Transcript Document

A Lecture Presentation
to accompany
Exploring Economics
3 Edition
by Robert L. Sexton
rd
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Printed in the United States of America
ISBN 0-324-26086-5
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Chapter 22
Fiscal Policy
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22.1 Fiscal Policy
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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
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government purchases
taxes
transfer payments
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Fiscal Stimulus Affects The
Budget
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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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
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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
When government wishes to stimulate
the economy by increasing AD, it will
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increase government purchases of goods
and services
increase transfer payments
lower taxes
use some combination of these approaches
Any of those options will increase the
budget deficit (reduce budget surplus).
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
Thus, expansionary fiscal policy
is associated with increased
government budget deficits.
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
If the government wishes to dampen an
economic boom by reducing AD, it will
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reduce its purchases of goods and services
increase taxes
reduce transfer payments
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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22.2 Government: Spending
and Taxation
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In the United States, the federal
government has followed a typical
practice of running at least a modest
deficit, with large deficits in recession
years.
From 1970 to 1997, the federal
budget was in deficit every year.
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Growth in Government
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In many of those years, particularly since
the 1970s, the deficit was fairly
substantial, often exceeding 2% of GDP.
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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Fiscal restraint and a growing
economy has led to sharp
improvements in the budget deficit
since 1993.
In 1998, we saw a budget surplus
that has lasted through 2001.
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Generating Government Revenue
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Governments have to pay their bills
like any person or institution that
spends money.
But how do they obtain revenue?
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Taxation
Borrowing
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Types of Taxation
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At the federal level, most taxes or
levies are on income.
Most of the remaining revenues come
from payroll taxes, which are levied
on work-related income—payrolls.
Other taxes on items like gasoline,
liquor, and tobacco products provide
for a small proportion of government
revenues.
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Customs duties, estate and gift taxes,
and some minor miscellaneous taxes
and other charges are also levied.
The U.S. federal government relies
more heavily on income-based taxes
than nearly any other government in
the world.
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Progressive taxes are designed so
that those with higher incomes pay a
greater proportion of their income in
taxes.
Payroll taxes, which are regressive
taxes, take a greater proportion of
the income of lower-income groups
than of higher-income groups.
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
Some consider an excise tax—a
sales tax on individual products such
as alcohol, tobacco, and gasoline—to
be the most unfair type of tax
because it is generally the most
regressive.
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Financing State and Local
Government Activities
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Historically, the major source of state
and local revenues has been property
taxes.
In recent decades, state and local
governments have relied increasingly
on sales and income taxes for
revenues.
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22.3 The Multiplier Effect
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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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Changes In RGDP
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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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
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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The Multiplier Effect
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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.
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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
The multiplier effect illustrated
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Government spends $10 billion to buy aircraft
carriers.
The government purchase provides $10 billion
in added income to the companies that
construct the aircraft carriers.
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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
What will input owners do with this
additional income?

While behavior 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
 saved

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
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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The Multiplier Effect At Work
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The multiplier effect is worked out
for an assumed MPC of two-thirds.
The initial $10 billion increase in
government purchases causes both
a $10 billion increase in aggregate
demand and an income increase of
$10 billion to suppliers of the inputs
used to produce aircraft carriers.
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
The owners of those inputs, in turn,
will spend an additional $6.67 billion
(two-thirds of $10 billion) on
additional consumption purchases.
A chain reaction has been started.
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
The added $6.67 billion in
consumption purchases by those
deriving income from the initial
investment brings a $6.67 billion
increase in aggregate demand and in
new income to suppliers of the inputs
that produced the goods and services.
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These persons, in turn, will spend some
two-thirds of their additional $6.67 billion
in income, or $4.44 billion on
consumption purchases.
This means a $4.44 billion more in
aggregate demand and income to still
another group of persons, who will then
proceed to spend two-thirds of that
amount, or $2.96 billion on consumption
purchases.
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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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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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Changes In The MPC Affect
The Multiplier Process

