Fiscal Policy
Changes in federal taxes and purchases
Where does the government spend its money?
Federal Government
Spending, 2010
Fiscal Policy
An Overview of Government Spending and Taxes
The Federal Government’s
Share of Total Government
Expenditures, 1929–2009
Fiscal Policy
An Overview of Government Spending and Taxes
Federal Purchases and Federal
Expenditures as a Percentage
of GDP, 1950–2010
Where does the government get its money?
Federal
Government
Revenue, 2010
Government
revenue
Laffer Curve (not in the book): there is
optimal amount of taxation
Tax
Government
spending/taxes and
aggregate demand
The Effects of Fiscal Policy
on Real GDP and the Price Level
Expansionary and Contractionary Fiscal Policy: An Initial Look
Using Fiscal Policy to Influence Aggregate Demand:
A More Complete Account
An Expansionary
Fiscal Policy
Using Fiscal Policy to Influence Aggregate Demand:
A More Complete Account
A Contractionary
Fiscal Policy
A Summary of How Fiscal Policy Affects Aggregate
Demand
Countercyclical Fiscal
Policy
ACTIONS BY CONGRESS
AND THE PRESIDENT
RESULT
PROBLEM
TYPE OF POLICY
Recession
Expansionary
Increase government
spending or cut taxes
Real GDP and the price
level rise.
Rising Inflation
Contractionary
Decrease government
spending or raise taxes
Real GDP and the price
level fall.
Don’t Let This Happen to YOU!
Don’t Confuse Fiscal Policy and Monetary Policy
Multiplier (again)
The Government Purchases and
Aggregate Demand
The Multiplier Effect and
Aggregate Demand
Taking into Account the Effects of Aggregate Supply
The Multiplier Effect
and Aggregate Supply
The Government Purchases and Tax
Multipliers
The Multiplier Effect
of an Increase in
Government Purchases
The Government Purchases and Tax
Multipliers
The ratio of the change in equilibrium real GDP to the
initial change in government purchases is known as the
government purchases multiplier:
Government purchases multiplier 
Change in equilibrium real GDP
Change in government purchases
The expression for the tax multiplier is:
Tax multiplier 
Change in equilibrium real GDP
Change in taxes
A cut in tax rates affects equilibrium real GDP
through two channels:
(1) A cut in tax rates increases the disposable
income of households, which leads them
to increase their consumption spending,
and
(2) a cut in tax rates increases the size of the
multiplier effect.
The Multipliers Work in Both Directions
Decrease and increases in government expenditure are multiplied
Decrease and increase in taxes are multiplied
Solved Problem
Fiscal Policy Multipliers
Briefly explain whether you agree or disagree with the
following statement: “Real GDP is currently $12.2
trillion, and potential real GDP is $12.5 trillion. If
Congress and the president would increase
government purchases by $300 billion or cut taxes by
$300 billion, the economy could be brought to
equilibrium at potential GDP.”
Government purchases multiplier 
Change in equilibrium real GDP
Change in government purchases
Crowding out
A decline in private expenditures as a result of
an increase in government purchases.
Crowding out limits Fiscal Policy in the short run.
Crowding Out in the Money Market
An Expansionary Fiscal Policy
Increases Interest Rates
Crowding Out in the Aggregate Demand and
Aggregate Supply Diagram
In the long run, the economy returns to
potential GDP.
Budget Deficit
Budget deficit The situation in which the government’s
expenditures are greater than its tax revenue.
Budget surplus The situation in which the government’s
expenditures are less than its tax revenue.
Deficits, Surpluses, and Federal
Government Debt
The Federal Budget Deficit,
1901–2009
Solved Problem
The Effect of Economic Fluctuations on the Budget Deficit
The federal government’s budget deficit was
$207.8 billion in 1983 and $185.4 billion in
1984. A student comments, “The government
must have acted during 1984 to raise taxes or
cut spending or both.”
Do you agree? Briefly explain.
Deficits, Surpluses, and Federal
Government Debt
How the Federal Budget Can Serve as an Automatic Stabilizer
Cyclically adjusted budget deficit or
surplus: The deficit or surplus in the
federal government’s budget if the
economy were at potential GDP.
Deficits, Surpluses, and Federal
Government Debt
Is Government Debt a Problem?
Debt can be a problem for a government for
the same reasons that debt can be a problem
for a household or a business.
Deficits, Surpluses, and Federal
Government Debt
Should the Federal Budget Always Be Balanced?
Although many economists believe that it is a
good idea for the federal government to have a
balanced budget when the economy is at
potential GDP, few economists believe that the
federal government should attempt to balance
its budget every year.
Making
the
Connection
•Did Fiscal Policy Fail during
the Great Depression?
FEDERAL
GOVERNMENT
EXPENDITURES
(BILLIONS OF
DOLLARS
Although government
spending increased during
the Great Depression, the
cyclically adjusted budget
was in surplus most years.
ACTUALFEDERAL
BUDGET DEFICIT
OR SURPLUS
(BILLIONS OF
DOLLARS)
CYCLICALLY
ADJUSTED
BUDGET DEFICIT
OR SURPLUS
(BILLIONS OF
DOLLARS)
CYCLICALLY
ADJUSTED
BUDGET DEFICIT
OR SURPLUS AS
A PERCENTAGE
OF GDP
1929
$2.6
$1.0
$1.24
1.20%
1930
2.7
0.2
0.81
0.89
1931
4.0
-2.1
-0.41
-0.54
1932
3.0
-1.3
0.50
0.85
1933
3.4
-0.9
1.06
1.88
1934
5.5
-2.2
0.09
0.14
1935
5.6
-1.9
0.54
0.74
1936
7.8
-3.2
0.47
0.56
1937
6.4
0.2
2.55
2.77
1938
7.3
-1.3
2.47
2.87
1939
8.4
-2.1
2.00
2.17
The Effects of Fiscal Policy in the
Long Run
The Long-Run Effects of Tax Policy
Tax wedge The difference between the
pretax and posttax return to an economic
activity.
We can look briefly at the effects on aggregate supply of
cutting each of the following taxes:
• Individual income tax.
• Corporate income tax.
• Taxes on dividends and capital gains.
Tax Simplification
In addition to the potential gains from cutting individual
taxes, there are also gains from tax simplification.
The Effects of Fiscal Policy in the
Long Run
The Economic Effect of Tax Reform
The Supply-Side Effects of
a Tax Change
The Effects of Fiscal Policy in the
Long Run
How Large Are Supply-Side Effects?
Most economists would agree that there are
supply-side effects to reducing taxes:
Decreasing marginal income tax rates will
increase the quantity of labor supplied, cutting
the corporate income tax will increase
investment spending, and so on.
The magnitude of the effects is subject to
considerable debate, however.