1. Fiscal Policy
Fiscal economic

2. Government in the Economy
Nothing arouses as much controversy as the role of government in the economy.
Government can affect the macroeconomy in two ways:
Fiscal policy is the manipulation of government spending and taxation.
Monetary policy refers to the behavior of the Federal Reserve regarding the nation’s money supply.

3. What is Fiscal Policy?
Fiscal policy is the deliberate manipulation of government purchases, transfer payments, taxes, and borrowing in order to influence macroeconomic variables such as employment, the price level, and the level of GDP

4. Government in the Economy
Discretionary fiscal policy refers to deliberate changes in taxes or spending.
The government can not control certain aspects of the economy related to fiscal policy. For example:
The government can control tax rates but not tax revenue. Tax revenue depends on household income and the size of corporate profits.
Government spending depends on government decisions and the state of the economy.

5. Net Taxes (T), and Disposable Income (Yd)
Net taxes are taxes paid by firms and households to the government minus transfer payments made to households by the government.
Disposable, or after-tax, income (Yd ) equals total income minus taxes.

6. Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

7. Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income
When government enters the picture, the aggregate income identity gets cut into three pieces:
And aggregate expenditure (AE) equals:

8. The Budget Deficit
A government’s budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period:
If G exceeds T, the government must borrow from the public to finance the deficit. It does so by selling Treasury bonds and bills. In this case, a part of household saving (S) goes to the government.

9. Adding Taxes to the Consumption Function
The aggregate consumption function is now a function of disposable, or after-tax, income.

10. Equilibrium Output: Y = C + I + G
Finding Equilibrium for I = 100, G = 100, and T = 100 (All Figures in Billions of Dollars)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
OUTPUT (INCOME) Y
NET TAXES T
DISPOSABLE INCOME Yd / Y - T
CONSUMPTION SPENDING (C = Yd)
SAVING S (Yd – C)
PLANNED INVESTMENT SPENDING I
GOVERNMENT PURCHASES G
PLANNED AGGREGATE EXPENDITURE C + I + G
UNPLANNED INVENTORY CHANGE Y - (C + I + G)
ADJUSTMENT TO DISEQUILIBRIUM
300
100
200
250
- 50
450
- 150
Output8
500
400
600
- 100
700
550 50
750
900
800
Equilibrium
1,100
1,000
850
150
1,050
+ 50
Output9
1,300
1,200
+ 100
1,500
1,400
1,150
1,350
+ 150

11. Finding Equilibrium Output/Income Graphically

12. The Government Spending Multiplier
The government spending multiplier is the ratio of the change in the equilibrium level of output to a change in government spending.

13. The Government Spending Multiplier
Finding Equilibrium After a $50 Billion Government Spending Increase (All Figures in Billions of Dollars; G Has Increased From 100 in Table 25.1 to 150 Here)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
OUTPUT (INCOME) Y
NET TAXES T
DISPOSABLE INCOME Yd / Y - T
CONSUMPTION SPENDING (C = Yd)
SAVING S (Yd – C)
PLANNED INVESTMENT SPENDING I
GOVERNMENT PURCHASES G
PLANNED AGGREGATE EXPENDITURE C + I + G
UNPLANNED INVENTORY CHANGE Y - (C + I + G)
ADJUSTMENT TO DISEQUILIBRIUM
300
100
200
250
- 50
150
500
- 200
Output8
400
650
- 150
700
600
550 50
800
- 100
900
950
1,100
1,000
850
Equilibrium
1,300
1,200
1,250
+ 50
Output9

14. The Effect on GDP of an Increase in Government Spending$
C+I+G’+(X-M)
45o
C+I+G+(X-M) G
Simple government expenditures multiplier = GDP/G = 1/(1-MPC)
GDP
Real GDP

15. The Government Spending Multiplier

16. The Tax Multiplier
A tax cut increases disposable income, and leads to added consumption spending. Income will increase by a multiple of the decrease in taxes.
A tax cut has no direct impact on spending. The multiplier for a change in taxes is smaller than the multiplier for a change in government spending.

