© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Fernando & Yvonn Quijano Prepared by: Chapter 27 Fiscal Policy

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 46 A Boon for H&R Block 27.1Define fiscal policy. 27.2Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilize the economy. 27.3Explain how the government purchases and tax multipliers work. 27.4Discuss the difficulties that can arise in implementing fiscal policy. 27.5Define federal budget deficit and federal government debt and explain how the federal budget can serve as an automatic stabilizer. 27.6Discuss the effects of fiscal policy in the long run. APPENDIX Apply the multiplier formula. Learning Objectives The tax laws have become increasingly complicated. …It is not surprising that millions of Americans have given up filling out their own income tax forms, or have to rely on software such as Intuit’s TurboTax or H&R Block’s TaxCut.

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 46 Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth. Learning Objective 27.1 Fiscal Policy What Fiscal Policy Is and What It Isn’t Automatic stabilizers Government spending and taxes that automatically increase or decrease along with the business cycle. Automatic Stabilizers versus Discretionary Fiscal Policy

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 46 Learning Objective 27.1 Fiscal Policy An Overview of Government Spending and Taxes FIGURE 27.1 The Federal Government’s Share of Total Government Expenditures, 1929–2006

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 46 Learning Objective 27.1 Fiscal Policy An Overview of Government Spending and Taxes FIGURE 27.2 Federal Purchases and Federal Expenditures as a Percentage of GDP, 1950–2006

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 46 Learning Objective 27.1 Fiscal Policy An Overview of Government Spending and Taxes FIGURE 27.3 Federal Government Expenditures, 2006

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 46 Learning Objective 27.1 Is Spending on Social Security and Medicare a Fiscal Time Bomb? Making the Connection Will the federal government be able to keep the promises made by the Social Security and Medicare programs?

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 46 Learning Objective 27.1 Fiscal Policy An Overview of Government Spending and Taxes FIGURE 27.4 Federal Government Revenue, 2006

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 46 Learning Objective 27.2 The Effects of Fiscal Policy on Real GDP and the Price Level Expansionary and Contractionary Fiscal Policy: An Initial Look FIGURE 27.5 Fiscal Policy

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 46 Learning Objective 27.2 The Effects of Fiscal Policy on Real GDP and the Price Level Using Fiscal Policy to Influence Aggregate Demand: A More Complete Account FIGURE 27.6 An Expansionary Fiscal Policy

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 46 Learning Objective 27.2 The Effects of Fiscal Policy on Real GDP and the Price Level Using Fiscal Policy to Influence Aggregate Demand: A More Complete Account FIGURE 27.7 A Contractionary Fiscal Policy

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 46 Learning Objective 27.2 A Summary of How Fiscal Policy Affects Aggregate Demand Table 27-1 Countercyclical Fiscal Policy PROBLEMTYPE OF POLICY ACTIONS BY CONGRESS AND THE PRESIDENTRESULT RecessionExpansionaryIncrease government spending or cut taxes Real GDP and the price level rise. Rising InflationContractionaryDecrease government spending or raise taxes Real GDP and the price level fall. The Effects of Fiscal Policy on Real GDP and the Price Level Don’t Let This Happen to YOU! Don’t Confuse Fiscal Policy and Monetary Policy

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 46 Multiplier effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures. Learning Objective 27.3 The Government Purchases and Tax Multipliers

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 46 Learning Objective 27.3 The Government Purchases and Tax Multipliers FIGURE 27.8 The Multiplier Effect and Aggregate Demand

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 46 Learning Objective 27.3 The Government Purchases and Tax Multipliers FIGURE 27.9 The Multiplier Effect of an Increase in Government Purchases

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 46 Learning Objective 27.3 The Government Purchases and Tax Multipliers The ratio of the change in equilibrium real GDP to the initial change in government purchases is known as the government purchases multiplier: The expression for this tax multiplier is:

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 46 Learning Objective 27.3 The Effect of Changes in Tax Rates The Government Purchases and Tax Multipliers A cut in tax rates affects equilibrium real GDP through two channels: (1)A cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending, and (2)a cut in tax rates increases the size of the multiplier effect.

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 46 Learning Objective 27.3 Taking into Account the Effects of Aggregate Supply The Government Purchases and Tax Multipliers FIGURE The Multiplier Effect and Aggregate Supply

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 46 Learning Objective 27.3 The Multipliers Work in Both Directions The Government Purchases and Tax Multipliers Increases in government purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP. Decreases in government purchases and increases in taxes also have a multiplier effect on equilibrium real GDP, only in this case, the effect is negative.

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 46 Solved Problem 27-3 Fiscal Policy Multipliers Learning Objective 27.3 Briefly explain whether you agree or disagree with the following statement: “Real GDP is currently $12.2 trillion, and potential real GDP is $12.5 trillion. If Congress and the president would increase government purchases by $300 billion or cut taxes by $300 billion, the economy could be brought to equilibrium at potential GDP.”

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 46 Crowding out A decline in private expenditures as a result of an increase in government purchases. Learning Objective 27.4 The Limits of Using Fiscal Policy to Stabilize the Economy Does Government Spending Reduce Private Spending?

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 46 Learning Objective 27.4 The Limits of Using Fiscal Policy to Stabilize the Economy Crowding Out in the Short Run FIGURE An Expansionary Fiscal Policy Increases Interest Rates

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 46 Learning Objective 27.4 The Limits of Using Fiscal Policy to Stabilize the Economy Crowding Out in the Short Run FIGURE The Effect of Crowding Out in the Short Run

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 46 To understand crowding out in the long run, recall from Chapter 24 that in the long run, the economy returns to potential GDP. Learning Objective 27.4 The Limits of Using Fiscal Policy to Stabilize the Economy Crowding Out in the Long Run

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 46 Learning Objective 27.4 Is Losing Your Job Good for Your Health? Making the Connection Recent research shows that, surprisingly, the health of people who are temporarily unemployed may improve.

