Transcript Ch16

A Lecture Presentation
in PowerPoint
to accompany
Exploring Economics
by Robert L. Sexton
and Peter Fortura
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.
Chapter 16
Fiscal Policy
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.
16.1 Fiscal Policy

The government can use fiscal policy to
stimulate the economy out of a
recession or to try to bring inflation
under control.

Fiscal policy alters real GDP and
price levels through
 government purchases,
 taxes, and
 transfer payments.
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16.1 Fiscal Policy


When government spending (for
purchases of goods and services and
transfer payments) exceeds tax
revenues, there is a budget deficit.
When tax revenues are greater than
government spending, a budget
surplus exists.
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16.1 Fiscal Policy

A balanced budget, where government
expenditures equal tax revenues, may
seldom occur unless efforts are made to
deliberately balance the budget as a
matter of public policy.
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16.1 Fiscal Policy


In Canada, the federal government has
followed a typical practice of running at
least a modest deficit, with large deficits
in recession years.
In many of those years, particularly
since the 1980s, the deficit was fairly
substantial
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16.1 Fiscal Policy
Federal government policy, until very
recently, seems to have gotten away
from the notion accepted by many
economic policy makers in earlier years
that the budget ought to be roughly
balanced over the business cycle,
running surpluses in good times and
offsetting deficits in bad times.
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16.1 Fiscal Policy

When government wishes to stimulate
the economy by increasing AD, it will





increase government purchases of
goods and services,
increase transfer payments,
lower taxes, or
use some combination of these
approaches.
Any of those options will increase the
budget deficit (reduce budget surplus).
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16.1 Fiscal Policy

If the government wishes to dampen an
economic boom by reducing AD, it will





reduce its purchases of goods and
services,
increase taxes,
reduce transfer payments, or
use some combination of these
approaches.
Thus, contractionary fiscal policy, will
tend to create/expand a budget surplus,
or reduce a budget deficit, if one exists.
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16.2 Government: Spending and
Taxation



By 2003, 39 percent of federal
government spending was for social
concerns.
Transfer payments for post-secondary
education and health care amounted to
15 percent.
Another large part (13 percent) of the
federal budget goes toward its
outstanding debt account.
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16.2 Government: Spending and
Taxation

Provincial and local spending is very different
than federal spending.



Education and health care account for over 50
percent of their expenditures.
Like the federal government, municipal and
provincial governments make interest payments
on their outstanding debts. This accounts for
about 9 percent.
Other important areas of spending (27
percent) include housing, transportation and
communication, police, and fire protection.
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Government Expenditures
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16.2 Government: Spending and
Taxation
How do governments obtain
revenue?
 Two major avenues are open:

taxation;
 borrowing.

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16.2 Government: Spending and
Taxation



A large majority of government activity
is financed by taxation.
At the federal level, most taxes are on
personal income and corporate income.
Most remaining revenue comes from
consumption taxes and social insurance
contributions which are used to help pay
for Social insurance and assistance.
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16.2 Government: Spending and
Taxation

Progressive taxes, such as the
federal income tax, require those with
higher incomes to pay a greater
proportion of their income in taxes.

Regressive taxes, such as property
taxes, are assessed at a set rate
regardless of the individuals ability to
pay.
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16.2 Government: Spending and
Taxation

Excise taxes are placed on individual
products such as tires, cigarettes and
gasoline.


Consumption taxes such as the
GST are placed on purchases.
Adding together all taxes, the federal
tax system is probably only slightly
progressive.
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16.2 Government: Spending and
Taxation

Provincial and municipal revenue
sources include:





property taxes;
consumption taxes
sales and provincial income taxes;
transfer payments;
license fees and user charges (e.g.,
utilities and tuition).
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Global Comparison of Taxation
60
Canada
50
France
Germany
Japan
Sweden
United Kingdom
United States
40
30
20
10
0
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Tax Revenues
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16.3 The Multiplier Effect

Real GDP will change any time the
amount of any one of the four forms of
purchases—consumption, investment,
government purchases, or net exports
—changes.

