Transcript Chap012

Fiscal
Policy
Chapter 12
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Fiscal Policy
• Fiscal policy is the use of government
taxes and spending to alter
macroeconomic outcomes.
• The premise of fiscal policy is that the
aggregate demand for goods and
services will not always be compatible
with economic stability.
LO-1
12-2
John Maynard Keynes
and Fiscal Policy
• John Maynard Keynes explained how a
deficiency in demand could arise in a
market economy.
• He showed how and why the
government should intervene to
achieve macroeconomic goals.
• He also advocated aggressive use of
fiscal policy to alter market outcomes.
LO-1
12-3
Components of
Aggregate Demand
• Aggregate demand is the total
quantity of output demanded at
alternative price levels in a given time
period, ceteris paribus.
LO-1
12-4
Components of
Aggregate Demand
• The four major components of
aggregate demand are:
– Consumption (C)
– Investment (I)
– Government spending (G)
– Net exports (exports minus imports) (XIM)
AD = C + I + G + (X - IM)
LO-1
12-5
Figure 12.1
12-6
Consumption (C)
• Consumption refers to expenditures
by consumers on final goods and
services.
• Consumption spending accounts for
approximately two-thirds of total
spending in the U.S. economy.
• Consumers often change their
spending behavior.
LO-1
12-7
Investment (I)
• Investment refers to expenditures on
(production of) new plant and
equipment in a given time period, plus
changes in business inventories.
LO-1
12-8
Government
Spending (G)
• Government spending includes
expenditures on all goods and services
provided by the public sector.
• Income transfers are not included:
– Income transfers are payments to
individuals for which no services are
exchanged.
LO-1
12-9
Net Exports (X-IM)
• Net exports is the difference between
export spending and import spending.
• Currently, Americans buy more goods
from abroad than foreigners buy from
us.
• This means that U.S. net exports are
negative.
LO-1
12-10
Aggregate Demand
in 2008-09
• A slowdown in consumer spending
reversed the growth path of AD.
• Businesses decreased inventories and
employment.
• Government increased spending in an
attempt to stimulate the economy.
• The trade deficit decreased as buyers
in the U.S. bought fewer imported
items.
LO-1
12-11
Equilibrium
• Aggregate demand is not a single
number but instead a schedule of
planned purchases.
• Macro equilibrium is the combination
of price level and real output that is
compatible with both aggregate
demand and aggregate supply.
LO-1
12-12
Equilibrium
• There is no guarantee that AD will
always produce an equilibrium at full
employment and price stability.
• Sometimes there will be too little
demand and sometimes there will be
too much.
LO-2
12-13
Figure 12.2
12-14
The Nature of
Fiscal Policy
• C + I + G + (X - IM) seldom adds up to
exactly the right amount of aggregate
demand.
• The use of government spending and
taxes to adjust aggregate demand is
the essence of fiscal policy.
LO-2
12-15
Figure 12.3
12-16
Fiscal Stimulus
• If AD falls short, there is a gap between
what the economy can produce and
what people want to buy.
• The GDP gap is the difference
between full-employment output and
the amount of output demanded at
current price levels.
LO-4
12-17
More Government
Spending
• To help with the 2008-09 recession,
President Obama created huge
increases in government spending.
• Increased government spending is a
form of fiscal stimulus:
– Fiscal stimulus–tax cuts or spending
hikes intended to increase (shift)
aggregate demand.
LO-4
12-18
Multiplier Effects
• An increase in spending results in
increased incomes.
• All income is either spent or saved:
– Saving–Income minus consumption; that
part of disposable income not spent.
LO-3
12-19
Multiplier Effects
• Part of each dollar spent is re-spent
several times.
• As a result, every dollar has a
multiplied impact on aggregate income.
LO-3
12-20
Multiplier Effects
• The marginal propensity to consume
(MPC) is the fraction of each additional
(marginal) dollar of disposable income
spent on consumption:
change in consumption
MPC =
change in disposable income
LO-3
12-21
Multiplier Effects
• The marginal propensity to save
(MPS) is the fraction of each additional
(marginal) dollar of disposable income
not spent on consumption:
change in saving
MPS =
change in disposable income
LO-3
12-22
Multiplier Effects
• Spending and saving decisions are
connected:
MPS = 1 – MPC
or
MPC + MPS = 1
LO-3
12-23
Multiplier Effects and
the Circular Flow
• The fiscal stimulus to aggregate
demand includes:
– The initial increase in government
spending.
