Chapter 13 Fiscal Policy

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Chapter 13

Fiscal Policy

Introduction

Countries belonging to the European Monetary

Union have agreed to follow a path of fiscal discipline, keeping government spending in line with tax receipts.

Under what conditions would a government be tempted to allow expenditures to exceed receipts?

Slide 13-2

Learning Objectives

 Use traditional Keynesian analysis to evaluate the effects of discretionary fiscal policy

 Discuss ways in which indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actions

Slide 13-3

Learning Objectives

 Explain why the Ricardian equivalence theorem calls into question the usefulness of tax changes

 List and define fiscal policy time lags and explain why they complicate efforts to engage in fiscal “fine tuning”

Slide 13-4

Learning Objectives

 Describe how certain aspects of fiscal policy function as automatic stabilizers for the country

Slide 13-5

Chapter Outline

 Fiscal Policy

 Possible Offsets to Fiscal Policy

 Discretionary Fiscal Policy in Practice

 Automatic Stabilizers

 What Do We Really Know About Fiscal

Policy?

Slide 13-6

Did You Know That...

 Federal government dollars are used to fund a variety of endeavors, such as the Rock and Roll Hall of Fame and the National Cowgirl Museum?

 There are economy-wide effects from changes in the level of government spending.

Slide 13-7

Fiscal Policy

 Discretionary Fiscal Policy

– The discretionary changes in government expenditures and/or taxes in order to achieve certain national economic goals

• High employment

• Price stability

• Economic growth

• Improvement of international payments balance

Slide 13-8

Fiscal Policy

 An increase in government spending will stimulate economic activity

 Changes in government spending

– Military spending

– Education spending

– Budgets for government agencies

Slide 13-9

Expansionary Fiscal Policy:

Changes in G

LRAS

SRAS

• The recessionary gap is caused by insufficient AD

• To increase AD, use expansionary fiscal policy to increase government spending

• With an increase in G ,

AD increases and real GDP increases to full employment 120

E

1

0

Figure 13-1, Panel (a)

11.5

12.0

Real GDP per Year

($ trillions)

AD

1

Slide 13-10

Expansionary Fiscal Policy:

Changes in G

LRAS

SRAS

130

120

E

2

• The recessionary gap is caused by insufficient AD

• To increase AD , use expansionary fiscal policy to increase government spending

• With an increase in G ,

AD increases and real GDP increases to full employment

E

1

0

Figure 13-1, Panel (a)

11.5

12.0

Real GDP per Year

($ trillions)

AD

1

AD

2

Slide 13-11

Fiscal Policy

 Questions

– Would the increase in government spending equal the size of the gap?

– What impact did the expansionary fiscal policy have on the price level?

Slide 13-12

Contractionary Fiscal Policy:

Changes in Government Spending

LRAS

SRAS

1

130 E

1

• The inflationary gap is caused by SR equilibrium > full employment

• To decrease AD, use contractionary fiscal policy to decrease government spending

• With a decrease in G , AD decreases and real GDP decreases to full employment

AD

1

0 12.0 12.5

Real GDP per Year

($ trillions)

Figure 13-1, Panel (b)

Slide 13-13

Contractionary Fiscal Policy:

Changes in Government Spending

LRAS

SRAS

1

130

120

E

2

E

1

• The inflationary gap is caused by SR equilibrium > full employment

• To decrease AD, use contractionary fiscal policy to decrease government spending

• With a decrease in G , AD decreases and real GDP decreases to full employment

AD

2

AD

1

0 11.5

12.0

Real GDP per Year

($ trillions)

Figure 13-1, Panel (b)

Slide 13-14

Fiscal Policy

 Change in taxes

– A rise in taxes causes a reduction in aggregate demand because it can reduce consumption spending, investment expenditures, and net exports

Slide 13-15

Expansionary Fiscal Policy:

Changes in Taxes

LRAS

SRAS

1

• The recessionary gap is caused by insufficient AD

• To increase AD, use expansionary fiscal policy to decrease taxes

• With a decrease in taxes,

AD increases and real

GDP increases to full employment

0

Figure 13-3, Panel (b)

AD

1

12.0

Real GDP per Year

($ trillions)

