Fiscal Policy and Its Effects

Fiscal Policy

  • Fiscal policy involves government purchases, taxes, and transfer payments to influence RGDP and the price level.

  • It's used to stimulate the economy during recessions or control inflation.

Fiscal Stimulus and Budget

  • Budget Deficit: Government spending exceeds tax revenues.

  • Budget Surplus: Tax revenues exceed government spending.

  • Balanced Budget: Government expenditures equal tax revenues; it rarely occurs without deliberate policy.

Government Actions to Stimulate the Economy (Increase AD)

  • Increase government purchases of goods and services.

  • Increase transfer payments.

  • Lower taxes.

  • Use a combination of these.

  • These actions increase the budget deficit and are associated with expansionary fiscal policy.

Government Actions to Dampen an Economic Boom (Reduce AD) bawasam

  • Reduce government purchases of goods and services.

  • Increase taxes.

  • Reduce transfer payments.

  • Use a combination of these.

  • These actions create or expand a budget surplus or reduce a budget deficit, representing contractionary fiscal policy.

Government and Total Spending

  • Aggregate Demand (AD) formula: AD = C + I + G + (X – M)

    • C = Consumer spending

    • I = Investment spending

    • G = Government purchases

    • X = Exports

    • M = Imports

  • The government directly controls government purchases (G).

  • It indirectly affects AD through taxes and transfer programs.

  • Increase in taxes or reduction in transfer payments reduces disposable income, decreasing consumer spending.

  • Decrease in taxes or increase in transfer payments increases disposable income, leading to increased consumer spending.

  • Government can also influence investment spending through business taxes.

  • Tax cuts for firms may increase investment spending, shifting the AD curve to the right.

Fiscal Policy and the AD/AS Model

  • Fiscal policy tools: government purchases, taxes, and transfer payments.

  • Fiscal policy can be expansionary or contractionary to close recessionary or inflationary gaps.

Expansionary Fiscal Policy to Close a Recessionary Gap

  • Increasing government purchases, decreasing taxes, and/or increasing transfer payments increases the government's budget deficit.

  • Budget deficits can stimulate the economy when it's operating below full capacity, moving it towards fuller employment.

  • If the government purchases more, cuts taxes, and/or increases transfer payments, the AD curve shifts to the right.

  • In a recession, this leads to an increase in both the price level and RGDP.

  • The multiplier process amplifies the change in AD, making it larger than the initial stimulus package.

  • If timed correctly, expansionary fiscal policy can pull the economy out of recession, achieving full employment.

Contractionary Fiscal Policy to Close an Inflationary Gap

  • Reducing government purchases, increasing taxes, or reducing transfer payments directly affects AD.

  • Tax increases on consumers or decreased transfer payments reduce disposable incomes, reducing consumption.

  • Higher business taxes reduce investment purchases.

  • Reductions in consumption, investment, and/or government purchases shift the AD curve leftward.

  • This lowers the price level and brings RGDP back to full employment, closing the inflationary gap.

The Multiplier Effect

  • Changes in AD’s components (C, I, G, X – M) can initiate shifts in aggregate demand, leading to a new short-run equilibrium.

  • Policymakers can manipulate government purchases to achieve a desired short-run equilibrium.

  • Multiplier effect: The ultimate increase in total purchases is greater than the initial increase.

  • Example: Government spends 10 billion on aircraft carriers, directly adding to the demand for goods and services.

  • This provides 10 billion in added income to the companies, who then hire more workers and buy more capital equipment.

Illustrating Marginal Propensity to Consume (MPC)

  • The fraction of additional disposable income that a household consumes rather than saves.

  • MPC = [Change in Consumption Spending (∆C)] / [Change in Disposable Income (∆DY)]

  • Example: Winning 1000 and spending 750 results in an MPC of 0.75.

  • Marginal refers to the extra amount of disposable income.

  • Propensity to consume refers to how much of additional income is spent on consumer goods and services.

  • Marginal Propensity to Save (MPS): The proportion of an addition to income that is saved.

  • MPS = [Change in Savings (∆S)] / [Change in Disposable Income (∆DY)]

  • In the lottery example, if you save 250, the MPS is 0.25.

  • MPC + MPS = 1

The Multiplier Effect at Work

  • For an MPC of two-thirds:

    • Initial 10 billion increase in government purchases increases both AD and income to suppliers.

    • Input owners spend an additional 6.67 billion (two-thirds of 10 billion) on consumption purchases.

    • This starts a chain reaction.

    • The added 6.67 billion in consumption brings a 6.67 billion increase in AD.

    • They spend two-thirds of their additional 6.67 billion, or 4.44 billion, on consumption.

    • This continues, with each round generating smaller increases due to savings and taxes.

  • Multiplier = 1 / (1 – MPC)

Changes in the MPC Affect the Multiplier Process

  • A larger MPC leads to a larger multiplier effect due to more consumption purchases.

The Multiplier and the Aggregate Demand Curve

  • Additional aircraft purchases increase incomes of input owners – the initial effect.

