chapter05 fiscal policy

mac

ro CHAPTER FIVE

FISCAL POLICY

Fiscal Policy

Fiscal policy is the use of the national budget to achieve macroeconomic objectives, such as full employment, sustained long-term economic growth, and price level stability.

In short, Fiscal policy is the setting of the level of government spending and taxation by government policymakers

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“In this world nothing is certain but death and taxes.” . . . Benjamin Franklin

020

4060

80100

Taxes paid in Ben Franklin’s time accounted for 5 percent of the

average American’s

income.1789

“In this world nothing is certain but death and taxes.” . . . Benjamin Franklin

020

4060

80100

1789 Today

Today, taxes account for up

to a third of the average American’s

income.

Receipts of the Federal Government 2004

Individual Income Tax, 43%

Social Insurance Tax, 39%

Corporate Tax, 10%

Other, 8%

Government spending, G G includes government spending on

goods and services. G excludes transfer payments when

calculating GDP Assume government spending is

exogenous:

G =G

Budget surpluses and deficits

• When T > G , budget surplus = (T – G ) = public saving

• When T < G , budget deficit = (G –T )and public saving is negative.

• When T = G , budget is balanced and public saving = 0.

The Government Budget

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GDP1 GDP2 GDP3

Real Domestic Output, GDP

Gov

ern

men

t E

xpen

dit

ure

s,G

, an

d T

ax R

even

ues

, T

Deficit

Surplus

T

G

Aggregate Demand and Supply

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Aggregate Demand (AD):- the total demand for all goods and services produced in a society- AD curve slope downward

Aggregate Demand and Supply

Changes in Aggregate Demand (AD) due to:

–Changes in consumption– the amount left over after savings, taxes– results from increased/decrease in prices, GDP,

employment

–Changes in investment– dependant on profits/losses– influenced by interest rates when borrowing funds

–Changes in government spending– increase/decrease; fiscal policy

–Changes in net exports– dependant on inflation rate, income levels, value of

the dollar

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The Long-Run Aggregate- Supply Curve...

Quantity ofOutput

Natural rateof output

Price Level

0

Long-runaggregate

supplyP1

P2 2. …does not affect the quantity of goods and services supplied in the long run.

1. A change in the price level…

The Long-Run Aggregate Supply Curve

The long-run aggregate supply curve is vertical at the natural rate of output.

This level of production is also referred to as potential output or full-employment output.

Why the Long-Run Aggregate Supply Curve Might Shift

Shifts arising from Labor

Shifts arising from Capital

Shifts arising from Natural Resources

Shifts arising from Technological Knowledge

The Short-Run Aggregate Supply Curve...

Quantity ofOutput

Price Leve

l

0

Short-runaggregate

supply

Y1

P1

Y2

2. reduces the quantity of goods and services supplied in the short run.

P2

1. A decrease in the price level

HOW FISCAL POLICY INFLUENCES AD & AS

Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes.

Fiscal policy influences saving, investment, and growth in the long run.

In the short run, fiscal policy primarily affects the aggregate demand.

Fiscal Policy and AD

When policymakers change the taxes, the effect on aggregate demand is indirect—through the spending decisions of firms or households.

When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly.


Expansionary fiscal policy

• an increase in G and/or decrease in T shifts AD right

Contractionary fiscal policy

• a decrease in G and/or increase in T shifts AD left

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There are two macroeconomic effects on AD from the Fiscal Policy : – The multiplier effect– The crowding-out effect

The Multiplier Effect

Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.

The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

The Multiplier Effect

If the govt buys $20b of planes from Boeing

Boeing’s revenue increases by $20b.

This is distributed to Boeing’s workers (as wages)

and owners (as profits or stock dividends).

These people are also consumers, and will spend a portion of the extra income.

This extra consumption causes further increases in aggregate demand.

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Figure 4 The Multiplier Effect

Quantity ofOutput

PriceLevel

0

Aggregate demand, AD1

$20 billion

AD2

AD3

1. An increase in government purchasesof $20 billion initially increases aggregatedemand by $20 billion . . .

2. . . . but the multipliereffect can amplify theshift in aggregatedemand.

A Formula for the Spending Multiplier

The formula for the multiplier is:– Multiplier = 1/(1 – MPC)– An important number in this formula

is the marginal propensity to consume (MPC).• It is the fraction of extra income that

a household consumes rather than saves.

A Formula for the Spending Multiplier

If the MPC = 3/4, then the multiplier will be:

Multiplier = 1/(1 – 3/4) = 4

In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

A larger MPC means a larger multiplier in an economy.

The multiplier effect is not restricted to changes in government spending.

EXPANSIONARY FISCAL POLICY

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the multiplier at work...

Real GDP (billions)

Full $20 billionincrease in aggregatedemand

AD2AD1

$5 billion initialincrease in spending

P1

$485 $505

CONTRACTIONARY FISCAL POLICY

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the multiplier at work...