Slide 13-16

Expansionary Fiscal Policy:

Changes in Taxes

LRAS

SRAS

1

120

110 E

1

E

2

• The recessionary gap is caused by insufficient AD

• To increase AD, use expansionary fiscal policy to decrease taxes

• With a decrease in taxes,

AD increases and real

GDP increases to full employment

0

Figure 13-3, Panel (b)

AD

1

11.5

12.0

Real GDP per Year

($ trillions)

AD

2

Slide 13-17

Expansionary Fiscal Policy:

Changes in Taxes

LRAS

SRAS

1

120

100 E

2

E

1

• The inflationary gap is caused by SR equilibrium > full employment

• To decrease AD, use contractionary fiscal policy to increase taxes

• With an increase in taxes AD decreases and real GDP decreases to full employment

AD

2

AD

1

0 12.0

12.5

Real GDP per Year

($ trillions)

Figure 13-3, Panel (a)

Slide 13-18

Fiscal Policy

 Question

– What would be the long-run impact on of a tax cut on real GDP if the economy is at full-employment equilibrium?

Slide 13-19

Fiscal Policy

 Tax rates and tax revenues

– Will an increase in tax rates always raise tax revenue?

Slide 13-20

Possible Offsets to Fiscal Policy

 Indirect crowding out

– Increases in government spending without raising taxes creates additional borrowing

Slide 13-21

Possible Offsets to Fiscal Policy

 Crowding-Out Effect

– The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption; this decrease normally results from the rise of interest rates

Slide 13-22

Figure 13-5

The Crowding-Out Effect

140

130

0

LRAS

SRAS

Expansionary policy causing deficit spending initially shifts from AD to AD

2

E

2

E

1

11.5

12.0

Real GDP per Year

($ trillions)

AD

1

AD

2

Equilibrium GDP below full-employment

GDP —recessionary gap

Slide 13-23

Figure 13-5

The Crowding-Out Effect

140

135

130

0

E

1

LRAS

SRAS

E

2

E

3

AD

AD

1

AD

3

2

Expansionary policy causing deficit spending initially shifts from AD to AD

2

Due to crowding out,

AD shifts inward to AD

3

Equilibrium GDP below full-employment

GDP —recessionary gap

11.5

12.0

11.75

Real GDP per Year

($ trillions)

Slide 13-24

Figure 13-4

The Crowding-Out Effect,

Step-By-Step

Slide 13-25

Possible Offsets to Fiscal Policy

 Direct crowding out

– Direct Expenditures Offsets

• Actions on the part of the private sector in spending money that offset government fiscal policy actions

• Any increase in government spending in an area that competes with the private sector

Slide 13-26

Possible Offsets to Fiscal Policy

 Planning for the future:

The Ricardian equivalence theorem

– Ricardian Equivalence Theorem

• The proposition that an increase in the government budget deficit has no effect on aggregate demand

Slide 13-27

Possible Offsets to Fiscal Policy

 Planning for the future:

The Ricardian equivalence theorem

– The reason for the offset

• People anticipate that a larger deficit today will mean higher taxes in the future and adjust their spending accordingly

Slide 13-28

Policy Example:

The Direct Offset of Government Grants

 Some scientific and engineering research is conducted by private companies that receive government grants as part of their funding.

 To the extent that this research would be conducted anyway, even without the grant, then the public expenditure is simply replacing a private one.

Slide 13-29

Possible Offsets to Fiscal Policy

 The supply-side effects of changes in taxes

– Expansionary fiscal policy involving the reduction of marginal tax rates in order to:

• increase productivity, since individuals will work harder and longer, save more, and invest more

• increase productivity, which will lead to more economic growth

Slide 13-30

Possible Offsets to Fiscal Policy

 Supply-Side Economics

– Creating incentives for individuals and firms to work more or to increase productivity will shift the aggregate supply curve to the right.

Slide 13-31

Possible Offsets to Fiscal Policy

 Question

– Would a tax increase cause you to work more or less?

