Transcript Fiscal Policy

C H A P T E R 10
Fiscal Policy
Copyright © 2012 Pearson
Prentice
Hall.
All rights
reserved.
Copyright
© 2012
Pearson
Prentice
Hall. All rights reserved.
10-1
CHAPTER
Fiscal Policy
10
As President Obama’s administration began in January 2009, the
economy was in the midst of a very severe recession.
PREPARED BY
Brock Williams
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
C H A P T E R 10
Fiscal Policy
APPLYING THE CONCEPTS
1
Why are the United States and many other countries
facing dramatically increasing costs for their government
programs?
Increasing Life Expectancy and Aging Populations
Spur Costs of Entitlement Programs
2
How are tax rates and tax revenues related?
The Confucius Curve?
3
Did President Obama’s fiscal stimulus work as
expected?
Evaluating the Obama Fiscal Stimulus
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10-3
C H A P T E R 10
Fiscal Policy
Fiscal Policy
●fiscal policy
Changes in government taxes
and spending that affect the
level of GDP.
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C H A P T E R 10
Fiscal Policy
10.1
THE ROLE OF FISCAL POLICY
Fiscal Policy and Aggregate Demand
 FIGURE 10.1
Fiscal Policy in Action
Panel A shows that an increase in government spending shifts the aggregate demand curve from
AD0 to AD1, restoring the economy to full employment. This is an example of expansionary policy.
Panel B shows that an increase in taxes shifts the aggregate demand curve to the left, from AD0 to
AD1, restoring the economy to full employment. This is an example of contractionary policy.
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10-5
C H A P T E R 10
Fiscal Policy
10.1
THE ROLE OF FISCAL POLICY (cont’d)
Fiscal Policy and Aggregate Demand
●expansionary policies
Government policy actions that lead
to increases in aggregate demand.
●contractionary policies
Government policy actions that lead
to decreases in aggregate demand.
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10-6
C H A P T E R 10
Fiscal Policy
10.1
THE ROLE OF FISCAL POLICY (cont’d)
The Fiscal Multiplier
•As the government develops policies to stabilize the economy, it needs to take
the multiplier into account.
•The total shift in aggregate demand will be larger than the initial shift. As we will
see later in this chapter,
•U.S. policymakers have taken the multiplier into account as they have developed
policies for the economy.
The Limits to Stabilization Policy
●stabilization policies
Policy actions taken to move the
economy closer to full employment
or potential output.
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10-7
C H A P T E R 10
Fiscal Policy
10.1
THE ROLE OF FISCAL POLICY (cont’d)
The Limits to Stabilization Policy
LAGS
●inside lags
The time it takes to formulate
a policy.
●outside lags
The time it takes for the policy
to actually work.
FORECASTING UNCERTAINTIES
What makes the problem of lags even worse is that economists are not very
accurate in forecasting what will happen in the economy.
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C H A P T E R 10
Fiscal Policy
LAGS
10.1
THE ROLE OF FISCAL POLICY (cont’d)
The Limits to Stabilization Policy
 FIGURE 10.2
Possible Pitfalls in Stabilization
Policy
Panel A shows an example of
successful stabilization policy.
The solid line represents the behavior of
GDP in the absence of policies. The
dashed line shows the behavior of GDP
when policies are in place. Successfully
timed policies help smooth out
economic fluctuations.
Panel B shows the consequences of illtimed policies.
Again, the solid line shows GDP in the
absence of policies and the dashed line
shows GDP with policies in place.
Notice how ill-timed policies make
economic fluctuations greater.
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10-9
C H A P T E R 10
Fiscal Policy
10.2
THE FEDERAL BUDGET
Federal Spending
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10-10
C H A P T E R 10
Fiscal Policy
10.2
THE FEDERAL BUDGET (cont’d)
Federal Spending
●discretionary spending
The spending programs that Congress
authorizes on an annual basis.
●entitlement and mandatory spending
Spending that Congress has authorized
by prior law, primarily providing support
for individuals.
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10-11
C H A P T E R 10
Fiscal Policy
10.2
THE FEDERAL BUDGET (cont’d)
Federal Spending
●Social Security
A federal government program to
provide retirement support and a host
of other benefits.
●Medicare
A federal government health program
for the elderly.
●Medicaid
A federal and state government health
program for the poor.
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10-12
C H A P T E R 10
Fiscal Policy
APPLICATION
1
INCREASING LIFE EXPECTANCY AND AGING POPULATIONS
SPUR COSTS OF ENTITLEMENT PROGRAMS
APPLYING THE CONCEPTS #1: Why are the United States
and many other countries facing dramatically increasing
costs for their government programs?
• Today, Social Security, Medicare, and Medicaid constitute approximately 10
percent of GDP.
• Experts estimate that in 2075 spending on these programs will be
approximately 22 percent of GDP.
How will our society cope with increased demands for these services?
Possible solutions:
• Leave the existing programs in place and just raise taxes to pay for them.
• The government should save and invest now to increase GDP in the future to
reduce the burden on future generations.
• Reform the entitlement systems, placing more responsibility on individuals and
families for their retirement and well-being.
• Reform the health-care system to encourage more competition to reduce
health-care expenditures.
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C H A P T E R 10
Fiscal Policy
10.2
THE FEDERAL BUDGET (cont’d)
Federal Revenues
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C H A P T E R 10
Fiscal Policy
10.2
THE FEDERAL BUDGET (cont’d)
Federal Revenues
SUPPLY-SIDE ECONOMICS AND THE LAFFER CURVE
●supply-side economics
A school of thought that emphasizes
the role that taxes play in the supply of
output in the economy.