If, for any reason, people generally decide
to purchase more in any of these
categories out of given income, AD will
shift rightward.
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16.3 The Multiplier Effect


Any one of the components of
purchases of goods and services (C, I,
G, or X – M) can initiate changes in
aggregate demand, and thus a new
short-run equilibrium.
Changes in total output are very often
brought about by alterations in
investment plans because investment
purchases are a relatively volatile
category of expenditures.
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16.3 The Multiplier Effect

However, if policy makers are unhappy
about the present short-run equilibrium
GDP, perhaps because they view
unemployment as being too high, they
can deliberately manipulate the level of
government purchases in order to
obtain a new short-run equilibrium
value.
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16.3 The Multiplier Effect

Similarly, by changing taxes or transfer
payments, they can alter the amount of
disposable income of households and
thus bring about changes in
consumption purchases.
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16.3 The Multiplier Effect

Multiplier effect

Usually, when an initial increase in
purchases of goods or services
occurs, the ultimate increase in total
purchases will tend to be greater than
the initial increase.
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16.3 The Multiplier Effect

The multiplier effect illustrated:




Government spends $100 million to buy
helicopters.
The government purchase provides $100
million in added income to the companies
that construct the helicopters.
Companies will hire more workers and buy
more capital equipment and inputs to
produce the new output.
Input owners therefore receive more
income.
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16.3 The Multiplier Effect

What will input owners do with this
additional income?

While behaviour will vary somewhat,
collectively a substantial part of the
additional income will be
spent on additional consumption
purchases,
 paid in additional taxes incurred because of
the income, and
 saved.

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16.3 The Multiplier Effect

The additional consumption purchases
made as a portion of the additional
income is measured by the marginal
propensity to consume (MPC).
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16.3 The Multiplier Effect


The multiplier effect is worked out for an
assumed MPC of two-thirds.
The initial $100 million increase in
government purchases causes both a
$100 million increase in aggregate
demand and an income increase of
$100 million to suppliers of the inputs
used to produce the helicopters.
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16.3 The Multiplier Effect

The owners of those inputs, in turn, will
spend an additional $66.7 million
(two-thirds of $100 million) on additional
consumption purchases. A chain
reaction has been started.
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16.3 The Multiplier Effect

The added $66.7 million in consumption
purchases by those deriving income
from the initial investment brings a
$66.7 million increase in aggregate
demand and in new income to suppliers
of the inputs that produced the goods
and services.
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16.3 The Multiplier Effect


These persons, in turn, will spend some
two-thirds of their additional $66.7
million in income, or $44.4 million on
consumption purchases.
This means a $44.4 million more in
aggregate demand and income to still
another group of persons, who will then
proceed to spend two-thirds of that
amount, or $29.6 million on
consumption purchases.
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16.3 The Multiplier Effect


The chain reaction continues, with each
new round of purchases providing
income to a new group of persons who,
in turn, increase their purchases.
At each round, the added income
generated and the resulting consumer
purchases gets smaller because some
of each round’s increase in income
goes to savings and tax payments.
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16.3 The Multiplier Effect


What is the total impact of the initial
increase in purchases, after all the
rounds of additional purchases and
income have occurred?
The multiplier is equal to 1 divided by 1
minus the marginal propensity to
consume
1
1 MPC
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The Multiplier Process
Change in
government purchases
$100. million—direct effect on AD
First change in consumption 66.7 million (2/3 of 100)
Second change
44.4 million (2/3 of 66.7)
Third change
29.6 million (2/3 of 44.4)
Fourth change
19.8 million (2/3 of 29.8)
Fifth change
13.2 million (2/3 of 19.8)
$300 million =
Total effect on purchases (AD)
The sum of the indirect effect on AD,
through induced additional consumption
purchases, is equal to $200 million.
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16.3 The Multiplier Effect

