BU204BU204

Unit 7 SeminarUnit 7 Seminar

Fiscal PolicyFiscal Policy

Chapter 13 Chapter 13

Chapter 13 is about Chapter 13 is about fiscal policyfiscal policy—government spending and —government spending and taxation—and its use as an economic tool. taxation—and its use as an economic tool.

The chapter discusses The chapter discusses expansionaryexpansionary fiscal policyfiscal policy, or the use of , or the use of government spending and/or taxation policy to stimulate the government spending and/or taxation policy to stimulate the economy, and economy, and contractionarycontractionary fiscal policyfiscal policy, the use of , the use of government spending and/or taxation policy to slow down the government spending and/or taxation policy to slow down the economy. economy.

We also explore the We also explore the multiplier effect multiplier effect of fiscal policy as well as the of fiscal policy as well as the affect of affect of automatic stabilizers automatic stabilizers on the size of the multiplier. on the size of the multiplier.

The chapter continues with the development of the The chapter continues with the development of the budget budget balance balance and how economic fluctuations affect this budget and how economic fluctuations affect this budget balance, and discusses the long-run consequences of balance, and discusses the long-run consequences of public debt public debt and the significance of the government’s implicit liabilities. and the significance of the government’s implicit liabilities.

Chapter 13 OverviewChapter 13 Overview

Sources of Tax Revenue in the United States - 2004 Sources of Tax Revenue in the United States - 2004

Government Spending in the United States - 2004Government Spending in the United States - 2004

The Government Budget and Total SpendingThe Government Budget and Total Spending

Fiscal policy is the use of taxes, government Fiscal policy is the use of taxes, government transfers, or government purchases of goods and transfers, or government purchases of goods and services to shift the aggregate demand curve.services to shift the aggregate demand curve.

Expansionary and Contractionary Fiscal PolicyExpansionary and Contractionary Fiscal Policy

Expansionary Fiscal Policy Can Close a Recessionary GapExpansionary Fiscal Policy Can Close a Recessionary Gap

Expansionary fiscal policy increases aggregate demand.

Recessionary gap

Expansionary and Contractionary Fiscal PolicyExpansionary and Contractionary Fiscal Policy

Contractionary Fiscal Policy Can Eliminate an Inflationary GapContractionary Fiscal Policy Can Eliminate an Inflationary Gap

Contractionary fiscal policy decreases aggregate demand.

Inflationary gap

Lags in Fiscal PolicyLags in Fiscal Policy

In the case of fiscal policy, there is an important reason for In the case of fiscal policy, there is an important reason for caution: there are significant lags in its use.caution: there are significant lags in its use.

Realize the recessionary/inflationary gap by collecting Realize the recessionary/inflationary gap by collecting and analyzing economic data and analyzing economic data takes time takes time

Government develops an action planGovernment develops an action plan takes time takes time

Implementation of the action plan Implementation of the action plan takes time takes time

Fiscal Policy and the MultiplierFiscal Policy and the Multiplier

Fiscal policy has a Fiscal policy has a multiplier effect multiplier effect on the economy. on the economy.

Expansionary Expansionary fiscal policy fiscal policy leads to an increase in real leads to an increase in real GDP larger than the initial rise in aggregate spending GDP larger than the initial rise in aggregate spending caused by the policy. caused by the policy.

Conversely, Conversely, contractionary contractionary fiscal policy fiscal policy leads to a fall leads to a fall in real GDP larger than the initial reduction in aggregate in real GDP larger than the initial reduction in aggregate spending caused by the policy. spending caused by the policy.

Fiscal Policy and the MultiplierFiscal Policy and the Multiplier

The size of the shift of the aggregate demand curve The size of the shift of the aggregate demand curve depends on the depends on the typetype of fiscal policy. of fiscal policy.

The multiplier on changes in The multiplier on changes in government purchasesgovernment purchases, , 1/(1 − MPC), is larger than the multiplier on changes in 1/(1 − MPC), is larger than the multiplier on changes in taxestaxes or or transferstransfers, MPC/(1 − MPC), because , MPC/(1 − MPC), because part of any part of any change in taxes or transfers is absorbed by savingschange in taxes or transfers is absorbed by savings. .

Changes in Changes in government purchases have a more government purchases have a more powerful effect on the economy than equal-sized powerful effect on the economy than equal-sized changes in taxes or transferschanges in taxes or transfers. .

The Multiplier Effect of an Increase in Government The Multiplier Effect of an Increase in Government Purchases of Goods and ServicesPurchases of Goods and Services

Multiplier Effects of Changes in Taxes and Government Multiplier Effects of Changes in Taxes and Government TransfersTransfers

ExampleExample: The government hands out $50 billion in the form : The government hands out $50 billion in the form of of tax cutstax cuts. .