  • Secondary effect: Greater income leads to increased consumer purchases.

  • Higher profits may lead firms to increase their investment purchases.

  • The initial effect has a multiplied effect on the economy.

  • The initial 10 billion purchase shifts AD right by 10 billion. Multiplier effect causes AD to shift an additional 20 billion to the right.

  • With an MPC of 2/3, a 10 billion increase in government purchases results in a 30 billion total effect on AD.

Tax Cuts and the Multiplier

  • Governments can stimulate the economy through tax cuts to boost business and consumer spending.

  • The size of the AD shift depends on the MPC.

  • The tax multiplier is smaller than the government spending multiplier because tax cuts have an indirect impact on AD.

  • Consumers save some of their income from the tax cut.

  • With a 10 billion tax cut and an MPC of 2/3, the initial increase in consumption is 2/3 * 10 billion = 6.67 billion.

  • The effect on AD is smaller than an equal change in government purchases.

  • The cumulative change in spending due to the 10 billion tax cut is 20 billion.

Taxes and Investment Spending

  • Cuts in corporate-profit taxes may increase investment spending.

  • Tax cuts for consumers and investors can stimulate both consumption (C) and investment (I).

A Reduction in Government Purchases and Tax Increases

  • These are magnified by the multiplier effect.

  • Cutbacks in government programs decrease government purchases directly.

  • Aerospace workers get laid off and cut back on consumption.

  • This initial cutback has a multiplying effect, leading to a greater reduction in aggregate demand.

  • Tax hikes reduce disposable income, leading to reduced consumption, and lower aggregate demand.

Time Lags, Saving, and Imports Reduce the Size of the Multiplier

  • The multiplier process is not instantaneous due to time lags.

  • The full increase in purchases may take a year or more.

  • Savings and spending on imports reduce the multiplier effect.

  • The multiplier effect applies to changes in any component of AD: consumption, investment, government purchases, or net exports.

  • The multiplier is most effective when it brings idle resources into production.

  • If all resources are fully employed, increased demand leads to a higher price level, not increased employment and RGDP.

The 2008-09 Recession

  • It led to the largest peacetime fiscal expansion in history.

  • Obama economists believed the multiplier for government purchases was close to 1.6 and for taxes closer to 1.

  • Other economists believed the multiplier was much smaller.

  • Economists agree that the multiplier is close to zero when the economy is at or near full employment.

Supply-Side Effects of Tax Cuts

  • Focus on the supply side of the economy, especially in the long run.

  • High taxes, transfer payments, and regulations can burden productive activities, reducing savings, work, and capital.

  • Fiscal policy can work on the supply side as well.

What Is Supply-Side Fiscal Policy?

  • Supply-siders encourage government to reduce individual and business taxes, deregulate, and increase spending on research and development.

  • These policies could cause greater long-term economic growth by stimulating personal income, savings, and capital formation.

Research and Development and the Supply-Side of the Economy

  • Investment in R&D can have long-run benefits for the economy.

  • Greater R&D can lead to new technology and knowledge, shifting both short- and long-run aggregate supply curves to the right.

  • Government encourages R&D investments through tax breaks or subsidies to firms, concentrating on productive R&D.

How Do Supply-Side Policies Affect Long-Run Aggregate Supply?

  • Supply-side policies increase both short-run and long-run aggregate supply curves.

  • Successful and maintained policies increase output and employment in the long run.

  • Deregulation and structural changes increase short- and long-run aggregate supply over time.

Critics of Supply-Side Economics

  • They are skeptical of the impact of lower taxes on work effort and deregulation on productivity.

  • They claim the 1980s tax cuts led to moderate real output growth, reduced real tax revenues, inflation, and large budget deficits.

  • They suggest real economic growth resulted from a large budget deficit.

  • Questions raised:

    • Impact on income distribution.

    • Will people save and invest more if capital gains taxes are reduced?

    • How much more work effort will we see if marginal tax rates are lowered?

    • Will new production offset benefits from regulation?

The Supply-Side And Demand-Side Effects of a Tax Cut

  • Tax cuts can lead to greater incentives to work and save—increasing AS—and to demand-side stimulus from increased disposable income—increasing AD.

  • The tax rate affects both aggregate demand and aggregate supply.

  • If the tax cut leads to a large increase in AD but only a small increase in SRAS:

    • The price level rises less than it would without the supply-side effect.

  • If the supply-side effect is much larger:

    • It can completely offset the higher price-level effect of expansionary fiscal policy, increasing RGDP while keeping the price level constant.

  • Most economists agree that taxes alter incentives and distort market outcomes.

  • Tax cuts that lead to the strongest incentives to work, save, and invest will lead to the greatest economic growth and will be the least inflationary.

Possible Obstacles to Effective Fiscal Policy

  • The multiplier effect of an increase in government purchases implies that the increase in aggregate demand will tend to be greater than the initial fiscal stimulus.

  • However, this may not be true because all other things will not tend to stay equal in this case.

