Transcript fiscal policy

An Applications Approach to
Contemporary Economics
By Robert J. Carbaugh
4th Edition
Chapter 13:
Fiscal Policy and the
Federal Budget
Copyright ©2006 by Thomson South-Western. All rights reserved.
Fiscal Policy
 Fiscal policy is the use of government
expenditures and taxes to promote particular
economic goals such as full employment, stable
prices and economic growth.
 Discretionary (tuy nghi) fiscal policy is the
deliberate use of changes in government
expenditures and taxation.
 Automatic stabilizers consist of changes in
government spending and tax revenues that
occur automatically as the economy fluctuates.
Carbaugh, Chap. 13
2
Discretionary Fiscal Policy
 Expansionary fiscal policy: Increase
government spending or cut taxes
 Increases real output, employment and income
 Is used to combat a recession
 Contractionary fiscal policy: Decrease
government spending or increase taxes.
 Decreases real output, employment and income
 Is used to fight inflation
Carbaugh, Chap. 13
3
Fiscal Policy and Aggregate Demand
 1. Combating a recession: When the
economy is in a recession, real output falls
below its potential (full employment) output,
the government can use expansionary
fiscal policy to increase aggregate demand:
 Increase government spending
 Decrease taxes
 Use combination of the two
Carbaugh, Chap. 13
4
Fiscal Policy and Aggregate Demand
 Combating a recession:
 Example: MPC = 0.75
 What happens to aggregate demand and thus
output if government:
 1. Increases its spending by $25 billion
 2. Cuts personal income tax by $25 billion
 3. how much should the G cut in tax to increase total
income by $100bn
 4. how much should the G increase in tax to decrease
total income by $100bn
Carbaugh, Chap. 13
5
Disposable income
 Disposable income = Income –taxes
Taxes increase, then Disposable income
(DI) decreases
Taxes decrease, then Disposable income
(DI) increase
Carbaugh, Chap. 13
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Fiscal Policy
Price level (price index)
Expansionary fiscal policy
AS0
100
A
Increase in
output
Full
employment
output
B
AD0
AD1
0
700
800
900
Real output ($ bill.)
Carbaugh, Chap. 13
7
Fiscal Policy and Aggregate Demand
 2.Combating inflation: When the economy
has high inflation (e.g.. demand-pull
inflation causes the real output higher than
the economy’s potential or full-employment
output), the government can use
contractionary fiscal policy to reduce
aggregate demand:
 Decrease government spending
 Increase taxes
 Use combination of the two
Carbaugh, Chap. 13
8
Fiscal Policy
Price level (price index)
Contractionary fiscal policy
Fall in
price level
AS0
B
120
A
AD1
110
AD0
Decrease in
real output
Full
employment
0
900 1,100
Real output ($ bill.)
Carbaugh, Chap. 13
9
Automatic Stabilizers
 Automatic stabilizers consist of changes in
government spending and tax revenues that
occur automatically as the economy fluctuates.
 The automatic stabilizers prevent aggregate
demand from decreasing as much in a recession
or increasing as much in an expansion, so as to
stabilize the economy.
 Automatic stabilizers: tax system, government
transfer payments.
Carbaugh, Chap. 13
10
Problems of Fiscal Policy
 Timing lags
 Irreversibility
 Crowding-out effect
 Foreign-trade effect
Carbaugh, Chap. 13
11
Timing Lags (do tre ve thoi gian)
 Recognition lag: A lag between the time when a
recession or inflation begins and the time when it
is aware of. It takes time for government to realize
that there is a recession or inflation.
 Administrative lag: A lag between the time when
the need for fiscal action is recognized and the
time when the action is taken.
 Operational lag: A lag between the time when
fiscal action is taken and the time when it has
effect on real output, employment or the price
level
Carbaugh, Chap. 13
12
Irreversibility
 It is difficult to reverse changes in
government spending or taxes
 Many expenditure programs and tax
changes become permanent
 Inflexibilities hinder the operation of fiscal
policy
Carbaugh, Chap. 13
13
Crowding-Out Effect (Tac dong chen
lan)
 When the economy is in a recession, government
enacts expansionary fiscal policy by increasing
government spending.
 To finance government budget deficit, the
government borrows funds in the money market.
 The increase in the demand for money raises the
interest rate.
 Higher interest rate lower investment. Some
investment will be crowded out(hat ra).
 The crowded-out effect may weaken the stimulus
of the expansionary fiscal policy.
Carbaugh, Chap. 13
14
Fiscal Policy
Crowding-out effect
Government spending
exceeds taxes, resulting
in a budget deficit.
The government enters
the loanable funds market
and issues more securities.
