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Fiscal Policy Chapter 13 SECOND CANADIAN EDITION MACROECONOMICS MACROECONOMICS Paul Krugman | Robin Wells Iris Au | Jack Parkinson © 2014 Worth Publishers

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  • Fiscal Policy Chapter 13 SECOND CANADIAN EDITION MACROECONOMICS MACROECONOMICS Paul Krugman | Robin Wells Iris Au | Jack Parkinson 2014 Worth Publishers
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  • What fiscal policy is and why it is an important tool in managing economic fluctuations Which policies constitute an expansionary fiscal policy and which constitute a contractionary fiscal policy Why fiscal policy has a multiplier effect and how this effect is influenced by automatic stabilizers Why a large public debt may be a cause for concern WHAT YOU WILL LEARN IN THIS CHAPTER
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  • The Economic Importance of Government Government Spending and Tax Revenue for Some High-Income Countries in 2007
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  • What Does Government Do? Government Spending (including transfers) in Canada, 2007
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  • How Does Government Pay for its Spending? Sources of Tax Revenue in Canada, 2007
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  • The Government Budget and Aggregate Spending Fiscal policy is the use of taxes (T), government transfers (TR), or government purchases of goods and services (G) to shift the aggregate demand curve (AD). Recall that:GDP = C + I + G + X-IM Fiscal policy works mainly through either: G (government spending) or; through the effects of tax and transfer policies on C (consumption spending). More minor possibilities? Taxes could affect investment (I); trade taxes (tariffs) could affect imports (IM).
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  • Expansionary Fiscal Policy: Increasing AD Expansionary fiscal policy raises AD. How? Increases government spending on goods and services (G) e.g. infrastructure spending Cuts taxes e.g. lower income tax rates, leaves households with more disposable income so consumption spending (C) rises. Raises transfers e.g. increase EI payments to the unemployed, this raises disposable income and raises C. The result: AD shifts right! These measures can eliminate a recessionary gap (see diagram).
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  • Expansionary Fiscal Policy
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  • Contractionary Fiscal Policy: Lowering AD Contractionary fiscal policy lowers AD. How? Lower government spending on goods and services (G) Raise taxes e.g. raise income tax rates, households have less disposable income so consumption spending (C) falls. Cut transfers e.g. decrease EI payments to the unemployed, this lowers disposable income and raises C. The result: AD shifts left! These policies can be used to eliminate an inflationary gap. (see diagram)
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  • Contractionary Fiscal Policy
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  • Can Expansionary Fiscal Policy Work? Some Objections Government spending displaces private spending $1 for $1. There is only so much income so that spent by government reduces spending by others. This is wrong since the extra spending can change output or income especially in recessions. Government borrowing to finance fiscal policy raises interest rates which crowds out investment spending so rise in G is offset by a fall in I. This makes some sense (see loanable funds model) But this effect is likely to be weaker in a recession if extra G raises real GDP. Ricardian equivalence. Increased spending now means higher future taxes households will respond by spending less, saving more in anticipation of higher future taxes. This assumes households are very forward-looking. Even if correct the reduced consumer spending will be spread across many years while the rise in G happens now. So AD will rise.
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  • A Cautionary Note: Lags in Fiscal Policy With fiscal policy, there is an important reason for caution: there are significant lags in its use. The government realizes there is a recessionary/inflationary gap by collecting and analyzing economic data takes time Government develops a spending plan takes time Implementation of the plan (spending the money takes time (e.g. planning, approvals, awarding contracts etc.) Will the problem (gap) still exist when the policy takes effect? i.e. will the SRAS already have shifted to eliminate the gap?
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  • Another Problem: Level of Potential Output The direction of fiscal policy depends on whether GDP is above or below its potential or full-employment level. Potential output is not directly observed. It must be estimated or inferred from the behavior of other macroeconomic variables. Incorrect estimates can result in policy mistakes. Fiscal policy makes most sense when departures from potential are large and so the direction of policy is clear. US in 2015 provides an example of the problem. Unemployment rate suggests they are at or near potential. Employment as a share of population and wage-price behavior suggest it is still below potential.
