Eco 6351Economics for Managers

Chapter 12. Fiscal Policy

Prof. Vera Adamchik

Undesired equilibrium• There is no guarantee that AD will always

produce an equilibrium at full employment and price stability.

• Sometimes there will be too little demand and sometimes there will be too much.

• Equilibrium output is not necessarily the same as the full employment level of output.

• Hence, the aggregate demand for goods and services will not always be compatible with economic stability.

Inadequate Demand

SRAS

AD2

AD*AD1

a

c

bP*

Q1 QFE

REAL OUTPUT (quantity per year)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

P2

Too little AD: Unemployment

Too much AD: Inflation

Q2

LRAS

Components of AD• The four major components of

aggregate demand are:

– consumption expenditure (C)

– investment (I)

– government expenditure (G)

– net exports (NX = exports minus imports = X-M)

• These four components of AD sum to real GDP (see Chapter 2)

Determinants of AD = C+I+G+NX

• Change in consumer spending (C):

– Consumer wealth

– Consumer expectations

– Consumer indebtedness

– Taxes

Determinants of AD = C+I+G+NX

• Change in investment spending (I):

– Real interest rates

– Expected returns

• Expected future business conditions

• Technology

• Degree of excess capacity

• Business taxes

Determinants of AD = C+I+G+NX

• Change in government spending (G)

• Change in net export spending (NX)

– National income abroad

– Exchange rates

Fiscal Policy

The government’s attempt to influence the economy by setting and changing taxes, its purchases of goods and services (that is, government spending), and transfer payments to achieve macroeconomic objectives such as full employment, sustained long-term economics growth, and low inflation.

• In the following discussion we assume a horizontal (Keynesian) segment of the SRAS curve.

Pri

ce L

evel

Real Domestic Output, GDP

Q

P SRAS

AD2

Increasing Demand in the Horizontal Range

Q1 Q2

P1

AD1

Pri

ce L

evel

Real Domestic Output, GDP

SRAS

AD1

Decreasing Demand in the Horizontal Range

Q2 Q1

P1

AD2

Fiscal Policy Tools:

Government Spending

AD1

bP1

5.6Q1

6.0QFE

aCurrent price level

REAL GDP($ trillions per year)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

GDP gap

A numerical example

Full employmentEquilibrium output

LRAS

SRAS

AD =GDP= C+I+G+(X-M)

5.6 tril. = 3 tril.+1 tril. + 0.9 tril. + 0.7 tril.

We would like to increase real GDP to 6 tril.

In order to increase AD, the government may increase its spending.

The question is: By how much?

Disposable Income

• Disposable income is the income earned from the supply of productive services - wages, interest, rent, and profit - PLUS transfer payments from the government MINUS taxes

Marginal Propensity to Consume

• The extent to which a change in disposable income changes consumption expenditure depends on the marginal propensity to consume

• The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is consumed

Marginal Propensity to Consume

• The marginal propensity to consume is calculated as the change in consumption expenditure divided by the change in disposable income:

Marginal Propensity to Save

• The extent to which a change in disposable income changes saving depends on the marginal propensity to save

• The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved

Marginal Propensities to Save

• The marginal propensity to save is calculated as the change in saving divided by the change in disposable income:

Marginal Propensities to Consume and Save

• The marginal propensity to consume plus the marginal propensity to save sum to 1:

MPC + MPS = 1

MPC and MPS

MPS = .25 MPC = .75

IN GOD WE

TRUST

IN GOD WE

TRUST

IN GOD WE

TRUST

IN GOD WE

TRUST

Multiplier Effects

• Each dollar spent is re-spent several times.

• As a result, every dollar has a multiplied impact on aggregate expenditure.

The Multiplier Process at Work

The Multiplier

• The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles.

The Government Expenditure Multiplier

The G Multiplier = 1/(1-MPC)

If MPC = 0.75,

The G Multiplier = 1/(1-0.75) = 4.

The Ultimate Effect The ultimate change in AD after an infinite

number of spending cycles = The G multiplier * The initial change in government spending = 4 * 100 bil. = 400 bil. (that is, 0.4 tril.)

The new eqm GDP = the old eqm GDP + the ultimate change in AD = 5.6 tril. + 0.4 tril. = 6.0 tril.

Q1 QF

P1

5.6 5.7 6.0

AD2 AD3

Current price level

Direct impact of rise in government spending + $100 billion

AD1

ab

REAL GDP ($ trillions per year)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

Indirect impact via increased consumption + $300 billion

Multiplier EffectsLRAS

SRAS

Fiscal Policy Tools:

Taxes

A numerical example (cont.)

• Rather than increasing its own spending, government can cut taxes to increase consumption or investment spending.

The Lump-Sum Tax Multiplier

The T Multiplier = -MPC/(1-MPC)

If MPC = 0.75,

The T Multiplier = -0.75/(1-0.75) = -3.

• The new eqm GDP = the old eqm GDP + the ultimate change in AD;

• 5.6 tril. + the ultimate change in AD = 6.0 tril.;• The ultimate change in AD = 6.0 - 5.6 = 0.4 tril. (that is, 400

bil.).

• The ultimate change in AD =

The T multiplier * The initial change in taxes;

• +400 bil. = -3 * the initial change in T;

• The init. change in T = 400/(-3) = -133.3 bil.;

• That is, the government should decrease taxes by 133.3 bil.

Multiplier and Price Level

Pri

ce L

evel

Real Domestic Output, GDP

Q

P SRAS

AD2

Increasing Demand in the Horizontal Range

Q1 Q2

P1

AD1

Inflation Worries

• Whenever the aggregate supply curve is upward sloping an increase in aggregate demand increases prices as well as output.

• Whenever the aggregate supply curve is vertical an increase in aggregate demand increases prices but has no impact on output.

Pri

ce L

evel

Real Domestic Output, GDP

Q

P SRAS

AD4

Increasing Demand in the Intermediate Range

Q3 Q4

P3

AD3

P4

Pri

ce L

evel

Real Domestic Output, GDP

Q

P SRAS

AD6

Increasing Demand in the Vertical Range

Qconstant

P5

AD5

P6

Pri

ce L

evel

Real Domestic Output, GDP

SRAS

AD2

Inflation and the Multiplier

GDP1 GDP2

P1

AD1

AD3

GDP3

P2

Full MultiplierEffect Reduced

MultiplierEffect Dueto Inflation

Fiscal Guidelines

• The fiscal strategy for attaining the goal of full employment is to shift the aggregate demand curve

Fiscal Guidelines

• Problem: insufficient demand

• Solution: increase AD• Methods:

– increase government spending,

– cut taxes,– increase transfer

payments.

• Problem: excess demand

• Solution: decrease AD• Methods:

– decrease government spending,

– raise taxes,– decrease transfer

payments.

Government Budget

Government Budget

• Governments:

– collect taxes, T

– spend G on goods and services

– Budget deficit: if G > T

– Budget surplus: if G < T

Unbalanced Budgets

• The use of fiscal policy to manage aggregate demand implies that the budget will often be unbalanced.

Budget Deficit

• Budget deficit: if G > T

• The government borrows money to pay for deficit spending.

Budget Deficit

• The federal government ran significant budget deficits between 1970 and 1997.

• The deficit peaked at nearly $300 billion in 1992.

Budget Surplus

• Budget surplus: if G < T

• By 1998, a combination of growing tax revenues and slower government spending created a budget surplus.

Unbalanced Budgets

• In Keynes’ view, an unbalanced budget is perfectly appropriate if macro conditions call for a deficit or surplus.