Fiscal Policy
How much spending does it take?
Introduction
• http://www.youtube.com/watch?v=1qhJPqyJR
o8&feature=plcp&context=C49f6c9cVDvjVQa1
PpcFMdkWSNt1EsUKtB5fYByDq14YICcdVaANI
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What is FISCAL
Policy?
Fiscal Policy Spending – where does it
all go?
• http://www.nytimes.com/interactive/2012/
02/13/us/politics/2013-budget-proposalgraphic.html
HOW FISCAL POLICY INFLUENCES AGGREGATE
DEMAND
• Fiscal policy – taxing, spending, and borrowing
• influences saving, investment, and growth in the
long run.
• In the short run, fiscal policy primarily affects the
aggregate demand.
• What are challenges to fiscal policy
implementation?
Changes in Government Purchases
• There are two macroeconomic effects from
the change in government purchases:
– The multiplier effect
– The crowding-out effect
http://www.youtube.com/watch?v=H3nyc8XHrQc
The Multiplier Effect
• Government purchases are said to have a
multiplier effect on aggregate demand.
– Each dollar spent by the government can raise the
aggregate demand for goods and services by more
than a dollar.
Price
Level
Figure 4 The Multiplier Effect
2. . . . but the multiplier
effect can amplify the
shift in aggregate
demand.
$20 billion
AD3
AD2
Aggregate demand,
0
1. An increase in government purchases
of $20 billion initially increases aggregate
demand by $20 billion . . .
AD1
Quantity of
Output
A Formula for the Spending Multiplier
• The formula for the multiplier is:
– Multiplier = 1/(1 – MPC)
– An important number in this formula is the
marginal propensity to consume (MPC).
• It is the fraction of extra income that a household
consumes rather than saves.
A Formula for the Spending Multiplier
• If the MPC = 3/4, then the multiplier will be:
Multiplier = 1/(1 – 3/4) = 4
• In this case, a $20 billion increase in
government spending generates $80 billion of
increased demand for goods and services.
The Crowding-Out Effect
• Fiscal policy may not affect the economy as
strongly as predicted by the multiplier.
• An increase in government purchases causes
the interest rate to rise.
• What are the consequences of a higer interest
rate?
The Crowding-Out Effect
• This reduction in demand that results when a
fiscal expansion raises the interest rate is
called the crowding-out effect.
• The crowding-out effect tends to dampen the
effects of fiscal policy on aggregate demand.
Figure 5 The Crowding-Out Effect
(a) The Money Market
Interest
Rate
(b) The Shift in Aggregate Demand
Price
Level
Money
supply
2. . . . the increase in
spending increases
money demand . . .
$20 billion
4. . . . which in turn
partly offsets the
initial increase in
aggregate demand.
r2
3. . . . which
increases
the
equilibrium
interest
rate . . .
AD2
r
AD3
MD2
Money demand,
0
Quantity fixed
by the Fed
Aggregate demand, AD1
MD
Quantity
of Money
0
1. When an increase in government
purchases increases aggregate
demand . . .
http://www.youtube.com/watch?v=RGlt0nEQdRI&feature=plc
p&context=C48ec1e6VDvjVQa1PpcFMdkWSNt1EsUByRZ_JiwO
oaMf6ZO6WVkJM%3D
Quantity
of Output
Changes in Taxes
• When the government cuts personal income
taxes, it increases households’ take-home pay.
• Households save some of this additional
income.
• Households also spend some of it on
consumer goods.
• Increased household spending shifts the
aggregate-demand curve to the right.
Changes in Taxes
• The size of the shift in aggregate demand
resulting from a tax change is affected by the
multiplier and crowding-out effects.
• It is also determined by the households’
perceptions about the permanency of the tax
change.
What are the Types of Taxes?
• Proportional Taxes
• A tax with a constant % paid regardless of income
• Flat tax
• Progressive Taxes
• A tax where the % paid in taxes increases as income
increases
• U.S. Personal Income Tax
• Regressive Taxes
• The lower your income the higher % you pay in taxes
• Sales Tax
Proportional, regressive, or
progressive?
USING POLICY TO STABILIZE THE
ECONOMY
• Economic stabilization has been an explicit
goal of U.S. policy since the Employment Act
of 1946, which states that:
– “it is the continuing policy and responsibility of
the federal government to…promote full
employment and production.”
The Case for Active Stabilization Policy
• The Employment Act has two implications:
– The government should avoid being the cause of
economic fluctuations.
– The government should respond to changes in the
private economy in order to stabilize aggregate
demand.
– What economic school of thought does this
follow? Who would be against active stablization?
The Case against Active Stabilization
Policy
• Some economists argue that monetary and
fiscal policy destabilizes the economy.
• Monetary and fiscal policy affect the economy
with a substantial lag – rational
expectations!!!
• They suggest the economy should be left to
deal with the short-run fluctuations on its
own.
Automatic Stabilizers
• Automatic stabilizers are changes in fiscal
policy that stimulate aggregate demand when
the economy goes into a recession without
policymakers having to take any deliberate
action.
• Automatic stabilizers include the tax system
and some forms of government spending.