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Fiscal Policy

• The Keynesian theory of macroinstability practically mandates

government intervention. – If AD is too little, unemployment arises.

– If AD is too much, ination arises.

• If the maret cannot correct theseimbalances, then the federalgovernment must.

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Fiscal Policy

• In this chapter !e e"amine #scal policytools.

• $ore issues are – $an government spending and ta" policies

ensure full employment%

– &hat policy actions !ill help #ght ination%

– &hat are the riss of government intervention%

• Fiscal policy' the use of government ta"esand spending to alter macroeconomicoutcomes.

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(earning )b*ectives

• ++-+. Kno! !hat the real DP gap and theAD shortfall measure.

•

++-/. Kno! the desired scope and tools of#scal stimulus.

• ++-0. Kno! !hat AD e"cess measures andthe desired scope and tools of #scal

restraint.• ++-1. Kno! ho! the multiplier a2ects #scal

policy.

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Ta"es and 3pending

• The federal government collects nearly 40trillion a year in ta" revenues, nearly half of

!hich comes from individual income ta"es.• (ess than half of government e"penditures

go to government purchases of goods andservices5 the rest are income transfers.

– Income transfers' payments to individuals for!hich no current goods or services aree"changed.

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Fiscal Policy

• These ta" and spending po!ers cangreatly inuence AD.

• overnment can alter AD by – Purchasing more or fe!er goods and

services.

–6aising or lo!ering ta"es.

– $hanging the level of income transfers.

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Fiscal Policy oals

• First, !e !ill e"plore #scal policy7spotential to ensure full employment.

• 3econd, !e !ill e"plore #scal policy7spotential to maintain price stability.

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Fiscal 3timulus

• If a recessionaryDP gap e"ists, a#scal stimulus could

be used to deliverthe economy to fullemployment DP.

• Fiscal stimulus' ta"cuts or spendinghies intended toincrease AD 8 thatis, shift AD right.

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The AD 3hortfall

• A3 slopes up!ard, so anAD shift right !ill induceprice level increases.

• The #scal stimulus needed

to close the DP gap mustbe larger than the gap.• AD shortfall' the amount

of additional AD needed toachieve full employmentafter allo!ing for pricelevel changes. – It is represented by the

distance bet!een point a and point e.

– It becomes the #scaltarget.

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9sing overnment 3pending

• Increased government spending is aform of #scal stimulus.

• All ne! government spending !ill have amultiplied impact on AD.

– The multiplier e2ect !ill stimulate additionalrounds of increased consumer spending.

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Desired Fiscal 3timulus

• Too little #scal stimulus% Theeconomy may stay in recession.

• Too much #scal stimulus% This mayrapidly lead to e"cessive spendingand ination.

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Ta" $uts

• The #scal stimulus can come frominducing increased consumption orinvestment spending.

• overnment can do this by lo!eringta"es. – Individual income ta" cut' disposable income

!ould increase, causing increasedconsumption spending.

– $orporate ta" cut' pro#ts !ould increase,spurring increased investment spending.

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Ta" $uts

• A ta" cut adds no more dollars to theeconomy. It allo!s earners to eep more

of their current preta" income. :o!much additional consumer spending iscontrolled by the si;e of

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Ta" $uts

• 3ince there is no initial ne! input ofspending, a ta" cut contains less

#scal stimulus than a governmentspending increase of the same si;e.

– The initial spending in*ection can be less

than the si;e of the ta" cut.

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=alanced =udget T ?5therefore, the budget de#cit increases.

• If the change in G and the change in T are the same, the de#cit !ould notgro!.

• :o! !ould this a2ect AD% – 3ince the e2ect of a change in G is greater

than the e2ect of a change in T , AD !ouldshift by the si;e of the change.

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Increased Transfers

• Increasing transfer payments raisesrecipients7 disposable income, and

spending increases.• The e2ect is much lie a ta" cut

since the recipients !ill save some of

the payment.

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Fiscal 6estraint

• If an inationaryDP gap e"ists, a#scal restraint could

be used to returnthe economy to fullemployment DP.

• Fiscal restraint' ta"hies or spendingcuts intended todecrease AD 8 thatis, shift AD left.

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The AD @"cess

• A3 slopes up!ard, so anAD shift left !ill induceprice level decreases.

• The #scal restraint neededto close the DP gap must

be larger than the gap.• AD e"cess' the amount by

!hich AD must be reducedto achieve fullemployment after allo!ingfor price level changes. –

It is represented by thedistance bet!een pointQ1 and point Q2.

– It becomes the #scaltarget.

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Desired Fiscal 6estraint

• Too little #scal restraint% Theeconomy may continue to beinationary.

• Too much #scal restraint% This mayrapidly lead to decreased spendingand rising unemployment.

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=udget $uts

• Decreased government spending is aform of #scal restraint.

• 6educed government spending !illhave a multiplied impact on AD. – The multiplier e2ect !ill generate

additional negative rounds of decreasedconsumer spending.