17. The Tax Multiplier

18. The Effect on GDP of a Decrease in Taxes$
C’+I+G+(X-M)
45o
C+I+G+(X-M)
Simple tax multiplier = GDP/T = -MPC/(1-MPC)
GDP
Real GDP

19. The Balanced-Budget Multiplier
The balanced-budget multiplier is the ratio of change in the equilibrium level of output to a change in government spending where the change in government spending is balanced by a change in taxes so as not to create any deficit.

20. The Balanced Budget Multiplier
A factor that show that identical changes in government purchases and net taxes change real GDP demanded by that same amount

21. The Balanced-Budget Multiplier
Finding Equilibrium After a $200 Billion Balanced Budget Increase in G and T (All Figures in Billions of Dollars; G and T Have Increased From 100 in Table 25.1 to 300 Here)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
OUTPUT (INCOME) Y
NET TAXES T
DISPOSABLE INCOME Yd / Y - T
CONSUMPTION SPENDING (C = Yd)
PLANNED INVESTMENT SPENDING I
GOVERNMENT PURCHASES G
PLANNED AGGREGATE EXPENDITURE C + I + G
UNPLANNED INVENTORY CHANGE Y - (C + I + G)
ADJUSTMENT TO DISEQUILIBRIUM
500
300
200
250
100
650
- 150
Output8
700
400
800
- 100
900
600
550
950
- 50
1,100
Equilibrium
1,300
1,000
850
1,250
+ 50
Output9
1,500
1,200
1,400
+ 100

22. Fiscal Policy Multipliers
Summary of Fiscal Policy Multipliers
POLICY STIMULUS
MULTIPLIER
FINAL IMPACT ON EQUILIBRIUM Y
Government- spending multiplier
Increase or decrease in the level of government purchases:
Tax multiplier
Increase or decrease in the level of net taxes:
Balanced-budget multiplier
Simultaneous balanced-budget increase or decrease in the level of government purchases and net taxes: 1

23. Fiscal Policy in Practice

24. Introduction
Before the 1930s, fiscal policy was not explicitly used to influence the macroeconomy
The classical approach implied that natural market forces, by way of flexible prices, wages, and interest rates, would move the economy toward its potential GDP
Thus there appeared to be no need for government intervention in the economy
Before the onset of the Great Depression, most economists believed that active fiscal policy would do more harm than good

25. The Great Depression and World War II
Three developments bolstered the use of fiscal policy
The publication of Keynes’ General Theory
War-time demand on production helped pull the U.S. out of the Great Depression
The Full Employment Act of 1946, which gave the federal government responsibility for promoting full employment and price stability

26. Automatic Stabilizers
Structural features of government spending and taxation that smooth fluctuations in disposable income over the business cycle
Examples include,
Our progressive income system with its increasing marginal income tax rates
Unemployment insurance
Welfare spending

27. The Economy’s Influence on the Government Budget
Fiscal drag is the negative effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion.

28. The Golden Age of Keynesian Fiscal Policy to Stagflation
The Early 1960s provided support for Keynesian theories
In particular, President Kennedy’s 1964 income tax cut did much to boost the economy and reduce unemployment
However, the 1970s were marked by significant supply-side shocks (increases in oil prices in addition to crop failures)
The economic ills brought about by these supply-side shocks to the economy could not be remedied by demand-side Keynesian economic theories

29. Lags in Fiscal Policy
The time required to approve and implement fiscal legislation may hamper its effectiveness and weaken fiscal policy as a tool of economic stabilization
In the case of an oncoming recession, it may take time to
Recognize the coming recession
Implement the policy
Let the policy have its impact

30. Discretionary Policy and Permanent Income
Permanent income is income that individuals expect to receive on average over the long run
To the extent that consumers base spending decisions on their permanent income, attempts to fine-tune the economy through discretionary fiscal policy will be less effective

31. Budgets, Deficits, and Public Policy

32. The Government Budget
A plan for government expenditures and revenues for a specified period, usually a year

33. The Federal Budget
The federal budget is the budget of the federal government.
The difference between the federal government’s receipts and its expenditures is the federal surplus (+) or deficit (-).

