Fiscal Policy

Fiscal economic

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.

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

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.

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.

Y Y Td

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

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:

Y Y Td

Y C Sd

Y T C S Y C S T

• And aggregate expenditure (AE) equals:

A E C I G

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:

B udget def G Ticit

• 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.

Adding Taxes to theConsumption Function

The aggregate consumption function is now a function of disposable, or after-tax, income.

C a bYd

Y Y Td

C a b Y T ( )

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

NETTAXES

T

DISPOSABLEINCOMEYd Y T

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)

SAVINGS

(Yd – C)

PLANNEDINVESTMENT

SPENDINGI

GOVERNMENTPURCHASES

G

PLANNEDAGGREGATE

EXPENDITURE C + I + G

UNPLANNEDINVENTORY

CHANGEY (C + I + G)

ADJUSTMENTTO

DISEQUILIBRIUM

300 100 200 250 50 100 100 450 150 Output500 100 400 400 0 100 100 600 100 Output

700 100 600 550 50 100 100 750 50 Output

900 100 800 700 100 100 100 900 0 Equilibrium

1,100 100 1,000 850 150 100 100 1,050 + 50 Output

1,300 100 1,200 1,000 200 100 100 1,200 + 100 Output

1,500 100 1,400 1,150 250 100 100 1,350 + 150 Output

C Yd 1 0 0 7 5. C Y T 1 0 0 7 5. ( )

Finding EquilibriumOutput/Income Graphically

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.

G overnm en t m ultip lierM P S

spend ing 1

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

NETTAXES

T

DISPOSABLEINCOMEYd Y T

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)

SAVINGS

(Yd – C)

PLANNEDINVESTMENT

SPENDINGI

GOVERNMENTPURCHASES

G

PLANNEDAGGREGATE

EXPENDITURE C + I + G

UNPLANNEDINVENTORY

CHANGEY (C + I + G)

ADJUSTMENTTO

DISEQUILIBRIUM

300 100 200 250 50 100 150 500 200 Output

500 100 400 400 0 100 150 650 150 Output

700 100 600 550 50 100 150 800 100 Output

900 100 800 700 100 100 150 950 50 Output

1,100 100 1,000 850 150 100 150 1,100 0 Equilibrium

1,300 100 1,200 1,000 200 100 150 1,250 + 50 Output

The Effect on GDP of an Increase in Government Spending

Real GDP

$

C+I+G+(X-M)

45o C+I+G’+(X-M)

GDP

G Simple government expenditures multiplier =

GDP/G = 1/(1-MPC)

Simple government expenditures multiplier =

GDP/G = 1/(1-MPC)

The Government Spending Multiplier

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.

The Tax Multiplier

YM P S

( in itia l in c rease in ag g reg a te ex p en d itu re )

1

Y T M P CM P S

TM P C

M P S

( )

1

T ax m ultipM P C

M P Slier

The Effect on GDP of a Decrease in Taxes

Real GDP

$

C+I+G+(X-M)

45o C’+I+G+(X-M)

GDP

Simple tax multiplier =

GDP/T = -MPC/(1-MPC)

Simple tax multiplier =

GDP/T = -MPC/(1-MPC)

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.

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

Change in Y Change in G1

1- MPC + Change in T

- MPC

1- MPC

Change in G Change in T

Change in Y Change in G1

1- MPC

MPC

1- MPC = Change in G

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

NETTAXES

T

DISPOSABLEINCOMEYd Y T

CONSUMPTIONSPENDING

(C = 100 + .75 Yd)

PLANNEDINVESTMENT

SPENDINGI

GOVERNMENTPURCHASES

G

PLANNEDAGGREGATE

EXPENDITURE C + I + G

UNPLANNEDINVENTORY

CHANGEY (C + I + G)

ADJUSTMENTTO

DISEQUILIBRIUM

500 300 200 250 100 300 650 150 Output

700 300 400 400 100 300 800 100 Output

900 300 600 550 100 300 950 50 Output

1,100 300 800 700 100 300 1,100 0 Equilibrium

1,300 300 1,000 850 100 300 1,250 + 50 Output

1,500 300 1,200 1,000 100 300 1,400 + 100 Output

Fiscal Policy Multipliers

Summary of Fiscal Policy Multipliers

POLICY STIMULUS MULTIPLIERFINAL IMPACT ON

EQUILIBRIUM Y

Government-spendingmultiplier

Increase or decrease in thelevel of governmentpurchases:

Tax multiplier Increase or decrease in thelevel of net taxes:

Balanced-budgetmultiplier

Simultaneous balanced-budgetincrease or decrease in thelevel of government purchasesand net taxes:

1

1

M P S

M P C

M P S

GM P S

1

TM P C

M P S

G

Fiscal Policy in Practice

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

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

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

The Economy’s Influenceon 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.

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

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

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

Budgets, Deficits,and Public Policy

The Government Budget

A plan for government expenditures and revenues for a specified period, usually a year

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 (-).

