Fiscal Policy How the government uses discretionary fiscal policy to influence the economies performance

Discretionary Fiscal Policy The deliberate use of changes in government spending or taxes to alter aggregate demand Examples of Expansionary Fiscal Policy Increase government spending Decrease taxes Increase government spending and taxes equally Examples of Contractionary Fiscal Policy Decrease government spending Increase taxes Decrease government spending and taxes equally

Price Level 155 150 AD2 AD1 Real GDP $6 $6.1 $6.2 Government Fiscal Policy to Combat a Recession Increase Government Spending Decrease Tax Price Level AS Increase in the aggregate demand curve Increase in the price level and the real GDP 155 150 AD2 AD1 Real GDP $6 $6.1 $6.2 full employment

C MPC = Y Spending Multiplier Calculating the Spending Multiplier Any initial change in spending leads to a chain reaction of more spending which causes a greater change in demand Calculating the Spending Multiplier The ratio of the change in real GDP to an initial change in aggregate expenditure Marginal Propensity to Consume (MPC) The change in consumption resulting from a change in income C Y MPC =

Spending Multiplier 1 1 – MPC MPC = 0.75 1 1 – 0.75 = 4 Real GDP increases with an increase in government spending of $50 billion M x ΔG = ΔQ 4 x $50 billion = $200 billion

Tax Multiplier Formula The change in aggregate demand (total spending) resulting from an initial change in taxes When government cuts taxes by $50 billion The multiplier process is less because initial spending increases only by $38 billion instead of $50 billion The tax cut has a smaller multiplier effect on aggregate demand than an equal increase in government spending Tax Multiplier Formula 1 – spending multiplier With spending multiplier of 4 the tax multiplier is 1 – spending multiplier = -3 Real GDP increases by $150 billion with a cut in taxes of $50 billion -3 x -$50 billion = $150 billion

The MPC can change from one time period to another Fiscal policy be used to combat inflation when the economy is operating in the intermediate range of the aggregate supply curve

Decrease in the price level Fiscal Policy to Combat Inflation Price Level Reduce Government Spending Increase Tax AD2 AS Decrease in the aggregate demand curve Decrease in the price level 160 155 AD1 Real GDP 6 6.1 full employment

What will happen to AD with a tax increase of 33.3 billion? What happens to Aggregate Demand (AD) with a cut in Government (G) spending of 25 billion? ΔG x GM = ΔAD GM = Government Spending Multiplier -$25 billion x 4 = -$100 billion What will happen to AD with a tax increase of 33.3 billion? ΔT x TM = ΔAD TM = Tax Multiplier $33.3 x -3 = -$100 billion

Automatic Stabilizers Federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction Government Expenditure Examples Transfer payments Unemployment compensation Welfare Progressive Income Tax The more a person earns the greater the percentage tax burden

Budget Surplus Budget Deficit A budget in which government revenues exceed government expenditures in a given time period Budget Deficit A budget in which government expenditures exceed government revenues in a given time period

Government Spending and Taxes Automatic Stabilizers T $1,000 Budget deficit Budget surplus $750 Government Spending and Taxes $500 G $250 $4 $6 $8 Real GDP

Automatic Stabilizers Increase in real GDP Tax collections rise and government transfer payments fall Budget surplus offsets inflation Decrease in real GDP Tax collections fall and government transfer payments rise Budget deficit offsets recession

Supply-side Fiscal Policy A fiscal policy that emphasizes government policies that increase aggregate supply Purpose: to achieve long-run growth in real output, full employment, and a lower price level

Demand-Side Fiscal Policy Price Level Increase in government spending; decrease in net taxes AD2 AS 250 Increase in the aggregate demand curve 200 150 100 AD1 2 4 6 8 10 Real GDP full employment

Supply-Side Fiscal Policy Price Level AS1 250 AS2 200 Decrease in resource prices; technological advances; subsidies; decrease in regulations 150 Increase in the aggregate supply curve 100 AD Real GDP 2 4 6 8 10 full employment

Supply-Side Policies Affect Labor Markets Wage rate Before tax-cut labor supply After tax-cut labor supply W1 W2 Labor Demand L1 L2 Quantity of Labor

Supply-side policy Tax rate cuts Higher disposable income boosts worker’s incentives to work harder and produce more Firms invest more and create new ventures, which increase jobs and output Aggregate supply curve increase Economy expands, employment rises, and inflation is reduced

Keynesian policy Tax rate cuts Higher disposable income increases money for spending People spend extra income on more goods and services Aggregate demand curve increase Economy expands, employment rises, but inflation rate rises

Taxes increases may lead to higher government revenues Laffer Curve Puts forth the idea that increasing taxes from zero will increase tax revenues up to a certain point Taxes increases may lead to higher government revenues Depends on where the economy is on the Laffer Curve When taxes increase beyond a certain point tax revenues begin to decline as the economic pie begins to shrink Economic pie begins to shrink as Workers have less incentive to work and investors have less of an incentive to invest as their taxes increase beyond a certain level

The Laffer Curve Rmax R Tmax T 100% Federal Tax Revenue Tmax T 100% Federal Tax Rate