copyright 2008 the mcgraw-hill companies 11-1 chapter 12 fiscal policy o 11.1

Copyright 2008 The McGraw-Hill Companies11-1

Chapter 12

Fiscal Policy

O 11.1


Learning objectives

In this chapter students will learn:In this chapter students will learn:

1.1. The purposes, tools, and limitations of fiscal The purposes, tools, and limitations of fiscal policy.policy.

2.2. The role of built-in stabilizers in moderating The role of built-in stabilizers in moderating business cycles. business cycles.

3.3. The problems, criticisms, and complications The problems, criticisms, and complications of fiscal policy.of fiscal policy.


• One major function of the government is to One major function of the government is to stabilize the economy (prevent unemployment stabilize the economy (prevent unemployment or inflation).or inflation).

• Stabilization can be achieved in part by Stabilization can be achieved in part by manipulating the public budget manipulating the public budget -government -government spending and tax collections-spending and tax collections- to increase to increase output and employment or to reduce inflation.output and employment or to reduce inflation.


Fiscal Policy and the AD/AS Model1. Discretionary fiscal policy (active1. Discretionary fiscal policy (active) ) • Refers to the deliberate manipulation of taxes and Refers to the deliberate manipulation of taxes and

government spending to government spending to alter real domestic outputalter real domestic output and employment, and employment, control inflationcontrol inflation, and stimulate , and stimulate economic growth (fiscal policy goals)economic growth (fiscal policy goals). .

• ““Discretionary” means the changes are at the Discretionary” means the changes are at the optionoption of the government. Discretionary fiscal of the government. Discretionary fiscal policy changes are often initiated by the country policy changes are often initiated by the country leader, on the advice of economic advisers.leader, on the advice of economic advisers.

1.1. Nondiscretionary or Automatic:Nondiscretionary or Automatic: • changes not directly resulting from congressional changes not directly resulting from congressional

actions are referred to as nondiscretionary (or actions are referred to as nondiscretionary (or “passive”) fiscal policy.“passive”) fiscal policy.


• Fiscal policy choices:Fiscal policy choices: 1.1. Expansionary fiscal policy:Expansionary fiscal policy:• is used to combat a is used to combat a recessionrecession. If there is a decline in. If there is a decline in I Igg

which has decreased AD from AD1 to AD2 so real which has decreased AD from AD1 to AD2 so real GDP has fallen and employment has declined (see GDP has fallen and employment has declined (see examples illustrated in Figure 11.1). Possible fiscal examples illustrated in Figure 11.1). Possible fiscal policy solutions follow:policy solutions follow:a. An increase in government spending (shifts AD to right by a. An increase in government spending (shifts AD to right by

more than change in G due to multiplier),more than change in G due to multiplier),b. A decrease in taxes (raises income, and consumption rises b. A decrease in taxes (raises income, and consumption rises

by MPC by MPC x change in income; AD shifts to right by a multiple change in income; AD shifts to right by a multiple of the change in consumption).of the change in consumption).

c. A combination of increased spending and reduced taxes. c. A combination of increased spending and reduced taxes.

• If the budget was initially balanced, expansionary If the budget was initially balanced, expansionary fiscal policy creates a fiscal policy creates a budget deficitbudget deficit..


Fiscal Policy and the AD-AS Model

Real Domestic Output, GDP

Pri

ce L

evel

AD2

RecessionsDecreaseAggregateDemand

AD1

$5 Billion AdditionalSpending

Full $20 Billion Increase in

Aggregate Demand

AS

$490 $510

P1

Expansionary Fiscal Policy


2. Contractionary fiscal policy2. Contractionary fiscal policy• Needed when Needed when demand‑pull inflationdemand‑pull inflation occurs as occurs as

illustrated by a shift from ADillustrated by a shift from AD33 to AD to AD44 up the short- up the short-run aggregate supply curve in Figure 11.2. Then run aggregate supply curve in Figure 11.2. Then contractionary policy is the remedy:contractionary policy is the remedy:

a. a. A decrease in government spendingA decrease in government spending shifts AD shifts AD44 back to AD back to AD33 once the multiplier process is complete. Here price level once the multiplier process is complete. Here price level returns to its pre-inflationary level Preturns to its pre-inflationary level P33 but GDP returns to but GDP returns to its noninflationary full-employment level of output ($510 its noninflationary full-employment level of output ($510 billion).billion).

b. b. An increase in taxesAn increase in taxes will reduce income and then will reduce income and then consumption at first by MPC consumption at first by MPC x fall in income, and then the fall in income, and then the multiplier process leads AD to shift leftward still further. multiplier process leads AD to shift leftward still further. In Figure 11.2 a tax increase of $6.67 billion decreases In Figure 11.2 a tax increase of $6.67 billion decreases consumption by 5 and multiplier causes eventual shift to consumption by 5 and multiplier causes eventual shift to ADAD33..


Pri

ce le

vel

Real GDP (billions)

CONTRACTIONARY FISCAL POLICY

Full $20 billiondecrease in aggregatedemand

AD3 AD4

$5 billion initial decrease in G spending or 6.67 increase in T

the multiplier at work...

P2

$510 $530

AS

P1


c. A combined spending decrease and tax increase could have c. A combined spending decrease and tax increase could have the same effect with the right combination ($2 billion the same effect with the right combination ($2 billion decline in G and $4 billion rise in T will have this effect).decline in G and $4 billion rise in T will have this effect).

• Policy options: G or T?Policy options: G or T?1.1. Economists tend to favor higher G during recessions Economists tend to favor higher G during recessions

and higher taxes during inflationary times if they are and higher taxes during inflationary times if they are concerned about concerned about unmet social needsunmet social needs or or infrastructureinfrastructure..

