1. © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney Prepared by: Fernando & Yvonn Quijano

2. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 2 of 31 The Akashi Kaikyo Bridge was built by the Japanese government in the 1990s to prop up aggregate demand. What you will learn in this chapter: ➤ What fiscal policy is and why it is an important tool in managing economic fluctuations ➤ Which policies constitute an expansionary fiscal policy and which constitute a contractionary fiscal policy ➤ Why fiscal policy has a multiplier effect and how this effect is influenced by automatic stabilizers ➤ Why governments calculate the cyclically adjusted budget balance ➤ Why a large public debt may be a cause for concern ➤ Why implicit liabilities of the government are also a cause for concern

3. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 3 of 31 Fiscal Policy: The Basics

4. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 4 of 31 Fiscal Policy: The Basics Taxes, Purchases of Goods and Services, Government Transfers, and Borrowing

5. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 5 of 31 Fiscal Policy: The Basics Taxes, Purchases of Goods and Services, Government Transfers, and Borrowing

6. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 6 of 31 Fiscal Policy: The Basics Taxes, Purchases of Goods and Services, Government Transfers, and Borrowing Social insurance programs are government programs intended to protect families against economic hardship. The Government Budget and Total Spending (17-1)GDP = C + I + G + X - IM

7. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 7 of 31 Fiscal Policy: The Basics Expansionary and Contractionary Fiscal Policy

8. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 8 of 31 Fiscal Policy: The Basics Expansionary and Contractionary Fiscal Policy Expansionary fiscal policy increases aggregate demand. Fiscal policy that increases aggregate demand normally takes one of three forms: ■ An increase in government purchases of goods and services, such as the Japanese government’s decision to launch a massive construction program ■A cut in taxes, such as the one the United States implemented in 2001 ■An increase in government transfers, such as unemployment benefits

9. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 9 of 31 Fiscal Policy: The Basics Expansionary and Contractionary Fiscal Policy

10. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 10 of 31 Fiscal Policy: The Basics Expansionary and Contractionary Fiscal Policy Contractionary fiscal policy reduces aggregate demand. A Cautionary Note: Lags in Fiscal Policy Many economists caution against an extremely active stabilization policy, arguing that a government that tries too hard to stabilize the economy—through either fiscal policy or monetary policy—can end up making the economy less stable.

11. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 11 of 31 Fiscal Policy and the Multiplier Multiplier Effects of an Increase in Government Purchases of Goods and Services

12. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 12 of 31 Fiscal Policy and the Multiplier Multiplier Effects of Changes in Government Transfers and Taxes Expansionary or contractionary fiscal policy need not take the form of changes in government purchases of goods and services. Governments can also change transfer payments or taxes.

13. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 13 of 31 Fiscal Policy and the Multiplier How Taxes Affect the Multiplier A lump-sum tax does not change when real GDP changes. A proportional tax increases when real GDP increases and decreases when real GDP decreases.

14. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 14 of 31 Fiscal Policy and the Multiplier How Taxes Affect the Multiplier Automatic stabilizers are government spending and taxation rules that cause fiscal policy to be expansionary when the economy contracts and contractionary when the economy expands. Discretionary fiscal policy is fiscal policy that is the result of deliberate actions by policy makers rather than of rules.

15. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 15 of 31 economics in action How Much Bang for the Buck? TABLE 17-1 Differences in the Effect of Expansionary Fiscal Policies Policy Estimated increase in real GDP per dollar of fiscal policy) Explanation of policy Extend emergency federal unemployment insurance benefits $1.73Extends the period for unemployment benefits, increasing transfers to the unemployed 10% personal income tax bracket1.34Reduces tax rate on some income from 15% to 10%, mainly benefiting middle-income families State government aid1.24Provides financial aid to state governments during recessions so states do not have to raise taxes or cut spending Child tax credit rebate1.04Increases the income tax reduction for each child, mainly benefiting middle- and lower-income families Marriage tax penalty0.74Reduces the “marriage penalty,” an increase in combined taxes that can occur when two working people marry

16. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 16 of 31 economics in action How Much Bang for the Buck? TABLE 17-1 (cont’d.) Differences in the Effect of Expansionary Fiscal Policies Policy Estimated increase in real GDP per dollar of fiscal policy)Explanation of policy Alternative minimum tax adjustments 0.67Revises the alternative minimum tax, designed to prevent wealthy people with many deductions from paying too little tax, to exclude those not considered sufficiently wealthy Personal marginal tax rate reductions 0.59Reduces tax rates for people in higher income brackets Business investment writeoff0.24Temporarily allows companies to deduct some investment spending from taxable profits Dividend–capital gain tax reduction 0.09Reduces taxes on dividends and capital gains Estate tax reduction0.00Reduces the tax paid on the value of assets passed to heirs upon a person’s death

17. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 17 of 31 The Budget Balance The Budget Balance as a Measure of Fiscal Policy The budget balance is the difference between tax revenue and government spending. The budget surplus is the difference between tax revenue and government spending when tax revenue exceeds government spending. The budget deficit is the difference between tax revenue and government spending when government spending exceeds tax revenue. (17-2)Budget Balance = T – G – TR

18. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 18 of 31 The Budget Balance The Business Cycle and the Cyclically Adjusted Budget Balance

19. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 19 of 31 The Budget Balance The Business Cycle and the Cyclically Adjusted Budget Balance

20. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 20 of 31 The Budget Balance The Business Cycle and the Cyclically Adjusted Budget Balance The cyclically adjusted budget balance is an estimate of what the budget balance would be if real GDP were exactly equal to potential output.

21. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 21 of 31 The Budget Balance The Business Cycle and the Cyclically Adjusted Budget Balance

22. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 22 of 31 The Budget Balance Should the Budget Be Balanced? Most economists don’t think so. They believe that the government should only balance its budget on average—that it should be allowed to run deficits in bad years, offset by surpluses in good years. Yet policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on— deficits are necessary.

23. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 23 of 31 Long-Run Implications of Fiscal Policy Deficits, Surpluses, and Debt Fiscal years run from October 1 to September 30 and are named by the calendar year in which they end. Public debt is government debt held by individuals and institutions outside the government.

24. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 24 of 31 Long-Run Implications of Fiscal Policy Deficits, Surpluses, and Debt

25. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 25 of 31 Long-Run Implications of Fiscal Policy Problems Posed by Rising Government Debt Crowding out is the negative effect of budget deficits on private investment.

26. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 26 of 31 Long-Run Implications of Fiscal Policy Deficits and Debt in Practice

27. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 27 of 31 Long-Run Implications of Fiscal Policy Deficits and Debt in Practice The debt–GDP ratio is government debt as a percentage of GDP.

28. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 28 of 31 Long-Run Implications of Fiscal Policy Deficits and Debt in Practice

29. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 29 of 31 Long-Run Implications of Fiscal Policy Implicit Liabilities Implicit liabilities are spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics.

30. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 30 of 31 Long-Run Implications of Fiscal Policy Implicit Liabilities

31. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 31 of 31 Social insurance Expansionary fiscal policy Contractionary fiscal policy Lump-sum tax Proportional tax Automatic stabilizers Discretionary fiscal policy Budget balance Budget surplus Budget deficit Cyclically adjusted budget balance Fiscal years Public debt Crowding out Debt–GDP ratio Implicit liabilities K E Y T E R M S