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=udget $uts

• $ut government e"penditures toinitiate a multiplier process to achieve

the desired #scal restraint. – For e"ample, decreased military spending

!ould cause layo2s at defense plants.

– Incomes !ould decrease and consumerspending !ould also decrease, triggeringthe negative multiplier rounds.

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Ta" :ies

• The direct e2ect of a ta" hie isreduced disposable income.

• People must reduce consumption andsaving to pay the added ta"es.

• This !ill trigger the negative

multiplier e2ect.• AD !ill shift to the left.

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6educed Transfers

• If transfer payments decrease,recipients7 disposable income falls

and spending decreases.• The e2ect is much lie a ta" hie.

• This option is politically unpopular.

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Fiscal uidelines

• The goal of #scal policy is toeliminate DP gaps by shifting AD.

•:o! much to shift is indicated by theAD shortfall or the AD e"cess.

• The si;e of the #scal initiative is lessthan the desired shift.

• &hat remains is to decide !hichpolicy tool to use.

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$ro!ding )ut

• $ro!ding out' a reduction in privatesector borro!ing >and spending? causedby increased government borro!ing. – A #scal stimulus !ould most liely be

#nanced by government borro!ing.

– (ess credit becomes available to the privatesector, !hich must reduce its borro!ing and

spending. – This private sector spending reduction o2sets

the government spending, reducing theimpact of the #scal stimulus.

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Fiscal Policy Problems

• Time lags' it taes time to – 6ecogni;e that a problem e"ists. – Develop a policy strategy. – Pass the reuired legislation. – Implement the policy. – enerate the many steps in the multiplier

process.

• This might tae months.

• )ther impacts on the economy may haveoccurred before the impact of the policytaes place.

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Fiscal Policy Problems

• Por barrel politics' $ongressmembers might

– $hannel spending to their o!n districts. – Protect favored pro*ects from cuts.

– 3teer a!ay from ta" hies or spending

cuts before an election.• These political moves can alter the

content and timing of #scal policy.

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Public vs. Private 3pending

• T!o camps have emerged' – )ne camp favors government solutions to

problems.

– The other camp is concerned aboute"cessively large government and assertsthat solutions are better left to theprivate sector.

• If government is divided bet!een thet!o groups, #scal policy !ill be delayedby arguments on these policy issues.

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Public vs. Private 3pending

• )ne camp favors government solutions toproblems. – They !ould increase government spending to

cover an AD shortfall. – They !ould hie ta"es to cover an AD e"cess.

• The other camp is concerned aboute"cessively large government and thinsthat solutions are better left to the private

sector. – They !ould cut ta"es to cover an AD shortfall. – They !ould reduce government spending to

cover an AD e"cess.

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The @conomy Tomorro!

• The concern for content.

• To move out of recession to fullemployment

DP, the primary concern is ho! muchspending >or ta" cuts? should be involved.

• Another concern is the content of thespending.

– Public sector or private sector% – A boost for businesses or more for the needy%

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• @ach policy tool !ould alter theeconomy7s mi" of consumption andinvestment and a di2erent distribution ofincome.

– )ne side' smaller ta" cut for the rich, more ta"relief for the poor, and more social programs.

–

The other side' cut ta"es for businesses andentrepreneurs, reduce the si;e and scope ofgovernment programs.

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• There is usually some form ofcompromise on issues lie these.

• :o!ever, you can e"pect to continueto see ma*or political conicts overthe di2ering vie!s of these t!o sets

of politicians in the economytomorro!.

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6evisiting the (earning

)b*ectives• ++-+. Kno! !hat the real DP gap and

the AD shortfall measure. – The real DP gap is the di2erence bet!een

e"isting DP and fullemployment DP.

– The AD shortfall measures ho! muchcumulative spending is reuired to move theeconomy bac to fullemployment DP.

– The scope of the stimulus is determined bythe AD shortfall divided by the multiplier.

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)b*ectives• ++-/. Kno! the desired scope and

the tools of #scal stimulus. –

Fiscal stimulus should be designed tomove the economy from its e"isting DPin recession to fullemployment DP.

– The tools of #scal stimulus are•

Increasing government purchases.• 6educing ta"es.• 6aising income transfers.

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)b*ectives• ++-0. Kno! !hat the AD e"cess

measures and the desired scope and

tools of #scal restraint. – The AD e"cess measures ho! muchcumulative reduction in spending isreuired to move the economy bac tofullemployment DP.

– The scope of the restraint is determinedby the AD e"cess divided by themultiplier.

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)b*ectives• ++-1. Kno! ho! the multiplier a2ects

#scal policy. – Initial changes in spending, ta"es, or

transfer payments begin a cycle in !hich,for e"ample, an increase in governmentspending becomes income to another. Thisincome is mainly spent, !hich becomesincome to yet another, etc.

– This repetitive cycle generates a multipliere2ect.

econ 202: chapter 11

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