Note that the larger MPC, the larger the
multiplier effect because relatively more
additional consumption purchases out
of any given income increase generates
relatively larger secondary and tertiary
income effects in successive rounds of
the process.
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16.3 The Multiplier Effect


Because an initial increase in one of the
AD components results in greater
income, including higher profits for
suppliers, it will lead to increased
consumer purchases.
So the effect of the initial increase will
tend to have a multiplied effect on the
economy.
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16.3 The Multiplier Effect



The initial impact of a $100 million
additional purchase by the government
directly shifts AD right by $100 million.
The multiplier effect then causes AD to
shift $200 million further to the right.
The total effect on AD of a $100 million
increase in government purchases is
therefore $300 million, if the marginal
propensity to consume equals 2/3.
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The Multiplier and Aggregate Demand
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16.3 The Multiplier Effect

Multiplier process is not instantaneous.


Time lags mean that the ultimate increase
in purchases resulting from an initial
increase in purchases may not be
achieved for a year or more.
The extent of the multiplier effect visible
within a short time period will be less than
the total effect indicated by the multiplier
formula.
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16.3 The Multiplier Effect

In addition, savings, taxes, and money
spent on import goods (which are not
part of aggregate demand for
domestically produced goods and
services) will reduce the size of the
multiplier because each of them
reduces the fraction of a given increase
in income that will go to additional
purchases of domestically produced
consumption goods.
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16.4 Fiscal Policy and the
AD/AS Model

The primary tools of fiscal policy can be
presented in the context of the
aggregate supply and demand model.




government purchases
taxes
transfer payments
Government can use fiscal policy as
either an expansionary or contractionary
tool to help control the economy, in
terms of the AD/AS model.
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Expansionary Fiscal Policy
LRAS
LRAS
SRAS1
PL1
E0
E1
PL0
AD1
Price Level
Price Level
SRAS0
PL2
E2
E1
PL1
PL0
E0
AD1
AD0
RGDP0 RGDPNR
RGDP
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AD0
RGDPNR RGDP1
RGDP
16.4 Fiscal Policy and the
AD/AS Model

When the government



purchases more,
taxes less and
increases transfer payments,
the size of the government’s budget
deficit will grow or the surplus will fall.
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16.4 Fiscal Policy and the
AD/AS Model


While budget deficits are often thought
to be bad, a case can be made for using
budget deficits to stimulate the economy
when it is operating at less than full
capacity.
Such expansionary fiscal policy has the
potential to move an economy out of a
recession and closer to full employment.
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16.4 Fiscal Policy and the
AD/AS Model

If the government decides to




purchase more,
cut taxes, and/or
increase transfer payments,
other things constant, total purchases
will rise, shifting AD curve to the right.
The effect of this increase in aggregate
demand depends on the position of the
macroeconomic equilibrium prior to the
government stimulus.
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16.4 Fiscal Policy and the
AD/AS Model


Starting from an initial recession
equilibrium, with real output below
potential RGDP, an increase in
government purchases, a tax cut,
and/or increase in transfer payments
would increase the size of the budget
deficit and lead to an increase in
aggregate demand, ideally to a new
short-run equilibrium at potential RGDP.
This result of such a change would be
an increase in the price level and an
increase in RGDP.
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16.4 Fiscal Policy and the
AD/AS Model

Remember, of course, that much of this
increase in aggregate demand is
caused by the multiplier process, so that
the magnitude of the change in
aggregate demand will be much larger
than the magnitude of the stimulus
package of tax cuts, increases in
transfer payments, and/or government
purchases.
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16.4 Fiscal Policy and the
AD/AS Model

If the policy change is of the right
magnitude and timed appropriately, the
expansionary fiscal policy could
stimulate the economy, pulling it out of
recession, resulting in full employment.
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16.4 Fiscal Policy and the AD/AS
Model

Suppose that the economy is currently
operating at full employment.



