Instructor: Bob DiPaolo ECON 151 – Macroeconomics Instructor: Bob DiPaolo Fiscal Policy Levers Chapter 11 Materials include content from McGraw-Hill/Irwin which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

Introduction Keynesian theory of macro instability leads directly to a mandate for government intervention This chapter confronts the following questions: Can government spending and tax policies help ensure full employment? What policy actions will help fight inflation? What are the roles of government intervention?

Taxes and Spending Up until 1915, the federal government collected few taxes and spent little. In 1902, it employed fewer than 350,000 people and spent $650 million. Today, it employs nearly 5 million people and spends more than $2 trillion.

Government Revenue Government expansion started with the 16th Amendment to the U.S. Constitution (1913) which extended the taxing power to incomes. Today, the federal government collects over $2 trillion a year in tax revenues.

Government Expenditure Government spending directly affects aggregate demand. Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

Purchases vs. Transfers To understand how government spending affects aggregate demand, we must distinguish between government purchases and income transfers.

Government Expenditure Government spending on defense, highways, and health care is part of aggregate demand. Income transfers don’t become part of AD until recipients decide to spend income. Income transfers are payments to individuals for which no current goods or services are exchanged, such as Social Security, welfare, unemployment benefits.

Fiscal Policy The federal government’s tax and spending powers give it a great deal of influence over aggregate demand. The federal government can alter aggregate demand by: Purchasing more or fewer goods and services. Raising or lowering taxes. Changing the level of income transfer.

Fiscal Policy Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes. From a macro perspective, the federal budget is a tool that can change aggregate demand and macroeconomic outcomes.

Fiscal Policy Internal market forces External shocks Policy levers: Fiscal policy Output Jobs Prices Growth International balances DETERMINANTS OUTCOMES AD AS

Fiscal Stimulus Suppose the economy is experiencing a recessionary GDP gap of $400 billion. The recessionary GDP gap is the difference between full-employment GDP and equilibrium GDP.

The Policy Goal AS QE = 5.6 a AD1 PE Price Level (average price) Real GDP (trillions of dollars per year) 6.0 = QF GDP Equilibrium Full-employment GDP b GDP gap

Keynesian Strategy The Keynesian model of the adjustment process shows not only how the economy can get into trouble, but also how it might get out. From a Keynesian perspective, the way out of recession is to get someone to spend more on goods and services. The source of new spending could be a fiscal stimulus.

Keynesian Strategy A fiscal stimulus is tax cuts or spending hikes intended to increase (shift) aggregate demand. The general strategy is clear; however, the scope of desired intervention is not.

Keynesian Strategy Two strategic policy questions must be answered: By how much do we want to shift the AD curve to the right? How can we induce the desired shift?

The Naive Keynesian Model If GDP gap is $400 billion, why not just increase AD by that muc The naive Keynesian policy fails to achieve full employment. An increase in aggregate demand by the amount of the GDP gap will achieve full employment only if the aggregate supply curve is horizontal.

Price Level Changes When the AD curve shifts to the right, the economy moves up the AS curve, not horizontally to the right, changing both real output and prices. Shifting (increasing) aggregate demand by the amount of the GDP gap will achieve full employment only if the price level doesn’t rise.

The AD Shortfall So long as the AS curve slopes upward, we must increase AD by more than the size of the recessionary GDP gap to achieve full employment. The AD shortfall is the amount of additional aggregate demand needed to achieve full employment after allowing for price level changes. The AD shortfall is the fiscal target.

The AD Shortfall AS QE = 5.6 a AD1 AD2 PE Price Level (average price) Real GDP (trillions of dollars per year) QF = 6.0 6.4 AD3 c d b e Recessionary GDP gap AD shortfall

Government Spending Multiplier Effects Increased government spending is a form of fiscal stimulus. Every dollar of new government spending has a multiplied impact on aggregate demand.

Multiplier Effects How much of a boost the economy gets depends on the value of the multiplier. The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles.

Total change in spending = multiplier X new spending injection Multiplier Effects The total spending change equals the multiplier times the new spending injections. Total change in spending = multiplier X new spending injection

Increase in AD = multiplier X fiscal stimulus Multiplier Effects The impact of fiscal stimulus on aggregate demand includes the new government spending plus all subsequent increases in consumer spending triggered by the additional government outlays: Increase in AD = multiplier X fiscal stimulus

Multiplier Effects Direct impact of rise in government spending + $200 billion Indirect impact via increased consumption + $600 billion Price Level (average price) a b Current price level P1 AD2 AD3 AD1 5.6 QE 5.8 6.4 Real GDP ($ trillions per year)

The Desired Stimulus The general formula for computing the desired stimulus is a simple rearrangement of the earlier formula:

Tax Cuts By lowering taxes, the government increases the disposable income of the private sector. Disposable income is the after-tax income of consumers; personal income less personal taxes.

