2. 7/2/2015© 2002 Claudia Garcia-Szekely1 Fiscal Policy Claudia Garcia-Szekely

3. War is the mother of taxes Saint Gregory Nazianzus 7/2/2015© 2002 Claudia Garcia-Szekely2 And also the mother of inflation…

4. 3 "We're going to be putting money in people's pockets so that they can spend on buying a new computer for their kid's school, so that they can, you know, make sure that they are able to deal with heat and groceries and all the other strains on the family budget,“ President elect, Obama.

5. 7/2/2015© 2002 Claudia Garcia-Szekely4 Fiscal Policy Changes in Government Spending and/ or Taxes. Induce a change in Aggregate Spending. Increase AE Decrease AE

6. 7/2/2015© 2002 Claudia Garcia-Szekely5 Expansionary Policy Increase Government Spending (  G) And or Decrease Taxes (  T) Increase AE Increase Output and Employment

7. Rest of World Households Firms G G Circular Flow Diagram G G Total Produced National Income generated from production National Income - Taxes + Transfers National Income - Taxes + Transfers to NX I I pay G T T S S C C

8. 7/2/2015© 2002 Claudia Garcia-Szekely7 Disposable Income is Income available for consumption. Income generated from production is used to: Buy goods and services: C. Save: S Pay taxes: Tx The government pays “income transfers” to households. Social Security Welfare Unemployment benefits

9. 7/2/2015© 2002 Claudia Garcia-Szekely8 Adding Net Taxes The government collects taxes The government pays Transfers We are only interested in the NET effect on Incomes. Use Tx for Taxes Use Tr for Transfers Use T for Net Taxes = Tx - Tr

10. 7/2/2015© 2002 Claudia Garcia-Szekely9 Net Taxes T = Tx - Tr Net amount paid in taxes to the government after subtracting transfers

11. 7/2/2015© 2002 Claudia Garcia-Szekely10 FixedTaxes (Lump Sum) Fixed taxes do not change with income.

12. 7/2/2015© 2002 Claudia Garcia-Szekely11 Disposable Income Yd = Y - T Income left after: Paying taxes Receiving Government Transfers Income available for Consumption and Saving

13. 7/2/2015© 2002 Claudia Garcia-Szekely12 The effect of the tax cut C = a + b Yd C = a + b (Y-T) C = a + bY- bT C = (a – bT) + bY A tax cut increases or increase in transfers the intercept of the consumption function. Changes in T shift the Consumption Function. Fixed taxes change the intercept of the consumption function

14. 7/2/2015© 2002 Claudia Garcia-Szekely13 Government Spending and Taxes affect AE differently Government Spending (G) Enters directly into AE AE = C+I+ G Enter in directly into AE via C Enter in directly into AE via C AE = +I+G+ C Taxes, transfers (T)

15. 7/2/2015© 2002 Claudia Garcia-Szekely14 The effect of a 70 tax cut When Taxes Decrease by  T = -70 Consumers have 70 more to spend Consumers have 70 more to spend Disposable Income increase by  Yd = 70 When  Yd = 70 C = a + MPC( Yd ) C increase by  C = 0.9 (70) When  C = 63 AE = C + I + G AE increase by  AE =  C = 63 When  AE = 63 AE = C + I + G AE line shifts up by 63.

16. 7/2/2015© 2002 Claudia Garcia-Szekely15 The effect of A Decrease in Taxes:  T = -70 MPC = 0.9  AE =  C=-  T(MPC) =-(-70)(0.9) =63 AE= C+I+G 45 0 AE= C +I+G Taxes change by (  T)=-70 Yd =Y-T change by –(  T)=70 Consumption changes by –(  T)MPC=70(0.9) AE shifts up by –(  T)MPC 63  Y =  C(1/1-MPC)  Y = 63(1/1-0.9)  Y = 63(10)=630 630  Y = 63(10)  C =630*0.9=567

17.  C =700*0.9=630 7/2/2015© 2002 Claudia Garcia-Szekely16 The effect of A Change in Government Spending  AE =  G = 70 AE 0 45 AE 1 If government Spending increases by  G = 70 AE line Shifts up by  AE=  G = 70  Y =  G(Multiplier) Equilibrium Income increases by:  Y = 70(1/1-MPC)  G =70  Y = 700

18. 7/2/2015© 2002 Claudia Garcia-Szekely17 The Tax Multiplier is smaller than the G Multiplier 45 63 630  Y = 63(10) 45  Y = 70(10) 700 70 Taxes decrease by 70 G increases by 70 AE 1 AE 0 AE 1 AE 0 An extra $70 in your hands doesn’t go as far as the same $70 spent by the government! Why?