Carbaugh, Chap. 13
As the demand for loanable
funds rises, interest
rates increase.
Firms and households
purchase less machinery,
equipment, autos, and homes.
Thus government spending
crowds out private
sector spending.
15
Foreign Trade Effect
 Suppose an expansionary fiscal policy is
implemented to increase output
 The expansionary fiscal policy can cause interest
rate to rise
 Higher interest rate attracts more international
funds
 Domestic currency appreciates that causes a fall
in net export and thus output, so partially offset
the expansionary fiscal policy
Carbaugh, Chap. 13
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Fiscal Policy and Aggregate Supply
 Supply-side effects of changes in taxes:
 Changes in tax rate will affect the incentive of
people to work, save and invest.
 Supply-side policy:
 A decrease in marginal tax rates will cause people to
work, save and invest more. Aggregate supply curve
shifts to the right resulting in a higher output and a
lower price level.
 A decrease in marginal tax rates may also cause
people to spend and thus increase aggregate demand.
Output increases but the price level may increase as
well.
Carbaugh, Chap. 13
17
Fiscal Policy
The goal of supply-side
tax cuts
Fall in
prices
100
AS0
AS1
A
B
Price level (price index)
Price level (price index)
Supply-side fiscal policy
A more dismal view of
supply-side tax cuts
AS0
AS1
B
110
A
100
AD1
90
AD0
AD0
Increase in
real output
0
0
800 900
Real output (billion dollars)
Carbaugh, Chap. 13
Real output (billion dollars)
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Fiscal Policy and Aggregate Supply
 Do cuts in tax rate cause tax revenues rise
or fall?
 Tax revenue = Tax rate x Taxable income
 The Laffer curve shows the relationship
between the income tax rate and the total
tax revenue.
 As the tax rate rises from 0 percent, total
revenue rises, reaches the maximum and
start to fall.
Carbaugh, Chap. 13
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Fiscal Policy
Tax revenue ($ billions)
The Laffer Curve
A
300
B
200
0
48
85
100
Tax rate (%)
Carbaugh, Chap. 13
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Government budget
 The main mechanism of fiscal policy is the federal
budget.
 Change in federal taxes or spendings are the
tools for shifting ADC or ASC.
 The use of federal budget to stabilize the
economy suggests that federal budget will often
be unbalanced.
 Budget deficit
 Budget surplus
 Balanced budget
Carbaugh, Chap. 13
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Government Budget
Government budget =
Tax revenue – Government spending
 If tax revenue = Government spending:
Balanced government budget
 If tax revenue > Government spending:
Government budget surplus
 If tax revenue < Government spending:
Government budget deficit
Carbaugh, Chap. 13
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Fiscal Policy
Deficits and surpluses of U.S. government
Source: From Economic Report of the President,2005
Carbaugh, Chap. 13
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Federal Deficit
Federal debt held by the public
Year
Federal
debt (bill.)
1940
1945
1955
1965
1975
1985
1995
2000
2004
$43.0
236.0
227.0
261.0
3954.0
1,500.0
3,603.0
3,410.0
4,721.0
Federal debt as
a % of GDP
44.0%
106.0
57.0
38.0
25.0
36.0
49.0
35.0
37.0
Source: Economic Report of the President, 2005
Carbaugh, Chap. 13
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Federal deficit and federal debts
 Federal deficit is the difference between federal
spending and revenue in a given year.
 federal debts represent the cumulative amount of
outstanding borrowing from the public over the
nation’s history
 Main measure of federal debts is the debt held by
the public.
 The amount of borrower itself does not make a
good indicator of the debt burden; it should be
viewed in relation to the nation’ income (GDP).
Carbaugh, Chap. 13
25
Sales and ownership of federal debts
 Federal government borrows by issuing
securities, most thru Treasury Department.
 The securities are marketable.
 These include: Treasury bills, notes and bonds
with variety of maturities (1-30 months).\
 Who lend government?




US treasury and other federal ageencies (42%)
Private domestic investors ( 25%)
Foreign investors ( 24%)
Federal reserve banks ( 9%)
Carbaugh, Chap. 13
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federal debts: Good or bad?
 Necessary if
 Borrowing during recessions help the economy
by maintaining income
 Wartime borrowing: improve national defense
 Federal borrowing for investment spending:
building roads, bridges, training workers….
 Bad if not for purposes mentioned because
cost may outweigh benefits: reduction of
funds for investment, interest rates, ….
Carbaugh, Chap. 13
27
Should there be a balanced-budget
amendment?
 Advantages:
 Disadvantages
 This would make recessions more freequent and
severe.
 Balabced budget requirement make recessions more
painful and longer
 By eliminating the automatic stabilizer that protect people in a
downturn
 By instead requiring measures to cut spending or increase
taxes during slowdown when the economy is already suffering
from the lack of demand.