An increase in government spending, an
increase in transfer payments, and/or a tax
cut causes an increase in AD.
Moving up along the SRAS curve, the price
level rises and real output rises as we
reach a new short-run equilibrium.
This is not a long-run (sustainable)
equilibrium. High level of AD at beyond full
capacity puts pressure on input markets,
increasing wages and input prices.
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16.4 Fiscal Policy and the
AD/AS Model


The higher costs that result from these
input price increases will shift the shortrun aggregate supply curve leftward,
until a sustainable long-run equilibrium
is reached.
Real output returns to the full
employment level, and the long-term
effect is an increase in the price level.
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16.4 Fiscal Policy and the
AD/AS Model



When the government purchases less,
taxes more, and/or decreases transfer
payments, the size of the government’s
budget deficit will fall or the size of the
budget surplus will rise, other things
equal.
Such a change in fiscal policy may help
“cool off” the economy when it has
overheated and inflation has become a
serious problem.
Then, contractionary fiscal policy has
the potential to offset an overheated,
inflationary boom.
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Contractionary Fiscal Policy
LRAS
LRAS
SRAS
SRAS0
E0
PL0
PL1
E1
AD0
Price Level
Price Level
SRAS1
E0
PL0
PL1
PL2
E1
E2
AD0
AD1
RGDPNR RGDP0
RGDP
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AD1
RGDP1 RGDPNR
RGDP
16.4 Fiscal Policy and the
AD/AS Model


Suppose the initial short-run equilibrium
is at a point beyond full-employment
output.
If the government decides to reduce its
purchases, increase taxes, and/or
reduce transfer payments these
changes will directly affect aggregate
demand.
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16.4 Fiscal Policy and the
AD/AS Model

A tax increase on consumers or a
decrease in transfer payments will



reduce households’ disposable
incomes,
reducing purchases of consumption
goods and services, and
higher business taxes will reduce
investment purchases.
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16.4 Fiscal Policy and the
AD/AS Model


The reductions in consumption,
investment, and/or government
purchases will shift the aggregate
demand curve leftward, ideally to a
long-run, full-employment level of
RGDP.
The result is a lower price level and fullemployment output; a new short- and
long-run equilibrium.
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16.4 Fiscal Policy and the AD/AS
Model

Now consider the case of an initial
short- and long-run equilibrium at full
employment, where AD intersects both
the SRAS curve and the LRAS curve.

A decrease in aggregate demand from that
results from a reduction in government
purchases, higher taxes, or lower transfer
payments leads to a short-run equilibrium
with lower prices and real output reduced
below its full-employment level.
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16.4 Fiscal Policy and the
AD/AS Model

As prices fall, input suppliers revise their
price level expectations downward.


That is, labourers and other input suppliers
are now willing to take less for the use of
their resources, and the resulting reduction
in production costs shift the short-run
supply curve right.
The resulting eventual long-run
equilibrium is a reduction in the price
level, with real output returning to its
full-employment level.
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16.5 Automatic Stabilizers

Some changes in government transfer
payments and taxes take place
automatically as business cycle
conditions change, without deliberations
in Parliament.
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16.5 Automatic Stabilizers

Automatic stabilizers
changes in government transfer
payments or tax collections that
automatically tend to counter
business cycle fluctuations
 The most important automatic
stabilizer is the tax system.

