Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved ECON Designed by Amy McGuire, B-books, Ltd. McEachern CHAPTER Fiscal Policy Macro

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Theory of Fiscal Policy LO 1  Fiscal policy –Government purchases, G –Transfer payment, TP –Taxes, T –Borrowing

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Fiscal Policy Tools LO 1  Automatic stabilizers –Revenue and spending programs –Adjust automatically E.g.: Federal income tax

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Fiscal Policy Tools LO 1  Discretionary fiscal policy –Deliberate manipulation of G, TP, and T –Increase in G or TP Increases real GDP demanded –Increase in net taxes Decreases real GDP demanded

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Discretionary Fiscal Policy  Expansionary fiscal policy  Contractionary gap  Price level < expected  Output < potential  Unemployment > natural rate  Increase G, decrease NT  Increase AD  Higher price level  Higher output

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Discretionary Fiscal Policy to Close a Contractionary Gap The aggregate demand curve AD and the short-run aggregate supply curve SRAS 130 intersect at point e. Output falls short of the economy’s potential. The resulting contractionary gap is $0.5 trillion. This gap could be closed by discretionary fiscal policy that increases aggregate demand by just the right amount. An increase in government purchases, a decrease in net taxes, or some combination could shift aggregate demand out to AD*, moving the economy out to its potential output at e*. LO 2 Exhibit 3 Price level AD SRAS 130 e Potential output LRAS Real GDP (trillions of dollars) AD* e’ e* e’’

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Contractionary Fiscal Policy  To close an expansionary gap  Output > potential  Unemployment < natural rate  Contractionary fiscal policy  Decrease G  Increase NT  Decrease AD  Decrease output  Decrease price level  Close the expansionary gap

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Discretionary Fiscal Policy to Close an Expansionary Gap The aggregate demand curve AD’ and the short-run aggregate supply curve SRAS 130 intersect at point e’ resulting in an expansionary gap of $0.5 trillion. Discretionary fiscal policy aimed at reducing aggregate demand by just the right amount could close this gap without inflation. An increase in net taxes, a decrease in government purchases, or some combination could shift aggregate demand back to AD* and move the economy back to its potential output at e*. LO 2 Exhibit 4 Price level AD’ SRAS 130 e’ Potential output LRAS Real GDP (trillions of dollars) AD* e* e’’

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Contractionary & Expansionary Fiscal Policy  Difficult to achieve  Potential output gauged accurately  Spending multiplier predicted accurately  AD shifts by just the right amount  Government entities – coordinate fiscal efforts  Shape of SRAS curve is known, unaffected by the policy

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 The Multiplier and the Time Horizon  Simple multiplier  Overstates ∆Real GDP  ∆Real GDP depends  Steepness of SRAS curve  Production costs increase  The steeper SRAS curve  Less impact of an AD shift on real GDP  More impact on price level  The smaller the spending multiplier

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Evolution of Fiscal Policy LO 3 1.Prior to the Great Depression  Classical economists –Laissez-faire; Free markets –Balanced budget –Natural market forces Flexible: Prices Wages Interest rates –No need for government intervention

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Evolution of Fiscal Policy LO 3 2.The Great Depression and World War II –Keynesian theory and policy Prices and wages: ‘Sticky’ downward Increase AD –WWII Increase production No cyclical unemployment –Employment Act of 1946, Government: Full employment Economic stability

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Automatic Stabilizers LO 3  Smooth out fluctuations DI –Stimulate AD (recessions) –Dampen AD (expansions)  Federal income tax –Progressive income tax  Unemployment insurance  Welfare payments

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Evolution of Fiscal Policy LO 3 3.From the Golden Age to Stagflation –1960s: demand-management policy Increase or decrease AD –1970s: Stagflation Higher inflation Higher unemployment From decreased AD Crop failures Higher OPEC-driven oil prices Adverse supply shocks

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Lags in Fiscal Policy LO 3  Fiscal policy –Time Approve Implement –Less effective –Too late –More harm than good

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Evolution of Fiscal Policy LO 3 4.Since 1990: from deficits to surpluses  1980s – mid-1990s: large deficits  1993 recovery under way –Increase tax on high-income households  1994: Decreased federal spending  1993 – 1998 –Tax revenues: +8.3% per year –Federal outlays: +3.2% per year

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Evolution of Fiscal Policy LO 3 4.Since 1990: from deficits to surpluses back to deficits –1998: Federal surplus $70 billion –2000: Federal surplus $236 billion –Early 2001 – Recession: 10-year tax cut –September 11, 2001: Terrorist attack –2003 – 2007 Recovery –Employment: +8 million –Federal deficit (2004) $400 billion –Federal deficit (2007) under $200 billion –Recession beginning December 2007 –Federal deficit increased to $450 billion in 2008; now forecast between $1 trillion and $2 trillion