Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 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. Fiscal Policy Automatic stabilizers Government spending and taxes that automatically increase or decrease along with the business cycle. Automatic Stabilizers versus Discretionary Fiscal Policy

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 46 An Overview of Government Spending and Taxes The Federal Government’s Share of Total Government Expenditures, 1929–2006

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 46 An Overview of Government Spending and Taxes Federal Purchases and Federal Expenditures as a Percentage of GDP, 1950–2006

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 46 Fiscal Policy An Overview of Government Spending and Taxes Federal Government Expenditures, 2006

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 46 Fiscal Policy An Overview of Government Spending and Taxes Federal Government Revenue, 2006

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 46 The Effects of Fiscal Policy on Real GDP and the Price Level Fiscal Policy Looks a lot like expansionary and contractionary monetary policy …except for impacts on interest rates and investment spending

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 46 A Summary of How Fiscal Policy Affects Aggregate Demand 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. 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 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 46 The Government Purchases and Tax Multipliers FIGURE 15.8 The Multiplier Effect and Aggregate Demand

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 46 Learning Objective 15.3 The Government Purchases and Tax Multipliers The Multiplier Effect of an Increase in Government Purchases This spending multiplier is analogous but not the same as the deposit multiplier

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 46 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 … it reduces the rate at which purchasing power leaks from the spending stream The less the marginal propensity to leak, the greater the spending multiplier.

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 46 Taking into Account the Effects of Aggregate Supply The Government Purchases and Tax Multipliers The Multiplier Effect and Aggregate Supply

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 46 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

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 46 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 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 46 The Effects of Fiscal Policy in the Long Run The Economic Effect of “Supply Side” Tax Reform The Supply-Side Effects of a Tax Change

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 46 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.

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 46 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 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 46 Deficits, Surpluses, and Federal Government Debt The Federal Government Debt The Federal Government Debt, 1901–2006

Chapter 15: Fiscal Policy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 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