Chapter 10 Fiscal Policy CoreEconomics 2 nd edition by Gerald W. Stone © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Slides By: Debbie Evercloud

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Fiscal Policy and Aggregate Demand Fiscal Policy and Aggregate Supply Implementing Fiscal Policy Chapter Outline

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone At the end of this chapter, the student will be able to: – Describe the tools that governments use to influence aggregate demand – Describe mandatory and discretionary fiscal policy – Describe the multiplier effect of increased government spending on the equilibrium output of an economy Learning Objectives

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone At the end of this chapter, the student will be able to: – Discuss drawbacks of discretionary fiscal policy – Describe expansionary and contractionary fiscal policy – Describe why tax changes have a smaller impact on the economy than changes in government spending Learning Objectives

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone At the end of this chapter, the student will be able to: – Describe the fiscal policies that governments use to influence aggregate supply – Describe the impact of automatic stabilizers, lag effects, and the crowding out effects in fiscal policymaking – Describe the debate over the size of government and economic policy Learning Objectives

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Fiscal Policy Fiscal policy is one way the government tries to manage the economy and to tame the business cycle. Fiscal policy involves a trade-off. – In a recessionary environment, higher output can be achieved at the expense of rising prices. – During times of inflation, the price level can be lowered at the expense of increased unemployment.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Discretionary Spending The federal budget can be split into two distinct types of spending: discretionary and mandatory. – Discretionary spending is that part of the budget that works its way through the appropriations process of Congress each year. – It includes such programs as national defense, transportation, science, environment, income security (some welfare programs like Medicaid), education, and veterans benefits and services.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Mandatory Spending Mandatory spending is authorized by permanent laws and does not go through the same appropriation process as discretionary spending. To change these entitlements, Congress must change the law. – Mandatory spending includes such programs as Social Security and interest on the national debt.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Discretionary Fiscal Policy The exercise of discretionary fiscal policy involves adjusting government spending and tax policies with the express short-run goal of moving the economy toward full employment, encouraging economic growth, or controlling inflation.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Discretionary Fiscal Policy Some examples of the use of discretionary fiscal policy include tax cuts enacted during the Kennedy, Reagan, and George W. Bush administrations. These tax cuts were designed to expand the economy, both in the near term and in the long run. They were meant to influence both aggregate demand and aggregate supply. The check is in the mail!

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone The Multiplier Effect When government spending is injected into the economy, the total level of economic activity will expand by an amount equal to the amount of the new expenditure times the multiplier. Because the short-run aggregate supply curve is upward-sloping, some of the increase in output is absorbed by rising prices.

The Multiplier Effect © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Aggregate Output Aggregate Price Level LRAS SRAS AD 1 AD 0 When government spending shifts aggregate demand to the right, the equilibrium level of output will increase along with the price level. Q1Q1 Q0Q0 P0P0 P1P1

How Big is the Multiplier? In order to determine the amount of the 2009 stimulus package, policy makers needed an estimate for the value of the multiplier. – Studies suggest that the spending multiplier is somewhere between 1 and 2. – There is evidence that the long-run tax multiplier may approach 3 because tax reductions have a longer running impact on the economy than short-run spending increases. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone

Taxes When taxes are increased, money is withdrawn from the economy’s spending stream. When taxes are reduced, consumers and business have more to spend. A tax increase (or decrease, for that matter) will have less of a direct impact on income, employment, and output than will an equivalent change in government spending.

Expansionary Fiscal Policy Expansionary fiscal policy can be used to shift aggregate demand to the right and close a recessionary gap. – Employment will increase as output expands. – The aggregate price level will rise. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone

Expansionary Fiscal Policy Aggregate Price Level (P) Aggregate Output (Q) LRAS AS 0 AD 1 QfQf Q0Q0 AD 0 e f P0P0 P1P1 If the economy begins at point e below full employment, expansionary fiscal policy can be implemented so as to boost aggregate demand to AD 1.