There is There is no direct effect no direct effect on aggregate demand by on aggregate demand by government purchases of goods and services; GDP goes up government purchases of goods and services; GDP goes up only because households spend some of that $50 billion.only because households spend some of that $50 billion. How much will they spend? How much will they spend?

MPC × $50 billion. For example, if MPC = 0.6, the MPC × $50 billion. For example, if MPC = 0.6, the first-round increase in consumer spending will be $30 first-round increase in consumer spending will be $30 billion (0.6 × $50 billion = $30 billion). billion (0.6 × $50 billion = $30 billion). This initial rise in consumer spending will lead to a This initial rise in consumer spending will lead to a series of subsequent rounds in which real GDP, series of subsequent rounds in which real GDP, disposable income, and consumer spending rise further.disposable income, and consumer spending rise further.

How Taxes Affect the MultiplierHow Taxes Affect the Multiplier

Rules governing taxes and some transfers act as Rules governing taxes and some transfers act as automatic stabilizersautomatic stabilizers, reducing the size of the , reducing the size of the multiplier and automatically reducing the size of multiplier and automatically reducing the size of fluctuations in the business cycle. fluctuations in the business cycle.

In contrast, In contrast, discretionary fiscal policy discretionary fiscal policy arises from arises from deliberate actions by policy makers deliberate actions by policy makers (e.g., Congress) (e.g., Congress) rather than from the business cyclerather than from the business cycle..

Differences in the Effect of Expansionary Fiscal PoliciesDifferences in the Effect of Expansionary Fiscal Policies

The Budget BalanceThe Budget Balance

How do How do surplusessurpluses and and deficitsdeficits fit into the fit into the analysis of fiscal policy? analysis of fiscal policy?

Are deficits ever a good thing and surpluses a Are deficits ever a good thing and surpluses a bad thing?bad thing?

The Budget Balance as a Measure of Fiscal PolicyThe Budget Balance as a Measure of Fiscal Policy

Discretionary expansionary fiscal policiesDiscretionary expansionary fiscal policies—increased —increased government purchases of goods and services, higher government purchases of goods and services, higher government transfers, or lower taxes—government transfers, or lower taxes—reduce the budget reduce the budget balancebalance for that year. for that year.

That is, That is, expansionary fiscal policies make a budget expansionary fiscal policies make a budget surplus smaller or a budget deficit biggersurplus smaller or a budget deficit bigger. .

Conversely, Conversely, contractionary fiscal policiescontractionary fiscal policies—smaller —smaller government purchases of goods and services, smaller government purchases of goods and services, smaller government transfers, or higher taxes—government transfers, or higher taxes—increase the budget increase the budget balance for that year, making a budget surplus bigger or a balance for that year, making a budget surplus bigger or a budget deficit smallerbudget deficit smaller..

The U.S. Federal Budget Deficit and the The U.S. Federal Budget Deficit and the Unemployment Rate Unemployment Rate

There is a close relationship between the budget balance and the business cycle: A recession moves the budget balance toward deficit, but an expansion moves it toward surplus.

Should the Budget Be Balanced?Should the Budget Be Balanced?

Most economists don’t believe the government Most economists don’t believe the government should be forced to run a balanced budget every year should be forced to run a balanced budget every year because this would undermine the role of taxes and because this would undermine the role of taxes and transfers as automatic stabilizers.transfers as automatic stabilizers.

Yet policy makers concerned about excessive deficits Yet policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary.setting an upper limit on—deficits are necessary.

Long-Run Implications of Fiscal PolicyLong-Run Implications of Fiscal Policy

U.S. government budget accounting is calculated on U.S. government budget accounting is calculated on the basis of the basis of fiscal yearsfiscal years. .

Persistent Persistent budget deficits budget deficits have long-run have long-run consequences because they lead to an consequences because they lead to an increase in increase in public debtpublic debt. .

Problems Posed by Rising Government DebtProblems Posed by Rising Government Debt

This can be a problem for two reasons:This can be a problem for two reasons:

Public debt may Public debt may crowd out investment spending, crowd out investment spending, which reduces long-run economic growthwhich reduces long-run economic growth. .

And in extreme cases, And in extreme cases, rising debt may lead to rising debt may lead to government government defaultdefault, resulting in economic and , resulting in economic and financial turmoil.financial turmoil.

Implicit LiabilitiesImplicit Liabilities

Implicit liabilities Implicit liabilities are spending promises made are spending promises made by governments that are effectively a debt by governments that are effectively a debt despite the fact that they are despite the fact that they are not included in the not included in the usual debt statisticsusual debt statistics..

The Implicit Liabilities of the U.S. GovernmentThe Implicit Liabilities of the U.S. Government

Chapter 13 conclusionChapter 13 conclusion

This concludes our coverage of key points from This concludes our coverage of key points from Chapter 13Chapter 13

Are there any questions?Are there any questions?