 With
the personal income tax, as
incomes rise, tax liabilities also increase
automatically.
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16.5 Automatic Stabilizers


Personal income taxes vary directly with
income, and in fact rise or fall by greater
percentage terms than income itself
rises or falls.
Big increases and big decreases in
GDP are both lessened by automatic
changes in income tax receipts.
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16.5 Automatic Stabilizers

If GDP declines, tax liabilities decline,
increasing disposable incomes and
stimulating consumption spending,
partly offsetting the initial decline in
aggregate demand.
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16.5 Automatic Stabilizers

Other income-related payroll taxes act
as automatic stabilizers, notably



Social Insurance taxes,
the corporate profit tax, and
the employment insurance benefit.
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16.5 Automatic Stabilizers



Because incomes, earnings, and profits
all fall during a recession, the
government collects less in taxes.
This reduced tax burden partially offsets
any recessionary fall in aggregate
demand.
During recessions, unemployment rises
and more people become eligible for
social assistance (welfare).
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16.5 Automatic Stabilizers



Unemployment compensation and
social assistance payments increase.
During boom periods, such payments
will fall as the number of the
unemployed declines.
Both these tax and spending programs
act as automatic stabilizers, stimulating
aggregate demand during recessions
and reducing aggregate demand during
booms.
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16.6 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, other things equal.
However, this may not be true because
all other things will not tend to stay
equal in this case.
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16.6 Possible Obstacles to Effective
Fiscal Policy


When the government borrows money to
finance a deficit, it drives up the interest
rate—when the federal government competes
with private borrowers for available savings it
drives up the interest rate and crowds out
private investment.
That is, as a result of the higher interest rate,
consumers may decide against buying some
interest-sensitive goods, and businesses may
cancel or scale back plans to expand or buy
new capital equipment.
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16.6 Possible Obstacles to Effective
Fiscal Policy

In short, the higher interest rate will
choke off private investment spending,
and as a result, the impact of the
increase in government purchases may
be smaller than we first assumed.

Economists call this the crowding-
out effect.
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16.6 Possible Obstacles to Effective
Fiscal Policy


An additional $100 million of
government spending on helicopters,
other things equal, would shift the
aggregate demand curve right by $100
million times the multiplier.
However, as this process takes place,
interest rates are bid up, crowding out
some investment and other interest
rate-sensitive purchases at the same
time.
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The Crowding-Out Effect
Net Effect
Price Level
LRAS
Crowding-out
Effect
Fiscal Policy
Effect
AD0
AD2 AD1
RGDPNR
RGDP
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16.6 Possible Obstacles to Effective
Fiscal Policy

Critics of the crowding-out effect
analysis argue that the increase in
government spending, particularly if the
economy is in a severe recession, could
actually improve consumer and
business expectations and actually
encourage private investment spending.
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16.6 Possible Obstacles to Effective
Fiscal Policy



It is also possible that the monetary
authorities could increase the money
supply to offset the higher interest rates
from the crowding-out effect.
Another form of crowding out can take
place in international markets.
Expansionary fiscal policy increases the
federal budget deficit.
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16.6 Possible Obstacles to Effective
Fiscal Policy


To finance a budget deficit, the
Canadian government borrows more
money, driving up the interest rate (the
basic crowding-out effect).
However, the higher interest rates will
attract funds from abroad, funds
foreigners will first have to convert from
their currencies into dollars.
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16.6 Possible Obstacles to Effective
Fiscal Policy


The increase in the demand for dollars
relative to other currencies will cause
the dollar to appreciate in value.
This will cause net exports to fall, by
making foreign imports relatively
cheaper Canada, increasing imports,
and by making Canadian made goods
more expensive to foreigners,
decreasing exports.
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16.6 Possible Obstacles to Effective
Fiscal Policy


This reduction in net exports causes a
fall in AD, partly crowding out the effects
of expansionary fiscal policy.
The larger the crowding-out effect, the
smaller the actual effect of a given
change in fiscal policy.
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16.6 Possible Obstacles to Effective
Fiscal Policy


It is important to recognize that fiscal
policy is implemented through the
political process, and that process takes
time.
Often, the lag between the time that a
fiscal response is desired and the time
an appropriate policy is implemented
and its effects felt is considerable.
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16.6 Possible Obstacles to Effective
Fiscal Policy

