1. Unit 4: Fiscal Policy Tools Chapter 11—Fiscal Policy

2. Growing Federal Government Pre-1913: 350T employees $650 M spending 1913: 16 th Amendment- Income Tax Est 2009: 4 M employees $2.6T spending

3. Government Outlays Spending: the “G” in C+I+G+(X-M) – Direct impact on GDP and AD curve Income Transfers : payments to individuals for which no G or S are exchanged – Social Security, Welfare, Unemployment Checks – No impact on AD curve, UNLESS people chose to spend it

4. The Fiscal Policy Tool Box Fiscal Policy: use of gov’t taxes and spending to change macro outcomes Government can alter AD with: – Increase or Decrease government spending – Increase or Decrease taxes – Increase or Decrease income transfers

5. Fiscal Policy Internal market forces External shocks Policy levers: Fiscal policy Output Jobs Prices Growth International balances DETERMINANTSOUTCOMES AD AS

6. Close that Recessionary Gap: Fiscal Stimulus Keynes Solution: make up for spending shortfalls in some sectors with increases in others Fiscal stimulus: decrease taxes, increase gov’t spending to shift AD right

7. Fiscal Stimulus Goal AS Q E = 5.6 a AD 1 PEPE Price Level (average price) Real GDP (trillions of dollars per year) 6.0 = Q F GDP Equilibrium Full-employment GDP b

8. The Naïve Keynesian Approach Assumes horizontal AS (no change in PL) Increase AD by $400M to fill recessionary gap – PROBLEM: Vertical AS erodes some of G with PL – AD shortfall is the amount of additional aggregate demand needed to achieve full employment after allowing for price level changes.

9. Solution: Compensate for PL Change AD shortfall as fiscal target how much to spend/reduce taxes Definition: the amount of additional aggregate demand needed to achieve full employment after allowing for price level changes.

10. The AD Shortfall AS Q E = 5.6 a AD 1 AD 2 PEPE Price Level (average price) Real GDP (trillions of dollars per year) Q F = 6.06.4 AD 3 c d be Recessionary GDP gap AD shortfall LO1

11. Check for Understanding What are the 3 tools of fiscal policy? Give 1 example of an income transfer. What is the problem with Keynes’s model? Taxes, Spending, Income Transfers Social Security, Welfare, Unemployment Benefit Upward slope of AS  some gov’t action eroded by price level change

12. Specific Stimulus Tool: Gov’t Spending Multiplier Effects: each new $ is magnified by multiplier OR Cumulative Increase=Original +Induced Spending

13. Multiplier Effects Real GDP ($ trillions per year) Price Level (average price) P1P1 5.6 QEQE 5.8 6.4 AD 2 AD 3 Current price level Direct impact of rise in government spending + $200 billion AD 1 a b Indirect impact via increased consumption + $600 billion LO3

14. The Desired Stimulus The general formula for computing the desired stimulus is a simple rearrangement of the earlier formula: LO3

15. Specific Stimulus Tool: Tax Cuts Decreasing Taxes  – More disposable income to consumers/investors – Impact of MPC: NOT ALL OF A TAX CUT IS SPENT Scope of Initial Stimulus: Tax Cut * MPC Scope of Overall Stimulus: Above * Multiplier Turn & Talk: Which is more effective—tax cut or gov’t spending? Why?

16. Final Tool: Increased Transfers Similar to tax cut—some is eroded by MPC

17. Final Tool: Increased Transfers Increasing transfer payments stimulates the economy. The initial fiscal stimulus of increased transfer payments is: increase in transfer payments X MPC Initial fiscal stimulus (injection)  LO3

18. Practice with Fiscal Policy (fixed taxes) Use the chart to identify eGDP, the MPC and multiplier. GDPTaxesYdYd CIGX-MAgg Exp 15005001000750 600-100 200050015001000750600-100 250050020001250750600-100 300050025001500750600-100 350050030001750750600-100

19. If pGDP is 3,000, create a Income Expenditure and Macro Model depicting the Recessionary Gap Income ExpenditureMacro Model

20. Close the GAP! 1.What can be done with govt. spending? – By how much? 2.What can be done with taxes? – By how much? 3.What can be done with income transfers? – By how much? Why is the answer for #1 different from 2 & 3?

21. Picture Worth a 1000 Words Create a visual summarizing a key point in today’s lesson – Uses images rather than words (labels are okay) – Use color Post Your image on the board Vote for your favorite

22. Fiscal Restraint Fiscal restraint : using tax hikes or spending cuts intended to reduce (shift) aggregate demand. 3 Tools: – Tax increases – Decrease government spending – Decrease income transfers LO1

23. Problem: Excess AD=Inflationary Gap AS Q 2 = 5.8 E2E2 f AD 1 AD 2 PEPE PFPF Price Level (average price) Real Output (trillions of dollars per year) E1E1 Q F = 6.0Q 1 = 6.2 Inflationary GDP gap Excess AD LO1

24. The Fiscal Target The AD excess is the amount by which aggregate demand must be reduced to achieve price stability after allowing for price- level changes. The AD excess exceeds the inflationary GDP gap. LO1

25. The Fiscal Target The first task is to determine how much AD needs to fall: LO1

26. Budget Cuts Budget cuts reduce government spending and induces cutbacks in consumer spending. OR Initial budget cut Xmultiplier Cumulative reduction in spending  LO3

27. Tax Hikes Tax increases reduce demand by reducing disposable income. Taxes must be increased more than a dollar to get a dollar of fiscal restraint. Desired increase in taxes = Desired fiscal restraint MPC LO2

28. Reduced Transfers A cut in transfer payments works like a tax hike, reducing the disposable income of transfer recipients. The desired reduction in transfers is the same as a desired tax increase. Rarely used because it focuses on the poor More likely, cuts in future increases of payments LO3

29. Caveats Some of the intended fiscal stimulus may be offset by the crowding out of private expenditure. – Crowding out is a reduction in private-sector borrowing (and spending) caused by increased government borrowing. – Time: lags in recognizing & address problems, seeing solutions in action New shocks could appear in the meantime!

30. Time Lags It takes time to recognize that a problem exists and then formulate policy to address the problem. The very nature of the macro problems could change if the economy is hit with other internal or external shocks.

31. Lots of lags… Informational Lags: time it takes to realize there is a problem – Equal for monetary/fiscal policy Policy Lags: time it takes to legislate policy – A problem for fiscal policy Reactionary Lags: time it takes for policy to take effect – A problem for monetary policy

32. Balanced Budgets? Because the multiplier for government spending is greater than that for consumption, equal spending and tax cuts will NOT offset each other. Tax cut Spending cut PL rGDP

33. Practice with Fiscal Policy (fixed taxes) Use the chart to identify eGDP, the MPC and multiplier. GDPTaxesYdYd CIGX-MAgg Exp 300050025001950750600-1003200 350050030002350750600-1003600 400050035002750750600-1004000 450050040003150750600-1004400 500050045003550750600-1004800

34. If pGDP is 3,000, create a Income Expenditure and Macro Model depicting the Inflationary Gap Income ExpenditureMacro Model

35. Close the GAP! 1.What can be done with govt. spending? – By how much? 2.What can be done with taxes? – By how much? 3.What can be done with income transfers? – By how much? Why is the answer for #1 different from 2 & 3?

36. ScenarioObjective for AD Action on Taxes Action on Spending Action on Transfers Unemployment rises to 12% Inflation rises to 14% per year Surveys show consumers are losing confidence in the economy, retail sales are sagging, and business inventories are rapidly rising. Business sales and investment are rapidly increasing and economists believe inflation lies ahead. Inflation persists while unemployment remains high. Which solution? Choose the appropriate policy options for each of the scenarios below:

37. PRACTICE MAKES PERFECT… Stimulus and restraint

38. GDPTaxesYdYd CIGX M Agg Exp 15005001000700750600200 150 200050015001000750600200 150 250050020001300750600200 150 300050025001600750600200 150 350050030001900750600200 150 Calculate Y e, the MPC and the multiplier…

39. If pGDP is 2,000, create a Income Expenditure and Macro Model depicting the Gap Income ExpenditureMacro Model

40. Close the GAP! 1.What can be done with govt. spending? – By how much? 2.What can be done with taxes? – By how much? 3.What can be done with income transfers? – By how much? Why is the answer for #1 different from 2 & 3?

41. Calculate Y e, the MPC and the multiplier… GDPTaxesYdYd CIGX M Agg Exp 280030025002000500 200 300 330030030002400500 200 300 380030035002800500 200 300 430030040003200500 200 300 480030045003600500 200 300

42. If pGDP is 4,000, create a Income Expenditure and Macro Model depicting the Gap Income ExpenditureMacro Model

43. Close the GAP! 1.What can be done with govt. spending? – By how much? 2.What can be done with taxes? – By how much? 3.What can be done with income transfers? – By how much? Why is the answer for #1 different from 2 & 3?

44. Create Your Own Quiz Write a 10 question quiz for chapter 11 – Multiple choice – Include correct answers on the back – Trade with a neighbor and evaluate

45. FISCAL POLICY WRAP UP Impact of Variable Vs. Fixed Taxes on the (Oversimplified) Multiplier

46. The Multiplier with Fixed Taxes Fixed Taxes: same regardless of income – i.e. local taxes (everyone pays 1.125% of income in New Britain Township) – the model used to date Increase in taxes changes autonomous consumption – Multiplier is unchanged AE curve shifts downward to reflect a less spending at every level of income

47. What does it look like? Income Expenditure Model AD-AS Model

48. Multiplier with Variable Taxes Variable Taxes change with level of income – i.e. personal income tax (higher incomes  higher taxes) – A more realistic model Increase in taxes changes slope of consumption schedule (flattens) – Multiplier is reduced! AE curve shifts downward AND flattens to reflect changes and reductions in spending at growing levels of income SO? A reduced multiplier means fiscal policy is less effective

49. If pGDP is 3000, what does it look like? Income Expenditure ModelAD-AS Model

50. How to Compute the Multiplier with Variable Taxes 1.Compute the MPC a.Change in C/Change in Yd 2.Compute the tax rate a.Change in taxes/Change in Income 3.Compute the slope of the new AE Function a.MPC-(MPC*tax rate) 4.Compute multiplier a.Use result in #3 in the multiplier formula (1/(1- slope of new AE function)

51. Practice with Variable Taxes Calculate eGDP, MPC, tax rate, the slope of AE and the multiplier. GDP (Y)TaxesYdCIGX-MAgg. Exp. 200040016001200650350-100 225045018001350650350-100 250050020001500650350-100 275055022001650650350-100 300060024001800650350-100

52. If pGDP is 3000, what does it look like? Income Expenditure ModelAD-AS Model

53. Close the GAP! 1.What can be done with govt. spending? – By how much? 2.What can be done with taxes? – By how much? 3.What can be done with income transfers? – By how much? Why is the answer for #1 different from 2 & 3?

54. Group Practice with Variable Taxes Calculate eGDP, MPC, tax rate, the slope of AE and the multiplier. GDP (Y) TaxesYdCIGXMAgg. Exp. 500050045004095695600300500 550055049504500695600300500 600060054004905695600300500 650065058505310695600300500 700070063005715695600300500

55. Close the GAP! 1.What can be done with govt. spending? – By how much? 2.What can be done with taxes? – By how much? 3.What can be done with income transfers? – By how much? Why is the answer for #1 different from 2 & 3?