Fiscal Policy
Chapter 11
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Fiscal Policy
• Government’s tax and spending activities
affect not only the level of output and prices
but the mix of output as well
– Can government spending and tax policies ensure
full employment?
– What policy actions will help fight inflation?
– What are the risks of government intervention?
11-2
Taxes and Spending
• Today, the federal government
– Employs over 4 million people and spends more
than $3.5 trillion a year
– Collects nearly $3 trillion a year in taxes, with
nearly half that from individual income taxes
– Spends all of its tax revenues—and more,
borrowing additional funds
11-3
Government Expenditure
• Government purchases are part of aggregate
demand, income transfers are not
• Income transfers: Payments to individuals for
which no current goods or services are
exchanged
11-4
Fiscal Policy
• The federal government can alter aggregate
demand by:
– Purchasing more or fewer goods and services
– Raising or lowering taxes
– Changing the level of income transfers
11-5
Fiscal Policy
• Fiscal policy: The use of government taxes
and spending to alter macroeconomic
outcomes
• The federal budget is a tool that can shift
aggregate demand and thereby alter
macroeconomic outcomes
11-6
Fiscal Policy
DETERMINANTS
Internal
market
forces
OUTCOMES
AS
Output
Jobs
Prices
External
shocks
Growth
Policy tools:
Fiscal
policy
AD
International
balances
11-7
Fiscal Stimulus
• Suppose the economy is experiencing a
recessionary GDP gap of $400 billion
• From a Keynesian perspective, the solution is
to get someone to spend more on goods and
services
11-8
The Policy Goal
AS
Price Level
Full-employment GDP
AD1
a
PE
b
The goal is to close
GDP gaps
GDP Equilibrium
GDP gap
QE = 5.6
6.0 = QF
Real GDP
11-9
Keynesian Strategy
• Fiscal stimulus: Tax cuts or spending hikes
intended to increase (shift) aggregate demand
• Two strategic policy questions:
– By how much do we want to shift the AD curve to
the right?
– How can we induce the desired shift?
11-10
The Naive Keynesian Model
• An increase in AD by $400 billion will achieve
full employment only if AS curve is horizontal
• Assumption of a horizontal AS curve seems
naïve today
• Although not every AD shift will raise prices,
inflationary pressures increase as AD expands
11-11
The AD Shortfall
• So long as the AS curve slopes upward, AD
must increase by more than the size of the
recessionary gap to achieve full employment
• AD shortfall: The amount of additional
aggregate demand needed to achieve full
employment after allowing for price-level
changes
11-12
The AD Shortfall
AS
AD3
Price Level
AD2
d
AD1
c
a
PE
b
e
Recessionary
GDP gap
AD shortfall
QE = 5.6
QF = 6.0
Real GDP
6.4
The AD shortfall is the fiscal policy target for achieving full employment.
11-13
More Government Spending
• Increased government spending is a form of
fiscal stimulus
• Every dollar of new government spending has
a multiplied impact on aggregate demand
• How much of a boost the economy gets
depends on the value of the multiplier
11-14
Multiplier Effects
• Impact of fiscal stimulus on aggregate demand
includes both the new government spending
and all subsequent increases in consumer
spending triggered by multiplier effects
Total change
new spending
 multiplier 
in spending
injection
11-15
Multiplier Effects
new spending
Cumulative increase
induced increase

injection

(horizontal shift ) in AD
in consumption
( fiscal stimulus)
 multiplier 
fiscal stimulus
(new spending injection)
• The second equation is identical to the first but
expressed in the terminology of fiscal policy
11-16
Multiplier Effects
Price Level
Direct impact of rise in
government spending
+ $200 billion
P1
Indirect impact via
increased consumption
+ $600 billion
a
b
AD2
Current
price level
AD3
AD1
5.6
QE
5.8
6.4
Real GDP
11-17
The Desired Stimulus
• The general formula for computing the desired
stimulus is a simple rearrangement of the
earlier formula:
AD shortfall
Desired fiscal stimulus 
the multiplier
11-18
Tax Cuts
• By lowering taxes, the government increases
disposable income, which stimulates the
consumption component of AD
• The amount consumption increases depends on
the marginal propensity to consume