Slide 13-32

Possible Offsets to Fiscal Policy

Laffer Curve

Tax rates and tax revenues rise together

Tax revenues are at a maximum

Tax rates and tax revenues fall together

Figure 13-6

Slide 13-33

Discretionary Fiscal Policy in Practice

 Question

– Is fiscal policy as precise as it appears?

Slide 13-34

Discretionary Fiscal Policy in Practice

 Time lags

– Recognition Time Lag

• The time required to gather information about the current state of the economy

Slide 13-35

Discretionary Fiscal Policy in Practice

 Time lags

– Action Time Lag

• The time required between recognizing an economic problem and putting policy into effect

– Particularly long for fiscal policy

Slide 13-36

Discretionary Fiscal Policy in Practice

 Time lags

– Effect Time Lag

• The time it takes for a fiscal policy to affect the economy

Slide 13-37

Discretionary Fiscal Policy in Practice

 Fiscal policy time lags are long.

A policy designed to correct a recession may not produce results until the economy is experiencing inflation.

 Fiscal policy time lags are variable in length (1 –3 years). The timing of the desired effect cannot be predicted.

Slide 13-38

Policy Example: An Unexpected

Leak in the Stream of Tax Revenues

 Federal income taxes are collected based on the dollar amount of wages and salaries.

 As employees have accepted more of their compensation in the form of health benefits, this has dampened growth of the tax base.

Slide 13-39

Automatic Stabilizers

 Automatic Stabilizers

– Changes in government spending and taxation that occur automatically without deliberate action of Congress

• Examples:

– The tax system

– Unemployment compensation

– Welfare spending

Slide 13-40

0

Figure 13-7

Automatic Stabilizers

Unemployment compensation and welfare

Tax revenues

Budget deficit

Budget surplus

The automatic changes tend to drive the economy back toward its full-employment output level

Y

2

Real GDP per Year

($ trillions)

Y

1

Slide 13-41

Automatic Stabilizers

Unemployment compensation and welfare

Tax revenues

Budget surplus

Budget deficit

0

Figure 13-7

Y

2

Y f

Real GDP per Year

($ trillions)

Y

1

Slide 13-42

What Do We Really Know

About Fiscal Policy?

 Fiscal policy during normal times

– Congress ends up doing too little too late to help in a minor recession.

– Fiscal policy that generates repeated tax changes (as it has done) creates uncertainty.

Slide 13-43

What Do We Really Know

About Fiscal Policy?

 Fiscal policy during abnormal times

– Fiscal policy can be effective

• The Great Depression

• Wartime

Slide 13-44

What Do We Really Know

About Fiscal Policy?

 The “soothing” effect of Keynesian fiscal policy

– Assume

• We know how to use fiscal policy to prevent another depression

– Results

• Stable expectations encourage a smoothing of investment spending

Slide 13-45

Issues and Applications:

U.S. Government Budget Projections

 Despite having agreed to certain terms of fiscal discipline, both France and Germany have allowed government spending to exceed tax receipts.

 Marginal tax rates were reduced in order to stimulate aggregate demand and to boost productivity.

 Because nether government reduced spending in the short term, both countries found that expenditures were exceeding tax receipts.

 This stimulative effect led to higher growth in real

GDP and a reduction in unemployment.

Slide 13-46

Summary Discussion of Learning Objectives

 The effects of discretionary fiscal policy using traditional Keynesian analysis

– Increases in government spending and decreases in taxes increase aggregate demand.

– Decreases in government spending and increases in taxes decrease aggregate demand.

Slide 13-47

Summary Discussion of Learning Objectives

 How indirect crowding out and direct expenditure offsets reduce the effectiveness of fiscal policy

– Deficits increase interest rates

– Some government spending replaces private spending

 The Ricardian equivalence theorem states that government borrowing to finance deficits causes people in anticipation of higher interest rates to repay the loans.

Slide 13-48

Summary Discussion of Learning Objectives

 Fiscal policy time lags and the effectiveness of fiscal “fine tuning”

– The time lags for fiscal policy are the recognition time lag, action time lag, and the effect time lag.

– The time lags are long and variable.

 Automatic stabilizers are changes in tax payments, unemployment compensation, and welfare payments that automatically change with the level of economic activity.

Slide 13-49

End of

Chapter 13

Fiscal Policy

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