34. The Federal Budget
Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)
AMOUNT
PERCENTAGE OF TOTAL
Receipts
Personal taxes
1,010.1
49.6
Corporate taxes
193.2
9.5
Indirect business taxes
111.0
5.5
Contributions for social insurance
720.6
35.4
Total
2,034.9
100.0
Current Expenditures
Consumption
514.1
26.9
Transfer payments
831.9
43.6
Grants-in-aid to state and local governments
274.2
14.4
Net interest payments
236.9
12.4
Net subsidies of government enterprises
52.5
2.7
1,909.6
Current Surplus (+) or deficit (-) (Receipts - Current Expenditures)
Source: U.S. Department of Commerce, Bureau of Economic Analysis.

35. Composition of Federal Expenditures: Fiscal Year 1995

36. The Presidential Role in the Budget Process
Early in this century, the president had very little involvement in the development of the federal budget
By the mid-1970s the president had been given the resources to translate policy into a budget proposal to be presented to Congress
Office of Management and Budget (1921)
Employment Act of 1946 (Council of Economic Advisers)

37. The Presidential Role in the Budget Process (continued)
The development of the president’s budget begins a year before it is submitted to Congress
The presidents proposed budget (The Budget of the United States Government) is supported by the Economic Report of the President
The budget is submitted in January for the upcoming fiscal year October 1-September 30

38. The Congressional Role in the Budget Process
House and Senate budget committees review the president’s budget proposal
An overall budget outline is approved by Congress (budget resolution) and given to the various congressional committees and subcommittees which authorize federal spending

39. Budget Deficits and Surpluses
When budgeted expenditures exceed projected tax revenues, the budget is projected to be in deficit
When projected tax revenues exceed budgeted expenditures, the budget is projected to be in surplus

41. The Federal Government Surplus (+) or Deficit (-) as a Percentage of GDP, 1970 I-2003 II

42. Problems with the Budget Process
Continuing resolutions
A continuing resolution is a budget agreement that allows agencies, in the absence of an approved budget, to spend at the rate of the previous year’s budget
Continuing resolutions are implemented due to delays in the budget process or problems with content of the budget
Overlapping committee authority
Length of the budget process
Uncontrollable budget items
Overly detailed budget

43. Entitlement Programs
Guaranteed benefits for those who qualify under government transfer programs such as Social Security and Aid to Families with Dependent Children
These programs represent a major “fixed” element of the budget, unless laws are passed to change eligibility requirements

44. Suggestions for Budget Reform
Biennial budget
The elimination of line item details before Congress
Congress would consider only the overall budget for a given agency, rather that detailed line items

45. Rationale for Budget Deficits
Large capital projects (highways, etc.)
The benefits from these project will benefit more than current taxpayers, so deficit financing is appropriate
Major Wars
Keynesian economics points to the use of deficits to stimulate the economy during periods of economic slowdown
Automatic stabilizers tend to increase deficits, since during times of recession, taxes are reduced while unemployment insurance and welfare payments are increased

46. Budget Philosophies
Annually balanced budget—Budget philosophy prior to the Great Depression; aimed at equating revenues with expenditures, except during times of war
Cyclically balanced budget—Budget philosophy calling for budget deficits during recessions to be financed by budget surpluses during expansions
Functional Finance—A budget philosophy aiming fiscal policy at achieving potential GDP rather than balancing budgets either annually or over the business cycle

47. Crowding Out and Crowding In
Crowding out--When the government undertakes expansionary fiscal policy, interest rates increase due to competition for borrowed funds and increased transactions demand for money
As a result, private investment is “crowded out” due to increases in public investment
Crowding in—If expansionary fiscal policy raises the general level of prosperity in the economy, private investors may expect greater investment-related profits, causing private investment to increase

48. Deficits and Interest Rates
Financing Deficits
Taxes
Bonds (borrowing)
Printing Money
Ricardian Equivalence

49. The Federal Deficit Versus the National Debt
The federal deficit is a flow variable measuring the amount by which expenditures exceed revenues in a particular year
The national debt is a stock variable measuring the accumulation of past deficits
In the U.S., it took 200 years for the national debt to reach $1 trillion
After the debt reached this level, it took only 15 years for the debt to reach the $5 trillion level

50. The Debt and Problems http://www.brillig.com/debt_clock/
Arguments about the Debt
We have to pay it back
We owe it to ourselves (much less so than years ago).

