Chapter 12 Fiscal Policy

John Maynard Keynes and Fiscal Policy John Maynard Keynes explained how a deficiency in demand could arise in a market economy. He showed how and why the government should intervene to achieve macroeconomic goals. He also advocated aggressive use of fiscal policy to alter market outcomes.

Fiscal Policy Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes. The premise of fiscal policy is that the aggregate demand for goods and services will not always be compatible with economic stability.

Components of Aggregate Demand Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

Components of Aggregate Demand The four major components of aggregate demand are: –Consumption (C) –Investment (I) –Government spending (G) –Net exports (exports minus imports) (X- IM) AD = C + I + G + (X - IM)

Components of Aggregate Demand

Consumption (C) Consumption refers to expenditures by consumers on final goods and services. Consumption spending accounts for approximately two-thirds of total spending in the U.S. economy. Consumers often change their spending behavior.

Investment (I) Investment refers to expenditures on (production of) new plant and equipment in a given time period, plus changes in business inventories.

Government Spending (G) Government spending includes expenditures on all goods and services provided by the public sector. Income transfers are not included: –Income transfers are payments to individuals for which no services are exchanged.

Net Exports (X-IM) Net exports is the difference between export and import spending. Currently Americans are buying more goods from abroad than foreigners are buying from us. This means that U.S. net exports are negative.

Equilibrium Aggregate demand is not a single number but instead a schedule of planned purchases. Macro equilibrium is the combination of price level and real output that is compatible with both aggregate demand and aggregate supply.

Equilibrium There is no guarantee that AD will always produce an equilibrium at full employment and price stability. Sometimes there will be too little demand and sometimes there will be too much.

Inadequate Demand AD could fall short of the full-employment equilibrium, leaving some potential output unsold at the equilibrium point.

Excessive Demand AD could generate too much spending, causing the economy to produce at more than the full-employment equilibrium.

The Desired Equilibrium

The Nature of Fiscal Policy C + I + G + (X - IM) seldom adds up to exactly the right amount of aggregate demand. The use of government spending and taxes to adjust aggregate demand is the essence of fiscal policy.

Fiscal Policy

Fiscal Stimulus If AD falls short, there is a gap between what the economy can produce and what people want to buy. The GDP gap is the difference between full-employment output and the amount of output demanded at current price levels.

Deficient Demand

More Government Spending Increased government spending is a form of fiscal stimulus: –Fiscal stimulus - tax cuts or spending hikes intended to increase (shift) aggregate demand.

Multiplier Effects An increase in spending results in increased incomes. All income is either spent or saved: –Saving - Income minus consumption or that part of disposable income not spent.

Multiplier Effects Each dollar spent is re-spent several times. As a result, every dollar has a multiplied impact on aggregate income.

Multiplier Effects The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption:

Multiplier Effects The marginal propensity to save (MPS) is the fraction of each additional (marginal) dollar of disposable income not spent on consumption:

Multiplier Effects Spending and saving decisions are connected: MPS = 1 – MPC or MPC + MPS = 1

MPC and MPS

Multiplier Effects and the Circular Flow The fiscal stimulus to aggregate demand includes: –The initial increase in government spending. –All subsequent increases in consumer spending triggered by the government outlays.

Multiplier Effects and the Circular Flow Income gets spent and respent in the circular flow.

The Circular Flow

Spending Cycles The demand stimulus initiated by increased government spending is a multiple of the initial expenditure.

The Multiplier Process at Work

Multiplier Formula The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles: Multiplier = 1/(1-MPC)

Multiplier Formula The multiplier process at work: Every dollar of fiscal stimulus has a multiplied impact on aggregate demand. Total change in spending = Multiplier x Initial change in government spending

Multiplier Effects

Tax Cuts Rather than increasing its own spending, government can cut taxes to increase consumption or investment spending. A tax cut directly increases disposable income: –Disposable income is the after-tax income of consumers.

Taxes and Consumption So long as the MPC is greater than zero, a tax cut will stimulate more consumer spending: Initial increase in consumption = MPC x tax cut

Taxes and Consumption The cumulative increase in aggregate demand equals a multiple of the tax induced change in consumption. Cumulative change in spending = multiplier x initial change in consumption

Taxes and Consumption A tax cut that increases disposable incomes stimulates consumer spending. The cumulative increase in aggregate demand is a multiple of the initial tax cut.

Taxes and Investment Tax cuts can increase investment spending by increasing the expectations of after-tax profits. Taxes were reduced in 1964 and in 1981 to stimulate spending. President Bush pushed even larger tax cuts in 2001, 2002, and 2003.

Inflation Worries Whenever the aggregate supply curve is upward-sloping, an increase in aggregate demand increases prices as well as output. President Clinton raised taxes partly because he feared inflationary pressures were building.

Fiscal Restraint Fiscal restraint may be the proper policy when inflation threatens: –Fiscal restraint - tax hikes or spending cuts intended to reduce (shift) aggregate demand.

Fiscal Restraint

Budget Cuts Cutbacks in government spending directly reduce aggregate demand. As with spending increases, the impact of spending cuts is magnified by the multiplier.

Multiplier Cycles Government cutbacks have a multiplied effect on aggregate demand: Cumulative reduction in spending = multiplier x initial budget cut

Tax Hikes Tax increases reduce disposable income and thus reduce consumption. This shifts the aggregate demand curve to the left. Tax increases have been used to “cool down” the economy.

Tax Hikes The Equity and Fiscal Responsibility Act of 1982 increased taxes to reduce inflationary pressures. President Clinton restrained aggregate demand in 1993 with a tax increase, but increased AD in 1997 with a five-year package of tax cuts.

Fiscal Guidelines The policy goal is to match aggregate demand with the full-employment potential of the economy. The fiscal strategy for attaining that goal is to shift the aggregate demand curve.

Fiscal Policy Guidelines

Unbalanced Budgets The use of the budget to manage aggregate demand implies that the budget will often be unbalanced.

Budget Deficit Budget deficit - the amount by which government expenditures exceed government revenues in a given time period: Budget deficit = Government spending > Tax revenues

Budget Deficit The government borrows money to pay for deficit spending. The federal government ran significant budget deficits between 1970 and 1997.

Budget Surplus Budget surplus - an excess of government revenues over government expenditures in a given time period: Budget surplus =Government spending < Tax revenues

Unbalanced Budgets

Budget Surplus By 1998, a combination of growing tax revenues and slower government spending created a budget surplus. Starting in 2003, however, the budget returned to a deficit.

Countercyclical Policy In Keynes’ view, an unbalanced budget is perfectly appropriate if macro conditions call for a deficit or surplus. A balanced budget is appropriate only if the resulting AD is consistent with full- employment equilibrium.

Fiscal Policy End of Chapter 12