fiscal policy
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Fiscal Policy•Keynesian view•Discretionary versus non-discretionary fiscal policy•The automatic stabilizers•Fiscal policy to close a contractionary gap.•The tax multiplier•Fiscal policy to close an expansionary gap.•Problems with fiscal policy
Fiscal PolicyThe use of the taxing and spending powers of government to regulate aggregate expenditure, and thereby to stabilize the economy
The economy needs to be stabilized. The economy
can be stabilized. The economy should be stabilized. This is the
Keynesian view
Employment Act of 1946
This legislation established a
responsibility for the federal government to promote “maximum
employment, production, and
purchasing power.”
Discretionary versusnon-discretionary spending
Discretionary fiscal policy is the deliberate manipulation of government purchases, taxation, and transfer payments to pursue macroeconomic goals such as full employment and price stability.
The Bush tax stimulus package of 2008 is an example of
discretionary fiscal policy
Automatic stabilizersNon-discretionary or “built-in” features of government spending and taxation that reduce fluctuations in disposable income, and thus consumption, over the business cycle.
•Tax rates for various types of income are set by elected officials. Tax collections depend on the employment levels/incomes, profits, capital gains, retails sales, . . .•Elected officials establish eligibility requirements and support levels for needs-tested transfer payments—e.g., TANF, food stamps, and unemployment compensation. Actual government outlays for needs-tested transfer payments depend on (1) the number of persons eligible; and (2) the number of those eligible that actually file claims.
As the economy enters a recession, federal revenues tend to decline while at the same time transfer payments rise. Thus recession
brings about an automatic decline of net taxes (NT)
DINTY
Remember that: DI = Y - NT
DINTY
Keynesian RxIf a lack of aggregate expenditure is
the problem, why not use the spending and taxing powers of the federal government to stimulate
aggregate expenditure
Using expansionary fiscal pol icyto c lose a contractionary gap
MXGIbNTa
AEAEAE’
Real GDP (Y)Y YF
YF is full-employment (potential) GDP.
Contractionary gap
•Increase in G•Decrease in NT
Effect of a $0.1 trillion increase in G on AE and real GDP demanded
C+I+G+(X-M)
a
14.0 14.50 Real GDP(trillions of dollars)
14.0
14.5
Aggr
egat
e ex
pend
iture
(tril
lions
of d
olla
rs)
45°
C+I+G’+(X-M)
bAs a result of a$0.1 trillion increase in government purchases, the aggregate expenditure line shifts up by $0.1 trillion, increasing the real GDP demanded by $0.5 trillion. This model assumes price level remains unchanged.
0.1
bGY
11
10
Effect of a $0.1 trillion decrease in net taxes on aggregate expenditure and real GDP demanded
C+I+G+(X-M)
a
14.0 14.50 Real GDP(trillions of dollars)
14.0
14.5
Aggr
egat
e ex
pend
iture
(tril
lions
of d
olla
rs)
45°
C’+I+G+(X-M)
b
As a result of a decrease in NT of $0.1 trillion, consumers, who are assumed to have a MPC of 0.8, spend $80 billion more and save $20 billion at every level of GDP. The consumption function shifts up by $80 billion, as does the AE line.
0.08
An $80 billion increase of AE line eventually increases real GDP demanded by $0.4 trillion. Keep in mind that the price level is assumed to remain constant during all this.
Simple tax multiplier
bNTbY
11)(
Note: We assume imports are autonomous. Thus the multiplier is given by:
b11
[1]
We can rewrite [1] as:
bbNTY
1
Tax multiplier
12
Discretionary fiscal policy: close a contractionary gapPr
ice
leve
l
125
130
AD
SRAS130
e
Potential outputLRAS
The aggregate demand curve AD and the short-run aggregate supply curve SRAS130 intersect at point e. Output falls short of the economy’s potential. The resulting contractionary gap is $0.5 trillion.
Real GDP (trillions of dollars)
0 14.0 14.513.5
AD*e’
e*
This gap could be closed by discretionary fiscal policy that increases aggregate demand by just the right amount. An increase in government purchases, a decrease in net taxes, or some combination could shift aggregate demand out to AD*, moving the economy out to its potential output at e*.
e’’
13
Discretionary fiscal policy: close expansionary gap
Pric
e le
vel
135
130AD’
SRAS130
e’
Potential outputLRAS
The aggregate demand curve AD’ and the short-run aggregate supply curve SRAS130 intersect at point e’ resulting in an expansionary gap of $0.5 trillion.
Real GDP (trillions of dollars)
0 14.0 14.5
AD*
e*
Discretionary fiscal policy aimed at reducing aggregate demand by just the right amount could close this gap without inflation. An increase in net taxes, a decrease in government purchases, or some combination could shift aggregate demand back to AD* and move the economy back to its potential output at e*.
e’’
Problems with (discretionary) fiscal policy
1. Policy lags2. Permanent income
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