Transcript Fiscal Policy

ECON 151 – Macroeconomics
Instructor: Bob DiPaolo
Fiscal Policy Levers
Chapter 11
Materials include content from McGraw-Hill/Irwin which has been modified by the
instructor and displayed with permission of the publisher. All rights reserved.
Introduction
Keynesian theory of macro instability leads
directly to a mandate for government
intervention
 This chapter confronts the following
questions:

 Can
government spending and tax policies
help ensure full employment?
 What policy actions will help fight inflation?
 What are the roles of government
intervention?
Taxes and Spending
Up until 1915, the federal government
collected few taxes and spent little.
 In 1902, it employed fewer than 350,000
people and spent $650 million.
 Today, it employs nearly 5 million people
and spends more than $2 trillion.

Government Revenue
Government expansion started with the
16th Amendment to the U.S. Constitution
(1913) which extended the taxing power to
incomes.
 Today, the federal government collects
over $2 trillion a year in tax revenues.

Government Expenditure

Government spending directly affects
aggregate demand.
 Aggregate
demand is the total quantity of
output demanded at alternative price levels in
a given time period, ceteris paribus.
Purchases vs. Transfers

To understand how government spending
affects aggregate demand, we must
distinguish between government
purchases and income transfers.
Government Expenditure
Government spending on defense,
highways, and health care is part of
aggregate demand.
 Income transfers don’t become part of AD
until recipients decide to spend income.

 Income
transfers are payments to individuals
for which no current goods or services are
exchanged, such as Social Security, welfare,
unemployment benefits.
Fiscal Policy
The federal government’s tax and
spending powers give it a great deal of
influence over aggregate demand.
 The federal government can alter
aggregate demand by:

 Purchasing
more or fewer goods and services.
 Raising or lowering taxes.
 Changing the level of income transfer.
Fiscal Policy
Fiscal policy is the use of government
taxes and spending to alter
macroeconomic outcomes.
 From a macro perspective, the federal
budget is a tool that can change aggregate
demand and macroeconomic outcomes.

Fiscal Policy
DETERMINANTS
Internal market
forces
OUTCOMES
AS
Output
Jobs
Prices
External
shocks
Growth
Policy levers:
Fiscal policy
AD
International
balances
Fiscal Stimulus

Suppose the economy is experiencing a
recessionary GDP gap of $400 billion.
 The
recessionary GDP gap is the difference
between full-employment GDP and
equilibrium GDP.
Price Level (average price)
The Policy Goal
AS
Full-employment GDP
AD1
a
PE
GDP Equilibrium
b
GDP gap
QE = 5.6
6.0 = QF
Real GDP (trillions of dollars per year)
Keynesian Strategy
The Keynesian model of the adjustment
process shows not only how the economy
can get into trouble, but also how it might
get out.
 From a Keynesian perspective, the way
out of recession is to get someone to
spend more on goods and services.


The source of new spending could be a
fiscal stimulus.
Keynesian Strategy
A fiscal stimulus is tax cuts or spending
hikes intended to increase (shift)
aggregate demand.
 The general strategy is clear; however, the
scope of desired intervention is not.

Keynesian Strategy

Two strategic policy questions must be
answered:
 By
how much do we want to shift the AD curve
to the right?
 How can we induce the desired shift?
The Naive Keynesian Model
If GDP gap is $400 billion, why not just
increase AD by that muc
 The naive Keynesian policy fails to
achieve full employment.
 An increase in aggregate demand by the
amount of the GDP gap will achieve full
employment only if the aggregate supply
curve is horizontal.

Price Level Changes
When the AD curve shifts to the right, the
economy moves up the AS curve, not
horizontally to the right, changing both real
output and prices.
 Shifting (increasing) aggregate demand by
the amount of the GDP gap will achieve
full employment only if the price level
doesn’t rise.

The AD Shortfall
So long as the AS curve slopes upward,
we must increase AD by more than the
size of the recessionary GDP gap to
achieve full employment.
 The AD shortfall is the amount of
additional aggregate demand needed to
achieve full employment after allowing for
price level changes.
 The AD shortfall is the fiscal target.

Price Level (average price)
The AD Shortfall
AS
AD3
AD2
d
AD1
c
a
PE
b
e
Recessionary
GDP gap
AD shortfall
QE = 5.6
QF = 6.0
6.4
Real GDP (trillions of dollars per year)
Government Spending Multiplier
Effects
Increased government spending is a form
of fiscal stimulus.
 Every dollar of new government spending
has a multiplied impact on aggregate
demand.

Multiplier Effects

How much of a boost the economy gets
depends on the value of the multiplier.
 The
multiplier is the multiple by which an
initial change in aggregate spending will alter
total expenditure after an infinite number of
spending cycles.
Multiplier Effects

The total spending change equals the
multiplier times the new spending
injections.
Total change in spending = multiplier X
new spending injection
Multiplier Effects

The impact of fiscal stimulus on aggregate
demand includes the new government
spending plus all subsequent increases in
consumer spending triggered by the
additional government outlays:
Increase in AD = multiplier X fiscal stimulus
Price Level (average price)
Multiplier Effects
Direct impact of rise
in government
spending + $200
billion
P1
Indirect impact via
increased consumption
+ $600 billion
a
b
AD1
5.6
QE
5.8
AD2
Current
price level
AD3
6.4
Real GDP
($ trillions per year)
The Desired Stimulus

The general formula for computing the
desired stimulus is a simple
rearrangement of the earlier formula:
Desired AD increase
Desired fiscal stimulus =
multiplier
Tax Cuts

By lowering taxes, the government
increases the disposable income of the
private sector.
 Disposable
income is the after-tax income of
consumers; personal income less personal
taxes.
Taxes and Consumption
Tax cuts directly increase the disposable
income of consumers.
 The more important question is how does
a tax cut affect spending.
 The amount consumption increases
depends on the marginal propensity to
consume.