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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The Multiplier And The
Aggregate Demand Curve
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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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The initial impact of a $10 billion
additional purchase by the government
directly shifts AD right by $10 billion.
The multiplier effect then causes AD to
shift $20 billion further to the right.
The total effect on AD of a $10 billion
increase in government purchases is
therefore $30 billion, if the marginal
propensity to consume equals 2/3.
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Time Lags, Saving, Taxes, And Imports
Reduce The Size Of The Multiplier

Multiplier process is not
instantaneous.
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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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
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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22.4 Fiscal Policy and the
AD/AS Model
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The primary tools of fiscal policy can be
presented in the context of the aggregate
supply and demand model.
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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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Budget Deficits And Fiscal Policy
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When the government purchases
more, taxes less and increases
transfer payments, the size of the
government’s budget deficit will
grow.
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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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
If the government decides to
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purchase more
cut taxes
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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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 AD, ideally to a new short-run
equilibrium at potential RGDP.
The result of such a change would be an
increase in the price level and an increase
in RGDP.
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
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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
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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
Suppose that the economy is currently
operating at full employment.
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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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The higher costs that result from
these input price increases will shift
the short-run 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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Budget Surpluses (Or Budget Deficit
Reductions) And Fiscal Policy
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When the government purchases less,
taxes more, 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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Suppose the initial short-run
equilibrium is at a point beyond
full-employment output.
If the government decides to reduce
its purchases, increase taxes, or
reduce transfer payments these
changes will directly affect aggregate
demand.
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A tax increase on consumers or a
decrease in transfer payments will
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reduce households’ disposable incomes,
reducing purchases of consumption
goods and services, and
higher business taxes will reduce
investment purchases.
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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
full-employment output; a new shortand long-run equilibrium.
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
Now consider the case of an initial
short- and long-run equilibrium at full
employment, where AD intersects
both the SRAS and LRAS curves.

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 fullemployment level.
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
As prices fall, input suppliers revise their
price level expectations downward.
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That is, laborers 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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22.5 Automatic Stabilizers
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Some changes in government transfer
payments and taxes take place
automatically as business cycle
conditions change, without
deliberations in Congress or the
executive branch of the government.
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Automatic Stabilizers
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Automatic stabilizers
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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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How Does The Tax System
Stabilize The Economy?
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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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
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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
Other income-related payroll taxes
act as automatic stabilizers, notably
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
Social Security taxes
corporate profit tax
unemployment compensation program
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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
public assistance (welfare).
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Unemployment compensation and public
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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22.6 Possible Obstacles to
Effective Fiscal Policy
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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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The Crowding-Out Effect
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When the government borrows money to
finance a deficit, it increases the overall
demand for money in the money market,
driving interest rates up.
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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In short, the higher interest rate will
choke off private spending on goods
and services, and as a result, the
impact of the increase in government
purchases may be smaller than we
first assumed.
Economists call this the crowdingout effect.
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An additional $10 billion of government
spending on aircraft carriers, other things
equal, would shift the aggregate demand
curve right by $10 billion times the
multiplier.
However, as this process takes place,
interest rates are bid up, crowding out
some investment and other interest ratesensitive purchases at the same time.
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By itself, this would reduce aggregate
demand by the purchases crowded out
times the multiplier.
Since both these processes are taking
place at the same time, the net effect is
the difference between the expansion of
government purchases and the private
sector purchases crowded out, times the
multiplier.
The crowding out effect also occurs with
a tax change.
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
Critics of the crowding-out effect
analysis argue that the increase in
government purchases (or tax cut),
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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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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To finance the deficit, the U.S.
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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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
in the United States, increasing imports,
and by making U.S.-made goods more
expensive to foreigners, decreasing
exports.
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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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
The argument is that an increase in
aggregate demand that would be
expected as a result of an increase in
government purchases or a current
reduction in net taxes will be partially
or fully offset by an increase in
savings (which is the same as a
reduction in consumption purchases).
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
If people realize that the increase in
government purchases will lead to
higher taxes in the future, they may
increase their savings now to pay for
those future taxes.
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
Thus, the expected increase in
aggregate demand as a result of an
increase in government purchases or
a decrease in net taxes is offset by
the reduction in current consumption
as individuals save for the future tax
increase.
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
Just as with the crowding-out effect,
this implies that fiscal policy will have
a smaller effect on aggregate demand
than otherwise predicted, with the
effect smaller, the more increased
current savings (reduced current
consumption) offsets the fiscal policy
stimulus.
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Time Lags In Fiscal Policy
Implementation
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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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
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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