Carbaugh, Chap. 13
28
Fiscal Policy
Price level (price index)
Expansionary fiscal policy and the multiplier
130
125
Direct effect of
an increase in
government
spending
Indirect effect
of increased AS
0
consumption
spending
120
115
110
105
100
B
A
C
95
AD2
90
85
650
AD1
AD0
700
750
800
850
900
950
Real output ($ bill.)
Carbaugh, Chap. 13
29
Expansionary fiscal policy and the
multiplier
 Notice that the particular increase in
Aggregate Demand take place within the
horizontal region of ASC, where the price
level is constant.
 → Thus the real output will increase by the
full amonut of the multiplier. But
unemployment falls because firms will
employ workers who were laid off during
the recession.
Carbaugh, Chap. 13
30
Question 3
 A tax reduction for households tends to increase
consumption spending and also aggregate demand.
Given an upward-sloping aggregate supply curve, the
increase in aggregate demand results in an increase in
output and also an increase in the price level.
 However, a tax reduction may also improve incentives to
work, save, and invest, which would cause the aggregate
supply curve to increase.
 An increase in aggregate supply results in an increase in
output but a decrease in the price level.
 If aggregate demand increases by a greater (smaller)
amount than aggregate supply, the economy’s price level
will increase (decrease).
Carbaugh, Chap. 13
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Question 4
 . Discretionary fiscal policy is the deliberate use of
changes in government expenditures and taxation to
affect aggregate demand and influence the economy’s
performance in the short run.
 The main advantage of using fiscal policy is that it has the
potential to stabilize the economy’s output and price level.
Recessions and inflation can be combated.
 The main disadvantage is that fiscal policy may not work
very well in practice. Among the problems facing fiscal
policy are timing lags, irreversibility, inflationary bias, the
crowding-out effect, and the foreign-trade effect
Carbaugh, Chap. 13
32
Question 5
 Discretionary fiscal policy is based on the multiplier
principle.
 If, for example, the government purchases its Air Force
aircraft from Boeing, its profits and employment increase.
As Boeing workers realize larger paychecks and the firm’s
owners realize higher dividends, they respond by
purchasing products such as automobiles from Ford Motor
Company. Therefore, Ford realizes higher profits and
hires additional workers, and consumer spending again
increases. Each round of added spending increases
aggregate demand. When all of these effects are
combined, the total impact on the quantity of goods and
services demanded will be larger than the initial stimulus
from increased government expenditures, according to the
multiplier effect.
Carbaugh, Chap. 13
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Question 7
 A balanced budget amendment could make
recessions more severe. Suppose the economy
enters a period of increasing unemployment and
declining incomes that results in decreasing tax
revenues.
 To balance its budget, the government must
either increase taxes or decrease spending. Both
of these policies cause aggregate demand to
decrease, which would tend to shove the
economy even deeper into the recession.
Carbaugh, Chap. 13
34
Question 8
 According to Keynesian economists, a tax cut increases
the take-home pay of households, which results in an
increase in consumption spending and an increase in
aggregate demand.
 According to supply-side economists, a tax cut increases
the returns to working, saving, and investment and thus
causes the aggregate supply curve to increase. In addition
to these economic effects, supply-siders also believe that
the government needs to look at tax revenues.
 If the tax rate were zero, for instance, the economy’s
output could be very high, but tax revenues would be zero
and the government would not have funding for the
provision of public goods and services.
Carbaugh, Chap. 13
35
Question 9
 When there is a crowding-out effect, private
spending (consumption spending or investment)
decreases as a result of increased government
expenditures and subsequent budget deficits.
Because of crowding out, expansionary fiscal
policy is less effective in combating recession
than it could be.
 Crowding out would most likely take place when
spending is robust and money is tight.
Carbaugh, Chap. 13
36
Question 10
 . To combat a recession, government would
enact an expansionary fiscal policy by
increasing expenditures or decreasing
taxes.
 To combat inflation, government would
enact a contractionary fiscal policy by
decreasing expenditures or increasing
taxes.
Carbaugh, Chap. 13
37
Question 11
 Given an upward-sloping aggregate supply curve, a tax
cut that increases aggregate supply would cause national
output to increase and the price level to decline.
 However, critics of supply-side economics maintain that
the impact of a tax cut on incentives to work, save, and
invest may not be as large as supply-side advocates
maintain.
 Moreover, supply-side advocates may underestimate the
effects of tax cuts on aggregate demand. Lastly, the tax
cut may result in falling tax revenues, depending on where
the economy is on the Laffer Curve.
Carbaugh, Chap. 13
38