FISCAL POLICY-MODULES 20/21

J.A.SACCO

Introduction

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One major government policy tool is fiscal policy, which involves changes in government spending,

changes in taxes, or both.

During periods when the economy is doing poorly, policymakers in Washington, D.C., have at times

recommended and enacted tax cuts. At other times, when the federal government was spending

much more that it was receiving in taxes, policymakers have recommended and enacted tax

increases.

Preview Questions• What is fiscal policy?• What is automatic fiscal policy, and how does it lend

stability to an economy?• How does the crowding-out effect offset expansionary

fiscal policy?• What types of time lags exists between the need for fiscal

stimulus and the time when such stimulus actually affects the national economy?

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Did You Know That...• The first type of income tax was probably established in

the 1200s and 1300s during times of war in the Italian city-states?

• America’s first income tax, enacted in 1861 to help pay for the Civil War, was 3 percent on incomes over $800 a year.

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Fiscal Policy• Fiscal Policy

• The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals• High employment• Price stability• Economic growth• Improvement of international payments balance

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FISCAL POLICY• Types of Fiscal Policy• Fiscal policy can be either

• Discretionary • Automatic

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FISCAL POLICY

• Discretionary fiscal policy• A fiscal policy action that is initiated by an act of

Congress.• Automatic fiscal policy• A fiscal policy action that is triggered by the state of the

economy• For example, an increase in unemployment induces an

increase in payments to the unemployed or in a recession marginal taxes decrease as incomes fall.

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FISCAL POLICY

• Discretionary Fiscal Policy: Demand-Side EffectsThe Government Expenditure Multiplier• The government expenditure multiplier is

magnification effect of a change in government expenditure on goods and services on aggregate demand.

• It works like the autonomous expenditure multiplier.

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FISCAL POLICY

The Tax Multiplier• The tax multiplier magnification effect of a change

in taxes on aggregate demand.• A decrease in taxes increases disposable income.

And an increase in disposable income increases consumption expenditure.

• With increased consumption expenditure, employment and incomes rise and consumption expenditure increases yet further.

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FISCAL POLICY• So a decrease in taxes works like an increase in government

expenditure. • Both actions increase aggregate demand and have a multiplier

effect.• The magnitude of the tax multiplier is smaller than the government

expenditure multiplier.

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Expansionary Fiscal Policy11

AD1

SRASSRAS

AD2

Real National Income per Year($ trillions)

Pric

e Le

vel

0

LRAS

7.0

130 E1

120

6.5

E2

What is this ?

1) Economy begins at E1, which is _________.

2) There is a decrease in aggregate demand to AD2 resulting in a ______.

3) According to the “classical economists”, how does the economy adjust to this situation?

4) According to Keynes how does this economy recover?

Expansionary Fiscal Policy12

AD2

SRASSRAS

AD1

Real National Income per Year($ trillions)

Pric

e Le

vel

0

LRAS

7.0

130 E2

120

6.5

E1

Contractionarygap

1) The contractionary gap is caused by insufficient AD2) To increase AD- use expansionary fiscal policy to increase government spending/ reduce taxes3) With an increase in G/decrease in taxes AD increases and real GDP increases to full employment

Fiscal Policy• Questions

• Would the increase in government spending/ decrease in taxes how to equal the size of the gap ($.5 trillion)?

• What impact did the expansionary fiscal policy have on the price level?

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Expansionary Fiscal Policy and the Multiplier

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Potential GDP is $10 trillion, real GDP is $9 trillion, and

1. There is a $1 trillion recessionary gap.

2. An increase in government expenditure or a tax cut increases expenditure by ∆E.

Expansionary Fiscal Policy

3. The multiplier increases induced expenditure. The AD curve shifts rightward to AD1.

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The price level rises to 110, real GDP increases to $10 trillion, and the recessionary gap is eliminated.

Contractionary Fiscal Policy:16

SRASSRAS

AD1

Real National Income per Year($ trillions)

Pric

e Le

vel

0

LRAS

7.0

120

7.5

E1

What is this?

1) Explain the state of this economy.2) If nothing is done, what will

eventually happen in this economy?

3) Why might even Keynesians agree with this?

Contractionary Fiscal Policy:

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AD2

SRASSRAS

AD1

Real National Income per Year($ trillions)

Pric

e Le

vel

0

LRAS

7.0

100 E2

120

7.5

E1

Expansionarygap

1) The expansionary gap is caused by SR equilibrium > full- employment2) To decrease AD, use contractionary fiscal policy to decrease government spending or increase taxes3) With a decrease in G or increase in taxes AD decreases and real GDP decreases to full employment and the price level drops

Contractionary Fiscal Policy

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Potential GDP is $10 trillion, real GDP is $11 trillion, and

1. There is a $1 trillion inflationary gap.

2. A decrease in government expenditure or a tax rise decreases expenditure by ∆E.

Contractionary Fiscal Policy

3. The multiplier decreases induced expenditure. The AD curve shifts leftward to AD1.

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The price level falls to 110, real GDP decreases to$10 trillion, and the inflationary gap is eliminated.

Fiscal Policy• Question

• What would be the long-run impact on real GDP of a tax cut if the economy is at full-employment equilibrium?

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