Government tax or spending (fiscal
policy) changes require both
congressional and presidential
approval.
Suppose the economy is beginning
a downturn.
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
It may take two or three months
before enough data are gathered to
indicate the actual presence of 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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
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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Finally, once the House and Senate
have completed their separate
deliberations and have arrived at a
final version of the bill, it is presented
to Congress for approval.
After congressional approval is
secured, the bill then goes to the
president for approval or veto.
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Even after fiscal policy legislation is
signed into law, it takes time to bring
about the actual fiscal stimulus desired.
If the legislation provides for a reduction
in withholding taxes, for example, it
might take a few months before the
changes actually show up in workers’
paychecks.
If it provides for changes in government
purchases, the delay is usually much
longer.
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
If the government increases spending
for public works projects like sewer
systems, new highways, or urban
renewal, 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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
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Such delays have actually lengthened in
recent years due to new government
regulations, such as environmental impact
statements, which often takes many
months or even years.
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.
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
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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
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.
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
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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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

Timed correctly, contractionary fiscal
policy could correct an inflationary
boom.
Timed incorrectly, it could cause a
recession.
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22.7 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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What Is Supply-Side Fiscal Policy?
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In particular, they believe that when
taxes, government transfer payments
(like welfare), and regulations are too
burdensome on productive activities
individuals will save less, work less,
and provide less capital.
In other words, fiscal policy can work
on the supply side of the economy as
well as the demand side.
Copyright © 2002 by Thomson Learning, Inc.
Impact Of Supply-Side Policies
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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 © 2002 by Thomson Learning, Inc.
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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.
Copyright © 2002 by Thomson Learning, Inc.
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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.
Copyright © 2002 by Thomson Learning, Inc.
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Businesses might get similar relief
through investment tax credits,
raising after tax rates of return on
investment, and encouraging firms to
invest in new capital, raising worker
productivity.
Copyright © 2002 by Thomson Learning, Inc.
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It is important that government
provides certain regulations for the
environment, workers’ safety,
consumer protection, and so on.
The costs imposed on producers as a
result of these regulations have the
same effect as taxes and make goods
and services more expensive.
Copyright © 2002 by Thomson Learning, Inc.
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Such government regulations shift the
short- and long-run aggregate supply
curves to the left because they increase
the cost of producing these goods, which
drives up prices for consumers, and they
reduce the economy’s potential real
output.
Supply-siders, therefore, support
reductions in government regulations
where the benefits don’t justify the costs.
Copyright © 2002 by Thomson Learning, Inc.
The Laffer Curve
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Some economists emphasize the idea
that higher marginal tax rates will
discourage people from working as
much as they otherwise would.
Workers are concerned with their
after-tax earnings.
Copyright © 2002 by Thomson Learning, Inc.

A lower marginal tax rate will raise aftertax earnings, improving productive
incentives.
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It may entice more people to seek work.
It may encourage workers to postpone their
retirement.
It may mean that more workers will work
longer hours.
It could lead to more two-income families in
the labor force.
Copyright © 2002 by Thomson Learning, Inc.