2.2. Others tend to favor lower T for recessions and Others tend to favor lower T for recessions and lower G during inflationary periods when they think lower G during inflationary periods when they think government is government is too large and inefficienttoo large and inefficient..


Built-In StabilityBuilt‑in stability:Built‑in stability: arises because arises because net taxesnet taxes (taxes (taxes minus transfers and subsidies) minus transfers and subsidies) change with GDPchange with GDP (recall that taxes reduce incomes and therefore, (recall that taxes reduce incomes and therefore, spending). spending).

• It is desirable It is desirable for spending to risefor spending to rise when the economy when the economy is is slumpingslumping and vice versa when the economy is and vice versa when the economy is becoming inflationary. Figure 11.3 illustrates how the becoming inflationary. Figure 11.3 illustrates how the built-in stability system behaves: built-in stability system behaves: 1.1. Taxes automatically rise with GDP because incomes rise Taxes automatically rise with GDP because incomes rise

and tax revenues fall when GDP falls. and tax revenues fall when GDP falls.

2.2. Transfers and subsidies rise when GDP falls; when these Transfers and subsidies rise when GDP falls; when these government payments (welfare, unemployment, etc.) rise, government payments (welfare, unemployment, etc.) rise, net tax revenues fall along with GDP. net tax revenues fall along with GDP.


• The size of automatic stability depends on The size of automatic stability depends on responsivenessresponsiveness of of changes in changes in taxestaxes to changes in GDP: The more to changes in GDP: The more progressiveprogressive the the tax system, the greater the economy’s built‑in stability. tax system, the greater the economy’s built‑in stability.

• In Figure 11.3 line T is steepest with a progressive tax system.In Figure 11.3 line T is steepest with a progressive tax system.

• The U.S. tax system reduces business fluctuations by as much The U.S. tax system reduces business fluctuations by as much as as 8 to 108 to 10 percent of the change in GDP that would otherwise percent of the change in GDP that would otherwise occur.occur.

• Automatic stability reduces instability, but Automatic stability reduces instability, but does notdoes not eliminateeliminate economic instability.economic instability.


Built-In Stability

G

T

Deficit

Surplus

GDP1 GDP2 GDP3

Real Domestic Output, GDP

Go

vern

men

t E

xpen

ses,

Gan

d T

ax R

even

ues

, T


Problems, Criticisms and Complications1.1. Problems of timingProblems of timing

• Recognition lagRecognition lag is the elapsed time between the beginning of is the elapsed time between the beginning of recession or inflation and awareness of this occurrence.recession or inflation and awareness of this occurrence.

• Administrative lagAdministrative lag is the difficulty in changing policy once is the difficulty in changing policy once the problem has been recognized.the problem has been recognized.

• Operational lagOperational lag is the time elapsed between change in is the time elapsed between change in policy and its impact on the economy.policy and its impact on the economy.


Problems, Criticisms and Complications

2.2. Political considerations: Political considerations: Government has other goals besides economic stability, Government has other goals besides economic stability, these may conflict with stabilization policy.these may conflict with stabilization policy.

• A political business cycle may destabilize the economy: A political business cycle may destabilize the economy: Election years have been characterized by more Election years have been characterized by more expansionary policies regardless of economic conditions.expansionary policies regardless of economic conditions.

3.3. Future Policy ReversalsFuture Policy Reversals• If households expects future reversals of policy, fiscal policy If households expects future reversals of policy, fiscal policy

may fail to achieve intended objectives. e.g., if tax payers may fail to achieve intended objectives. e.g., if tax payers believes that tax reduction is temporary they will save their believes that tax reduction is temporary they will save their tax savings. Tax reductions thus, do not boast consumption tax savings. Tax reductions thus, do not boast consumption and AD. and AD.


Problems, Criticisms and Complications

4.4. The crowding‑out effect The crowding‑out effect The crowding‑out effect may be caused by fiscal policy.The crowding‑out effect may be caused by fiscal policy.

• ““Crowding‑out” may occur with government Crowding‑out” may occur with government deficitdeficit spending. It may increase the interest rate and reduce spending. It may increase the interest rate and reduce private spending which weakens or private spending which weakens or cancelscancels the the stimulus of stimulus of fiscal policyfiscal policy. .

• Some economists argue that Some economists argue that littlelittle crowding out will occur crowding out will occur during a during a recessionrecession..

• Economists agree that government Economists agree that government deficitsdeficits should should notnot occur occur at at full employmentfull employment, it is also argued that monetary , it is also argued that monetary authorities could counteract the crowding‑out by increasing authorities could counteract the crowding‑out by increasing the the money supplymoney supply to accommodate the expansionary fiscal to accommodate the expansionary fiscal policy.policy.


Current thinking on fiscal policyCurrent thinking on fiscal policy

• Some economists Some economists opposeoppose the use of fiscal policy, believing that the use of fiscal policy, believing that monetary policymonetary policy is more effective or that the economy is is more effective or that the economy is sufficiently self-correcting.sufficiently self-correcting.

• Most economists support the use of Most economists support the use of fiscal policyfiscal policy to help “ to help “push push the economythe economy” in a desired direction, and using ” in a desired direction, and using monetary monetary policypolicy more for “ more for “fine tuningfine tuning.” .”

• Economists agree that the potential impacts (positive and Economists agree that the potential impacts (positive and negative) of fiscal policy on long-term productivity growth negative) of fiscal policy on long-term productivity growth should be evaluated and considered in the decision-making should be evaluated and considered in the decision-making process, along with the short-run cyclical effects. process, along with the short-run cyclical effects.

copyright 2008 the mcgraw-hill companies 11-1 chapter 12 fiscal policy o 11.1

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