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End of
ECON 151 – PRINCIPLES
OF MACROECONOMICS
Chapter
10
Chapter 13: Fiscal Policy
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
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Discretionary Fiscal Policy
Discretionary Fiscal Policy
The
discretionary changes in government
expenditures and/or taxes in order to achieve certain
national economic goals is the realm of fiscal policy.
High employment (low unemployment)
Price stability
Economic growth
Improvement of international payments balance
Discretionary Fiscal Policy
(cont'd)
Fiscal Policy
The
discretionary changing of government
expenditures or taxes to achieve national
economic goals, such as high employment
with price stability
Discretionary Fiscal Policy
(cont'd)
An increase in government spending will
stimulate economic activity
Changes in government spending
Military
spending
Education spending
Budgets for government agencies
Figure 13-1 Expansionary and
Contractionary Fiscal Policy: Changes in
Government Spending, Panel (a)
If there is a recessionary gap
in panel (a), fiscal policy can
presumably increase
aggregate demand
Figure 13-1 Expansionary and
Contractionary Fiscal Policy: Changes in
Government Spending, Panel (b)
If there is an inflationary gap,
fiscal policy can presumably
decrease aggregate demand
Figure 13-2 Contractionary and
Expansionary Fiscal Policy: Changes
in Taxes, Panel (a)
• In panel (a), the economy is
initially at E1, where real GDP
exceeds long-run equilibrium
• Contractionary fiscal policy can
move aggregate demand to
AD2 via a tax increase
• A new equilibrium is at E2 at a
lower price level
• Real GDP is now consistent
with LRAS
Figure 13-2 Contractionary and
Expansionary Fiscal Policy: Changes
in Taxes, Panel (b)
• In panel (b) with a
recessionary gap (in this case
$500 billion) taxes are cut
• AD1 moves to AD2
• The economy moves from E1
to E2, and real GDP is now at
$12 trillion per year
• We are at the long-run
equilibrium level
Discretionary Fiscal Policy
(cont'd)
Change in taxes
A
rise in taxes causes a reduction in
aggregate demand because it can reduce
consumption spending, investment
expenditures, and net exports.
Possible Offsets to Fiscal Policy
Fiscal policy does not operate in a vacuum
and important questions must be
answered.
How
are expenditures financed and
by whom?
If
taxes are increased what does government
do with the taxes?
What
will happen if individuals worry about
increases in future taxes?
Possible Offsets
to Fiscal Policy (cont'd)
Crowding-Out Effect
The
tendency of expansionary fiscal policy to
cause a decrease in planned investment or
planned consumption in the private sector;
this decrease normally results from the rise of
interest rates.
Figure 13-3 The Crowding-Out
Effect, Step by Step
Figure 13-4
The Crowding-Out Effect
Expansionary policy causing
deficit spending initially shifts
from AD1 to AD2
Due to crowding out,
AD shifts inward to AD3
Equilibrium GDP
below full-employment
GDP—recessionary gap
Possible Offsets to Fiscal Policy (cont'd)
Planning for the future:
the Ricardian equivalence theorem
Ricardian
The proposition that an increase in the government
budget deficit has no effect on aggregate demand
The
Equivalence Theorem
reason for the offset
People anticipate that a larger deficit today will
mean higher taxes in the future and adjust their
spending accordingly.
Possible Offsets
to Fiscal Policy (cont'd)
Direct Expenditure Offsets
Actions
on the part of the private sector in
spending income that offset government fiscal
policy actions
Any
increase in government spending
in an area that competes with the
private sector will have some direct
expenditure offset.
Possible Offsets
to Fiscal Policy (cont'd)
The supply-side effects of changes
in taxes
Expansionary
fiscal policy could involve
reducing marginal tax rates.
Advocates argue this increases productivity since
individuals will work harder and longer, save more,
and invest more.
The increased productivity will lead to more
economic growth.
Possible Offsets
to Fiscal Policy (cont'd)
Supply-Side Economics
The
suggestion that creating incentives for
individuals and firms to increase productivity
will cause the aggregate supply curve to shift
outward
Figure 13-5 Laffer Curve
Tax rates and
tax revenues
rise together
Tax revenues
are at a maximum
Tax rates and tax
revenues fall
together
Discretionary Fiscal Policy in Practice:
Coping with Time Lags
Recognition
The time required to gather information about the
current state of the economy
Action
Time Lag
The time required between recognizing an
economic problem and putting policy into effect
Effect
Time Lag
Time Lag
The time it takes for a fiscal policy to affect
the economy
Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
Fiscal policy time lags are long and a policy designed to
correct a recession may not produce results until the
economy is experiencing inflation.
Fiscal policy time lags are variable in length (1–3 years),
and the timing of the desired effect cannot be predicted.
Because fiscal policy time lags tend to be variable,
policymakers have a difficult time fine-tuning the
economy.
Automatic Stabilizers
Automatic or Built-In Stabilizers
Changes
in government spending and
taxation that occur automatically without
deliberate action of Congress
The tax system
Unemployment compensation
Welfare spending
Figure 13-6 Automatic
Stabilizers
The automatic changes
tend to drive the economy
back toward its fullemployment output level
What Do We Really Know
About Fiscal Policy?
Fiscal policy during normal times
Congress
ends up doing too little too late to
help in a minor recession.
Fiscal
policy that generates repeated
tax changes (as has happened)
creates uncertainty.
What Do We Really Know
About Fiscal Policy? (cont'd)
Fiscal policy during abnormal times
Fiscal
policy can be effective
The Great Depression—fiscal policy may be able
to stimulate aggregate demand.
Wartime—during World War II real GDP increased
dramatically.
What Do We Really Know
About Fiscal Policy? (cont'd)
The “soothing” effect of Keynesian fiscal
policy
Should
we encounter a severe downturn,
fiscal policy is available.
Knowing this may reassure consumers
and investors.
Stable expectations encourage a smoothing of
investment spending.
End of
ECON 151 – PRINCIPLES
OF MACROECONOMICS
Chapter
10
Chapter 13: Fiscal Policy
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
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