Chapter 12 Econ104 Parks Fiscal Policy

Stabilization Policy Stabilization policy is an attempt to dampen the fluctuations in the economy's level of output through time to achieve low inflation and low unemployment. The government's attempt to stabilize the economy is know as fiscal policy, while the Federal Reserve's attempt at stabilization is called monetary policy. Stabilization policy is an attempt to dampen the fluctuations in the economy's level of output through time to achieve low inflation and low unemployment. The government's attempt to stabilize the economy is know as fiscal policy, while the Federal Reserve's attempt at stabilization is called monetary policy.

Fiscal Policy Fiscal policy is the attempt by the government to deliberately manipulate its budget position with a goal of stabilizing prices, promoting growth, and minimizing unemployment. Two scenarios that potentially leave room for fiscal policy are recessionary gaps and inflationary gaps. Fiscal policy is the attempt by the government to deliberately manipulate its budget position with a goal of stabilizing prices, promoting growth, and minimizing unemployment. Two scenarios that potentially leave room for fiscal policy are recessionary gaps and inflationary gaps.

Recessionary Gap A recessionary gap occurs when actual equilibrium output (Y E ) is less than potential output (Y P ), or Y E < Y P.

© OnlineTexts.com p. 5 A recessionary gap, in economics, is the amount by which the aggregate expenditures schedule must shift upward to increase the real GDP to its full-employment, noninflationary level. A recessionary gap can also be referred to as a deflationary gap. The GAP is actually the amount on the prior diagram DIVIDED by the multiplier!!! At times it is only defined in the constant price simple model.

Inflationary Gap An inflationary gap occurs when equilibrium output exceeds potential output, or Y E > Y P.

Adding Government to the Fixed-Price Model With inclusion of G in the model, equilibrium output is Y = C + I + G. Adding G to the equation simply shifts the Aggregate Demand curve to the right. With inclusion of G in the model, equilibrium output is Y = C + I + G. Adding G to the equation simply shifts the Aggregate Demand curve to the right.

Tools of Fiscal Policy The government has three "tools" to conduct fiscal policy: –change in the level of government expenditures, –change in taxes, and –change in transfer payments. The government has three "tools" to conduct fiscal policy: –change in the level of government expenditures, –change in taxes, and –change in transfer payments.

Tool #1: Change in Government Expenditures An increase in government expenditures shifts the Aggregate Demand curve to the right (from AD0 to AD1), which leads to the usual multiplier effects.

Tool #2: Change in Taxes An increase in taxes, therefore, shifts the Aggregate Demand curve to the left. The change in output is equal to the tax change times the tax multiplier. An increase in taxes, therefore, shifts the Aggregate Demand curve to the left. The change in output is equal to the tax change times the tax multiplier.

The Tax Multiplier For an increase in taxes, the initial decrease in Aggregate Demand is not the amount of the tax change, but the MPC times the tax change, or The term -MPC/(1-MPC) is the tax multiplier. For an increase in taxes, the initial decrease in Aggregate Demand is not the amount of the tax change, but the MPC times the tax change, or The term -MPC/(1-MPC) is the tax multiplier.

© OnlineTexts.com p. 12 APE = C + I + G + (X-M) C = CA + (Y-TA)*mpc TA = autonomous taxes APE = CA – TA*mpc + I + G + (X-M) + Y*mpc Yeq = (CA–TA*mpc+I+G+(X-M))/(1-mpc) Increase TA, decrease autonomous expenditures by TA*mpc APE = C + I + G + (X-M) C = CA + (Y-TA)*mpc TA = autonomous taxes APE = CA – TA*mpc + I + G + (X-M) + Y*mpc Yeq = (CA–TA*mpc+I+G+(X-M))/(1-mpc) Increase TA, decrease autonomous expenditures by TA*mpc

Tool #3: Change in Transfer Payments Transfer payments (TR) are distributions of income to individuals who do not directly work for the income. An increase in TR shifts the AD curve to the right. Transfer payments (TR) are distributions of income to individuals who do not directly work for the income. An increase in TR shifts the AD curve to the right.