19. 7/2/2015© 2002 Claudia Garcia-Szekely18 Government Spending vs. Tax Cuts The $787 B stimulus package includes $70 billion in tax cuts, which some economists believe will not create as many new jobs as $70 billion in spending would…

20. 45 Y0Y0 Y1Y1 AD 0 AD 1 P0P0 Y1Y1 The size of the change in equilibrium Y is the size of the shift in AD AE 0 AE 1 Y0Y0 When taxes decrease by 70 70*MPC * Multiplier MPC=0.9 70*0.9 70*0.9 * 10 630

21. 45 Y0Y0 Y1Y1 AD 0 AD 1 P0P0 Y1Y1 The size of the change in equilibrium Y is the size of the shift in AD AE 0 AE 1 Y0Y0 When G increases by 70 70* Multiplier MPC=0.9 70 70*10 700

22. 45 Output The G Multiplier Y0Y0 Y1Y1 cc  Y =  G (1/(1-b))  Y =  G +  C GG Incomes Increase

23. 45 Output The G Multiplier  Y   =  +   Y =  G +  C 

24. 45 Output The G Multiplier Y0Y0 Y1Y1 cc  Y =  G (1/(1-b))  Y =  c +  C cc Incomes Increase

25. 45 Output The T Multiplier  Y   =  +   Y =  C +  C 

26. Change in Consumption When government spending changes: The resulting change in spending is the sum of the extra government spending + extra consumption induced by the increase in incomes  Y =  G +  C  C =  Y –  G  C = 700 – 70 =630 When taxes change all the resulting change in spending is the extra consumption induced by the increase in incomes:  C =  Y = 630

27. Changes in Budget Deficit When government spending changes, the resulting change in the Budget Deficit is:  Deficit =  G= 70 When taxes change, the resulting change in the Budget Deficit is:  Deficit = -  T=-(-70)

28. 7/2/2015© 2002 Claudia Garcia-Szekely27  Y =  T [ (1- MPC) ] -  (MPC) The Tax Multiplier  C=-  T(MPC)  Y =  C x [ (1- MPC) ] 1  Y = -  T(MPC) x [ (1- MPC) ] 1

29. 7/2/2015© 2002 Claudia Garcia-Szekely28 The Tax Multiplier  Y =  T [ (1- MPC) ] -  (MPC)  Y =  T [- (MPS) ] (MPC)

30. 7/2/2015© 2002 Claudia Garcia-Szekely29 The Tax Multiplier Formula A negative Number! A negative Number! Taxes and Output move in opposite directions  Y =  T [ (1- MPC) ] -  (MPC)

31. The Tax Multiplier 7/2/2015© 2002 Claudia Garcia-Szekely30  Y =  G [+ (MPS) ] 1  Y =  T [- (MPS) ] (MPC) Smaller Negative

32. 7/2/2015© 2002 Claudia Garcia-Szekely31 The Balanced Budget Multiplier Captures the effect on equilibrium output from simultaneous identical changes in Taxes and Government Spending

33. 7/2/2015© 2002 Claudia Garcia-Szekely32 Increase Both G and T by 40 1 1-MPC  Y =  G -MPC 1-MPC  Y =  T 1 1-0.75  Y = 40 -0.75 1-0.75  Y = 40  Y = 40 (4)=160  Y = 40 (-3)=-120  Y = 160 – 120= 40 What happens if we finance the extra spending with higher taxes?

