CHAPTER
Fiscal Policy
Chapter 12
Part I
1
Countercyclical Fiscal Policy
• A change in government spending or net
taxes (taxes or transfer payments)
designed to reverse or prevent a recession
or a boom
• Fiscal policy affects AE and has in the
short run demand-side effects on output
and employment
• We will discuss supply-side effects later
2
Short-run Countercyclical Fiscal Policy
Real AE ($ billions)
A
AE1
AE2
Consumption
B
Function
45°
$9,000
(Recession Output)
Initially, equilibrium
is at full-employment
output of $10,000
billion (Point A). Then
a decrease in private
investment spending
(IP) or consumption
spending (C) shifts
the aggregate
expenditure line
down to AE2, and the
economy starts
heading toward point
B - a recession.
$10,000 Real GDP ($ billions)
(Full-Employment Output)
3
Recessionary Gap:
Real AE ($ billions)
A
AE1
AE2
Consumption
B
Function C
Recessionary Gap:
Distance B to C = $1,000
45°
$9,000
(Recession Output)
$10,000 Real GDP ($ billions)
(Full-Employment Output)
4
Countercyclical Fiscal Policy
Policy Option: Increase Government Spending
• Direct way to address a recession
– increase G and shift the aggregate
expenditure line upward
– ΔGDP = (Multiplier) ˣ ΔG
– where the simple multiplier = 1/(1-MPC)
• If the MPC is 0.75, how much should G
increase to close the recessionary gap of
$1,000?
5
Countercyclical Fiscal Policy
Policy Option: Cut Net Taxes
• Increase disposable income
– increase consumption spending (less
direct than increasing G)
– aggregate expenditure line shifts upward
– ΔGDP = (tax multiplier) ˣ Δ Net taxes
– tax multiplier = - MPC/(1-MPC)
6
Policy Option: Cut Net Taxes
• Increase disposable income
– increase consumption spending (less
direct than increasing G)
– aggregate expenditure line shifts upward
– ΔGDP = (tax multiplier) ˣ Δ Net taxes
– tax multiplier = - MPC/(1-MPC)
Another multiplier!
7
Policy Option: Cut Net Taxes
• Increase disposable income
– increase consumption spending (less
direct than increasing G)
– aggregate expenditure line shifts upward
– ΔGDP = (tax multiplier) ˣ Δ Net taxes
– tax multiplier = - MPC/(1-MPC)
• If the MPC is 0.75, how much should
taxes decrease or transfers increase to
close the recessionary gap of $1,000?
8
Countercyclical Fiscal Policy Close the
The government
Recessionary Gap
Real AE ($ billions)
AE1
A
AE2
Consumption
B
Function
C
ΔG↑ or ΔT↓
45°
$9,000
(Recession Output)
could shift the AE
line back to its
original position by
increasing spending
(G), or by decreasing
net taxes (T) with a
change in tax or
transfer policies.
ΔY
If the change were
enacted quickly
enough, the
government could
prevent the
$10,000 Real GDP ($ billions)
recession.
(Full-Employment Output)
9
Short-run Countercyclical Fiscal Policy
• Combining fiscal changes
– Government might decide to increase
government purchases, cut taxes, and
increase transfer payments
• all at the same time !
– The final impact on equilibrium GDP
• add up the separate multiplier effects of
each policy change
10
Combining Different Types of Fiscal
Stimulus
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11
Short-run Countercyclical Fiscal Policy
• Another policy option would be to
increase government purchases and
net taxes by equal amounts
• Why? No increase in the budget deficit
– GDP rises by the same amount
• Balanced budget multiplier
– The multiplier for a change in government
purchases that is matched by an equal
change in taxes
12
Case Study: American Reinvestment
and Recovery Act (ARRA) -2009
–A roughly two-year fiscal stimulus
• Originally estimated at $787 billion, and later
revised to $862 billion
–One-third was tax cuts - T↓
–One-third was increased government
purchases - G↑
–One-third was increased transfer
payments - T↓
13
Range of Estimates for Multipliers in the ARRA
Spending multiplier estimates larger than tax and transfer
payment multiplier estimates.
One-time payments and one-year tax cuts the lowest estimates.
14
Problems with Countercyclical Fiscal Policy
• Timing problems
–Recognition lag
–Implementation lag
–Response lag
• Irreversibility
– Spending should be temporary offsetting
temporary reduction in private spending
• Taxes and forward looking behavior
– Temporary vs. permanent!
• The reaction of the Federal Reserve
15
The Multiplier
•All of the multipliers we derive are a sub-set
of a general macro model for an open
economy with taxes and imports that depend
on the level of income (Y).
•The process described on the following slides
is to first define the model and then through a
series of substitutions, solve for the
equilibrium level of income (Y).
16
The Multiplier
• The model for an open economy when
taxes and imports depend on the level of
income (Y) is described by the
following eight equations:
17
The Multiplier
• (1) Y = C + I + G + (X – M), equilibrium condition
from chapter 11.
• (2) C = a + b (Yd), consumption equation from
chapter 11.
• (3) Yd = Y – T, disposable income as defined in
chapter 11.
• (4) T = T0 + t(Y), tax equation, this is new.
• (5) I = IP, planned investment from chapter 11.
• (6) G = G0, government spending from chapter 11.
• (7) X = X0, exports from chapter 11.
• (8) M = mY, import equation, this is new.
18
Equations (4) and (8) are new formulas
• T = T0 + t(Y), tax equation. This says the T is
equal to some fixed level plus a fraction (t) of Y.
• t is the tax rate. If t=0.33, households pay 33 cents
of each extra dollar earned to the government.
• M = mY, import equation. This simply says as Y
increases household import more stuff.
• Little m is called the marginal propensity to
∆𝑀
import: m =
∆𝑌
19
The Multiplier
• Substitute equations (2) through (8) into the
equilibrium condition, equation (1):
• (9) Y = a + b(Y - T) + IP + Go + X0 - mY
• (10) Y = a + b(Y - (T0+ tY)) +IP+ G0+X0 – mY
•
• (11) Y = a + b(Y-T0 - tY) +IP+G0+X0 – mY
•
• (12) Y = a + bY- bT0 - btY+IP+G0+X0 - mY
20
The Multiplier
Now solve Equation (12) for Y:
(13) Y- bY+ btY+ mY = a - bT0+ IP+ G0+ X0
(14 )Y 
a  bT 0  I
(15 )  Y 
P
 G0 X
0
1  b  bt  m
a  bT 0  I
P
 G 0  X
0
1  b  bt  m
21
From Equation (15), the government spending and lump-sum
tax multipliers in an open economy with an income tax
system are:
Y
G
Y
T 0


1
1  b  bt  m
b
1  b  bt  m
22
What happens if there is no foreign sector (a closed economy)
and taxes are lump-sum. This is the model presented in
chapters 11 and 12 of Hall and Lieberman. Equations (7) and
(8) listed on the previous slide disappear and the tax rate (t) in
Equation (4) equals zero. X, t and m in Equations (14) are
equal to zero:
a  bT 0  I  G 0
P
Y 
1 b
a  bT 0  I  G 0
P
Y 
1 b
23
We get the investment spending, government
spending, and tax multipliers presented in
Chapters 11 and 12:
Y
I

Y
T
Y
G


1
1 b
b
1 b
24