Fiscal Policy Chapter 11 Discretionary Fiscal Policy (active): Discretionary Fiscal Policy (active): Tax or spending changes that are enacted by choiceTax or spending changes that are enacted by choice Example: 2007 stimulus checks and the 2001 tax cuts (income, estate, and gift)Example: 2007 stimulus checks and the 2001 tax cuts (income, estate, and gift) Expansionary Fiscal Policy Expansionary Fiscal Policy Tax or spending changes that are intended to increase Aggregate DemandTax or spending changes that are intended to increase Aggregate Demand Tax cuts, spending increases, or bothTax cuts, spending increases, or both

Fiscal Policy Chapter 11 (cont.) Contractionary Fiscal Policy Contractionary Fiscal Policy Tax or spending changes that are intended to decrease Aggregate DemandTax or spending changes that are intended to decrease Aggregate Demand Tax increase, spending decrease, or bothTax increase, spending decrease, or both Fiscal policy is a source of a great deal of political strife Fiscal policy is a source of a great deal of political strife Traditionally Republicans have advocated tax cuts while Democrats have supported spending increasesTraditionally Republicans have advocated tax cuts while Democrats have supported spending increases This clear distinction has changed in recent timesThis clear distinction has changed in recent times

Fiscal Policy Chapter 11 (cont.) Non-Discretionary Fiscal Policy Non-Discretionary Fiscal Policy A.K.A.—Passive, built-in, or automatic stabilizersA.K.A.—Passive, built-in, or automatic stabilizers These are taxes or spending that automatically change depending on the economyThese are taxes or spending that automatically change depending on the economy Progressive tax systemProgressive tax system Transfer payments—unemployment payments, welfareTransfer payments—unemployment payments, welfare

Fiscal Policy Chapter 11 (cont.) Various types of tax Various types of tax Progressive, average tax increases as income rises—ex. Tax brackets (our income tax system)Progressive, average tax increases as income rises—ex. Tax brackets (our income tax system) Proportional, average tax is the same at all income levels—ex. Flat income taxProportional, average tax is the same at all income levels—ex. Flat income tax Regressive, average tax decreases as income rises—ex. $1 tax on a pack of cigarettesRegressive, average tax decreases as income rises—ex. $1 tax on a pack of cigarettes

Problems With Fiscal Policy Timing: Timing: Recognition Lag—The it takes for policy makers to realize economic problemsRecognition Lag—The it takes for policy makers to realize economic problems Administrative Lag—The time it takes to decide on a particular policyAdministrative Lag—The time it takes to decide on a particular policy Operational Lag—The time it takes for a given policy to impact the economyOperational Lag—The time it takes for a given policy to impact the economy Changes in taxes are typically faster than spending changes Changes in taxes are typically faster than spending changes

Problems With Fiscal Policy (cont.) Political considerations: Political considerations: Fiscal policy can be used for the wrong reasonsFiscal policy can be used for the wrong reasons Crowding-Out Effect: Crowding-Out Effect: When the government borrows $ for increased spending, resulting in higher interest rates that slow Investment DemandWhen the government borrows $ for increased spending, resulting in higher interest rates that slow Investment Demand This may blunt the increase in AD that was intendedThis may blunt the increase in AD that was intended

You’re the Politician What should you do if we are in a recession or if we are having high inflation?: What should you do if we are in a recession or if we are having high inflation?: RecessionRecession Cut taxes Cut taxes Increase spending Increase spending InflationInflation Increase taxes Increase taxes Decrease spending Decrease spending But by how much? But by how much?

Fixing The Problem Using the “3 Amigos” (∆ in spending) (Multiplier) = ∆ in GDP 1. Determine if we are in a recession or if we are having inflation 2. Determine if you should use expansionary or contractionary fiscal policy 3. Determine the size of the GDP gap PL RGDP SRAS 1 LRAS Y fe 900B AD 1 Y 1 650B PL 1 MPC=.8

(∆ in spending) (5) = 250B 4. Fill in what you know PL RGDP SRAS 1 LRAS Y fe 900B AD 1 Y 1 650B PL 1 MPC=.8

∆ in spending = 50B 5. Solve PL RGDP SRAS 1 LRAS Y fe 900B AD 1 Y 1 650B PL 1 MPC=.8

∆ in spending = 50B AD will shift by the initial change in spending and eventually reach the full employment level of output due to the multiplier AD will shift by the initial change in spending and eventually reach the full employment level of output due to the multiplier PL RGDP SRAS 1 LRAS Y fe 900B AD 1 Y 1 650B PL 1 MPC=.8 50B AD 2

How about using a tax change? (∆ in tax) (tax multiplier) = ∆ in GDP 1. Fill in what you know PL RGDP SRAS 1 LRAS Y fe 900B AD 1 Y 1 650B PL 1 MPC=.8

(∆ in tax) (4) = 250B (∆ in tax) (4) = 250B 1. Solve PL RGDP SRAS 1 LRAS Y fe 900B AD 1 Y 1 650B PL 1 MPC=.8

∆ in tax = 62.5B AD will shift by the initial change in tax and eventually reach the full employment level of output due to the multiplier AD will shift by the initial change in tax and eventually reach the full employment level of output due to the multiplier PL RGDP SRAS 1 LRAS Y fe 900B AD 1 Y 1 650B PL 1 MPC= B AD 2

Fix the problem using the components of Aggregate Demand Remember that: AD=C+I+G+X n C = a + b Y d Where C= consumption a= autonomous spending b= Marginal Propensity to Consume Y d = Disposable Income Equilibrium is found where AD=Y d Find the equilibrium level of production when: AD = Y d C IG X n AD = ( Y d )

C IG X n AD = ( Y d ) Y d =.8 Y d Y d = 152 Y d = 760

-Now draw a AD/AS graph with a full employment level of production that equals1100 -What is the problem? -What is the size of the initial gap? -Fix the problem using a spending change. -Now fix the problem using a tax change. -Finally, fix 20% of the problem using a spending change and 80% using a tax change

Answers to policy questions are in bold: --Problem= recession --The gap is the difference between the equilibrium level of GDP and the full-employment level of GDP: =340 GDP Gap= (∆ spend) (5) = 340 Increase spending by 68 --(∆ tax) (4) = 340 Decrease tax by 85 --Combination Take 20% of 340 to find how much of the gap needs to be changed using the spending increase:.2 x 340 = 68 (∆ spend) (5) = 68 20% spending increase = 13.6 Take 80% of 340 to find how much of the gap needs to be changed using a tax decrease:.8 x 340 = 272 (∆ tax) (4) = % tax cut = 68