1. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved ECON Designed by Amy McGuire, B-books, Ltd. McEachern 2010- 2011 12 CHAPTER Fiscal Policy Macro

2. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Fiscal Policy Tools LO 1  Automatic stabilizers –Revenue and spending programs –Adjust automatically E.g.: Federal income tax

3. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Fiscal Policy Tools LO 1  Discretionary fiscal policy –Deliberate manipulation of G, TP, and T –Increase in G or TP Increases real GDP demanded –Increase in net taxes Decreases real GDP demanded

4. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Changes in Government Purchases LO 1  Increase government purchases –Stimulate the economy –Upward shift of AE line –Increase in GDP

5. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 1 Effect of a $0.1 Trillion Increase in Government Purchases on Aggregate Expenditure and Real GDP Demanded C + I + G + (X - M) a 14.014.5 0 Real GDP (trillions of dollars) 14.0 14.5 Aggregate expenditure (trillions of dollars) 45° C + I + G’ + (X - M) b As a result of a $0.1 trillion increase in government purchases, the aggregate expenditure line shifts up by $0.1 trillion, increasing the real GDP demanded by $0.5 trillion. This model assumes price level remains unchanged. 0.1 Exhibit 1

6. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Changes in Net Taxes LO 1  Decrease in net taxes –Increases DI by ∆NT –Increases C by MPC ×∆NT –Upward shift of AE line –Increase in GDP

7. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 14.014.40 Real GDP (trillions of dollars) Effect of a $0.1 Trillion Decrease in Net Taxes on Aggregate Expenditure and Real GDP Demanded C + I + G + (X - M) a 14.0 14.4 Aggregate expenditure (trillions of dollars) 45° C’ + I + G + (X - M) c As a result of a decrease in NT of $0.1 trillion, consumers, who are assumed to have a MPC of 0.8, spend $80 billion more and save $20 billion at every level of GDP. The consumption function shifts up by $80 billion, as does the AE line. 0.08 An $80 billion increase of AE line eventually increases real GDP demanded by $0.4 trillion. Keep in mind that the price level is assumed to remain constant during all this. LO 1 Exhibit 2

8. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Discretionary Fiscal Policy  Expansionary fiscal policy  Contractionary gap  Price level < expected  Output < potential  Unemployment > natural rate  Increase G, decrease NT  Increase AD  Higher price level  Higher output

9. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Expansionary Fiscal Policy  To close a contractionary gap  Output < potential  Unemployment > natural rate  Expansionary fiscal policy  Increase G  Decrease NT  Increase AD  Increase output  Increase price level  Close the contractionary gap

10. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Discretionary Fiscal Policy to Close a Contractionary Gap The aggregate demand curve AD and the short-run aggregate supply curve SRAS 130 intersect at point e. Output falls short of the economy’s potential. The resulting contractionary gap is $0.5 trillion. This gap could be closed by discretionary fiscal policy that increases aggregate demand by just the right amount. An increase in government purchases, a decrease in net taxes, or some combination could shift aggregate demand out to AD*, moving the economy out to its potential output at e*. LO 2 Exhibit 3 Price level 125 130 AD SRAS 130 e Potential output LRAS Real GDP (trillions of dollars) 0 14.014.513.5 AD* e’ e* e’’

11. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Contractionary Fiscal Policy  To close an expansionary gap  Output > potential  Unemployment < natural rate  Contractionary fiscal policy  Decrease G  Increase NT  Decrease AD  Decrease output  Decrease price level  Close the expansionary gap

12. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Discretionary Fiscal Policy to Close an Expansionary Gap The aggregate demand curve AD’ and the short-run aggregate supply curve SRAS 130 intersect at point e’ resulting in an expansionary gap of $0.5 trillion. Discretionary fiscal policy aimed at reducing aggregate demand by just the right amount could close this gap without inflation. An increase in net taxes, a decrease in government purchases, or some combination could shift aggregate demand back to AD* and move the economy back to its potential output at e*. LO 2 Exhibit 4 Price level 135 130 AD’ SRAS 130 e’ Potential output LRAS Real GDP (trillions of dollars) 0 14.014.5 AD* e* e’’

13. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 Contractionary & Expansionary Fiscal Policy  Difficult to achieve  Potential output gauged accurately  Spending multiplier predicted accurately  AD shifts by just the right amount  Government entities – coordinate fiscal efforts  Shape of SRAS curve is known, unaffected by the policy

14. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved LO 2 The Multiplier and the Time Horizon  Simple multiplier  Overstates ∆Real GDP  ∆Real GDP depends  Steepness of SRAS curve  Production costs increase  The steeper SRAS curve  Less impact of an AD shift on real GDP  More impact on price level  The smaller the spending multiplier

15. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Evolution of Fiscal Policy LO 3 1.Prior to the Great Depression  Classical economists –Laissez-faire; Free markets –Balanced budget –Natural market forces Flexible: Prices Wages Interest rates –No need for government intervention

16. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Evolution of Fiscal Policy LO 3 2.The Great Depression and World War II –Keynesian theory and policy Prices and wages: ‘Sticky’ downward Increase AD –WWII Increase production No cyclical unemployment –Employment Act of 1946, Government: Full employment Economic stability

17. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Automatic Stabilizers LO 3  Smooth out fluctuations DI –Stimulate AD (recessions) –Dampen AD (expansions)  Federal income tax –Progressive income tax  Unemployment insurance  Welfare payments

18. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Evolution of Fiscal Policy LO 3 3.From the Golden Age to Stagflation –1960s: demand-management policy Increase or decrease AD –1970s: Stagflation Higher inflation Higher unemployment From decreased AD Crop failures Higher OPEC-driven oil prices Adverse supply shocks

19. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Fiscal Policy and Natural UR LO 3  Underestimate natural rate of unemployment –Expansionary fiscal policy Increase AD; Short run: Increase output Decrease unemployment Expansionary gap; Long run: Decrease SRAS Inflation Decrease output

20. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved When Discretionary Fiscal Policy Overshoots Potential Output If public officials underestimate the natural rate of unemployment, they may attempt to stimulate AD even if the economy is already producing at its potential output, a. This expansionary policy yields a short- run equilibrium at b, where the price level and output are higher and unemployment is lower, so the policy appears to succeed. But the resulting expansionary gap will, in the long-run, reduce the SRAS, eventually reducing output to its potential level of $14.0 trillion while increasing the price level to 140. Thus, attempts to increase production beyond its potential GDP lead only to inflation in the long-run LO 3 Exhibit 5 Price level 130 140 AD SRAS 130 Potential output LRAS Real GDP (trillions of dollars) 0 14.014.2 AD’ b a SRAS 140 c

21. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Lags in Fiscal Policy LO 3  Fiscal policy –Time Approve Implement –Less effective –Too late –More harm than good

22. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Evolution of Fiscal Policy LO 3 4.Since 1990: from deficits to surpluses  1980s – mid-1990s: large deficits  1993 recovery under way –Increase tax on high-income households  1994: Decreased federal spending  1993 – 1998 –Tax revenues: +8.3% per year –Federal outlays: +3.2% per year

23. Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved Evolution of Fiscal Policy LO 3 4.Since 1990: from deficits to surpluses back to deficits –1998: Federal surplus $70 billion –2000: Federal surplus $236 billion –Early 2001 – Recession: 10-year tax cut –September 11, 2001: Terrorist attack –2003 – 2007 Recovery –Employment: +8 million –Federal deficit (2004) $400 billion –Federal deficit (2007) under $200 billion –Recession beginning December 2007 –Federal deficit increased to $450 billion in 2008; now forecast between $1 trillion and $2 trillion