Fiscal Policy

Chapter 11

Fiscal Policy

• Government’s tax and spending activities affect not only the level of output and prices but the mix of output as well– Can government spending and tax policies

ensure full employment?– What policy actions will help fight inflation?– What are the risks of government

intervention?

Taxes and Spending• In 1902, the federal government employed

fewer than 350,000 people and spent about $650 million.

• Today, the federal government– Employs over 4 million people and spends more

than $3.5 trillion a year– Collects nearly $3 trillion a year in taxes, with

nearly half that from individual income taxes– Spends all of its tax revenues—and more,

borrowing additional funds

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 nearly $3 trillion a year in taxes.

Government Expenditure

• Government purchases are part of aggregate demand, income transfers are not

• Income transfers: Payments to individuals for which no current goods or services are exchanged

Fiscal Policy

• The federal government can alter aggregate demand by:– Purchasing more or fewer goods and services– Raising or lowering taxes– Changing the level of income transfers

Fiscal Policy

• Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes

• The federal budget is a tool that can shift aggregate demand and thereby alter macroeconomic outcomes

Fiscal Policy

Internal market forces

External shocks

Policy tools: Fiscal

policy

Output

Jobs

Prices

Growth

International balances

DETERMINANTS OUTCOMES

AD

AS

Fiscal Stimulus

• Suppose the economy is experiencing a recessionary GDP gap of $400 billion

• From a Keynesian perspective, the solution is to get someone to spend more on goods and services

The Policy Goal

AS

QE = 5.6

a

AD1

PE

Pri

ce L

evel

Real GDP

6.0 = QF

GDP Equilibrium

Full-employment GDP

b

GDP gap

The goal is to close GDP gaps

Keynesian Strategy

• Fiscal stimulus: Tax cuts or spending hikes intended to increase (shift) aggregate demand

• Two strategic policy questions:– By how much do we want to shift the AD

curve to the right?– How can we induce the desired shift?

Review “In the News” on pg. 231.

The Naive Keynesian Model

• An increase in AD by $400 billion will achieve full employment only if AS curve is horizontal

• Assumption of a horizontal AS curve seems naïve today

• Although not every AD shift will raise prices, inflationary pressures increase as AD expands

The AD Shortfall

• So long as the AS curve slopes upward, AD must increase by more than the size of the recessionary gap to achieve full employment

• AD shortfall: The amount of additional aggregate demand needed to achieve full employment after allowing for price-level changes

The AD ShortfallAS

QE = 5.6

a

AD1

AD2

PE

Pri

ce L

evel

Real GDP

QF = 6.0 6.4

AD3

cd

b e

Recessionary GDP gap

AD shortfall

The AD shortfall is the fiscal policy target for achieving full employment.

Multiplier Effects

• Impact of fiscal stimulus on aggregate demand includes both the new government spending and all subsequent increases in consumer spending triggered by multiplier effects

Total change new spending

multiplierin spending injection

Multiplier Effects

• The second equation is identical to the first but expressed in the terminology of fiscal policy

( ) AD

( )

( )

new spendingCumulative increase induced increase

injectionhorizontal shift in in consumption

fiscal stimulus

fiscal stimulusmultiplier

new spending injection

Multiplier Effects

Real GDP

Pri

ce L

evel

P1

5.6QE

5.8 6.4

AD2 AD3

Current price level

Direct impact of rise in government spending

+ $200 billion

AD1

ab

Indirect impact via increased consumption

+ $600 billion

The Desired Stimulus

• The general formula for computing the desired stimulus is a simple rearrangement of the earlier formula:

AD shortfallDesired fiscal stimulus

the multiplier

Tax Cuts

• By lowering taxes, the government increases disposable income, which stimulates the consumption component of AD

• The amount consumption increases depends on the marginal propensity to consume

Initial increase

MPC tax cutin consumption

Multiplier Effects

• A dollar of tax cut contains less stimulus than a same size increase in government purchases

desired fiscal stimulusDesired tax cut

MPC

Cumulative change initial change

multiplierin spending in consumption

The Tax Cut Multiplier

First round of spending:

Second round of spending:

Third round of spending:

More income

More consumption

More income

More consumption

Tax Cut

More consumption= MPC X tax cut

More saving= MPS X tax cut

More saving

More saving

Cumulative change in saving: = tax cut

Taxes and Investment

• A tax cut may also be an effective mechanism for increasing investment spending

• If a cut in corporate taxes raises potential after-tax profits, it should encourage investment

• Once additional investment spending enters the circular flow, it, too, has a multiplier effect

Increased Transfers

• Increasing transfer payments stimulates the economy

( ) Initial fiscal increase in

MPCstimulus injection transfer payments

Fiscal Restraint

• At times the economy is expanding too fast and fiscal restraint is more appropriate

• Inflationary GDP gap: The amount by which equilibrium GDP exceeds full-employment

• Fiscal restraint: Tax hikes or spending cuts intended to reduce (shift) aggregate demand

The Fiscal Target

• AD excess: The amount by which aggregate demand must be reduced to achieve full-employment equilibrium after allowing for price-level changes

• The AD excess exceeds the inflationary GDP gap

The Fiscal Target

• First determine the size of the AD excess

• Then we compute how much government spending or taxes must be changed to achieve the desired shift, taking into account multiplier effects

excess ADDesired fiscal restraint

the multiplier

Excess Aggregate Demand

AS

Q2 = 5.8

E2

f

AD1

AD2

PE

PF

Pri

ce L

evel

Real Output

E1

QF = 6.0 Q1 = 6.2

Inflationary GDP gap

Excess AD

AD must shift by more

than the GDP gap

Budget Cuts

• Budget cuts reduce government spending and induce cutbacks in consumer spending

• Budget cuts should equal the size of the desired fiscal restraint

( )Cumulative reduction initial budget cut

multiplierin spending fiscal restraint

Tax Hikes

• Tax hikes can be used to shift the AD curve to the left by reducing disposable income

• Taxes must be increased more than a dollar to get a dollar of fiscal restraint

desired fiscal restraintDesired tax hike

MPC

Reduced Transfers

• A cut in transfer payments works like a tax hike, reducing the disposable income of transfer recipients

• The desired reduction in transfers is the same as a desired tax increase

Fiscal Guidelines

• The essence of fiscal policy is the deliberate shifting of the aggregate demand curve

• Steps required to formulate fiscal policy:– Specify the amount of the desired AD shift– Select the policy tools needed to induce the

desired shift

Weak Economy: Fiscal Stimulus

AD shortfallDesired fiscal stimulus

the multiplier

Policy Tools Amount

Increase government purchases

desired fiscal stimulus

Cut taxes desired fiscal stimulus

MPC

Increased transfers desired fiscal stimulus

MPC

Overheated Economy: Fiscal Restraint

excess ADDesired fiscal restraint

the multiplier

Policy Tools Amount

Reduce government purchases

desired fiscal restraint

Increase taxes desired fiscal restraint

MPC

Reduce transfers desired fiscal restraint

MPC

A Warning: Crowding Out

• Some of the intended fiscal stimulus may be offset by the crowding out of private expenditure

• Crowding out: A reduction in private-sector borrowing (and spending) caused by increased government borrowing

Time Lags

• It takes time to recognize that a problem exists and then formulate policy to address it

• The very nature of the macro problems could change if the economy is hit with other internal or external shocks

Pork-Barrel Politics

• Members of Congress want their constituents to get the biggest tax savings

• They don’t want spending cuts in their own districts

• They don’t want a tax hike or spending cut before an election