Fiscal Policy

Chapter 11
McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Fiscal Policy
Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes The federal budget is a tool that can shift aggregate demand and thereby alter macroeconomic outcomes

11-2

The Policy Goal

Full-employment GDP Price Level AD1 PE a AS

b
The goal is to close GDP gaps

GDP Equilibrium

GDP gap QE = 5.6 Real GDP 6.0 = QF

11-3

Keynesian Strategy
Fiscal stimulus: Tax cuts or spending hikes intended to increase (shift) aggregate demand Two strategic policy questions:
By how much do we want to shift the AD curve to the right? How can we induce the desired shift?

11-4

The AD Shortfall
So long as the AS curve slopes upward, AD must increase by more than the size of the recessionary gap to achieve full employment AD shortfall: The amount of additional aggregate demand needed to achieve full employment after allowing for price-level changes

11-5

Multiplier Effects
Impact of fiscal stimulus on aggregate demand includes both the new government spending and all subsequent increases in consumer spending triggered by multiplier effects
Total change new spending multiplier in spending injection

11-6

Multiplier Effects
new spending Cumulative increase induced increase injection (horizontal shift ) in AD in consumption ( fiscal stimulus ) fiscal stimulus multiplier (new spending injection)

The second equation is identical to the first but expressed in the terminology of fiscal policy

11-7

Multiplier Effects
Direct impact of rise in government spending + $200 billion Indirect impact via increased consumption + $600 billion

Price Level

P1

Current price level

AD2 AD1 5.6 QE 5.8

AD3

6.4

Real GDP

11-8

The Desired Stimulus

The general formula for computing the desired stimulus is a simple rearrangement of the earlier formula:
AD shortfall Desired fiscal stimulus the multiplier

11-9

Tax Cuts
By lowering taxes, the government increases disposable income, which stimulates the consumption component of AD The amount consumption increases depends on the marginal propensity to consume
Initial increase MPC tax cut in consumption

11-10

Multiplier Effects
Cumulative change initial change multiplier in spending in consumption

A dollar of tax cut contains less stimulus than a same size increase in government purchases
desired fiscal stimulus Desired tax cut MPC

11-11

Increased Transfers
Increasing transfer payments stimulates the economy
Initial fiscal increase in MPC stimulus (injection) transfer payments

11-12

The Fiscal Target

AD excess: The amount by which aggregate demand must be reduced to achieve fullemployment equilibrium after allowing for price-level changes The AD excess exceeds the inflationary GDP gap

11-13

The Fiscal Target

First determine the size of the AD excess Then we compute how much government spending or taxes must be changed to achieve the desired shift, taking into account multiplier effects
excess AD Desired fiscal restraint the multiplier

11-14

Budget Cuts
Budget cuts reduce government spending and induce cutbacks in consumer spending Budget cuts should equal the size of the desired fiscal restraint
Cumulative reduction initial budget cut multiplier in spending ( fiscal restraint )

11-15

Tax Hikes
Tax hikes can be used to shift the AD curve to the left by reducing disposable income Taxes must be increased more than a dollar to get a dollar of fiscal restraint
desired fiscal restraint Desired tax hike MPC

11-16

Weak Economy: Fiscal Stimulus

AD shortfall Desired fiscal stimulus the multiplier
Policy Tools Increase government purchases Cut taxes Amount desired fiscal stimulus

desired fiscal stimulus MPC

Increased transfers

desired fiscal stimulus MPC

11-17

Overheated Economy: Fiscal Restraint

excess AD Desired fiscal restraint the multiplier
Policy Tools Reduce government purchases Increase taxes Amount desired fiscal restraint

desired fiscal restraint MPC

Reduce transfers

desired fiscal restraint MPC

11-18

A Warning: Crowding Out

Some of the intended fiscal stimulus may be offset by the crowding out of private expenditure Crowding out: A reduction in private-sector borrowing (and spending) caused by increased government borrowing

11-19

Fiscal Policy
End of Chapter 11
McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.