Fiscal Policy-Modules 20/21 J.A.SACCO

Introduction One major government policy tool is fiscal policy, which involves changes in government spending, changes in taxes, or both. During periods when the economy is doing poorly, policymakers in Washington, D.C., have at times recommended and enacted tax cuts. At other times, when the federal government was spending much more that it was receiving in taxes, policymakers have recommended and enacted tax increases.

Preview Questions What is fiscal policy? What is automatic fiscal policy, and how does it lend stability to an economy? How does the crowding-out effect offset expansionary fiscal policy? What types of time lags exists between the need for fiscal stimulus and the time when such stimulus actually affects the national economy?

Did You Know That... The first type of income tax was probably established in the 1200s and 1300s during times of war in the Italian city-states? America’s first income tax, enacted in 1861 to help pay for the Civil War, was 3 percent on incomes over $800 a year.

Fiscal Policy Fiscal Policy The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals High employment Price stability Economic growth Improvement of international payments balance

FISCAL POLICY Types of Fiscal Policy Fiscal policy can be either Discretionary Automatic

FISCAL POLICY Discretionary fiscal policy Automatic fiscal policy A fiscal policy action that is initiated by an act of Congress. Automatic fiscal policy A fiscal policy action that is triggered by the state of the economy For example, an increase in unemployment induces an increase in payments to the unemployed or in a recession marginal taxes decrease as incomes fall.

FISCAL POLICY Discretionary Fiscal Policy: Demand-Side Effects The Government Expenditure Multiplier The government expenditure multiplier is magnification effect of a change in government expenditure on goods and services on aggregate demand. It works like the autonomous expenditure multiplier. Students don’t have much trouble grasping how discretionary fiscal policy works. They are able to see that changes in government spending and taxes have an impact on aggregate planned expenditure and on aggregate demand. Automatic stabilizers are a different story. Many students find them intuitively difficult because by this time they have been led to believe that the economy does not automatically correct itself. For many students the possibility that something like an automatic stabilizer could exist appears to be incongruent with what they know to be true. To combat this confusion, I like to use the term “stability” as it is used in a physics class. In physics, stability is equated with maintaining an equilibrium position or resuming its original position after displacement. A simple analogy is in order. Ships are built in a way so as to provide for some measure of automatic stability. The shape of the hull is designed in such a way so that as wind pummels it from one side to the other, the ship will tip back in the opposite direction. In fact, the ballast in the ship assists in this way as well. Ballast is the heavy material that is placed in the hold of a ship to enhance stability. After giving this explanation, you can ask your students if the existence of the ballast and the shape of the hull guarantee that the ship will remain in an upright position. The answer is “no.” Heavy rains or gale force winds could tip the ship over with virtually no hope of righting itself! What the stability-enhancing characteristic of the shape of the hull and ballast provide is that the ship will not tip over in less than catastrophic conditions. This analogy holds true for the economy as well. Automatic stabilizers are not insulators from recession or depression but serve as devices that help the economy from reeling out of control when it is hit with less than catastrophic shocks.

FISCAL POLICY The Tax Multiplier The tax multiplier magnification effect of a change in taxes on aggregate demand. A decrease in taxes increases disposable income. And an increase in disposable income increases consumption expenditure. With increased consumption expenditure, employment and incomes rise and consumption expenditure increases yet further.

FISCAL POLICY So a decrease in taxes works like an increase in government expenditure. Both actions increase aggregate demand and have a multiplier effect. The magnitude of the tax multiplier is smaller than the government expenditure multiplier.

Expansionary Fiscal Policy LRAS 7.0 Economy begins at E1, which is _________. There is a decrease in aggregate demand to AD2 resulting in a ______. According to the “classical economists”, how does the economy adjust to this situation? According to Keynes how does this economy recover? SRAS AD1 AD2 Price Level 130 E1 120 6.5 E2 What is this ? Real National Income per Year ($ trillions)

Expansionary Fiscal Policy LRAS 7.0 1) The contractionary gap is caused by insufficient AD 2) To increase AD- use expansionary fiscal policy to increase government spending/ reduce taxes 3) With an increase in G/decrease in taxes AD increases and real GDP increases to full employment SRAS AD2 AD1 Price Level 130 E2 120 6.5 E1 Contractionary gap Real National Income per Year ($ trillions)

Fiscal Policy Questions Would the increase in government spending/ decrease in taxes have to equal the size of the gap ($.5 trillion)? What impact did the expansionary fiscal policy have on the price level?

Expansionary Fiscal Policy and the Multiplier Potential GDP is $10 trillion, real GDP is $9 trillion, and 1. There is a $1 trillion recessionary gap. 2. An increase in government expenditure or a tax cut increases expenditure by ∆E.

Expansionary Fiscal Policy 3. The multiplier increases induced expenditure. The AD curve shifts rightward to AD1. The price level rises to 110, real GDP increases to $10 trillion, and the recessionary gap is eliminated.

Contractionary Fiscal Policy: LRAS 7.0 Explain the state of this economy. If nothing is done, what will eventually happen in this economy? Why might even Keynesians agree with this? SRAS AD1 Price Level 120 7.5 E1 What is this? Real National Income per Year ($ trillions)

Contractionary Fiscal Policy: LRAS 7.0 1) The expansionary gap is caused by SR equilibrium > full- employment 2) To decrease AD, use contractionary fiscal policy to decrease government spending or increase taxes 3) With a decrease in G or increase in taxes AD decreases and real GDP decreases to full employment and the price level drops SRAS AD1 AD2 Price Level 120 7.5 E1 Expansionary gap 100 E2 Real National Income per Year ($ trillions)

Contractionary Fiscal Policy Potential GDP is $10 trillion, real GDP is $11 trillion, and 1. There is a $1 trillion inflationary gap. 2. A decrease in government expenditure or a tax rise decreases expenditure by ∆E.

Contractionary Fiscal Policy 3. The multiplier decreases induced expenditure. The AD curve shifts leftward to AD1. The price level falls to 110, real GDP decreases to $10 trillion, and the inflationary gap is eliminated.

Fiscal Policy Question What would be the long-run impact on real GDP of a tax cut if the economy is at full-employment equilibrium?