It is also possible that the high tax
rates reduce work efforts in the legal
sector and encourage work efforts in
the underground economy instead,
where cash and barter transactions
are very difficult to observe and tax.
Copyright © 2002 by Thomson Learning, Inc.
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Higher marginal tax rates will also
lead investors to spend more scarce
resources looking for tax shelters,
which harms the economy, as highreturn but highly taxed investments
give way to lower-return tax shelters.

An example is tax-free municipal bonds,
substituted for higher-return taxable
investments.
Copyright © 2002 by Thomson Learning, Inc.
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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.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
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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 © 2002 by Thomson Learning, Inc.

A very high marginal tax rate on the rich
actually might
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reduce the incentive to work
save
invest
produce
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 © 2002 by Thomson Learning, Inc.

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 © 2002 by Thomson Learning, Inc.
Research And Development And
The Supply-Side Of The Economy
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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 © 2002 by Thomson Learning, Inc.

The government encourages
investments in research and
development by giving tax breaks
or subsidies to firms.
Copyright © 2002 by Thomson Learning, Inc.
How Do Supply-Side Policies Affect
Long-Run Aggregate Supply?

Rather than being primarily
concerned with short-run economic
stabilization, supply-side policies are
aimed at increasing both the shortrun and long-run aggregate supply
curves.
Copyright © 2002 by Thomson Learning, Inc.

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.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
Critics Of Supply-Side Economics

Critics of supply-side economics
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skeptical of the magnitude of the impact of
lower taxes on work effort and of deregulation
on productivity.
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new production that occurs from deregulation enough
to offset the benefits of regulation?
claim the 1980s tax cuts led to moderate real
output growth through a reduction in real tax
revenues, inflation, and large budget deficits
question amount of increased saving and
investment from reduced capital gains taxes
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The Supply-Side And DemandSide Effects Of A Tax Cut
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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 © 2002 by Thomson Learning, Inc.

Defenders of the supply-side approach
argue that the real tax revenues of those
in the highest marginal tax brackets
actually increased as their tax rates fell
in the 1980s (as they also had for earlier
reductions in tax rates on the most heavily
taxed high income groups) and that,
compared to other developed countries
in the world, the United States had very
prosperous growth from 1982 to 1989.
Copyright © 2002 by Thomson Learning, Inc.
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In addition, many supply-siders argue
that most of their policy prescriptions
were never really even tried, for at
least three reasons.
First, many supply-side proposals for
improving productive incentives were
ignored, and in some cases,
productive incentives were made
worse rather than better.
Copyright © 2002 by Thomson Learning, Inc.
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Second, the real output effects of the
initial tax cuts were minimized by the
restrictive, inflation fighting policies
of the Federal Reserve in the early
1980s.
Third, Congress did not reduce
federal expenditures, which was at
least partially responsible for the
growing deficit.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
22.8 The National Debt

Historically the largest budget deficits
and a growing government debt occur
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during war years, when defense
spending escalates
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.
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How Government Finances
The Debt
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
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 © 2002 by Thomson Learning, Inc.
22.7 The National Debt
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Policy makers now have to decide what
to do with budget surpluses.
Some favor continuing to pay down the
national debt to drive interest rates
down further and stimulate investment.
Others favor cutting taxes, to reduce
their misallocation of resources and the
temptation toward special interest
spending.
Copyright © 2002 by Thomson Learning, Inc.
22.7 The National Debt

These raise an important question:
are we getting government goods
and services with benefits that are
greater than the costs?
Copyright © 2002 by Thomson Learning, Inc.
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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 © 2002 by Thomson Learning, Inc.
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
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.
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
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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Copyright © 2002 by Thomson Learning, Inc.
Why Run A Budget Deficit?


From 1960 through 1997, the federal
budget was in deficit every year
except one.
They 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 © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.
The Burden Of Public Debt

The “burden” of the national debt is
a topic that has long interested
economists, particularly whether it
falls on present or future generations.
Copyright © 2002 by Thomson Learning, Inc.

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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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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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.
Copyright © 2002 by Thomson Learning, Inc.


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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
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 © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.