Sometimes a fiscal policy designed to
deal with a contracting economy may
actually take effect during a period of
economic expansion, or vice versa,
resulting in a stabilization policy that
actually destabilizes the economy.
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.
16.6 Possible Obstacles to Effective
Fiscal Policy


Suppose the economy is beginning a
downturn.
(Sometimes a future downturn can be
forecast through econometric models or
by looking at the index of leading
indicators, but usually decision makers
are hesitant to plan policy on the basis
of forecasts that are not always
accurate).
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.
16.6 Possible Obstacles to Effective
Fiscal Policy

It may take three to six months before
enough data are gathered to indicate
the actual presence of a downturn

This is called the recognition lag.
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.
16.6 Possible Obstacles to Effective
Fiscal Policy

Once policy makers decide that some
policy change is necessary, there is a
consultation phase, during which many
decisions with profound political
consequences must be made, so
reaching a decision is not always easy
and usually involves much compromise
and a great deal of time.
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.
16.6 Possible Obstacles to Effective
Fiscal Policy

Finally, once a budget is formulated by
the Ministry of Finance it is presented to
Parliament for approval. This whole
process could take quite a bit of time
and consequently becomes known as
an implementation lag.
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.
16.6 Possible Obstacles to Effective
Fiscal Policy



Even after fiscal policy legislation is
enacted, it takes time to bring about the
actual fiscal stimulus desired.
If the legislation provides for a reduction
in taxes, for example, it might take a few
months before the changes actually
show up in workers’ paycheques.
If it provides for changes in government
purchases, the delay is usually much
longer.
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.
16.6 Possible Obstacles to Effective
Fiscal Policy

If the government increases spending
for public works projects like sewers,
new highways, or transit systems, it
takes time to draw up plans and get
permissions, to advertise for bids from
contractors, to get contracts, and then
to begin work.
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.
16.6 Possible Obstacles to Effective
Fiscal Policy



Such delays have actually lengthened in
recent years due to new government
regulations, such as environmental impact
assessment, which often takes many months
or even years. This is called the impact
lag.
The timing of fiscal policy is crucial.
Because of the significant lags before the
fiscal policy has its effect, the increase in
aggregate demand may occur at the wrong
time.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.6 Possible Obstacles to Effective
Fiscal Policy

In response to current low levels of
output and high rates of unemployment,
policy makers may decide to increase
government purchases and implement a
tax cut.
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.
16.6 Possible Obstacles to Effective
Fiscal Policy

But during the period from when policy
makers recognized the problem to when
the policies had a chance to work
themselves through the economy, say
there was a large increase in business
and consumer confidence, shifting the
aggregate demand curve rightward,
increasing real GDP and employment.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.6 Possible Obstacles to Effective
Fiscal Policy


When the fiscal policy takes effect, the
policies will have the undesired effect of
causing inflation, with little permanent
effect on output and employment.
The same timing problems exist for
fiscal policy designed to combat high
inflation rates.
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.
16.6 Possible Obstacles to Effective
Fiscal Policy


Timed correctly, contractionary fiscal
policy could correct an inflationary boom
Timed incorrectly, it could cause a
recession.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
Timing Expansionary Fiscal Policy
Price
LRAS
SRAS1
Level
SRAS0
E3
PL2
PL1
PL0
E2
E1
E0
AD2
AD1
AD0
RGDP0
RGDP2
RGDPNR
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
RGDP
16.7 Supply-Side Fiscal Policy


When policy makers discuss methods to
stabilize the economy, the traditional
focus has been on managing the
economy through demand-side policies.
But there are economists who believe
that we should be focusing on the
supply side of the economy as well,
especially in the long run, rather than
just on the demand side.
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.
16.7 Supply-Side Fiscal Policy

In particular, they believe that when
taxes, government transfer payments
and regulations are too burdensome on
productive activities




individuals will save less,
work less, and
provide less capital.
In other words, fiscal policy on the
supply side of the economy has
important effects on as well as the
demand side.
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.
16.7 Supply-Side Fiscal Policy


