Fiscal Policy Fiscal policy – changes in government expenditures and taxation to achieve macroeconomic goals. Fiscal policy may affect whether the economy produces at Natural Real GDP in the short run. Fiscal policy may affect the level of economic growth in the long run.

Fiscal Policy and the Budget Changes in fiscal policy affect the federal government’s budget. Budget deficit – when government expenditures are greater than tax revenues. Budget surplus – when tax revenues are greater than government expenditures.

Keynesian Fiscal Policy According to Keynesian theory, the level of Real GDP is determined by the level of Total Expenditures. The level of Total Expenditures may not be the level that will cause the economy to achieve Natural Real GDP.

The federal government may be able to move the level of TE toward the ideal level (and move Real GDP toward Natural Real GDP) by using fiscal policy. Keynesian Fiscal Policy

Keynesian Fiscal Policy and a Recessionary Gap To close a recessionary gap, Keynesian theory calls for the use of expansionary fiscal policy (an increase in government expenditures or a decrease in taxation). Keynesian theory calls for the use of deficit spending to close a recessionary gap.

Keynesian Fiscal Policy and a Recessionary Gap Example 1: If Real GDP is $15,000 billion and Natural Real GDP is $15,500 billion, the economy is in a recessionary gap. If the MPC is.80, an increase in government purchases of $100 billion would cause an eventual increase in Real GDP of $500 billion, closing the recessionary gap.

Recessionary Gap

Return to Natural Real GDP

Keynesian Fiscal Policy and an Inflationary Gap To close an inflationary gap, Keynesian theory calls for the use of contractionary fiscal policy (a decrease in government expenditures or an increase in taxation). Keynesian theory calls for the use of budget surpluses to close an inflationary gap.

Keynesian Fiscal Policy and an Inflationary Gap Example 2: If Real GDP is $16,000 billion and Natural Real GDP is $15,500 billion, the economy is in an inflationary gap. If the MPC is.80, a decrease in government purchases of $100 billion would cause an eventual decrease in Real GDP of $500 billion, closing the inflationary gap.

Inflationary Gap

Return to Natural Real GDP

Certain transfer payments (e.g. unemployment compensation) will automatically increase during a recessionary gap and decrease during an inflationary gap. Certain taxes (e.g. income tax) will automatically decrease during a recessionary gap and increase during an inflationary gap. Automatic Stabilizers

Automatic stabilizers – taxes and transfer payments that automatically tend to move equilibrium Real GDP toward Natural Real GDP. Example 3: The unemployment rate increased from 4% in 2000 to 6% in Unemployment compensation increased from $23 billion in 2000 to $57 billion in Corporate income taxes decreased from $207 billion in 2000 to $132 billion in 2003.

Potential Problems with Fiscal Policy 1. There may be a political bias toward expansionary fiscal policy at all times. Contractionary fiscal policy may be politically unpopular. Since Keynesian theory was introduced in 1936, the federal government has had budget deficits in all but 12 years.

Potential Problems with Fiscal Policy 2. Crowding out – increases in government spending lead to decreases in private spending. a. If increased government spending is paid for with increased taxes, this will mainly reduce consumption. b. If increased government spending is paid for with deficit spending, this will mainly reduce investment.

3. Fiscal policy may be mistimed because of lags; a. The information lag. Government policy makers have access to information about the business cycle only after some time has passed. See Example 6A on page 9-6. Potential Problems with Fiscal Policy

3. Fiscal policy may be mistimed because of lags; b. The policy lag. Enacting a change fiscal policy (e.g. a tax cut, a new spending program) takes time. See Example 6B on page 9-6. Potential Problems with Fiscal Policy

3. Fiscal policy may be mistimed because of lags; c. The impact lag. Once a change in fiscal policy is enacted, it takes time before the new policy has its full effect on Real GDP. See Example 6C on page 9-7. Potential Problems with Fiscal Policy

4. Fiscal policy may be miscalculated. The government doesn’t really know how large the multiplier will be, what Natural Real GDP is, or even what the current level of Real GDP is.

Supply-side Fiscal Policy Supply-side economists argue that Keynesian fiscal policy has had a harmful effect on the supply side of the economy. Deficit spending has led to a growing federal government. See Examples 7A and 7B on page 9-8.

The growing federal government has led to high marginal tax rates. High marginal tax rates reduce incentives, and can thus reduce both SRAS and, especially, LRAS. See Example 8 on page 9-8. Supply-side Fiscal Policy

Lower Marginal Tax Rates Supply-side economists support lowering marginal tax rates. Lowering marginal tax rates would increase incentives, and would thus increase production in both the short run and the long run.

The Laffer Curve The relationship between tax rates and tax revenue can be illustrated on a Laffer curve. The Laffer curve indicates that lowering tax rates might increase tax revenue.

The Laffer Curve

Supply-side Tax Cuts During the Reagan presidency, the top marginal tax rate was lowered from 70% to 28%. The supply-side tax cuts of the 1980s led to an increase in real federal tax paid by higher income taxpayers. See Example 10A and 10B on page 9-9.

History of the Federal Government’s Budget Since Keynesian theory was introduced in 1936, the federal government has had budget deficits in all but 12 years. See the Table on page 9-10.

Appendix: The Importance of Incentives A fundamental assumption of economic reasoning is that people respond to incentives. See the Appendix on page 9-11.