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  • ECONOMICS IN ACTION What Was in Canadas 2009 Economic Action Plan The 2009-2010 budget impact of the Action Plan can be broken down into four categories: Infrastructure and other spending $10.97 billion (48%) Tax cuts $7.56 billion (33%) Transfer payments to persons $2.19 billion (10%) Transfer payments to lower level governments $2.03 billion (9%) The Action Plan included elements that affected G (infrastructure spending), taxes and transfers: all were intended to boost AD.
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  • Fiscal Policy and the Multiplier Fiscal policy has a multiplier effect on the economy. Expansionary fiscal policy leads to an increase in Aggregate Demand larger than the initial rise in aggregate spending caused by the policy. Conversely, contractionary fiscal policy leads to a fall in Aggregate Demand larger than the initial reduction in aggregate spending caused by the policy. As in Chapter 11 multiplier works through interdependence between income and spending. Critical parameter: MPC = marginal propensity to consume.
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  • Fiscal Policy and the Multiplier The size of the shift of the aggregate demand curve depends on the type of fiscal policy. Increases in G have a larger effect than equivalent-sized changes in taxes or transfers. Why? A rise in G directly increases spending by the amount of the increase; while only a share of the tax cut/transfer increase is spent. The government spending multiplier works just like Ch. 11: Say we have a $50 billion rise in G: Round 1: $50 b. rise in G immediately raises incomes by $50 b. Round 2: MPC of this is spent on consumer goods, leading to MPC x $50 billion more output and income Round 3: MPC of round 2 income is spent giving MPC 2 x$50 billion extra spending etc. End result? $50 billion x 1/(1 MPC) of extra spending from $50 billion of extra G.
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  • Tax and Transfer Multiplier Say we have a $50 billion tax cut or $50 billion transfer increase. Round 1:Spending increases by MPC x $50 billion since only MPC of the extra income is spent, income rises by MPC x $50 billion. Round 2:MPC of the extra income from round 1 is spent so incomes rise in round 2 by MPC 2 x$50 billion i.e. at each round the effect is scaled down (compared to the effect of a rise in G) by multiplying by MPC End result?$50 billlion x MPC/(1-MPC) of extra spending from the $50 billion tax cut or transfer increase.
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  • Multiplier Effects of Changes in Taxes and Government Transfers Hypothetical Effects of a Fiscal Policy with Marginal Propensity to Consume (MPC) of 0.5 (Y=change in Y, G=change in G) So the multiplier is larger for the rise in G than for a transfer increase or tax cut.
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  • Discretionary and Automatic Fiscal Policy Discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle. i.e. changes to G or to tax or transfer policies (like above) Automatic stabilizers dont require a discretionary change in policy. They work via the effect of existing policies on the size of the multiplier and automatically reduce the effect of fluctuations in spending. How? Spending rise, incomes rise but part of the rise goes to government as taxes or reduced transfers leaving less for additional spending (multiplier smaller). Spending falls, incomes fall but part of the fall is reduced taxes, and part is offset by rising transfers) so spending falls by less than if there was no tax-transfer system.
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  • ECONOMICS IN ACTION Multipliers and the 2009 Economic Action Plan Canadas Economic Action Plan was an example of discretionary fiscal expansion. Based on the Department of Finances Canadian Economic and Fiscal Model, the stimulus plan would create an estimated 220,000 jobs by the end of 2010. The size of the multipliers on items in the stimulus plan ranges from 0.3 (corporate income tax change) to 1.7 (measures for low-income people). (Source: Parliamentary Budget Officer Kevin Page (from T-Bay!))
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  • ECONOMICS IN ACTION Multipliers and the 2009 Economic Action Plan
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  • The Budget Balance How do government surpluses and deficits fit into the analysis of fiscal policy? Are deficits ever a good thing and surpluses a bad thing? Recall from Chapter 10: S Public = T TR G (T= taxes, TR = Transfers, G = government spending on goods and services) Other things equal, discretionary expansionary fiscal policies increased G, higher TR, or lower Treduce the budget balance for that year. That is, expansionary fiscal policies make a budget surplus smaller or a budget deficit bigger. Automatic stabilizers also affect this balance in the same direction. Recessions:T falls, TR rises (deficit growing or surplus shrinks)