Supply-siders would encourage
government to reduce individual and
business taxes, deregulate, and
increase spending on research and
development.
Supply-siders believe that these types
of government policies could cause
greater long-term economic growth by
stimulating personal income, savings,
and capital formation.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.7 Supply-Side Fiscal Policy


Supply-siders believe that savings and
investment could be improved through
lowering taxes.
Taxes on interest earnings reduce the
after tax return to saving, which
discourages people from saving, and
the greater investment and capital
formation that would result.
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.
16.7 Supply-Side Economics



Investment is important because
workers without capital cannot be very
productive.
Worker productivity (output per worker)
depends to a large extent on the capital
that is available to the worker.
So taxing savings and investment
heavily will reduce new capital
investment, which will reduce the
growth of worker productivity.
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.
16.7 Supply-Side Economics


High tax rates could conceivably reduce
work incentives to the point that
government revenues are lower at high
marginal tax rates than they would be at
somewhat lower rates.
Economist Arthur Laffer has argued that
point graphically in what has been
called the Laffer curve.
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.
Tax Revenues
The Laffer Curve
C
D
B
E
100%
A
0%
Tax Rate
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.
16.7 Supply-Side Economics



When tax rates are low, increasing the
federal tax rate will increase federal
revenues.
However, at very high federal tax rates,
disincentive effects and increased tax
evasion may actually reduce federal tax
revenue.
Over this range of tax rates, lowering
them may actually increase federal tax
revenue.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.7 Supply-Side Economics

A very high marginal tax rate on the rich
actually might





reduce the incentive to work,
save,
invest and
produce, and
perhaps as important, shift transactions
to the underground economy.

If tax evasion becomes common, the equity
and revenue-raising efficiency of the tax system
suffers, as does general respect for the law.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.7 Supply-Side Economics

While all economists believe that
incentives matter, there is considerable
disagreement on the shape of the Laffer
curve, and where the economy actually
is on the Laffer curve.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.7 Supply-Side Economics


Some economists believe that
investment in R&D will have long-run
benefits for the economy.
In particular, greater R&D will lead to
new technology and knowledge, which
will permanently shift the short- and
long-run aggregate supply curves to the
right.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.7 Supply-Side Economics

The government encourages
investments in research and
development by giving tax breaks or
subsidies to firms.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.7 Supply-Side Economics

Rather than being primarily concerned
with short-run economic stabilization,
supply-side policies are aimed at
increasing both the short-run and longrun aggregate supply curves.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.7 Supply-Side Economics

If these policies are successful and
maintained, both short- and long-run
aggregate supply will increase over
time, as the effects of deregulation and
major structural changes in plant and
equipment work their way through the
economy, which takes some time.
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.
The Impact of Supply-Side Policies on
Short-Run and Long-Run Aggregate Supply
LRAS0 LRAS1
SRAS0
SRAS1
E1
E0
PL0
AD1
AD0
0
RGDPNR
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
RGDP´NR
RGDP
16.7 Supply-Side Economics

Critics of the effects of supply-side
economics

skeptical of the magnitude of the impact
of lower taxes on work effort and of
deregulation on productivity.


new production that occurs from deregulation
enough to offset the benefits of regulation?
question amount of increased saving
and investment from reduced capital
gains taxes
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.7 Supply-Side Economics


Supply-side initiatives affect aggregate
demand as well as aggregate supply.
If tax rates are reduced, it is quite
possible that the demand-side stimulus
from the increased disposable income
that results may be equal to, or even
greater than the supply-side effects,
causing higher price levels, and even
greater short-run real output levels,
although the long-run real output level
increases with the long-run aggregate
supply curve.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.7 Supply-Side Economics

