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Part 4: Fiscal Policy Tools
Chapter 11: Fiscal Policy:1. Background: Some History on Taxes
& Spending.
2. Fiscal Stimulus.
3. Fiscal Restraint.
4. Fiscal Guidelines.
3
1. Background:Taxes & Spending.
(Brief Overview)
5
Taxes and Spending
The federal government:1902:
employed < than 350,000 people,
Spending = $650 million.
Today, employs > 4 million people,
Spending = $3 trillion.
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Government Revenue
granted the power to tax incomes.
Today, the federal government collects nearly $3 trillion a year in taxes.
All of this government spending directly affects aggregate demand.
Government expansion started with the 16th Amendment to the U.S. Constitution (1913):
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Purchases vs. Transfers
Government purchases:
part of aggregate demand.
Spent on resources to provide services.
Income transfers (“transfer payments”):
payments to individuals for which no current goods or services are exchanged.
It contributes to consumer income.
Not part of AD until spent by consumers.
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Fiscal Policy
Fiscal Policy:
The federal government can alter aggregate demand and macro outcomes by changing its own level of:
Spending,
Taxing,
Income transfers.
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Fiscal Policy
Internal market forces
External shocks
Policy levers:
Output
Jobs
Prices
Growth
International balances
DETERMINANTS OUTCOMES
AD
AS
Fiscal policy
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2. Fiscal Stimulus.-The naïve Keynesian model.-The AD shortfall.-The multiplier.-The formula for desired fiscal stimulus.-Translating fiscal stimulus into spending, tax, or income transfer changes.
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Fiscal Stimulus
Keynesian Strategy:
the way out of recession is to get someone to spend more on goods and services.
It can start with the government.
Fiscal Stimulus: Tax cuts/spending ortransfer payment increases.
intended to increase AD.
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Keynesian Strategy
Two strategic policy questions must be answered:1. By how much do we want to shift the
AD curve to the right?
2. How to induce the desired shift?
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The Policy Goal
AS
QE = 5.6
a
AD1
PE
Pri
ce L
eve
l (av
era
ge p
rice
)
Real GDP (trillions of dollars per year)
6.0 = QF
GDP Equilibrium
Full-employment GDP
b
GDP gap
The goal is to close GDP gaps
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The Naive Keynesian Model
The Naive Keynesian Model:The desired spending (AD) increase = the GDP gap.
An increase in AD by $400 billion will achieve full employment.
BUT…
…This is only possible if the aggregate supply curve is horizontal.
AS
QE = 5.6
a
AD1
PE
Pric
e L
eve
l
Real GDP (trillions of dollars per year)
6.0 = QF
GDP Equilibrium
Full-employment GDP
b
GDP gap
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Naïve Keynesian Model
AS
QE = 5.6
a
AD1
AD2
PE
Pri
ce L
eve
l (av
era
ge p
rice
)
Real GDP (trillions of dollars per year)
QF = 6.0
c
b
Recessionary GDP gap
LO1
17
The AD Shortfall
AS
QE = 5.6
a
AD1
AD2
PE
Pri
ce L
eve
l (av
era
ge p
rice
)
Real GDP (trillions of dollars per year)
QF = 6.0 6.4
AD3
cd
b e
Recessionary GDP gap
AD shortfall
LO1
18
The AD Shortfall
AS
QE = 5.6
a
AD1
PE
Pri
ce L
eve
l (av
era
ge p
rice
)
Real GDP (trillions of dollars per year)
QF = 6.0 6.4
AD3
d
e
Recessionary GDP gap
AD shortfall
LO1
20
The AD Shortfall
The “fiscal target…” (total new spending needed to reach Qf at equilibrium)
is (=)…
…the “AD shortfall:”
the amount of additional AD needed to achieve full employment …
***…after allowing for price level changes.
* * * * * However…
LO1
21
The Multiplier
How much of a boost the economy gets depends on the value of the multiplier:
the multiple by which an initial change in aggregate spending will alter total expenditure…
…after an infinite number of spending cycles.
LO2
= MPS1( )
24
Multiplier
Multiplier Example:
an MPC of .75 = Multiplier of 4:
1/(1-.75) =
What would the multiplier be if the MPC=
.8?
.9?
.95?
.98?
So…LO3
1/.25 = 4
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Multiplier Effects
Example:
If the gov’t. spent $800 billion (AD shortfall),
given an MPC of .75,
LO3
$800 billionTotal Change in Spending
= = $3.2 trillion!x 4
Initial change in
spending multiplier Total change in
spending
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Multiplier Effects
So…
…for government spending, the impact of fiscal stimulus on AD includes:
1. The amount of new government spending (“first round”), plus…
2. All subsequent increases in consumer spending triggered by multiplier effects.
LO3
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The AD Shortfall
AS
QE = 5.6
AD1
AD2
PE
Pri
ce L
eve
l (av
era
ge p
rice
)
Real GDP (trillions of dollars per year)
QF = 6.0 6.4
AD3
AD shortfall
LO1
28
Multiplier Effects
So…
Desired increase in
AD (Ad shortfall)
fiscal stimulus (new spending injection)
multiplierX
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The AD Shortfall
AS
QE = 5.6
AD1
AD2
PE
Pri
ce L
eve
l (av
era
ge p
rice
)
Real GDP (trillions of dollars per year)
QF = 6.0 6.4
AD3
AD shortfall
LO1
MPC = .75
30
Multiplier Effects
800 billion 4
=200 billion
32
Tax Cuts
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Taxes and Consumption
Tax cuts:
A dollar of tax cut contains less fiscal stimulus than a government spending increase of the same size
(money is siphoned off to savings in the “first round”).