Pri

ce le

vel

Real GDP (billions)

P3

$515

Full $20 billiondecrease in aggregatedemand

AD4

AD3

$5 billion initialdecrease in spending

P4

The Crowding-Out Effect

Fiscal policy may not affect the economy as strongly as predicted by the multiplier.

An increase in government purchases reduces national saving and causes the interest rate to rise.

A higher interest rate reduces investment spending.


This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.

The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

Figure 5 The Crowding-Out Effect

Quantityof Money

Quantity fixedby the Fed

0

InterestRate

r

Money demand, MD

Moneysupply

(a) The Money Market

3. . . . whichincreasestheequilibriuminterestrate . . .

2. . . . the increase inspending increasesmoney demand . . .

MD2

Quantityof Output

0

PriceLevel

Aggregate demand, AD1

(b) The Shift in Aggregate Demand

4. . . . which in turnpartly offsets theinitial increase inaggregate demand.

AD2

AD3

1. When an increase in government purchases increases aggregatedemand . . .

r2

$20 billion


When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.

Changes in Taxes

When the government cuts personal income taxes, it increases households’ take-home pay.

Households save some of this additional income.

Households also spend some of it on consumer goods.

Increased household spending shifts the aggregate-demand curve to the right.

Changes in Taxes

The size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding-out effects.

It is also determined by the households’ perceptions about the permanency of the tax change.

Active learning 1

The economy is in recession. Shifting the AD curve rightward by $200b would end the recession.

A. If MPC = .8 and there is no crowding out, howmuch should Congress increase G to end the recession?

B. If there is crowding out, will Congress need to increase G more or less than this amount?

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Fiscal policy and aggregate supply

Most economists believe the short-run effects of fiscal policy mainly work through AD.

But fiscal policy might also affect AS.

People respond to incentives. A cut in the tax rate gives workers incentive to work more, so it might increase the quantity of g&s supplied and shift AS to the right.

People who believe this effect is large are called “Supply-siders.”

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Fiscal policy and aggregate supply

Govt purchases may also affect AS:

Suppose govt increases spending on roads (or other public capital).

Better roads may increase business productivity, which increases the quantity of g&s supplied, shifts AS to the right.

This effect is probably more relevant in the long run, as it takes time to build the new roads and put them into use. slide 34

USING POLICY TO STABILIZE THE ECONOMY

Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946, which states that:– “it is the continuing policy and

responsibility of the federal government to…promote full employment and production.”

The Case for Active Stabilization Policy

The Employment Act has two implications:– The government should avoid being

the cause of economic fluctuations.– The government should respond to

changes in the private economy in order to stabilize aggregate demand.

The Case for Active Stabilization Policy

when GDP falls below its natural rate, should use expansionary monetary or fiscal policy to prevent or reduce a recession

when GDP rises above its natural rate, should use contractionary policy to prevent or reduce an inflationary boom

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The Case against Active Stabilization Policy

Some economists argue that monetary and fiscal policy destabilizes the economy.

Monetary and fiscal policy affect the economy with a substantial lag.

They suggest the economy should be left to deal with the short-run fluctuations on its own.

policymakers should focus on long-run goals, like economic growth and low inflation.

Automatic Stabilizers

Automatic stabilizers are changes in fiscal policy that stimulate AD when the economy goes into a recession without policymakers having to take any deliberate action.

Automatic stabilizers include the tax system and some forms of government spending.

Financing the Budget deficit

Borrowing from the Public, and foreign organizations

Raising Taxes / Reducing Government Expenditure.

Printing Money

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Drawbacks and Limitations of Fiscal Policy

Time lags– recognition lag, decision lag,

implementation lag, impact lag

Changing spending and taxation policies

Size of debt

Crowding out

Future generations compromised

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The U.S. Federal Government Budget

(T -G) as a % of GDP

-12

-8

-4

0

4

1940 1950 1960 1970 1980 1990 2000

% o

f G

DP

The Federal Budget

GLOBAL PERSPECTIVE

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BUDGET DEFICITS OR SURPLUSESAS A PERCENTAGE OF GDP, 1999

-8 -6 -4 -2 0 2 4

DenmarkCanadaSweden

United KingdomUnited States

GermanyItaly

FranceCzech Republic

HungaryJapan

Source: Organization for Economic Development and Cooperation

The Government Debt

Government debt is the total amount that the government has borrowed—that the government owes. It is the accumulation of all past deficits.

The U.S. Federal Government Debt

0

20

40

60

80

100

120

1940 1950 1960 1970 1980 1990 2000

Per

cent

of G

DP

Fun fact: In the early 1990s, nearly 18 cents of every tax dollar went to pay interest on the debt. (Today it’s about 9 cents.)

Fun fact: In the early 1990s, nearly 18 cents of every tax dollar went to pay interest on the debt. (Today it’s about 9 cents.)

chapter05 fiscal policy

Documents

deficitswhen t g

level of government

public savingwhen t

government budgetslide

federal government

government policymakers

supply slide

gdpassume government