Initial increase in consumption = MPC X tax cut Taxes and Consumption Tax cuts directly increase the disposable income of consumers. The more important question is how does a tax cut affect spending. The amount consumption increases depends on the marginal propensity to consume. Initial increase in consumption = MPC X tax cut

Taxes and Consumption A tax cut contains less fiscal stimulus than an increase in government spending of the same size. The initial spending injection is less than the size of the tax cut. An AD shortfall can be closed with a tax cut.

Cumulative change in saving: = tax cut The Tax Cut Multiplier Tax Cut More consumption = MPC X tax cut More saving = MPS X tax cut First round of spending: More income More saving Second round of spending: More consumption More income More saving Third round of spending: More consumption Cumulative change in saving: = tax cut

Taxes and Investment A tax cut may also be an effective mechanism for increasing investment spending. Tax cuts have been used numerous times to stimulate the economy.

Increased Transfers Increasing transfer payments such as social security, welfare, unemployment benefits, and veterans’ benefits can stimulate the economy. The initial fiscal stimulus of increased transfer payments is: Initial fiscal stimulus (injection) = MPC X increase in transfer payments

Fiscal Restraint There are times when the economy is expanding too fast and fiscal restraint is more appropriate. Fiscal restraint is using tax hikes or spending cuts intended to reduce (shift) aggregate demand.

The Fiscal Target The AD excess is the amount by which aggregate demand must be reduced to achieve price stability after allowing for price-level changes. The first task is to determine how much AD needs to fall. The AD excess exceeds the GDP gap.

Excess Aggregate Demand AS Q2 = 5.8 E2 f AD1 AD2 PE PF Price Level (average price) Real Output (trillions of dollars per year) E1 QF = 6.0 Q1 = 6.2 Inflationary GDP gap Excess AD

Cumulative reduction in spending = multiplier X initial budget cut Budget Cuts Budget cuts reduce government spending and induces cutbacks in consumer spending. The budget cuts have a multiplied effect on AD equal to: Cumulative reduction in spending = multiplier X initial budget cut The budget cuts should be equal to the size of the desired fiscal restraint.

Tax Hikes Tax hikes can be used to shift the AD curve to the left. The direct effect of tax increases is a reduction in disposable income.

Tax Hikes Taxes must be increased more than a dollar to get a dollar of fiscal restraint. Tax increases have been used to “cool” the economy several times.

Reduced Transfers A third option for fiscal restraint is to reduce transfer payments. A cut in transfer payments works like a tax hike, reducing the disposable income of transfer recipients.

Reduced Transfers The desired reduction in transfers is the same as a desired tax increase. Reduced transfers are seldom used since recipients include the aged, poor, unemployed and disabled.

A Primer: Simple Rules The essence of fiscal policy is the deliberate shifting of the aggregate demand curve. The steps required to formulate fiscal policy are: Specify the amount of the desired AD shift. Select the policy tools needed to induce the desired shift.

Fiscal Stimulus

Fiscal Restraint

A Warning: Crowding Out Fiscal policy guidelines are a useful tool but neglect a critical dimension of fiscal policy. How is the government going to finance its expenditures?

A Warning: Crowding Out Some of the intended fiscal stimulus may be offset by the crowding out of private investment expenditure. Crowding out is a reduction in private-sector borrowing (and spending) caused by increased government borrowing.

Time Lags Fiscal policy is somewhat hampered because it takes time to recognize that a problem exists and then formulate policy to address the problem. In addition, the very nature of the macro problems could change if the economy is hit with other internal or external shocks.

Pork-Barrel Politics Once a tax or spending plan arrives at the U.S. Capitol, politics take over. If taxes are cut, they want their constituents to get the biggest tax savings. No member of Congress wants spending cuts in their own districts. No-one in Congress wants a tax hike or spending cut before the election.

The Concern for Content Guidelines for fiscal policy do not say anything about how the government spends its money or whom it taxes. It does matter whether federal expenditures are devoted to military hardware, urban transit systems, or tennis courts.

The “Second Crisis” Our economic goals include not only full employment and price stability, but also a desirable mix of output, equitable distribution of income, and adequate economic growth.

The “Second Crisis” The relative emphasis on, and sometimes exclusive concern for, stabilization objectives – to the neglect of related GDP content – has been designated by Joan Robinson as the “second crisis of economic theory”

Private vs. Public Spending Fiscal policy can be directed toward private expenditure (C + I) or public expenditure (G).

Output Mixes within Each Sector In addition to choosing whether to increase public or private spending, fiscal policy must also consider the specific content of spending within each sector.

ECON 151 - MACROECONOMICS Fiscal Policy Levers End of Chapter 11