34. 7/2/2015© 2002 Claudia Garcia-Szekely33 The Balanced Budget Multiplier is ONE If  G =  T = 40  Y = 40 (1)

35. Changes in Consumption When government spending changes: The resulting change in spending is the sum of the extra government spending + extra consumption induced by the increase in incomes:  C =  Y -  G When taxes change all the resulting change in spending is the extra consumption induced by the increase in incomes:  C =  Y Balanced Budget change: multiplier effect is completely eliminated. There is NO extra consumption because the increase in incomes and consumption triggered by the increase in G is eliminated by the drop in incomes and consumption resulting from higher taxes:  Y=  G ;  C = 0

36. Changes in Budget Deficit When government spending changes, the resulting change in the Budget Deficit is:  Deficit =  G When taxes change, the resulting change in the Budget Deficit is:  Deficit = -  T When both Government Spending and Taxes change by the same amount (a balanced budget change), there is no change in the Budget Deficit :  Deficit = 0

37. VARIABLE TAXES Income Tax: changes with income 7/2/2015© 2002 Claudia Garcia-Szekely36

38. Variable Taxes:  Y Fixed Taxes C = a + b(Y-T) C = a + bY – bT C = (a –bT) + bY Example: C = 1000 + 0.9(Y-700) C = 1000 + 0.9*Y – 0.9*700 C = (1000 –0.9*700) + 0.9*Y C = (1000 – 630) + 0.9Y Variable Taxes T= t Y C = a + b(Y- t Y) C = a + bY-b t Y C = a + (b-b t ) Y Example: C = 1000 + 0.9(Y-0.25Y) C = 1000 + 0.9Y – 0.9*0.25Y C = 1000+ Y(0.9-0.9*0.25) C = 1000 + (0.9-0.225)Y 37 C and AE Slope =b C and AE Slope =b-b t slope smaller O.675

39. Variable Taxes:  Y Fixed Taxes C = a + b(Y-T) C = a + bY – bT C = (a –bT) + bY Example: C = 1000 + 0.9(Y-700) C = 1000 + 0.9*Y – 0.9*700 C = (1000 –0.9*700) + 0.9*Y C = (1000 – 630) + 0.9Y Variable Taxes T=T + t Y C = a + b(Y- (T +t Y)) C = a + bY-b(T +t Y) C = a + bY-bT-b t Y C = (a –bT)+ (b-b t )Y Example: C = 1000 + 0.9(Y-700 -0.25Y) C = (1000 – 630) + (0.9- 0.9*0.25)Y C = (1000–630) + Y(0.9-0.225) C = 1000–630 + O.675Y 38 C and AE Slope =b C and AE Slope =b-b t Intercept same, slope smaller

40. Variable taxes make C and AE flatter 7/2/2015© 2002 Claudia Garcia-Szekely39 C = (a –bT) + bY AE = (I+G+NX+a–bT) + bY C = a-bT + (b-b t ) Y a –bT a-bT I+G+NX+a–bT I+G+NX+a AE = (I+G+NX+a) + (b-b t )Y flatter Steeper When T Increases: C shifts down When t Increases: C becomes flatter

41. Variable taxes make C and AE flatter  Y=100  C=100*MPC = 100*0.9 = 90  C=100*(MPC-MPC*  ) = 100*(0.9-0.9*0.25)= 67.5 Part of the increase in income goes to pay taxes so consumption does not increase as much. Steeper: increase in C is larger Flatter: increase in C is smaller C C

42. Fixed Taxes Variable Taxes  Y =  G [ (1- b) ] 1  Y =  G [ (1-b+b  ) ] 1  Y =  T [ (1- b) ] -b  Y =  T [ (1-b+b  ) ] -b Variable Taxes(  Y) affect the multipliers Both multipliers become smaller When  rate increases, multiplier decreases

43. The G multiplier when taxes change with income (Income Taxes) The effect of an increase in G is smaller with income taxes because as income increases, the government taxes a portion of the increase in income.  Y =  G +  C;  C is smaller than before The effect of a tax cut is also smaller with income taxes because as income increases, the government taxes a portion of the increase in income.  Y =  C;  C is smaller than before The oversimplified formula overstates the size of the multiplier

44. 7/2/2015© 2002 Claudia Garcia-Szekely43 Permanent Tax Cut or Tax Holiday? A tax cut has more potential impact in the long run than a tax holiday. A payroll tax credit would provide more of a spending boost since it is a permanent change in the tax code Households are more likely to spend a tax cut if it is the result of a permanent change rather than a temporary one Households are more likely to save a temporary tax cut.

