Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives high employment price stability high rates of economic growth. Automatic stabilizers Government spending and taxes that automatically increase or decrease along with the business cycle progressive income tax unemployment benefits food stamps / other entitlements. Automatic Stabilizers versus Discretionary Fiscal Policy

The Federal Government’s Share of Total Government Expenditures, 1929–2006

Federal Purchases and Federal Expenditures as a Percentage of GDP, 1950–2006

An Overview of Government Spending and Taxes Federal Government Expenditures, 2006 Federal Government Revenue, 2006

The Effects of Fiscal Policy on Real GDP and the Price Level Looks a lot like expansionary and contractionary monetary policy …except for impacts on interest rates and investment spending

How Fiscal Policy Affects Aggregate Demand, Real GDP and the Price Level 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 Inflation ContractionaryDecrease government spending or raise taxes Real GDP and the price level fall. Don’t Let This Happen to YOU! Don’t Confuse Fiscal Policy and Monetary Policy!

Government Purchase and Tax Multipliers The Multiplier Effect and Aggregate Demand

Government Purchase Multiplier The Multiplier Effect of an Increase in Government Purchases This spending multiplier is analogous but not the same as the deposit multiplier

The Government Tax Multiplier A cut in tax rates affects equilibrium real GDP in two ways: (1)disposable income rises  consumption spending rises (2)the rate at which purchasing power leaks from the spending stream declines  the spending multiplier increases The less the marginal propensity to leak, the greater the spending multiplier. Recall: Spending Multiplier = 1/[Marginal Propensity to Leak] = 1/[Propensity Not to Respend Additional Income Domestically] =1/[Propensity to pay taxes, save and buy things from abroad]

Taking into Account the Effects of Aggregate Supply The Government Purchases and Tax Multipliers Because the Price Level rises, Real GDP does not increase as much as it otherwise would  The multiplier effect is reduced

The Limits of Using Fiscal Policy to Stabilize the Economy An Expansionary Fiscal Policy Increases Interest Rates Crowding out A decline in private expenditures as a result of an increase in government purchases. Money market

The Limits of Using Fiscal Policy to Stabilize the Economy Crowding Out in the Short Run

Deficits, Surpluses, and Federal Government Debt The Federal Budget Deficit, 1901–2006 Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

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$1.0$ %

Deficits, Surpluses, and Federal Government Debt The Federal Government Debt: Is it a problem? Vicious circle: Deficit  Debt  i  Interest expense  Deficit

Tax wedge The difference between the pre-tax and post-tax return to an economic activity.  Disincentive to work??? The Effects of Fiscal Policy in the Long Run Individual income tax. Corporate income tax. Taxes on dividends and capital gains: double taxation. Impacts of supply-side tax cuts Tax Simplification: A flat–tax??? —pros and cons

The Effects of Fiscal Policy in the Long Run The Economic Effect of “Supply Side” Tax Reform

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