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Chapter 13: Fiscal Policy

End of Chapter 10

1

ECON 151 – PRINCIPLES OF MACROECONOMICS

Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

Discretionary Fiscal Policy

Discretionary Fiscal Policy

The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals is the realm of fiscal policy.

High employment (low unemployment)

Price stability

Economic growth

Improvement of international payments balance

Discretionary Fiscal Policy (cont'd) Fiscal Policy

The discretionary changing of government expenditures or taxes to achieve national economic goals, such as high employment with price stability

Discretionary Fiscal Policy (cont'd) An increase in government spending will

stimulate economic activity

Changes in government spendingMilitary spendingEducation spendingBudgets for government agencies

Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (a)

If there is a recessionary gap in panel (a), fiscal policy can presumably increase aggregate demand

Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (b)

If there is an inflationary gap, fiscal policy can presumably decrease aggregate demand

Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a)

•In panel (a), the economy is initially at E1, where real GDP exceeds long-run equilibrium

•Contractionary fiscal policy can move aggregate demand to AD2 via a tax increase

•A new equilibrium is at E2 at a lower price level

•Real GDP is now consistent with LRAS

Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (b)

• In panel (b) with a recessionary gap (in this case $500 billion) taxes are cut

• AD1 moves to AD2

• The economy moves from E1 to E2, and real GDP is now at $12 trillion per year

• We are at the long-run equilibrium level

Discretionary Fiscal Policy (cont'd) Change in taxes

A rise in taxes causes a reduction in aggregate demand because it can reduce consumption spending, investment expenditures, and net exports.

Possible Offsets to Fiscal Policy Fiscal policy does not operate in a vacuum

and important questions must be answered.How are expenditures financed and

by whom?

If taxes are increased what does government do with the taxes?

What will happen if individuals worry about increases in future taxes?

Possible Offsets to Fiscal Policy (cont'd) Crowding-Out Effect

The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector; this decrease normally results from the rise of interest rates.

Figure 13-3 The Crowding-Out Effect, Step by Step

Figure 13-4 The Crowding-Out Effect

Expansionary policy causing deficit spending initially shifts from AD1 to AD2

Due to crowding out, AD shifts inward to AD3

Equilibrium GDPbelow full-employment GDP—recessionary gap

Possible Offsets to Fiscal Policy (cont'd)

Planning for the future: the Ricardian equivalence theorem

Ricardian Equivalence Theorem The proposition that an increase in the government

budget deficit has no effect on aggregate demand

The reason for the offset People anticipate that a larger deficit today will mean

higher taxes in the future and adjust their spending accordingly.

Possible Offsets to Fiscal Policy (cont'd) Direct Expenditure Offsets

Actions on the part of the private sector in spending income that offset government fiscal policy actions

Any increase in government spending in an area that competes with the private sector will have some direct expenditure offset.

Possible Offsets to Fiscal Policy (cont'd) The supply-side effects of changes

in taxes

Expansionary fiscal policy could involve reducing marginal tax rates.

Advocates argue this increases productivity since individuals will work harder and longer, save more, and invest more.

The increased productivity will lead to more economic growth.

Possible Offsets to Fiscal Policy (cont'd) Supply-Side Economics

The suggestion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward

Figure 13-5 Laffer CurveTax rates andtax revenuesrise together

Tax revenues are at a maximum

Tax rates and tax revenues fall together

Discretionary Fiscal Policy in Practice: Coping with Time Lags

Recognition Time Lag The time required to gather information about the current

state of the economy

Action Time Lag The time required between recognizing an economic

problem and putting policy into effect

Effect Time Lag The time it takes for a fiscal policy to affect

the economy

Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd)

Fiscal policy time lags are long and a policy designed to correct a recession may not produce results until the economy is experiencing inflation.

Fiscal policy time lags are variable in length (1–3 years), and the timing of the desired effect cannot be predicted.

Because fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy.

Automatic Stabilizers

Automatic or Built-In Stabilizers

Changes in government spending and taxation that occur automatically without deliberate action of Congress

The tax system

Unemployment compensation

Welfare spending

Figure 13-6 Automatic Stabilizers

The automatic changes tend to drive the economy back toward its full-employment output level

What Do We Really Know About Fiscal Policy? Fiscal policy during normal times

Congress ends up doing too little too late to help in a minor recession.

Fiscal policy that generates repeated tax changes (as has happened) creates uncertainty.

What Do We Really Know About Fiscal Policy? (cont'd) Fiscal policy during abnormal times

Fiscal policy can be effective The Great Depression—fiscal policy may be able

to stimulate aggregate demand.

Wartime—during World War II real GDP increased dramatically.

What Do We Really Know About Fiscal Policy? (cont'd) The “soothing” effect of Keynesian fiscal

policy

Should we encounter a severe downturn, fiscal policy is available.

Knowing this may reassure consumers and investors.

Stable expectations encourage a smoothing of investment spending.

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Chapter 13: Fiscal Policy

End of Chapter 10

26

ECON 151 – PRINCIPLES OF MACROECONOMICS

Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.