Defenders of the supply-side approach
argue that the real tax revenues of
those in the highest marginal tax
brackets actually increase as their tax
falls.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
Price
Price
Two Possible Supply-Side
Effects of a Tax Cut
SRAS0
SRAS0
SRAS1
PL2
PL1
PL0
SRAS1
PL0
AD1
AD0
AD0
0
RGDP0
RGDP1
Real GDP
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
0
RGDP0
RGDP1
Real GDP
AD1
16.8 The Federal Government Debt

Historically the largest budget deficits
and a growing government debt occur



during war years, when defense spending
escalates, and
during recessions as taxes are cut and
government spending is increased.
In the 1980s, deficits and debt soared in
a relatively peaceful and prosperous
time.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.8 The Federal Government Debt


When the government borrows to
finance a budget deficit, it causes the
interest to rise, which crowds out private
investment, reducing capital formation.
But a budget surplus adds to national
savings and lowers the interest rate,
stimulating private investment and
capital formation.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.8The Federal Government Debt




For many years, the government ran
continuous budget deficits and built up a
large federal debt.
How did it pay for those budget deficits?
After all, it has to have some means of
paying out the funds necessary to
support government expenditures that
are in excess of the funds derived from
tax payments.
One thing the government could do is
simply print money.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.8 The Federal Government Debt



Printing money to finance activities is
highly inflationary and also undermines
confidence in the government.
Typically, the budget deficit is financed
by issuing debt.
The federal government in effect
borrows an amount necessary to cover
the deficit by issuing bonds, or IOUs,
payable typically at some maturity date.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.8 The Federal Government Debt

The sum total of the values of all bonds
outstanding constitutes the federal debt.
The tendency of the federal government
to engage in budget deficits has led to
increasing federal debt over time.
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.
Federal Budget Balance, 1989-2003
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.
16.8 The Federal Government Debt


Until 1998 the federal budget was in
deficit every year. In 1998 the
government ran its first budget surplus
in almost 25 years.
Budget surpluses can be important
because they provide the federal
government with the flexibility to
respond appropriately to changing
circumstances, such as special
emergencies or to avert an economic
downturn.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.8 The Federal Government Debt

The “burden” of the national debt is a
topic that has long interested
economists, particularly whether it falls
on present or future generations.
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.
16.8 The Federal Government Debt

Arguments can be made that the
generation of taxpayers living at the
time that the debt is issued shoulders
the true cost of the debt because the
debt permits the government to take
command of resources that might be
available for other, private uses.
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.
16.8 The Federal Government Debt


In a sense, the resources its takes to
purchase government bonds might take
away from private activities, such as
private investment financed by private
debt.
The issuance of debt does involve some
intergenerational transfer of incomes;
after federal debt is issued, a new
generation of taxpayers is making
interest payments to persons of the
generation that bought the bonds issued
to finance that debt.
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.
16.8 The Federal Government Debt


If public debt is created intelligently,
however, the “burden” of the debt
should be less than the benefits derived
from the resources acquired as a result
This is particularly true when the debt
permits an expansion in real economic
activity or for the development of vital
infrastructure for the future.
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.
16.8The Federal Government Debt


The opportunity cost of expanded public
activity may also be small in terms of
private activity that must be forgone to
finance the public activity, if unemployed
resources are put to work.
Parents can offset some of the
intergenerational debt by leaving larger
bequests.
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.
Debt, Federal Government,
Selected Years
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.
16.8 Federal Government Debt

If they save now to bear the cost of the
burden of future taxes, the reduced
consumption and increased savings will
lower interest rates, or, more precisely,
offset some or all of the higher interest
rates caused by the government deficit.
Copyright © 2007, Nelson, a division of Thomson Canada Ltd.
.
16.8 The Federal Government Debt

If a budget deficit led people to believe
there would be higher future taxes, a
budget surplus might lead people to
think that there would be lower future
taxes, perhaps saving less and
consuming more.
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.
Reducing a Budget Deficit—
The Short-Run Effects
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.
Reducing a Budget Deficit—
The Long-Run Effect
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.