The Federal Budget

Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)

AMOUNTPERCENTAGE

OF TOTAL

ReceiptsPersonal taxes 1,010.1 49.6

Corporate taxes 193.2 9.5Indirect business taxes 111.0 5.5Contributions for social insurance 720.6 35.4

Total 2,034.9 100.0

Current ExpendituresConsumption 514.1 26.9Transfer payments 831.9 43.6Grants-in-aid to state and local governments 274.2 14.4Net interest payments 236.9 12.4Net subsidies of government enterprises 52.5 2.7

Total 1,909.6 100.0

Current Surplus (+) or deficit () (Receipts Current Expenditures) + 125.3Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Composition of Federal Expenditures: Fiscal Year 1995

14.5%

15.3% 33.8%

18.0%

19.5%

Welfare

Net interest

Social security &medicare

National defense

All other

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)

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

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

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

The Federal Government Surplus (+) or Deficit (-) as a Percentage of GDP, 1970 I2003 II

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

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

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

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

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

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

Deficits and Interest Rates

Financing Deficits Taxes Bonds (borrowing) Printing Money

Ricardian Equivalence

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

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).

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

Size of Government

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.

The Federal Government Debt as a Percentage of GDP, 1970 I2003 II

The percentage began to fall in the mid 1990s.

The Economy’s Influenceon 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.

The Economy’s Influenceon 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.

Review Terms and Concepts

automatic stabilizersautomatic stabilizers

balanced-budget balanced-budget multipliermultiplier

budget deficitbudget deficit

cyclical deficitcyclical deficit

discretionary fiscal policydiscretionary fiscal policy

disposable, or after-tax, disposable, or after-tax, incomeincome

federal budgetfederal budget

federal debtfederal debt

federal surplus (+) or federal surplus (+) or deficit (-)deficit (-)

fiscal dragfiscal drag

fiscal policyfiscal policy

full-employment budgetfull-employment budget

government spending government spending multipliermultiplier

monetary policymonetary policy

net taxesnet taxes

privately held federal debtprivately held federal debt

structural deficitstructural deficit

tax multipliertax multiplier

The Economy’s Influenceon 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.

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

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

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

Appendix: The Government Expenditures and Tax Multipliers

Yb

a bNT I G X M

Yb

b NT G

G Yb

bNT

G T Yb

bNT NT

1

11

1

01

1

1

Appendix: The Government Multiplier with Income Taxes

C a b Y tY a b t Y

Y a b t Y I G X M

Y b t a I G X M

Ya I G X M

b t

Yb t

G

C

1

1

1 1

1 1

1

1 1

Appendix: The Multiplier with Income Taxes and Variable Imports

Y a b t Y I G X m t Y

Y b m t b m a I G X

Ya I G X

b m t b m

Yb m t b m

G

C M

1 1

1

1

1

1

Appendix A:Deriving the Fiscal Policy Multipliers

The government spending and tax multipliers algebraically:

Y C I G C a b Y T ( )

Y a b Y T I G ( )

Y a bY bT I G Y bY a bT I G Y b a bT I G( )1

1( )

1Y a bT I G

b

Appendix A:Deriving the Fiscal Policy Multipliers

The balanced-budget multiplier is found by combining the effects of government spending and taxes:

G T

1( )Y G MPS G

MPS

• The balanced-budget multiplier equals one. An increase in G and T by one dollar each causes a one-dollar increase in Y.

Gincrease in spending:

( )C T MPC - decrease in spending:

( )G T MPC = net increase in spending

Appendix B: The Case In WhichTax Revenues Depend on Income

Y C I G

dY Y T

200 1 3T Y

T T tY 0

Appendix B: The Case In WhichTax Revenues Depend on Income

dC a bY

dY Y T 200 1 3T Y

( 200 1 3 )dY Y Y

200 1 3 )dY Y Y

100 .75( 200 1 3 )C Y Y

900Y Y C I G 100I 100G

Yb bt

a bT I G

1

1 0( )

Appendix B: The Case In WhichTax Revenues Depend on Income

The Government Spending and Tax Multipliers Algebraically:

( )C a b Y T

0C a bY bT btY 0( )C a b Y T tY

0Y a bY bT btY I G Y C I G

Yb bt

a bT I G

1

1 0( )

Appendix B: The Case In WhichTax Revenues Depend on Income

The government spending and tax multipliers when taxes are a function of income are derived as follows:

Y C I G C a b Y T ( )

0C a bY bT btY 0( )C a b Y T tY

Y a bY bT btY I G 0

Y bY btY a bT I G 0

Y b b t a bT I G( )1 0

A Contractionary Gap Can be Closed by Expansionary Fiscal Policy

Real GDP

PriceLevel SRAS

AD

Potentialoutput

contractionarygap

AD*

An Expansionary Gap Can be Closed by Contractionary Fiscal Policy

Real GDP

PriceLevel SRAS

AD

Potentialoutput

expansionarygap

AD*

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,

S T I G

A E C I G Y C S T

C S T C I G