51. Reducing the Deficit
Line-item veto (signed into law in April 1996 struck by the Supreme Court in 1998)
A provision to allow the president to reject particular portions of the budget rather than simply accept or reject the entire budget
Balanced budget amendment
Proposed amendment to the U.S. Constitution requiring a balanced federal budget

52. Size of Government

53. The Debt
The federal debt is the total amount owed by the federal government. The debt is the sum of all accumulated deficits minus surpluses over time.
Some of the federal debt is held by the U.S. government itself and some by private individuals. The privately held federal debt is the private (non-government-owned) portion of the federal debt.

54. The Federal Government Debt as a Percentage of GDP, 1970 I-2003 II
The percentage began to fall in the mid 1990s.

55. The Economy’s Influence on the Government Budget
The full-employment budget is what the federal budget would be if the economy were producing at a full-employment level of output.

56. The Economy’s Influence on the Government Budget
The cyclical deficit is the deficit that occurs because of a downturn in the business cycle.
The structural deficit is the deficit that remains at full employment.

57. Review Terms and Concepts
automatic stabilizers
balanced-budget multiplier
budget deficit
cyclical deficit
discretionary fiscal policy
disposable, or after-tax, income
federal budget
federal debt
federal surplus (+) or deficit (-)
fiscal drag
fiscal policy
full-employment budget
government spending multiplier
monetary policy
net taxes
privately held federal debt
structural deficit
tax multiplier

58. The Economy’s Influence on the Government Budget
Automatic stabilizers are revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP.

59. The Budget Deficits of the 1980s and 1990s
The tax cuts of the early 1980s together with large increases government spending caused the annual government deficit and the national debt to grow significantly
Although both fiscal policy measures stimulated the economy, the resulting tax revenues were not sufficient to manage the large government deficits

60. Fiscal Policy and the Natural Rate of Unemployment
If there is a natural rate of unemployment, fiscal policy that increases aggregate demand will appear to succeed in the short run because output and employment will both expand
But stimulating aggregate demand will, in the long run, result only in a higher price level, while the level of output will fall back to the economy’s potential

61. Feedback Effects of Fiscal Policy on Aggregate Supply
Both automatic stabilizers and discretionary fiscal policy may affect individual incentives to work spend, save, and invest, though these effects are usually unintended

62. Appendix: The Government Expenditures and Tax Multipliers

63. Appendix: The Government Multiplier with Income Taxes

64. Appendix: The Multiplier with Income Taxes and Variable Imports

65. Appendix A: Deriving the Fiscal Policy Multipliers
The government spending and tax multipliers algebraically:

66. Appendix A: Deriving the Fiscal Policy Multipliers
The balanced-budget multiplier is found by combining the effects of government spending and taxes:
increase in spending:
- decrease in spending:
= net increase in spending
The balanced-budget multiplier equals one. An increase in G and T by one dollar each causes a one-dollar increase in Y.

67. Appendix B: The Case In Which Tax Revenues Depend on Income

68. Appendix B: The Case In Which Tax Revenues Depend on Income

69. Appendix B: The Case In Which Tax Revenues Depend on Income
The Government Spending and Tax Multipliers Algebraically:

70. Appendix B: The Case In Which Tax Revenues Depend on Income
The government spending and tax multipliers when taxes are a function of income are derived as follows:

71. A Contractionary Gap Can be Closed by Expansionary Fiscal Policy
Potential
output
Price
Level
SRAS
AD* AD
Real GDP
contractionary
gap

72. An Expansionary Gap Can be Closed by Contractionary Fiscal Policy
Potential
output
Price
Level
SRAS
AD* AD
Real GDP
expansionary
gap

73. The Leakages/Injections Approach
Taxes (T) are a leakage from the flow of income. Saving (S) is also a leakage.
In equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE), and leakages (S + T) must equal planned injections (I + G). Algebraically,