Contractionary Fiscal Policy When an economy moves to a point beyond full employment, an inflationary spiral has set in. One way to reduce such inflationary pressures is by a contractionary fiscal policy: reducing government spending, transfer payments, or raising taxes (increasing withdrawals from the economy). © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone

Contractionary Fiscal Policy If the economy is beyond the point of full employment, contractionary fiscal policy can be used to dampen inflationary pressures. This requires an increase in taxes or a decrease in government spending.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Contractionary Fiscal Policy Aggregate Price Level (P) Aggregate Output (Q) LRAS AS 0 AD 0 QfQf AD 1 Q0Q0 P1P1 P0P0 a e A contractionary fiscal policy that would shift aggregate demand from AD 0 to AD 1 will lower the price level as it reduces aggregate output.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Supply-Side Fiscal Policies Supply-side fiscal policies are different from policies to influence aggregate demand in that they do not always require such tradeoffs between price levels and output. Supply-side policies require more time to work than do demand-side policies. – They aim to shift the long-run aggregate supply curve to the right.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Supply-Side Outcomes Modern growth theory suggests governments can do a lot to create the right environment to encourage economic growth. – Provide infrastructure – Create a fair and efficient legal system – Establish a stable financial system – Provide for the development of human capital – Encourage the diffusion of technology

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone The Laffer Curve Lower tax rates may increase productivity. The Laffer Curve shows that tax revenues can sometimes be increased by lowering tax rates. – Reducing tax rates should encourage risk-taking by entrepreneurs since lower taxes mean higher after-tax returns on investments. Similarly, cutting taxes should encourage private saving and business investment.

Supply-Side Outcomes Another aspect of supply-side policy focuses on the incentive effects associated with income tax rates. At times, marginal tax rates have been reduced to stimulate incentives for business formation. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone

Encouraging Investment Investment can be encouraged by such policies as investment tax credits and more rapid depreciation schedules for plant and equipment. – When a firm can expense its capital equipment over a shorter period of time, it cuts taxes now rather than later, and so earns a higher net return.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Encouraging Investment Similarly, government grants for basic research help firms increase their budgets for research and development, which results in new products brought to market.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Curbing Regulation Another way of increasing supply without raising prices involves repealing unnecessarily onerous regulations that simply hamper business and add to costs. Examples of excessively regulated industries have included trucking and the airlines. – When these industries were deregulated in the 1980s, prices fell and productivity improved.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Automatic Stabilizers Tax revenues and transfer payments are the two principal automatic stabilizers. Without any overt action by Congress or other policy makers, these components of the federal budget will expand or contract in ways that help counter movements of the business cycle.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Automatic Stabilizers The income tax is a powerful stabilizer because of its progressivity. – When incomes fall, tax revenues fall faster since people do not just pay taxes on smaller incomes, but they also pay at lower rates as their incomes fall. Disposable income, in other words, falls more slowly than aggregate income.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Automatic Stabilizers The key point to remember here is that automatic stabilizers reduce the intensity of business fluctuations. Automatic stabilizers do not eliminate fluctuations in the business cycle, but they render business cycles smoother and less chaotic.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Fiscal Policy Timing Lags Information lag – Most of the macroeconomic data that policy makers need to enact the proper fiscal policies are not available until at least one quarter after the fact. Recognition lag – Even if the most recent data suggest the economy is trending into a recession, it may take several quarters to confirm the record.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Fiscal Policy Timing Lags Decision lag – Congress and the White House must agree on an approach. Implementation lag – Fiscal policy requires a long and often contentious legislative and implementation process.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone The Crowding-Out Effect The crowding-out effect of fiscal policy arises from deficit spending, which requires the government to borrow. This borrowing can drive up interest rates. A higher cost of borrowing will dampen consumer spending on durable goods such as cars or refrigerators. It will also discourage business investment.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone The Crowding-Out Effect While deficit spending is usually expansionary, its impact can be partially offset by reductions in private spending.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Chapter Summary Governments try to influence aggregate demand by using fiscal policy. The government’s main fiscal policy tools are spending on goods and services, transfer payments, and taxes. Fiscal policy is powerful because of the multiplier effect, which tells us that added government spending will raise equilibrium income and output by the multiplier times the added expenditure.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Chapter Summary Expansionary fiscal policies include increasing government spending; increasing transfer payments such as social security, unemployment compensation, and welfare payments; and decreasing taxes. These policies put more money into the hands of consumers and businesses. – The opposite policies are contractionary. The size of the spending multiplier will depend on how much slack there is in the economy.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Chapter Summary Supply-side policies do not require such tradeoffs; they can expand output without raising prices. - The goal of supply-side economics is to shift the long-run aggregate supply curve to the right. Automatic stabilizers such as transfer payments and the progressive income tax counteract fluctuations of the business cycle.

© 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Chapter Summary Using fiscal policy to smooth out the short-term business cycle is difficult because of several lags associated with implementing it. The crowding-out effect arises when the government engages in deficit spending, thereby driving up interest rates. This action can reduce spending on durable goods and business investment. Deficit spending has an expansionary effect on the economy, but this effect can be diminished by offsetting reductions in private spending.