Transcript Fiscal Policy

13e
Chapter 11:
Fiscal Policy
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
11-2
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.
11-3
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.
11-4
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.
11-5
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.
11-6
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.
11-7
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.
11-8
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
11-9
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:
Desired fiscal stimulus =
AD shortfall
Multiplier
11-10
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.
11-11
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
in spending
=
Multiplier
Initial change in
X consumption
11-12
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.
11-13
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.
11-14
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.
11-15
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.
11-16
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.
11-17
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:
Desired fiscal restraint =
AD excess
Multiplier
11-18
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
11-19
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.
11-20
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.
11-21
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.
11-22
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.
11-23
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.
11-24
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.
11-25
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.
11-26
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.
11-27