Principles of Economics: Macroeconomics - Econ101 Fiscal Policy Chapter 11 McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

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

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

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

The Policy Goal AS QE = 5.6 a AD1 PE Price Level Real GDP 6.0 = QF GDP Equilibrium Full-employment GDP b The goal is to close GDP gaps GDP gap

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?

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

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

The AD Shortfall AS QE = 5.6 a AD1 AD2 PE Price Level Real GDP QF = 6.0 6.4 AD3 c d b e Recessionary GDP gap AD shortfall The AD shortfall is the fiscal policy target for achieving full employment.

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

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

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

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

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

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

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

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

Weak Economy: Fiscal Stimulus

Overheated Economy: Fiscal Restraint

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