●Laffer curve
A relationship between the tax rates and
tax revenues that illustrates that high
tax rates could lead to lower tax
revenues if economic activity is severely
discouraged.
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C H A P T E R 10
Fiscal Policy
APPLICATION
2
THE CONFUCIUS CURVE?
APPLYING THE CONCEPTS #2: How are tax rates and tax
revenues related?
•While the idea that cutting tax rates might actually increase tax revenue is
often attributed to economist Arthur Laffer, in fact, it is actually a much older
idea than that.
•Yu Juo, one of the twelve wise men who succeeded Confucius in ancient
China, was asked what should be done in the case of a famine if the
government had insufficient funds. He replied that the tax rate should be
cut to 10 percent. Skeptical government bureaucrats did not have enough
funds at a 20 percent rate, so how could they cut it to 10 percent?
•Yu Juo replied, “Cutting taxes and limiting your expenses allow people to
raise their standard of living. Afterwards, you will no longer need to worry
about famine and shortage.”
•Revenue estimators in Washington, D.C, do not share entirely in Yu Juo’s
wisdom, but they do recognize that cutting tax rates will stimulate economic
activity.
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C H A P T E R 10
Fiscal Policy
10.2
THE FEDERAL BUDGET (cont’d)
The Federal Deficit and Fiscal Policy
●budget deficit
The amount by which government
spending exceeds revenues in a given
year.
●budget surplus
The amount by which government
revenues exceed government
expenditures in a given year.
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C H A P T E R 10
Fiscal Policy
10.2
THE FEDERAL BUDGET (cont’d)
Automatic Stabilizers
The increased federal budget deficit works through three channels:
1
Increased transfer payments such as unemployment insurance, food stamps,
and other welfare payments increase the income of some households, partly
offsetting the fall in household income.
2
Other households whose incomes are falling pay less in taxes, which partly
offsets the decline in their household income. Because incomes do not fall as
much as they would have in the absence of the deficit, consumption spending
does not decline as much.
3
Because the corporation tax depends on corporate profits and profits fall in a
recession, taxes on businesses also fall. Lower corporate taxes help to prevent
businesses from cutting spending as much as they would otherwise during a
recession.
●automatic stabilizers
Taxes and transfer payments that stabilize GDP
without requiring policymakers to take explicit action.
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C H A P T E R 10
Fiscal Policy
10.2
THE FEDERAL BUDGET (cont’d)
Are Deficits Bad?
No – Automatic Stabilizers
Yes – Crowding Out
PRINCIPLE OF OPPORTUNITY COST
The opportunity cost of something is what you sacrifice to get it.
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C H A P T E R 10
Fiscal Policy
10.3
FISCAL POLICY IN U.S. HISTORY
The Depression Era
During the 1930s, politicians did not believe in modern fiscal policy, largely because
they feared the consequences of government budget deficits. According to Brown,
fiscal policy was expansionary only during two years of the Great Depression, 1931
and 1936.
The Kennedy Administration
Although modern fiscal policy was not deliberately used during the 1930s, the growth
in military spending at the onset of World War II in 1941 increased total demand in the
economy and helped pull the economy out of its long decade of poor performance. But
to see fiscal policy in action, we need to turn to the 1960s. It was not until the
presidency of John F. Kennedy during the early 1960s that modern fiscal policy came
to be accepted.
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10-20
C H A P T E R 10
Fiscal Policy
10.3
FISCAL POLICY IN U.S. HISTORY (cont’d)
The Vietnam War Era
●permanent income
An estimate of a household’s long-run
average level of income.
The Reagan Administration
The tax cuts enacted during 1981 at the beginning of the first term of President Ronald
Reagan were significant. However, they were not proposed to increase aggregate
demand. Instead, the tax cuts were justified on the basis of improving economic
incentives and increasing the supply of output.
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10-21
C H A P T E R 10
Fiscal Policy
10.3
FISCAL POLICY IN U.S. HISTORY (cont’d)
The Clinton and George W. Bush Administrations
 FIGURE 10.3
Federal Taxes, Spending,
and Deficits, 1996–2009
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In late 1990’s, tax increases, limited government spending, and economic
growth which increased revenues resulted in the U.S. experienced a surplus
Tax cuts and stimulus packages designed to stimulate the economy after
the recessions of 2001 and 2008 resulted in U.S. deficits again.
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Fiscal Policy
APPLICATION
3
EVALUATING THE OBAMA FISCAL STIMULUS
APPLYING THE CONCEPTS #3: Did President Obama’s fiscal
stimulus work as expected?
•The Council of Economic Advisors was required to determine the effectiveness of the
stimulus package and make regular reports to Congress.
•They determined that employment and growth were higher in the second and third
quarter of 2009 than would have been expected, but could not be sure the stimulus
package was the cause.
•Using conventional models and comparisons with other countries, the council
determined that the package avoided the loss about one million jobs.
•However, unemployment was still almost 10 percent and high unemployment will
linger for years.
•Even if there was a positive effect, the lingering effect of the recession would still be
painful.
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C H A P T E R 10
Fiscal Policy
KEY TERMS
automatic stabilizers
Laffer curve
budget deficit
Medicaid
budget surplus
Medicare
contractionary policies
outside lags
discretionary spending
permanent income
entitlement and mandatory spending
Social Security
expansionary policies
stabilization policies
fiscal policy
supply-side economics
inside lags
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10-24