Transcript No Slide Title

The
President
Congress
BUDGET
Taxes
Spending
Fiscal
Policy
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.
Fiscal Policy: Demand Side
Transmission Mechanism
Expansionary Fiscal Policy
Government
Spending
Rises
Interest Rates
Rise
Deficit
Increases
Aggregate
Spending
Increases
Investment
Spending is
Crowded Out
Export
Spending is
Crowded Out
Imports Rise
Exports Fall
Taxes
Decrease
Price Level
Rises
Spending
Decreases
Fiscal Policy: Demand Side
Transmission Mechanism
Expansionary Fiscal Policy
Government
Spending
Rises
Interest Rates
Rise
Investment
Spending is
Crowded Out
Export Spending
Is Crowded Out
Deficit
Increases
Aggregate
Spending
Increases
Imports Rise
Exports Fall
Taxes
Decrease
Price Level
Rises
Spending
Decreases
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
$90
$81
$72.90
$65.61
$100
$90
$81
$72.90
$65.61
$90
$81
$72.90
$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.
Fiscal Policy: Demand Side
Transmission Mechanism
Expansionary Fiscal Policy
Government
Spending
Rises
Interest Rates
Rise
Deficit
Increases
Aggregate
Spending
Increases
Investment
Spending is
Crowded Out
Export
Spending is
Crowded Out
Imports Rise
Exports Fall
Taxes
Decrease
Price Level
Rises
Spending
Decreases
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
P
Expansionary fiscal policy
shifts the AD curve from AD1 to AD2.
LRAS
SRAS
P2
P1
0
Y1 Y2* Y3
AD2
AD1
Y
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 and
investment and net exports
to 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.
Contractionary Demand Side Fiscal
Policy
P
LRAS
SRAS
But as Y falls, money demand falls,
causing interest rates to fall and
investment and net exports
to fall by smaller amounts. As Y
falls, less competition for resources
causes other prices to fall.
P2
P1
0
Contractionary fiscal policy
shifts the AD curve from AD2 to AD1.
If prices do not fall, the fiscal
contraction causes Y to fall to Y1.
Y1 Y2* Y3
AD2
AD1
Y
Equilibrium Y occurs at Y2 and P1.
National income falls from Y1
to Y2. Prices fall from P2 to P1.
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
Transmission Mechanism
Inflation Falls
Unemployment Falls
After-tax Wage
Higher
Increase in
Labor Supply
Savings Rise
Interest Rates
Fall
After-tax ROR
Rises
Investment Rises
Aggregate Supply
Rises
Lower Personal
Tax Rates
Lower Business
Tax Rates
Productivity
Rises
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
P
Expansionary fiscal policy
shifts the AS curve from AS1 to AS2.
LRAS
SRAS1 SRAS
2
As productivity rises and costs fall,
output increases while prices fall.
P1
Equilibrium Y occurs at Y2 and P2.
P2
National income rises from Y1
to Y2. Prices fall from P1 to P2.
0
Y1 Y2*
AD1
Y
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.