So, the tax cut must be larger than the desired fiscal stimulus to counterbalance the MPS.
LO2
35
Taxes and Consumption
36
Taxes and Consumption
Or TRANSFER PAYMENT ↑
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Taxes and Investment
A tax cut may also be an effective mechanism for increasing investment spending.
Tax cuts have been used numerous times to stimulate the economy.
LO2
40
Practice 1:
If the MPC is .90, what is the initial (“first round”) fiscal impact of the following gov’t actions:
$1 billion spending increase?
v.
$1 billion tax decrease?
v.
$1 billion transfer payment increase?
41
Practice 2:
If the MPC is .90, what is the cumulative fiscal impact of the following gov’t actions:
$1 billion spending increase?(Cumulative Impact = Spending Δ · Multiplier)
v.
$1 billion tax decrease?(Cumulative Impact = MPC · TaxΔ · Multiplier)
v.
$1 billion transfer payment increase?
(Cumulative Impact = MPC · Transfer Δ · Multiplier)
42
Practice 3:
If the MPC is .98, the recessionary GDP gap is $200 billion, and the AD shortfall is $600 billion:
1. What is the fiscal target?
2. What size gov’t spending increase is needed to close the GDP gap?
3. What size tax decrease is needed to close the GDP gap?
4. What size transfer payment increase is needed to close the GDP gap?
43
Taxes and Consumption
Or TRANSFER PAYMENT ↑
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3. Fiscal Restraint
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The Fiscal Target
Fiscal restraint:
the use of tax hikes or spending cuts to reduce (shift) aggregate demand.
The AD excess:
the amount by which aggregate demand must be reduced to achieve price stability…
…after allowing for price-level changes.
LO1
46
Excess Aggregate Demand
AS
Q2 = 5.8
E2
AD1
AD2
PE
PF
Pri
ce L
eve
l (av
era
ge p
rice
)
Real Output (trillions of dollars per year)
E1
QF = 6.0 Q1 = 6.2
Inflationary GDP gap
Excess AD
LO1
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Taxes and Consumption
Or TRANSFER PAYMENT ↓
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The Fiscal Target
The AD excess and the multiplier are used to calculate the desired fiscal restraint.
LO1
49
Delivering Fiscal Restraint
There are three choices for implementing the fiscal restraint:
Spending (budget) cuts,
Tax increases,
Transfer payment cuts.
59
Fiscal Responsibility
“Balanced budget politics:”
Spending increases can be paid for with equal tax increases (and vice versa) and still stimulate the economy:
Why?
A dollar of spending change has more power than a dollar of tax change.
60
4. Fiscal Guidelines
63
Weak Economy:Fiscal Stimulus
Desired fiscal stimulusAD shortfall
the multiplier
Policy Tools Amount
Increase government purchases desired fiscal stimulus
Cut taxes desired fiscal stimulus
MPC
Increased transfers desired fiscal stimulus
MPC
LO3
64
Overheated Economy:Fiscal Restraint
Desired fiscal restraintexcess AD
the multiplier
Policy Tools Amount
Reduce government purchases desired fiscal restraint
Increase taxes desired fiscal restraint
MPC
Reduce transfers desired fiscal restraint
MPC
LO3
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Problems with the Implementation of Fiscal Policy
66
Crowding Out
Some of the intended fiscal stimulus may be offset by the crowding out of private expenditure.
Crowding out: the reduction in private-sector borrowing (and therefor spending) caused by increased government borrowing.
the government’s new borrowing “crowds out” others from the credit market.
67
Time Lags
It takes time to recognize that a problem exists and then formulate policy to address the problem.
The very nature of the macro problems could change if the economy is hit with other internal or external shocks.
68
“Pork-Barrel” Politics
Members of Congress want their constituents to get the biggest tax savings.
They don’t want spending cuts in their own districts.
They don’t want a tax hike or spending cut before the election.
69
Practice – Fiscal Stimulus
1. Recessionary GDP gap =
2. AD shortfall =
3. Naïve Keynesian policy suggests the value of increased demand needed to achieve QF =
4. The gov’t spending increase needed to achieve full employment equilibrium =
5. What size tax cut would achieve full employment equilibrium?
LO1
AS
QE = 12.6
aAD1
AD2
PE
Pric
e Le
vel
Real GDP (trillions of dollars per year)
QF = 13.2 14.4
AD3
cd
b eMPC = .90
600 billion
1,800 billion
600 billion
180 billion
200 billion
70
Practice – Fiscal Restraint
1. AD excess =
2. Inflationary GDP gap =
3. The gov’t spending decrease that would achieve full employment equilibrium =
4. What size transfer payment cut would achieve full employment equilibrium?
LO1
AS
Q2 = 5.6
E2
f
AD1
AD2
PE
PFPric
e
Real Output (trillions of dollars per year)
E1
QF = 6.0 Q1 = 6.3
MPC = .98
700 billion
300 billion
14 billion
14.29 billion
71
Practice
Given: C = 400 billion + .95Yd
1. What would be the total impact of a $10 billion spending decrease by the gov’t?
2. What would be the total impact of a $20 billion tax decrease by the gov’t?
3. Would a transfer payment cut be used to close an AD shortfall or excess?
4. What size transfer payment cut would be used to eliminate a $700 billion AD excess.
LO1
-$200 billion AD decrease
$380 billion AD increase
Excess
$36.84 billion
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies, All Rights Reserved
Fiscal Policy
End of Chapter 11
