Congress The President BUDGET TaxesSpending Fiscal Policy

Fiscal Policy A tool of macroeconomic policy that seeks to influence the level of economic activity through control of government expenditure and taxation. There are two types of fiscal policy: –Automatic Stabilizers –Discretionary Policies

Fiscal Policy: Automatic Stabilizers Automatic stabilizers –Built in, non-discretionary elements in fiscal policy that serve to reduce the impact of economic events automatically. For example, A fall in output and national income reduces government tax liabilities and increases unemployment and welfare payments. –Lower tax receipts and higher transfer payments increase the government’s budget deficit and restore some of the lost income.

Fiscal Policy: Discretionary Policy Discretionary Fiscal Policy –Expansionary Fiscal Policy Decreases in taxes and/or increases in spending that tend to increase economic activity. –Contractionary Fiscal Policy Increases in taxes and/or decreases in spending that tend to dampen economic activity. Fiscal policy may work on the demand side of the economy or the supply side.

Government Spending Rises Taxes Decrease Fiscal Policy: Demand Side Transmission Mechanism Investment Spending is Crowded Out Export Spending is Crowded Out Aggregate Spending Increases Price Level Rises Spending Decreases Interest Rates Rise Deficit Increases Imports Rise Exports Fall Expansionary Fiscal Policy

Government Spending Rises Taxes Decrease Fiscal Policy: Demand Side Transmission Mechanism Export Spending Is Crowded Out Investment Spending is Crowded Out Aggregate Spending Increases Price Level Rises Spending Decreases Interest Rates Rise Deficit Increases Imports Rise Exports Fall Expansionary Fiscal Policy

Demand Side Logic: The Multiplier Expansionary fiscal policy causes aggregate demand to rise such that demand exceeds supply. –Government spending affects aggregate demand directly. –Changing tax rates affects aggregate demand primarily through changes in consumption spending.

Demand Side Logic: The Multiplier Inventories fall unexpectedly, prompting firms to produce more output. As output increases, income rises, causing consumption to rise. Once again, demand exceeds supply, causing inventories to fall…….etc.

The Multiplier: Summary /\ Gov’t Spend /\ Inventories /\ Income /\ Consumption $100$100 $100 $90 $90 $90 $81 $81 $81 $72.90 $72.90 $72.90 $65.61 $65.61 $65.61 $59.05 $100 $1000 $1000 $900

The Multiplier: An Example 1) Government spending rises by $100. 2) Aggregate demand rises by $100 and now exceeds current aggregate supply by $100. 3) Inventories fall by $100. 4) Firms produce just enough to replace the inventories.

The Multiplier: An Example 5) Production and national income rise by $100. 6) Consumption now rises, but not by $100. –Consumption rises by less than $100 because some part of the increase in income is saved. 7) Let consumption rise by $90. 8) Repeat from step 2.

Government Spending Rises Taxes Decrease Fiscal Policy: Demand Side Transmission Mechanism Investment Spending is Crowded Out Export Spending is Crowded Out Aggregate Spending Increases Price Level Rises Spending Decreases Interest Rates Rise Deficit Increases Imports Rise Exports Fall Expansionary Fiscal Policy

Demand Side Logic: Interest Rates As the economy expands, demand for credit increases. If the Federal Reserve does not fully accommodate the rise in credit demand, interest rates rise. –Rising interest rates tend to dampen investment spending.

Demand Side Logic: Interest Rates If as interest rates rise, assets in the USA become more attractive than assets in the rest of the world, the dollar rises. –An increase in the value of the dollar tends to cause exports to fall.

Demand Side Logic: Price Level As the economy expands, firms compete with each other for resources. –There is a tendency at some point for factor payments to rise. If monetary policy is accommodative, the price level rises. At full employment of resources, further expansion of spending results in pure inflation.

Expansionary Demand Side Fiscal Policy AD 1 SRAS Y P Y 1 Y 2 * Y 3 P1P1 AD 2 P2P2 Expansionary fiscal policy shifts the AD curve from AD 1 to AD 2. If prices do not rise, the fiscal stimulus causes Y to rise to Y 3. But as Y rises money demand rises, causing interest rates to rise and investment and net exports to rise by smaller amounts. As Y rises, competition for resources causes other prices to rise. Equilibrium Y occurs at Y 2 and P 2. National income rises from Y 1 to Y 2 *. Prices rise from P 1 to P 2. 0 LRAS

Contractionary Demand Side Fiscal Policy AD 1 SRAS Y P Y 1 Y 2 * Y 3 P1P1 AD 2 P2P2 Contractionary fiscal policy shifts the AD curve from AD 2 to AD 1. If prices do not fall, the fiscal contraction causes Y to fall to Y 1. But as Y falls, money demand falls, causing interest rates to fall and investment and net exports to fall by smaller amounts. As Y falls, less competition for resources causes other prices to fall. Equilibrium Y occurs at Y 2 and P 1. National income falls from Y 1 to Y 2. Prices fall from P 2 to P 1. 0 LRAS

Demand Side Fiscal Policy and Deficits Summary: –Tax cuts and increased government spending lead to government budget deficits. –But, as output rises, so do tax revenues so ultimately the revenues lost because of the rate decrease are recovered as the tax base expands. Conclusion: The deficit may increase or decrease.

Fiscal Policy: Supply Side Expansionary fiscal policy –The federal government decreases taxes. People work more: People save more: Firms invest more. Aggregate supply increases, unemployment falls, inflation falls.

Fiscal Policy: Supply Side Contractionary fiscal policy –The federal government increases taxes. People work less: People save less: Firms invest less. Aggregate supply decreases, unemployment rises, inflation rises.

Fiscal Policy: Supply Side Transmission Mechanism Productivity Rises After-tax ROR Rises Investment Rises Interest Rates Fall After-tax Wage Higher Increase in Labor Supply Lower Business Tax Rates Lower Personal Tax Rates Savings Rise Aggregate Supply Rises Unemployment Falls Inflation Falls

Tax Cuts: Labor Supply The decrease in marginal income tax rates encourages people to work more. –People are willing to work more because they now keep more of their wages. More specifically, they get to keep more of the last dollar earned. –Therefore, the increased labor supply increases output without putting upward pressure on wages.

Tax Cuts: Saving and Investment Business tax cuts increase business profits. –Higher profits encourage investment in new capital. Individual tax cuts stimulate household savings. –Increased savings contribute to lower interest rates and increased investment in new capital. New capital increases productivity, thus, lowering costs and inflationary pressures.

Expansionary Supply Side Fiscal Policy AD 1 SRAS 1 Y P Y 1 Y 2 * P1P1 P2P2 Expansionary fiscal policy shifts the AS curve from AS 1 to AS 2. As productivity rises and costs fall, output increases while prices fall. Equilibrium Y occurs at Y 2 and P 2. National income rises from Y 1 to Y 2. Prices fall from P 1 to P 2. 0 SRAS 2 LRAS

Supply Side Fiscal Policy and Deficits Summary: –Tax cuts lead to increased economic activity. –As output rises, so do tax revenues so ultimately the revenues lost because of the rate decrease are recovered as the tax base expands. Conclusion: The deficit may decrease if government spending does not rise.