. A portion of the transfer payment increase
gets saved. This amount is determined by the MPC. Therefore
both increased transfer payments and tax cuts are less
effective than increased government spending at shifting
aggregate demand (spending) to the right.
Multiplier Effect – Summary
$100 billion, MPC .75
Increase
Gov’t
Spending
Tax Cuts
Initial
Effect
$100 billion
$100 X .75 =
$75 billion
Total
Effect
$100 X 1/1-.75 $75 X 1/1-.75
= $400 billion = $300 billion
Increase
Transfer
Payments
$100 X .75 =
$75 billion
$75 X 1/1-.75
= $300 billion
Fiscal Restraint
Sometimes we want to decrease aggregate demand.
This occurs when we have an inflationary GDP gap.
Instead of an AD shortfall we have AD excess.
AD excess is the amount by which aggregate demand must be
reduced to achieve full-employment equilibrium after allowing
for price-level changes. Our equilibrium point is above the level
of full-employment output.
Price Level (average price)
Excess Aggregate Demand
Target
AS
PE
f
E1
E2
PF
Inflationary
GDP gap
Excess AD
Q2 = 5.8
QF = 6.0
AD1
AD2
Q1 = 6.2
Real Output (in trillions $)
Excess Aggregate Demand
The previous slide illustrates excessive AD at AD1. The goal is
to shift AD to the left, from the equilibrium point E1 to E2.
Falling prices will cause demand to increase. Therefore our
policy target is to shift AD far enough to the left to compensate
for increased demand due to lower prices.
Our output target is found at point f on the new demand curve
AD2. We fail to achieve that target because of falling prices,
but we reach equilibrium at E2 which is full employment output.
Concept 4: Fiscal Restraint/Inflationary GDP Gap
When we have AD excess we will need to reduce aggregate
demand by an amount greater than the inflationary gap.
This is necessary because as we reduce aggregate demand,
average prices decline and spending increases (desired fiscal
restraint).
The desired fiscal restraint = excess AD / the multiplier
If our multiplier is 4 (MPC = .75) and our excess AD = $400 billion,
then our desired fiscal restraint = $400 billion / 4 = $100 billion.
Concept 4: Fiscal Restraint/Inflationary GDP Gap
Once we have a dollar target for our fiscal restraint, then the
federal budget can be reduced to accomplish our goal.
Another way to look at fiscal restraint is to take an amount and
determine the total effect.
If we cut spending by $100 billion, then our cumulative effect =
multiplier X initial budget cut.
A cut of $100 billion, with an MPC of .75 (multiplier = 4)
provides a cumulative effect of 4 X $100 billion = $400 billion.
Concept 4: Fiscal Restraint/Inflationary GDP Gap
Similar to increased spending, decreased government
spending has a multiplier effect for each dollar cut.
We could also increase taxes to reduce aggregate demand.
If we wish to increase taxes, then we must recognize that we
will need to increase them more than our target for government
spending. Why? Because once again we must contend with
the fact that currently a portion of all consumer spending is
saved and this savings must also be considered when taxes
are increased.
Concept 4: Fiscal Restraint/Inflationary GDP Gap
To determine the amount of a tax increase:
Desired Increase/Taxes = desired fiscal restraint / MPC
The desired fiscal restraint = excess AD / the multiplier
So once we know the amount of excess AD we have, and the
multiplier, we can determine the amount of tax increase
necessary to reduce AD.
Concept 4: Fiscal Restraint/Inflationary GDP Gap
Let’s figure it out!
Desired fiscal restraint = excess AD / the multiplier
If our MPC = .75, the multiplier is 4. If our excess AD = $400
billion, then the desired fiscal restraint =
$400 billion / 4 = $100 billion. $100 billion is our desired fiscal
restraint (spending reduction).
Concept 4: Fiscal Restraint/Inflationary GDP Gap
Now we can take our value for fiscal restraint of $100 billion,
and determine our tax increase.
Desired Increase/taxes = fiscal restraint / MPC
$100 billion / .75 = $133 billion
So if we increase taxes by $133 billion, consumption drops by
$100 billion initially, and the cumulative effect is $400 billion.
Concept 4: Fiscal Restraint/Inflationary GDP Gap
The third option for fiscal restraint is similar to the third option
for increased spending – changing transfer payments.
Reducing transfer payments has the same effect as a tax hike.
The disposable income of recipients is reduced and spending
declines.
Reductions in transfer payments target specific groups of
people who may not be the proper target for reduced spending.
Therefore it is unlikely that this group would be targeted in an
effort to reduce spending.
Concept 4: Fiscal Restraint/Inflationary GDP Gap
To determine the amount of a transfer payment decrease:
Desired transfer payment decrease = desired fiscal restraint /
MPC
The desired fiscal restraint = excess AD / the multiplier
So once we know the amount of excess AD we have, and the
multiplier, we can determine the amount that transfer payments
need to be reduced to cause a reduction in AD.
Concept 4: Fiscal Restraint/Inflationary GDP Gap
To determine the reduction in transfer payments we first
determine the amount of the desired fiscal restraint.
Desired fiscal restraint = excess AD / the multiplier
If our MPC = .90, the multiplier is 10. If our excess AD = $400
billion, then the desired fiscal restraint = $400 billion / 10 = $40
billion.
Concept 4: Fiscal Restraint/Inflationary GDP Gap
Now we can take our value for fiscal restraint of $40 billion, and
determine the amount that transfer payments need to be
reduced.
Desired reduction in transfer payments = fiscal restraint / MPC
Since our MPC = .90, we solve the equation by:
Desired reduction in transfer payments = $40 billion / .90 =
$44.44 billion. Therefore if we reduce transfer payments by
$44.44 billion, consumer consumption (demand) decreases by
$40 billion, and the cumulative effect is $400 billion.
Concept 5: Problems
Several problems can occur with the implementation of fiscal
policy decisions.
Crowding out – If the government borrows significant funds to
finance its spending, the borrowing may “crowd out” some
private sector borrowing and cause a further reduction in AD.
Businesses may postpone further investment.
Time Lags – Implementing changes in fiscal policy requires
time, budgetary, and congressional approval. It may take some
time to determine the economy is in trouble. In addition it takes
time for the multiplier effect to occur. All of these factors limit
the effectiveness of fiscal policy decisions.
Concept 5: Problems
One problem that may cause a significant problem is PorkBarrel Politics. Members of Congress have their own needs
and priorities and spending cuts, tax cuts, or tax increases may
not be popular. Pork-Barrel politics refers to the situation when
elected officials are more interested in spending and programs
that help them get reelected than overall fiscal responsibility.
Tax cuts may be popular among some politicians but deciding
who gets the cuts and how much should they receive could be
a problem. If changes in spending are proposed, how is the
money going to be spent? Often these decisions require
additional debate and time. Finally, no one likes to raise taxes,
especially near an election!
Summary
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Fiscal policy.
Fiscal Stimulus.
AD Shortfall.
Multiplier effect.
Calculating the desired fiscal stimulus.
Excess AD.
Fiscal Restraint.
Crowding out, time lags.
Pork Barrel Politics.