Expansionary Fiscal Policy Expansionary fiscal policy is desirable if the economy is in a recessionary gap. The tools of expansionary fiscal policy include –increase government expenditures –decrease taxes –increase transfer payments Expansionary fiscal policy is desirable if the economy is in a recessionary gap. The tools of expansionary fiscal policy include –increase government expenditures –decrease taxes –increase transfer payments

Contractionary Fiscal Policy Contractionary fiscal policy is desirable if the economy is in an inflationary gap. The tools of expansionary fiscal policy include –decrease government expenditures –increase taxes –decrease transfer payments Contractionary fiscal policy is desirable if the economy is in an inflationary gap. The tools of expansionary fiscal policy include –decrease government expenditures –increase taxes –decrease transfer payments

Fiscal Policy with an upward-sloping AS Curve If the Aggregate Supply curve is upward sloping rather than horizontal (as we assume in the fixed-price model), then two things are different about fiscal policy: –An increase in government expenditures increases both output and the price level –Output multiplier effects will be smaller because some of the impact will be felt in higher prices If the Aggregate Supply curve is upward sloping rather than horizontal (as we assume in the fixed-price model), then two things are different about fiscal policy: –An increase in government expenditures increases both output and the price level –Output multiplier effects will be smaller because some of the impact will be felt in higher prices

Discretionary Fiscal Policy vs. Automatic Stabilizers Discretionary fiscal policy is policy that must be deliberately enacted by Congress and/or the President. Examples include tax cuts or a change in rules governing unemployment insurance or welfare benefits – and of course the Stimulus Package.

Difficulties in conducting discretionary fiscal policy Severe time lags –Recognition lag: the time needed for legislators to recognize that policy needs to be changed due to a change in the business cycle. –Implementation lag: the time needed to change the policy. Decisions on taxes, transfer payments, and government spending are usually made with more concern for politics than for economics. –Impact lag: the time elapsed between the implementation of the changed policy and its impact on the economy. Affect on budget deficit Severe time lags –Recognition lag: the time needed for legislators to recognize that policy needs to be changed due to a change in the business cycle. –Implementation lag: the time needed to change the policy. Decisions on taxes, transfer payments, and government spending are usually made with more concern for politics than for economics. –Impact lag: the time elapsed between the implementation of the changed policy and its impact on the economy. Affect on budget deficit

Automatic stabilizers Automatic stabilizers are policies that increase government outlays and decrease taxes automatically during recessions, and reduce government outlays and increase taxes automatically during inflationary periods. –No deliberate government action is required. –Examples are welfare payments, unemployment insurance, and proportional income taxes. –These policies are free from politics, recognition and implementation lags. Automatic stabilizers are policies that increase government outlays and decrease taxes automatically during recessions, and reduce government outlays and increase taxes automatically during inflationary periods. –No deliberate government action is required. –Examples are welfare payments, unemployment insurance, and proportional income taxes. –These policies are free from politics, recognition and implementation lags.

Supply-Side Economics Supply-side economics is a school of thought that challenges the emphasis of Keynesian economics on the demand side of the economy. The goal is to achieve growth by stimulating the supply side of the economy. Supply-side economics is a school of thought that challenges the emphasis of Keynesian economics on the demand side of the economy. The goal is to achieve growth by stimulating the supply side of the economy.

Unleashing Labor and Capital Resources A supply-side theme is that government regulations and high taxes constrain the growth of the supply-side of the economy. Policy reforms call for reductions in income taxes and business taxes such as capital gains taxes to encourage labor and capital formation. A supply-side theme is that government regulations and high taxes constrain the growth of the supply-side of the economy. Policy reforms call for reductions in income taxes and business taxes such as capital gains taxes to encourage labor and capital formation.

The Laffer Curve Won’t tax cuts increase the budget deficit? Yes, unless: –government spending is also reduced in conjunction with the tax cuts, or –the economy is on the right side of the Laffer curve. If the tax reductions stimulate enough growth in GDP by increases in labor and capital supply, then the tax base, and potentially tax revenues, increase over time. Won’t tax cuts increase the budget deficit? Yes, unless: –government spending is also reduced in conjunction with the tax cuts, or –the economy is on the right side of the Laffer curve. If the tax reductions stimulate enough growth in GDP by increases in labor and capital supply, then the tax base, and potentially tax revenues, increase over time.

The Laffer Curve The Laffer curve plots the tax rate against tax revenues. To the left of point B, a tax cut results in tax revenue declines. But to the right of point B, tax cuts actually increase tax revenue.

Supply-Side Economics: Is There Consensus? Most economists do not argue about the theory of supply-side economics. –General consensus is that a reduction in labor and capital taxes will stimulate the supply side of the economy. The real disagreement is over the size of the supply-side effects. –Keynesian economists argue that the demand-side effects of tax cuts swamp the (small) supply-side effects. Most economists do not argue about the theory of supply-side economics. –General consensus is that a reduction in labor and capital taxes will stimulate the supply side of the economy. The real disagreement is over the size of the supply-side effects. –Keynesian economists argue that the demand-side effects of tax cuts swamp the (small) supply-side effects.