Initial increase
 MPC  tax cut
in consumption
11-19
Multiplier Effects
Cumulative change
initial change
 multiplier 
in spending
in consumption
• A dollar of tax cut contains less stimulus than
a same size increase in government purchases
desired fiscal stimulus
Desired tax cut 
MPC
11-20
The Tax Cut Multiplier
Tax Cut
First round of spending:
Second round of spending:
More consumption
= MPC X tax cut
More saving
= MPS X tax cut
More income
More saving
More consumption
More income
Third round of spending:
More saving
More consumption
Cumulative change in
saving: = tax cut
11-21
Taxes and Investment
• A tax cut may also be an effective mechanism
for increasing investment spending
• If a cut in corporate taxes raises potential aftertax profits, it should encourage investment
• Once additional investment spending enters
the circular flow, it, too, has a multiplier effect
11-22
Increased Transfers
• Increasing transfer payments stimulates the
economy
Initial fiscal
increase in
 MPC 
stimulus (injection)
transfer payments
11-23
Fiscal Restraint
• At times the economy is expanding too fast
and fiscal restraint is more appropriate
• Inflationary GDP gap: The amount by which
equilibrium GDP exceeds full-employment
• Fiscal restraint: Tax hikes or spending cuts
intended to reduce (shift) aggregate demand
11-24
The Fiscal Target
• AD excess: The amount by which aggregate
demand must be reduced to achieve fullemployment equilibrium after allowing for
price-level changes
• The AD excess exceeds the inflationary GDP
gap
11-25
The Fiscal Target
• First determine the size of the AD excess
• Then we compute how much government
spending or taxes must be changed to achieve
the desired shift, taking into account multiplier
effects
excess AD
Desired fiscal restraint 
the multiplier
11-26
Excess Aggregate Demand
Price Level
AS
f
PE
AD must shift
by more
than the GDP
gap
E1
E2
PF
Inflationary
GDP gap
Excess AD
Q2 = 5.8
QF = 6.0
AD1
AD2
Q1 = 6.2
Real Output
11-27
Budget Cuts
• Budget cuts reduce government spending and
induce cutbacks in consumer spending
• Budget cuts should equal the size of the
desired fiscal restraint
Cumulative reduction
initial budget cut
 multiplier 
in spending
( fiscal restraint )
11-28
Tax Hikes
• Tax hikes can be used to shift the AD curve to
the left by reducing disposable income
• Taxes must be increased more than a dollar to
get a dollar of fiscal restraint
desired fiscal restraint
Desired tax hike 
MPC
11-29
Reduced Transfers
• A cut in transfer payments works like a tax
hike, reducing the disposable income of
transfer recipients
• The desired reduction in transfers is the same
as a desired tax increase
11-30
Fiscal Guidelines
• The essence of fiscal policy is the deliberate
shifting of the aggregate demand curve
• Steps required to formulate fiscal policy:
– Specify the amount of the desired AD shift
– Select the policy tools needed to induce the desired
shift
11-31
Weak Economy: Fiscal Stimulus
AD shortfall
Desired fiscal stimulus 
the multiplier
Policy Tools
Increase government
purchases
Amount
desired fiscal stimulus
Cut taxes
desired fiscal stimulus
MPC
Increased transfers
desired fiscal stimulus
MPC
11-32
Overheated Economy: Fiscal Restraint
excess AD
Desired fiscal restraint 
the multiplier
Policy Tools
Reduce government
purchases
Amount
desired fiscal restraint
Increase taxes
desired fiscal restraint
MPC
Reduce transfers
desired fiscal restraint
MPC
11-33
A Warning: Crowding Out
• Some of the intended fiscal stimulus may be
offset by the crowding out of private
expenditure
• Crowding out: A reduction in private-sector
borrowing (and spending) caused by increased
government borrowing
11-34
Time Lags
• It takes time to recognize that a problem exists
and then formulate policy to address it
• The very nature of the macro problems could
change if the economy is hit with other internal
or external shocks
11-35
Pork-Barrel Politics
• Members of Congress want their constituents
to get the biggest tax savings
• They don’t want spending cuts in their own
districts
• They don’t want a tax hike or spending cut
before an election
11-36
Fiscal Policy
End of Chapter 11
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.