Chapter 11:Fiscal Policy

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Fiscal Policy

• The Keynesian theory of macro instability practically mandates government intervention.– If AD is too little, unemployment arises.– If AD is too much, inflation arises.

• If the market cannot correct these imbalances, then the federal government must.

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Fiscal Policy• In this chapter we examine fiscal policy tools. • Core issues are– Can government spending and tax policies ensure

full employment?– What policy actions will help fight inflation?– What are the risks of government intervention?

• Fiscal policy: the use of government taxes and spending to alter macroeconomic outcomes.

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Learning Objectives

• 11-01. Know what the real GDP gap and the AD shortfall measure.

• 11-02. Know the desired scope and tools of fiscal stimulus.

• 11-03. Know what AD excess measures and the desired scope and tools of fiscal restraint.

• 11-04. Know how the multiplier affects fiscal policy.

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Taxes and Spending

• The federal government collects nearly $3 trillion a year in tax revenues, nearly half of which comes from individual income taxes.

• Less than half of government expenditures go to government purchases of goods and services; the rest are income transfers.– Income transfers: payments to individuals for

which no current goods or services are exchanged.

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Fiscal Policy

• These tax and spending powers can greatly influence AD.

• Government can alter AD by– Purchasing more or fewer goods and services.– Raising or lowering taxes.– Changing the level of income transfers.

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Fiscal Stimulus• If a recessionary GDP

gap exists, a fiscal stimulus could be used to deliver the economy to full-employment GDP.

• Fiscal stimulus: tax cuts or spending hikes intended to increase AD – that is, shift AD right.

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The AD Shortfall• AS slopes upward, so an AD

shift right will induce price level increases.

• The fiscal stimulus needed to close the GDP gap must be larger than the gap.

• AD shortfall: the amount of additional AD needed to achieve full employment after allowing for price level changes.– It is represented by the

distance between point a and point e.

– It becomes the fiscal target.

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Using Government Spending• Increased government spending is a form of

fiscal stimulus.• All new government spending will have a

multiplied impact on AD.– The multiplier effect will stimulate additional

rounds of increased consumer spending.

Horizontal shift in AD = Fiscal stimulus + Induced increases in consumption

= Multiplier X Fiscal stimulus

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Desired Fiscal Stimulus

• Too little fiscal stimulus? The economy may stay in recession.

• Too much fiscal stimulus? This may rapidly lead to excessive spending and inflation.

• We can use this formula to estimate how much fiscal stimulus is needed:

AD shortfallDesired fiscal stimulus = Multiplier

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Tax Cuts

• The fiscal stimulus can come from inducing increased autonomous consumption or investment spending.

• Government can do this by lowering taxes.– Individual income tax cut: disposable income

would increase, causing increased consumption spending.

– Corporate tax cut: profits would increase, spurring increased investment spending.

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Tax Cuts

• A tax cut adds no more dollars to the economy. It allows earners to keep more of their current pretax income. How much additional consumer spending is controlled by the size of MPC.

Initial increase in consumption = MPC X Tax cut

Cumulative change Initial change in in spending = Multiplier X consumption

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Tax Cuts

• Since there is no initial new input of spending, a tax cut contains less fiscal stimulus than a government spending increase of the same size.– The initial spending injection can be less than

the size of the tax cut.

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Balanced Budget Multiplier• Spending increases raise expenditures (G), and

tax cuts decrease revenues (T); therefore, the budget deficit increases.

• If the change in G and the change in T are the same, the deficit would not grow.

• How would this affect AD?– Since the effect of a change in G is greater than the

effect of a change in T, AD would shift by the size of the change.

– The balanced budget multiplier, therefore, equals 1.

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Increased Transfers

• Increasing transfer payments raises recipients’ disposable income, and spending increases.

• The effect is much like a tax cut since the recipients will save some of the payment.

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Fiscal Restraint• If an inflationary GDP

gap exists, a fiscal restraint could be used to return the economy to full-employment GDP.

• Fiscal restraint: tax hikes or spending cuts intended to decrease AD – that is, shift AD left.

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The AD Excess• AS slopes upward, so an AD

shift left will induce price level decreases.

• The fiscal restraint needed to close the GDP gap must be larger than the gap.

• AD excess: the amount by which AD must be reduced to achieve full employment after allowing for price level changes.– It is represented by the

distance between point Q1 and point Q2.

– It becomes the fiscal target.

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Desired Fiscal Restraint• Too little fiscal restraint? The economy may

continue to be inflationary.• Too much fiscal restraint? This may rapidly

lead to decreased spending and rising unemployment.

• We can use this formula to estimate how much fiscal restraint is needed:

AD excessDesired fiscal restraint = Multiplier

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Budget Cuts• Decreased government spending is a form

of fiscal restraint.• Reduced government spending will have a

multiplied impact on AD.– The multiplier effect will generate additional

negative rounds of decreased consumer spending.

Horizontal shift in AD = Fiscal restraint + Induced decreases in consumption

= Multiplier x Fiscal restraint

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Budget Cuts

• Cut government expenditures to initiate a multiplier process to achieve the desired fiscal restraint.– For example, decreased military spending

would cause layoffs at defense plants. – Incomes would decrease and consumer

spending would also decrease, triggering the negative multiplier rounds.

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Tax Hikes

• The direct effect of a tax hike is reduced disposable income.

• People must reduce consumption and saving to pay the added taxes.

• This will trigger the negative multiplier effect.

• AD will shift to the left.

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Reduced Transfers

• If transfer payments decrease, recipients’ disposable income falls and spending decreases.

• The effect is much like a tax hike.• This option is politically unpopular.

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Crowding Out• Crowding out: a reduction in private sector

borrowing (and spending) caused by increased government borrowing.– A fiscal stimulus would most likely be financed by

government borrowing. – Less credit becomes available to the private sector,

which must reduce its borrowing and spending.– This private sector spending reduction offsets the

government spending, reducing the impact of the fiscal stimulus.

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Fiscal Policy Problems• Time lags: it takes time to– Recognize that a problem exists.– Develop a policy strategy.– Pass the required legislation.– Implement the policy.– Generate the many steps in the multiplier process.

• This might take months.• Other impacts on the economy may have

occurred before the impact of the policy takes place.

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Fiscal Policy Problems

• Pork barrel politics: Congress members might– Channel spending to their own districts.– Protect favored projects from cuts.– Steer away from tax hikes or spending cuts

before an election.

• These political moves can alter the content and timing of fiscal policy.

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Public vs. Private Spending• Two camps have emerged:– One camp favors government solutions to

problems.– The other camp is concerned about excessively

large government and asserts that solutions are better left to the private sector.

• If government is divided between the two groups, fiscal policy will be delayed by arguments on these policy issues.

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Public vs. Private Spending• One camp favors government solutions to

problems.– They would increase government spending to cover

an AD shortfall.– They would hike taxes to cover an AD excess.

• The other camp is concerned about excessively large government and thinks that solutions are better left to the private sector.– They would cut taxes to cover an AD shortfall.– They would reduce government spending to cover

an AD excess.