Initial increase in consumption =
MPC X tax cut
Taxes and Consumption



A tax cut contains less fiscal stimulus than an
increase in government spending of the same
size.
The initial spending injection is less than the size
of the tax cut.
An AD shortfall can be closed with a tax cut.
Desired fiscal stimulus
Desired tax cut =
MPC
The Tax Cut Multiplier
Tax Cut
First round of spending:
Second round of spending:
More consumption
= MPC X tax cut
More saving
= MPS X tax cut
More income
More saving
More consumption
More income
Third round of spending:
More saving
More consumption
Cumulative change in
saving: = tax cut
Taxes and Investment
A tax cut may also be an effective
mechanism for increasing investment
spending.
 Tax cuts have been used numerous times
to stimulate the economy.

Increased Transfers
Increasing transfer payments such as
social security, welfare, unemployment
benefits, and veterans’ benefits can
stimulate the economy.
 The initial fiscal stimulus of increased
transfer payments is:

Initial fiscal stimulus (injection) = MPC X
increase in transfer payments
Fiscal Restraint
There are times when the economy is
expanding too fast and fiscal restraint is
more appropriate.
 Fiscal restraint is using tax hikes or
spending cuts intended to reduce (shift)
aggregate demand.

The Fiscal Target
The AD excess is the amount by which
aggregate demand must be reduced to
achieve price stability after allowing for
price-level changes.
 The first task is to determine how much
AD needs to fall.
 The AD excess exceeds the GDP gap.

Price Level (average price)
Excess Aggregate Demand
AS
PE
f
E1
E2
PF
Inflationary
GDP gap
Excess AD
Q2 = 5.8
QF = 6.0
AD1
AD2
Q1 = 6.2
Real Output (trillions of dollars per year)
Budget Cuts
Budget cuts reduce government spending
and induces cutbacks in consumer
spending.
 The budget cuts have a multiplied effect
on AD equal to:

Cumulative reduction in spending =
multiplier X initial budget cut

The budget cuts should be equal to the
size of the desired fiscal restraint.
Tax Hikes
Tax hikes can be used to shift the AD
curve to the left.
 The direct effect of tax increases is a
reduction in disposable income.

Tax Hikes

Taxes must be increased more than a
dollar to get a dollar of fiscal restraint.
Desired fiscal restraint
Desired increase in taxes =
MPC

Tax increases have been used to “cool”
the economy several times.
Reduced Transfers
A third option for fiscal restraint is to
reduce transfer payments.
 A cut in transfer payments works like a tax
hike, reducing the disposable income of
transfer recipients.

Reduced Transfers
The desired reduction in transfers is the
same as a desired tax increase.
 Reduced transfers are seldom used since
recipients include the aged, poor,
unemployed and disabled.

A Primer: Simple Rules
The essence of fiscal policy is the
deliberate shifting of the aggregate
demand curve.
 The steps required to formulate fiscal
policy are:

 Specify
the amount of the desired AD shift.
 Select the policy tools needed to induce the
desired shift.
Fiscal Stimulus
AD shortfall
Desired fiscal stimulus 
the multiplier
Policy Option
Amount
Increase government purchases
desired fiscal stimulus
Cut taxes
desired fiscal stimulus
MPC
Increased transfers
desired fiscal stimulus
MPC
Fiscal Restraint
Desired fiscal restraint 
Policy Option
excess AD
the multiplier
Amount
Reduce government purchases
desired fiscal restraint
Increase taxes
desired fiscal restraint
MPC
Reduce transfers
desired fiscal restraint
MPC
A Warning: Crowding Out
Fiscal policy guidelines are a useful tool
but neglect a critical dimension of fiscal
policy.
 How is the government going to finance its
expenditures?

A Warning: Crowding Out
Some of the intended fiscal stimulus may
be offset by the crowding out of private
investment expenditure.
 Crowding out is a reduction in privatesector borrowing (and spending) caused by
increased government borrowing.

Time Lags
Fiscal policy is somewhat hampered
because it takes time to recognize that a
problem exists and then formulate policy
to address the problem.
 In addition, the very nature of the macro
problems could change if the economy is
hit with other internal or external shocks.

Pork-Barrel Politics
Once a tax or spending plan arrives at the
U.S. Capitol, politics take over.
 If taxes are cut, they want their
constituents to get the biggest tax savings.
 No member of Congress wants spending
cuts in their own districts.
 No-one in Congress wants a tax hike or
spending cut before the election.

The Concern for Content
Guidelines for fiscal policy do not say
anything about how the government
spends its money or whom it taxes.
 It does matter whether federal
expenditures are devoted to military
hardware, urban transit systems, or tennis
courts.

The “Second Crisis”

Our economic goals include not only full
employment and price stability, but also a
desirable mix of output, equitable
distribution of income, and adequate
economic growth.
The “Second Crisis”

The relative emphasis on, and sometimes
exclusive concern for, stabilization
objectives – to the neglect of related GDP
content – has been designated by Joan
Robinson as the “second crisis of
economic theory”
Private vs. Public Spending

Fiscal policy can be directed toward
private expenditure (C + I) or public
expenditure (G).
Output Mixes within Each
Sector

In addition to choosing whether to
increase public or private spending, fiscal
policy must also consider the specific
content of spending within each sector.
ECON 151 - MACROECONOMICS
Fiscal Policy Levers
End of Chapter 11