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 46 Budget deficit The situation in which the government’s expenditures are greater than its tax revenue. Budget surplus The situation in which the government’s expenditures are less than its tax revenue. Learning Objective 27.5 Deficits, Surpluses, and Federal Government Debt

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 46 Learning Objective 27.5 Deficits, Surpluses, and Federal Government Debt FIGURE The Federal Budget Deficit, 1901–2006

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 of 46 Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP. Learning Objective 27.5 Deficits, Surpluses, and Federal Government Debt How the Federal Budget Can Serve as an Automatic Stabilizer

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 46 Learning Objective 27.5 Did Fiscal Policy Fail during the Great Depression? Making the Connection Although government spending increased during the Great Depression, the cyclically adjusted budget was in surplus most years. FEDERAL GOVERNMENT EXPENDITURES (BILLIONS OF DOLLARS ACTUALFEDERAL BUDGET DEFICIT OR SURPLUS (BILLIONS OF DOLLARS) CYCLICALLY ADJUSTED BUDGET DEFICIT OR SURPLUS (BILLIONS OF DOLLARS) CYCLICALLY ADJUSTED BUDGET DEFICIT OR SURPLUS AS A PERCENTAGE OF GDP 1929$2.6$1.0$ %

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 46 Solved Problem 27-5 The Effect of Economic Fluctuations on the Budget Deficit Learning Objective 27.5 The federal government’s budget deficit was $207.8 billion in 1983 and $185.4 billion in A student comments, “The government must have acted during 1984 to raise taxes or cut spending or both.” Do you agree? Briefly explain.

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 31 of 46 Although many economists believe that it is a good idea for the federal government to have a balanced budget when the economy is at potential GDP, few economists believe that the federal government should attempt to balance its budget every year. Learning Objective 27.5 Deficits, Surpluses, and Federal Government Debt Should the Federal Budget Always Be Balanced?

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 32 of 46 Learning Objective 27.5 Deficits, Surpluses, and Federal Government Debt The Federal Government Debt FIGURE The Federal Government Debt, 1901–2006

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 33 of 46 Debt can be a problem for a government for the same reasons that debt can be a problem for a household or a business. Learning Objective 27.5 Deficits, Surpluses, and Federal Government Debt Is Government Debt a Problem?

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 34 of 46 Tax wedge The difference between the pretax and posttax return to an economic activity. Learning Objective 27.6 The Effects of Fiscal Policy in the Long Run The Long-Run Effects of Tax Policy Individual income tax. Corporate income tax. Taxes on dividends and capital gains. We can look briefly at the effects on aggregate supply of cutting each of the following taxes: In addition to the potential gains from cutting individual taxes, there are also gains from tax simplification. Tax Simplification

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 35 of 46 Learning Objective 27.6 Should the United States Adopt the “Flat Tax”? Making the Connection The flat tax would simplify tax preparation. COUNTRYFLAT TAX RATE YEAR FLAT TAX WAS INTRODUCED Estonia26%1994 Lithuania Latvia Russia Serbia Ukraine Slovakia Georgia Romania162005

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 36 of 46 Learning Objective 27.6 The Effects of Fiscal Policy in the Long Run The Economic Effect of Tax Reform FIGURE The Supply-Side Effects of a Tax Change

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 37 of 46 Most economists would agree that there are supply-side effects to reducing taxes: Decreasing marginal income tax rates will increase the quantity of labor supplied, cutting the corporate income tax will increase investment spending, and so on. The magnitude of the effects is subject to considerable debate, however. Learning Objective 27.6 The Effects of Fiscal Policy in the Long Run How Large Are Supply-Side Effects?

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 38 of 46 An Inside LOOK Can Congress Afford to Fix the Alternative Minimum Tax? Congress’s Taxing Hurdle: The AMT The number of taxpayers affected by the AMT will increase substantially under current U.S. tax laws.

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 39 of 46 K e y T e r m s Automatic stabilizers Budget deficit Budget surplus Crowding out Cyclically adjusted budget deficit or surplus Fiscal policy Multiplier effect Tax wedge

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 40 of 46 A Closer Look at the Multiplier Appendix An Expression for Equilibrium Real GDP (1) C = 1, (Y−T) Consumption function (2) I = 1,500Planned investment function (3) G = 1,500Government purchases function (4) T = 1,000Tax function (5) Y = C + I + GEquilibrium condition

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 41 of 46 A Closer Look at the Multiplier Appendix An Expression for Equilibrium Real GDP The letters with “bars” represent fixed or autonomous values that do not depend on the values of other variables. So, represents autonomous consumption, which had a value of 1,000 in our original example. Now, solving for equilibrium we get: or,

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 42 of 46 A Formula for the Government Purchases Multiplier Appendix

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 43 of 46 Appendix A Formula for the Tax Multiplier Or:

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 44 of 46 The “Balanced Budget” Multiplier Appendix

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 45 of 46 The Effects of Changes in Tax Rates on the Multiplier Appendix

Chapter 27: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 46 of 46 The Multiplier in an Open Economy Appendix We can define the marginal propensity to import (MPI) as the fraction of an increase in income that is spent on imports. So, our expression for imports is: Imports = MPI x Y We can substitute our expressions for exports and imports into the expression we derived earlier for equilibrium real GDP: where the expression represents net exports. We can now find an expression for the government purchases multiplier by using the same method as we did previously: