Fiscal Policy Chapter 12 Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

12-2 Fiscal Policy Fiscal policy22 is the use of government taxes and spending to alter macroeconomic outcomes. The premise of fiscal policy is that the aggregate demand for goods and services will not always be compatible with economic stability. LO-1

12-3 John Maynard Keynes and Fiscal Policy John Maynard Keynes explained how a deficiency in demand could arise in a market economy. He showed how and why the government should intervene to achieve macroeconomic goals. He also advocated aggressive use of fiscal policy to alter market outcomes. LO-1

12-4 Components of Aggregate Demand The four major components of aggregate demand are: –Consumption (C) –Investment (I) –Government spending (G) –Net exports (exports minus imports) (X- IM) AD = C + I + G + (X - IM) LO-1

12-5 Figure 12.1

12-6 Equilibrium Aggregate demand is not a single number but instead a schedule of planned purchases. Macro equilibrium is the combination of price level and real output that is compatible with both aggregate demand and aggregate supply. LO-1

12-7 The Nature of Fiscal Policy C + I + G + (X - IM) seldom adds up to exactly the right amount of aggregate demand. The use of government spending and taxes to adjust aggregate demand is the essence of fiscal policy. LO-2

12-8 Figure 12.3

12-9 Fiscal Stimulus If AD falls short, there is a gap between what the economy can produce and what people want to buy. The GDP gap is the difference between full-employment output and the amount of output demanded at current price levels. LO-4

12-10 Multiplier Effects The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption: LO-3

12-11 The marginal propensity to save (MPS) is the fraction of each additional (marginal) dollar of disposable income not spent on consumption: Multiplier Effects LO-3

12-12 Multiplier Formula The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles: Multiplier = 1 / (1-MPC) LO-3

12-13 Total change in spending = Multiplier x Initial change in government spending The multiplier process at work: Every dollar of fiscal stimulus has a multiplied impact on aggregate demand. Multiplier Formula LO-3

12-14 Tax Cuts Rather than increasing its own spending, government can cut taxes to increase consumption or investment spending. A tax cut directly increases disposable income: –Disposable income is the after-tax income of consumers. LO-4

12-15 Budget Cuts Cutbacks in government spending directly reduce aggregate demand. As with spending increases, the impact of spending cuts is magnified by the multiplier. LO-3

12-16 Tax Hikes Tax increases reduce disposable income and thus reduce consumption. This shifts the aggregate demand curve to the left. Tax increases have been used to “cool down” the economy. LO-4

12-17 The Equity and Fiscal Responsibility Act of 1982 increased taxes to reduce inflationary pressures. President Clinton restrained aggregate demand in 1993 with a tax increase, but increased aggregate demand in 1997 with a five-year package of tax cuts. Tax Hikes LO-4

12-18 Budget Deficit Budget deficit–the amount by which government expenditures exceed government revenues in a given time period: Budget deficit = Government spending > Tax revenues LO-5

End of Chapter 12