Fiscal Policy Chapter 11 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

11-2 Fiscal Policy Government’s tax and spending activities affect not only the level of output and prices but the mix of output as well –Can government spending and tax policies ensure full employment? –What policy actions will help fight inflation? –What are the risks of government intervention?

11-3 Taxes and Spending Today, the federal government –Employs over 4 million people and spends more than $3.5 trillion a year –Collects nearly $3 trillion a year in taxes, with nearly half that from individual income taxes –Spends all of its tax revenues—and more, borrowing additional funds

11-4 Government Expenditure Government purchases are part of aggregate demand, income transfers are not Income transfers: Payments to individuals for which no current goods or services are exchanged

11-5 Fiscal Policy The federal government can alter aggregate demand by: –Purchasing more or fewer goods and services –Raising or lowering taxes –Changing the level of income transfers

11-6 Fiscal Policy Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes The federal budget is a tool that can shift aggregate demand and thereby alter macroeconomic outcomes

11-7 Fiscal Policy Internal market forces External shocks Policy tools: Fiscal policy Output Jobs Prices Growth International balances DETERMINANTSOUTCOMES AD AS

11-8 Fiscal Stimulus Suppose the economy is experiencing a recessionary GDP gap of $400 billion From a Keynesian perspective, the solution is to get someone to spend more on goods and services

11-9 The Policy Goal AS Q E = 5.6 a AD 1 PEPE Price Level Real GDP 6.0 = Q F GDP Equilibrium Full-employment GDP b GDP gap The goal is to close GDP gaps

11-10 Keynesian Strategy Fiscal stimulus: Tax cuts or spending hikes intended to increase (shift) aggregate demand Two strategic policy questions: –By how much do we want to shift the AD curve to the right? –How can we induce the desired shift?

11-11 The Naive Keynesian Model An increase in AD by $400 billion will achieve full employment only if AS curve is horizontal Assumption of a horizontal AS curve seems naïve today Although not every AD shift will raise prices, inflationary pressures increase as AD expands

11-12 The AD Shortfall So long as the AS curve slopes upward, AD must increase by more than the size of the recessionary gap to achieve full employment AD shortfall: The amount of additional aggregate demand needed to achieve full employment after allowing for price-level changes

11-13 The AD Shortfall AS Q E = 5.6 a AD 1 AD 2 PEPE Price Level Real GDP Q F = AD 3 c d be Recessionary GDP gap AD shortfall The AD shortfall is the fiscal policy target for achieving full employment.

11-14 More Government Spending Increased government spending is a form of fiscal stimulus Every dollar of new government spending has a multiplied impact on aggregate demand How much of a boost the economy gets depends on the value of the multiplier

11-15 Multiplier Effects Impact of fiscal stimulus on aggregate demand includes both the new government spending and all subsequent increases in consumer spending triggered by multiplier effects

11-16 Multiplier Effects The second equation is identical to the first but expressed in the terminology of fiscal policy

11-17 Multiplier Effects Real GDP Price Level P1P1 5.6 QEQE AD 2 AD 3 Current price level Direct impact of rise in government spending + $200 billion AD 1 a b Indirect impact via increased consumption + $600 billion

11-18 The Desired Stimulus The general formula for computing the desired stimulus is a simple rearrangement of the earlier formula:

11-19 Tax Cuts By lowering taxes, the government increases disposable income, which stimulates the consumption component of AD The amount consumption increases depends on the marginal propensity to consume

11-20 Multiplier Effects A dollar of tax cut contains less stimulus than a same size increase in government purchases

11-21 The Tax Cut Multiplier First round of spending: Second round of spending: Third round of spending: More incomeMore consumptionMore incomeMore consumption Tax Cut More consumption = MPC X tax cut More saving = MPS X tax cut More saving Cumulative change in saving: = tax cut

11-22 Taxes and Investment A tax cut may also be an effective mechanism for increasing investment spending If a cut in corporate taxes raises potential after- tax profits, it should encourage investment Once additional investment spending enters the circular flow, it, too, has a multiplier effect

11-23 Increased Transfers Increasing transfer payments stimulates the economy

11-24 Fiscal Restraint At times the economy is expanding too fast and fiscal restraint is more appropriate Inflationary GDP gap: The amount by which equilibrium GDP exceeds full-employment Fiscal restraint: Tax hikes or spending cuts intended to reduce (shift) aggregate demand

11-25 The Fiscal Target AD excess: The amount by which aggregate demand must be reduced to achieve full- employment equilibrium after allowing for price-level changes The AD excess exceeds the inflationary GDP gap

11-26 The Fiscal Target First determine the size of the AD excess Then we compute how much government spending or taxes must be changed to achieve the desired shift, taking into account multiplier effects

11-27 Excess Aggregate Demand AS Q 2 = 5.8 E2E2 f AD 1 AD 2 PEPE PFPF Price Level Real Output E1E1 Q F = 6.0Q 1 = 6.2 Inflationary GDP gap Excess AD AD must shift by more than the GDP gap

11-28 Budget Cuts Budget cuts reduce government spending and induce cutbacks in consumer spending Budget cuts should equal the size of the desired fiscal restraint

11-29 Tax Hikes Tax hikes can be used to shift the AD curve to the left by reducing disposable income Taxes must be increased more than a dollar to get a dollar of fiscal restraint

11-30 Reduced Transfers A cut in transfer payments works like a tax hike, reducing the disposable income of transfer recipients The desired reduction in transfers is the same as a desired tax increase

11-31 Fiscal Guidelines The essence of fiscal policy is the deliberate shifting of the aggregate demand curve Steps required to formulate fiscal policy: –Specify the amount of the desired AD shift –Select the policy tools needed to induce the desired shift

11-32 Weak Economy: Fiscal Stimulus

11-33 Overheated Economy: Fiscal Restraint

11-34 A Warning: Crowding Out Some of the intended fiscal stimulus may be offset by the crowding out of private expenditure Crowding out: A reduction in private-sector borrowing (and spending) caused by increased government borrowing

11-35 Time Lags It takes time to recognize that a problem exists and then formulate policy to address it The very nature of the macro problems could change if the economy is hit with other internal or external shocks

11-36 Pork-Barrel Politics Members of Congress want their constituents to get the biggest tax savings They don’t want spending cuts in their own districts They don’t want a tax hike or spending cut before an election

Fiscal Policy End of Chapter 11 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin