1. Fiscal Policy
How the government uses discretionary fiscal policy to influence the economies performance

2. Discretionary Fiscal Policy
The deliberate use of changes in government spending or taxes to alter aggregate demand
Examples of Expansionary Fiscal Policy
Increase government spending
Decrease taxes
Increase government spending and taxes equally
Examples of Contractionary Fiscal Policy
Decrease government spending
Increase taxes
Decrease government spending and taxes equally

3. Price Level 155 150 AD2 AD1 Real GDP $6 $6.1 $6.2
Government Fiscal Policy to Combat a Recession
Increase Government Spending
Decrease Tax
Price Level AS
Increase in the aggregate demand curve
Increase in the price level and the real GDP
155
150
AD2
AD1
Real GDP $6
$6.1
$6.2
full employment

4. C MPC = Y Spending Multiplier Calculating the Spending Multiplier
Any initial change in spending leads to a chain reaction of more spending which causes a greater change in demand
Calculating the Spending Multiplier
The ratio of the change in real GDP to an initial change in aggregate expenditure
Marginal Propensity to Consume (MPC)
The change in consumption resulting from a change in income C Y
MPC =

5. Spending Multiplier 1 1 – MPC MPC = 0.75 1 1 – 0.75 = 4
Real GDP increases with an increase in government spending of $50 billion
M x ΔG = ΔQ
4 x $50 billion = $200 billion

6. Tax Multiplier Formula
The change in aggregate demand (total spending) resulting from an initial change in taxes
When government cuts taxes by $50 billion
The multiplier process is less because initial spending increases only by $38 billion instead of $50 billion
The tax cut has a smaller multiplier effect on aggregate demand than an equal increase in government spending
Tax Multiplier Formula
1 – spending multiplier
With spending multiplier of 4 the tax multiplier is
1 – spending multiplier = -3
Real GDP increases by $150 billion with a cut in taxes of $50 billion
-3 x -$50 billion = $150 billion

7. The MPC can change from one time period to another
Fiscal policy be used to combat inflation when the economy is operating in the intermediate range of the aggregate supply curve

8. Decrease in the price level
Fiscal Policy to Combat Inflation
Price Level
Reduce Government Spending
Increase Tax
AD2 AS
Decrease in the aggregate demand curve
Decrease in the price level
160
155
AD1
Real GDP 6
6.1
full employment

9. What will happen to AD with a tax increase of 33.3 billion?
What happens to Aggregate Demand (AD) with a cut in Government (G) spending of 25 billion?
ΔG x GM = ΔAD
GM = Government Spending Multiplier
-$25 billion x 4 = -$100 billion
What will happen to AD with a tax increase of 33.3 billion?
ΔT x TM = ΔAD
TM = Tax Multiplier
$33.3 x -3 = -$100 billion

10. Automatic Stabilizers
Federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction
Government Expenditure Examples
Transfer payments
Unemployment compensation
Welfare
Progressive Income Tax
The more a person earns the greater the percentage tax burden

11. Budget Surplus Budget Deficit
A budget in which government revenues exceed government expenditures in a given time period
Budget Deficit
A budget in which government expenditures exceed government revenues in a given time period

12. Government Spending and Taxes
Automatic Stabilizers T
$1,000
Budget deficit
Budget surplus
$750
Government Spending and Taxes
$500 G
$250 $4 $6 $8
Real GDP

13. Automatic Stabilizers
Increase in real GDP
Tax collections rise and government transfer payments fall
Budget surplus offsets inflation
Decrease in real GDP
Tax collections fall and government transfer payments rise
Budget deficit offsets recession

14. Supply-side Fiscal Policy
A fiscal policy that emphasizes government policies that increase aggregate supply
Purpose: to achieve long-run growth in real output, full employment, and a lower price level

15. Demand-Side Fiscal Policy
Price Level
Increase in government spending; decrease in net taxes
AD2 AS
250
Increase in the aggregate demand curve
200
150
100
AD1 2 4 6 8 10
Real GDP
full employment

16. Supply-Side Fiscal Policy
Price Level
AS1
250
AS2
200
Decrease in resource prices; technological advances; subsidies; decrease in regulations
150
Increase in the aggregate supply curve
100 AD
Real GDP 2 4 6 8 10
full employment

17. Supply-Side Policies Affect Labor Markets
Wage rate
Before tax-cut labor supply
After tax-cut labor supply W1 W2
Labor Demand L1 L2
Quantity of Labor

18. Supply-side policy Tax rate cuts
Higher disposable income boosts worker’s incentives to work harder and produce more
Firms invest more and create new ventures, which increase jobs and output
Aggregate supply curve increase
Economy expands, employment rises, and inflation is reduced

19. Keynesian policy Tax rate cuts
Higher disposable income increases money for spending
People spend extra income on more goods and services
Aggregate demand curve increase
Economy expands, employment rises, but inflation rate rises

20. Taxes increases may lead to higher government revenues
Laffer Curve
Puts forth the idea that increasing taxes from zero will increase tax revenues up to a certain point
Taxes increases may lead to higher government revenues
Depends on where the economy is on the Laffer Curve
When taxes increase beyond a certain point tax revenues begin to decline as the economic pie begins to shrink
Economic pie begins to shrink as Workers have less incentive to work and investors have less of an incentive to invest as their taxes increase beyond a certain level

21. The Laffer Curve Rmax R Tmax T 100% Federal Tax Revenue
Tmax T
100%
Federal Tax Rate