45. Condition that must be satisfied for equilibrium: Y = C + I + G + X-M Since: Y = C + S + T (Income is used to consume, save and pay taxes) We can rewrite the equilibrium condition as: C + S + T= C + I + G +X-M S = I + (G – T)+(X-M) Rest of World Households Firms S I T G G C Total Income Total Production Total Spending NX Open Economy with Government S+T = I + G + X-M S+T+M = I + G + X S+T = I + G + X-M S+T+M = I + G + X leakages = Injections Savings must finance Investment, the government’s deficit and the trade deficit.

46. S+T+M I+G+X Y Equilibrium AE I+G+X=S+T+M Leakages = Injections Y above equilibrium Inventories increase Inventories fall Y below equilibrium Leakages < Injections Y < AE Leakages > Injections Y > AE

47. What is the equilibrium GDP? For what value of GDP is: Y = AE? For what value of GDP is: S = I +(G-T) +(X-M)? At Y = 5,000 are inventories rising? Falling? Unchanged? For what value of GDP is: Y = AE? At Y = 3,000 are inventories rising? Falling? Unchanged? I + (G-T) + (X-M)

48. 7/2/2015© 2002 Claudia Garcia-Szekely47 Automatic Stabilizers Features of the economy that reduce its sensitivity to shocks

49. AUTOMATIC STABILIZERS Personal Income Taxes 7/2/2015© 2002 Claudia Garcia-Szekely48

50. 7/2/2015© 2002 Claudia Garcia-Szekely49 1. Personal Income Taxes When GDP rises, we earn more income but we also pay more taxes and thus consumption does not rise as much as it would if taxes did not rise with income. When GDP falls, we earn less income but we also pay less taxes and thus consumption does not fall as much as it would if taxes did not fall with income.

51. AUTOMATIC STABILIZERS Unemployment Compensation, Income supplements for the poor 7/2/2015© 2002 Claudia Garcia-Szekely50

52. 7/2/2015© 2002 Claudia Garcia-Szekely51 2. Unemployment Compensation, Income Supplements for the poor When GDP falls, more people receive unemployment insurance payments thus dampening the fall in incomes (and consumption) that would occur with a falling GDP. When GDP rises, fewer people receive unemployment insurance payments thus dampening the rise in incomes (and consumption) that comes with a rising GDP.

53. Chart 2-3. The Federal Government Dollar— Where It Comes From

54. 7/2/2015© 2002 Claudia Garcia-Szekely53 2008 Mandatory Spending Discretionary Spending

55. Fiscal Policy MPC = 0.9. Find  G/  T necessary to close the gap. Calculate for each  C,  Deficit.

56. Fiscal Policy MPC = 0.9. Find  G/  T necessary to close the gap. Calculate for each  C,  Deficit.

57. Effect on C, AE, AD, GDP and prices Increase (decrease) in taxes (fixed or variable) Increase (decrease) in transfers Increase (decrease) in G 7/2/2015© 2002 Claudia Garcia-Szekely56

58. 7/2/2015© 2002 Claudia Garcia-Szekely57 Example: C = 200 +0.8 (Y-T) I = 300 G = 150 T = 100 AE = 650 + 0.8 (Y – 100) Add to get AE AE =650 – 0.8(100) + 0.8Y AE = 570 + 0.8Y

59. 7/2/2015© 2002 Claudia Garcia-Szekely58 Equilibrium Output AE = 570 + 0.8Y Set Y = AE and solve for Y: Y = 570 + 0.8 Y Y – 0.8Y = 570 Y(1-0.8) = 570 Y = 570/0.2 Y = 2,850

60. 7/2/2015© 2002 Claudia Garcia-Szekely59 Equilibrium C = 200 +0.8 (Y-T) I = 300 G = 150 T = 100 45 AE=2,850 Y=2,850 AE = 570+0.8Y 570 - 80

61. C = 200 +0.8 (2,850-100) I = 300 G = 150 T = 100 AE = 570+0.8Y 45 S+T I+G Y=2,850 AE=2,850 I+G=S+T S = Y-C-T S = 2,850 – 2,400-100 C = 2,400 S = 350T = 100 + 450