Fiscal PolicyChapter 12

Part I

CHAPTER

1

Countercyclical Fiscal Policy• A change in government spending or net

taxes (taxes or transfer payments) designed to reverse or prevent a recession or a boom

• Fiscal policy affects AE and has in the short run demand-side effects on output and employment

• We will discuss supply-side effects later2

Initially, equilibrium is at full-employment output of $10,000 billion (Point A). Then a decrease in private investment spending (IP) or consumption spending (C) shifts the aggregate expenditure line down to AE2, and the economy starts heading toward point B - a recession.

3

Real GDP ($ billions)

Consumption

Function

Real AE ($ billions)

AE1

45°

A

AE2

B

$9,000

(Recession Output)

$10,000

(Full-Employment Output)

Short-run Countercyclical Fiscal Policy

4

Real GDP ($ billions)

Consumption

Function

Real AE ($ billions)

AE1

45°

A

AE2

B

$9,000

(Recession Output)

$10,000

(Full-Employment Output)

Recessionary Gap: Distance B to C = $1,000

C

Recessionary Gap:

Countercyclical Fiscal PolicyPolicy Option: Increase Government Spending

• Direct way to address a recession– increase G and shift the aggregate

expenditure line upward– ΔGDP = (Multiplier) ˣ ΔG– where the simple multiplier = 1/(1-MPC)

• If the MPC is 0.75, how much should G increase to close the recessionary gap of $1,000?

5

Countercyclical Fiscal PolicyPolicy Option: Cut Net Taxes • Increase disposable income

– increase consumption spending (less direct than increasing G)

– aggregate expenditure line shifts upward

– ΔGDP = (tax multiplier) ˣ Δ Net taxes

– tax multiplier = - MPC/(1-MPC)

6

Policy Option: Cut Net Taxes

• Increase disposable income– increase consumption spending (less

direct than increasing G)– aggregate expenditure line shifts upward– ΔGDP = (tax multiplier) ˣ Δ Net taxes– tax multiplier = - MPC/(1-MPC)

7

Another multiplier!

Policy Option: Cut Net Taxes

• Increase disposable income– increase consumption spending (less

direct than increasing G)– aggregate expenditure line shifts upward– ΔGDP = (tax multiplier) ˣ Δ Net taxes– tax multiplier = - MPC/(1-MPC)

8

• If the MPC is 0.75, how much should taxes decrease or transfers increase to close the recessionary gap of $1,000?

The government could shift the AE line back to its original position by increasing spending (G), or by decreasing net taxes (T) with a change in tax or transfer policies.

If the change were enacted quickly enough, the government could prevent the recession.

Countercyclical Fiscal Policy Close the Recessionary Gap

9

Real GDP ($ billions)

Consumption

Function

Real AE ($ billions)

AE1

45°

A

AE2

B

$9,000

(Recession Output)

$10,000

(Full-Employment Output)

C

ΔYΔG↑ or ΔT↓

Short-run Countercyclical Fiscal Policy• Combining fiscal changes

– Government might decide to increase government purchases, cut taxes, and increase transfer payments

•all at the same time !

– The final impact on equilibrium GDP• add up the separate multiplier effects of

each policy change

10

Combining Different Types of Fiscal Stimulus

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Short-run Countercyclical Fiscal Policy• Another policy option would be to

increase government purchases and net taxes by equal amounts

• Why? No increase in the budget deficit– GDP rises by the same amount

• Balanced budget multiplier– The multiplier for a change in government

purchases that is matched by an equal change in taxes

12

Case Study: American Reinvestment and Recovery Act (ARRA) -2009

–A roughly two-year fiscal stimulus • Originally estimated at $787 billion, and later

revised to $862 billion

–One-third was tax cuts - T↓–One-third was increased government

purchases - G↑–One-third was increased transfer

payments - T↓13

Range of Estimates for Multipliers in the ARRA

14

Spending multiplier estimates larger than tax and transfer payment multiplier estimates.

One-time payments and one-year tax cuts the lowest estimates.

Problems with Countercyclical Fiscal Policy• Timing problems

–Recognition lag– Implementation lag–Response lag

• Irreversibility– Spending should be temporary offsetting

temporary reduction in private spending

• Taxes and forward looking behavior– Temporary vs. permanent!

• The reaction of the Federal Reserve

15

The Multiplier

16

•All of the multipliers we derive are a sub-set of a general macro model for an open economy with taxes and imports that depend on the level of income (Y).

•The process described on the following slides is to first define the model and then through a series of substitutions, solve for the equilibrium level of income (Y).

The Multiplier

17

• The model for an open economy when taxes and imports depend on the level of income (Y) is described by the following eight equations:

The Multiplier

18

• (1) Y = C + I + G + (X – M), equilibrium condition from chapter 11.

• (2) C = a + b (Yd), consumption equation from chapter 11.

• (3) Yd = Y – T, disposable income as defined in chapter 11.

• (4) T = T0 + t(Y), tax equation, this is new.

• (5) I = IP, planned investment from chapter 11. • (6) G = G0, government spending from chapter 11.

• (7) X = X0, exports from chapter 11.

• (8) M = mY, import equation, this is new.

• T = T0 + t(Y), tax equation. This says the T is equal to some fixed level plus a fraction (t) of Y.

• t is the tax rate. If t=0.33, households pay 33 cents of each extra dollar earned to the government.

• M = mY, import equation. This simply says as Y increases household import more stuff.

• Little m is called the marginal propensity to import:

Equations (4) and (8) are new formulas

19

The Multiplier

20

• Substitute equations (2) through (8) into the equilibrium condition, equation (1):

• (9) Y = a + b(Y - T) + IP + Go + X0 - mY

• (10) Y = a + b(Y - (T0+ tY)) +IP+ G0+X0 – mY• • (11) Y = a + b(Y-T0 - tY) +IP+G0+X0 – mY• • (12) Y = a + bY- bT0 - btY+IP+G0+X0 - mY

The Multiplier

21

Now solve Equation (12) for Y:

(13) Y- bY+ btY+ mY = a - bT0+ IP+ G0+ X0

mbtb

XGIbTaY

P

1

)14(000

mbtb

XGITbaY

P

1

)15(000

From Equation (15), the government spending and lump-sum tax multipliers in an open economy with an income tax system are:

22

mbtb

b

T

Y

10

mbtbG

Y

1

1

23

What happens if there is no foreign sector (a closed economy) and taxes are lump-sum. This is the model presented in chapters 11 and 12 of Hall and Lieberman. Equations (7) and (8) listed on the previous slide disappear and the tax rate (t) in Equation (4) equals zero. X, t and m in Equations (14) are equal to zero:

b

GIbTaY

P

1

00

b

GITbaY

P

1

00

24

We get the investment spending, government spending, and tax multipliers presented in Chapters 11 and 12:

bG

Y

I

Y

1

1

b

b

T

Y

1