– All subsequent increases in consumer
spending triggered by the government
outlays.
• Income gets spent and re-spent in the
circular flow.
LO-3
12-24
Figure 12.6
12-25
Spending Cycles
• The demand stimulus initiated by
increased government spending is a
multiple of the initial expenditure.
LO-3
12-26
Multiplier Formula
• The multiplier is the multiple by which
an initial change in aggregate spending
will alter total expenditure after an
infinite number of spending cycles:
Multiplier = 1 / (1-MPC)
LO-3
12-27
Multiplier Formula
• The multiplier process at work:
Total change
in spending
= Multiplier
x
Initial change
in
government
spending
• Every dollar of fiscal stimulus has a
multiplied impact on aggregate demand.
LO-3
12-28
Tax Cuts
• Rather than increasing its own
spending, government can cut taxes to
increase consumption or investment
spending.
• A tax cut directly increases disposable
income:
– Disposable income is the after-tax
income of consumers.
LO-4
12-29
Taxes and Consumption
• As long as the MPC is greater than
zero, a tax cut will stimulate more
consumer spending:
Initial increase in consumption =
MPC x tax cut
LO-3
12-30
Taxes and Consumption
• The cumulative increase in aggregate
demand equals a multiple of the taxinduced change in consumption.
Cumulative change in spending =
multiplier x initial change in consumption
LO-3
12-31
Taxes and Consumption
• A tax cut that increases disposable
incomes stimulates consumer
spending.
• The cumulative increase in aggregate
demand is a multiple of the initial tax
cut.
LO-3
12-32
Inflation Worries
• Whenever the aggregate supply curve
is upward-sloping, an increase in
aggregate demand increases prices as
well as output.
• President Clinton raised taxes partly
because he feared inflationary
pressures were building.
LO-4
12-33
Fiscal Restraint
• Fiscal restraint may be the proper
policy when inflation threatens:
– Fiscal restraint–tax hikes or spending
cuts intended to reduce (shift) aggregate
demand.
LO-4
12-34
Figure 12.8
12-35
Budget Cuts
• Cutbacks in government spending
directly reduce aggregate demand.
• As with spending increases, the impact
of spending cuts is magnified by the
multiplier.
LO-3
12-36
Multiplier Cycles
• Government cutbacks have a
multiplied effect on aggregate demand:
Cumulative reduction in spending =
multiplier x initial budget cut
LO-3
12-37
Tax Hikes
• Tax increases reduce disposable
income and thus reduce consumption.
• This shifts the aggregate demand
curve to the left.
• Tax increases have been used to “cool
down” the economy.
LO-4
12-38
Tax Hikes
• The Equity and Fiscal Responsibility
Act of 1982 increased taxes to reduce
inflationary pressures.
• President Clinton restrained aggregate
demand in 1993 with a tax increase,
but increased aggregate demand in
1997 with a five-year package of tax
cuts.
LO-4
12-39
Fiscal Guidelines
• The policy goal is to match aggregate
demand with the full-employment
potential of the economy.
• The fiscal strategy for attaining that
goal is to shift the aggregate demand
curve.
LO-4
12-40
Unbalanced Budgets
• The use of the budget to manage
aggregate demand implies that the
budget will often be unbalanced.
LO-5
12-41
Figure 12.9
12-42
Budget Deficit
• Budget deficit–the amount by which
government expenditures exceed
government revenues in a given time
period:
Budget deficit = Government spending >
Tax revenues
LO-5
12-43
Budget Deficit
• The government borrows money to pay
for deficit spending.
• The federal government ran significant
budget deficits between 1970 and
1997.
LO-5
12-44
Budget Surplus
• Budget surplus–an excess of
government revenues over government
expenditures in a given time period:
Budget surplus = Government spending <
Tax revenues
LO-5
12-45
Budget Surplus
• By 1998, a combination of growing tax
revenues and slower government
spending created a budget surplus.
• Starting in 2003, however, the budget
returned to a deficit due to tax cuts,
increased defense spending, and the
Iraq War.
• By 2010, the federal budget deficit
exceeded $1.3 trillion.
LO-5
12-46
Countercyclical Policy
• In Keynes’ view, an unbalanced budget
is perfectly appropriate if macro
conditions call for a deficit or a surplus.
• A balanced budget is appropriate only
if the resulting aggregate demand is
consistent with full-employment
equilibrium.
LO-5
12-47
End of
Chapter 12