The Crowding-Out Effect

  • Government borrowing to finance a deficit increases demand for money, driving interest rates up.

  • Higher interest rates discourage consumers from buying interest-sensitive goods, and businesses may cancel expansion plans.

  • Higher interest rates choke off private spending, reducing the impact of increased government purchases.

  • Additional 10 billion in government spending shifts the AD curve right by 10 billion times the multiplier.

  • However, rising interest rates crowd out investment spending, shifting the AD curve left.

Critics Argument on the Crowding-Out Effect

  • Increase in government purchases, may improve consumer and business expectations and encourage private investment spending.

  • Monetary authorities can increase the money supply to offset the higher interest rate.

  • Increased government spending leads to higher demand for money, driving up interest rates.

  • Higher interest rates attract funds from abroad, increasing demand for dollars and causing the dollar to appreciate.

  • Foreign imports become cheaper in the United States, and U.S. exports become more expensive in other countries.

  • Net exports (X – M) fall.

  • Fiscal policy will have a smaller effect on aggregate demand.

Time Lags In Fiscal Policy Implementation

  • Fiscal policy is implemented through the political process, which takes time.

  • The lag between the desired fiscal response and the policy implementation is considerable.

  • A fiscal policy designed for a contracting economy may take effect during an expansion, destabilizing the economy.

  • Government tax or spending changes require congressional and presidential approval.

    • Recognition Lag: delay to gather enough data to indicate the actual presence of a downturn

    • Implementation Lag: consultation phase, House and Senate deliberations

    • Impact Lag: time to bring about the actual fiscal stimulus desired, environmental impact statement.

Automatic Stabilizers

  • Changes in government transfer payments and taxes that occur automatically as business cycle conditions change.

  • Automatic Stabilizers counter business cycle fluctuations.

  • The most important automatic stabilizer is the tax system.

  • Personal income taxes vary directly with income.

How Does The Tax System Stabilize the Economy?

  • Increases and decreases in GDP are lessened by changes in income tax receipts.

  • During a recession, incomes fall, and the government collects less in taxes.

  • Reduced tax burden partially offsets the magnitude of the recession.

  • Unemployment compensation programs provide automatic stabilization.

  • During recessions, unemployment is high, and compensation payments increase.

  • During boom periods, such payments fall as the number of unemployed decreases.

  • Public assistance payments grow during recessions and decline during booms.

The National Debt

  • Budget Deficit: Government spending exceeds tax revenues.

  • Budget Surplus: Tax revenues are greater than government spending.

  • Balanced Budget: Occurs through deliberate efforts that are a matter of public policy.

How Government Finances The Debt

  • The government can print more money, but it is highly inflationary.

  • Budget deficits are typically financed by issuing debt.

  • The federal government borrows by issuing bonds (IOUs).

  • The total value of all bonds outstanding constitutes the federal debt.

Why Run a Budget Deficit?

  • Budget deficits provide the federal government with the flexibility to respond to changing economic circumstances.

  • The government may also use a budget deficit to avert an economic downturn.

  • Historically, the largest budget deficits occur during war years and recessions.

  • Huge peacetime budget deficits and a growing national debt continued through the early 1990s.

  • After economic growth, a budget surplus was recorded under Clinton’s presidency.

  • In 2001, the budget surplus slipped into a deficit.

Budget Deficit Reduction

  • When the government borrows to finance a budget deficit, interest rates rise, crowding out private investment.

  • Short Run: Deficit reduction results in tax increases and/or a reduction in government purchases, shifting the AD curve to the left, causing a lower price level and lower RGDP.

  • Unless offset by expansionary monetary policy, aggressive deficit reduction can lead to a recession.

Reducing a Budget Deficit—The Long-Run Effects

  • Lowering the budget deficit leads to a lower real interest rate, increasing private investment and stimulating higher growth in capital formation and economic growth.

  • Deficit reduction increased output, shifting the SRAS and LRAS curves rightward during the 1990s.

  • Higher RGDP and a lower price level result.

  • Both investment and RGDP grew as the budget deficit shrank.

  • The short-run recessionary effects of budget deficit reduction can be avoided through appropriate monetary policy.

The Burden of Public Debt

  • The generation of taxpayers living at the time the debt is issued shoulders the true cost.

  • The debt permits the government to take command of resources that might be available for other, private uses.

  • Issuance of debt involves an intergenerational transfer of incomes.

  • A new generation of taxpayers makes interest payments to bondholders of the generation that bought the bonds issued to finance that debt.

  • The burden of debt should be less than the benefits derived from the resources acquired, especially if the debt permits an expansion in real economic activity or vital infrastructure development.

  • The opportunity cost of expanded public activity may be small if unemployed resources are put to work.

  • Parents can offset some of the intergenerational debt by leaving larger bequests.

  • The important issue is whether the government’s activities have benefits that are greater than their costs; whether it is done through raising taxes, printing money, or running deficits is, for the most part, a “financing issue.”