Chapter 25
Fiscal Policy
and the
Business
Cycle
Introduction to Economics
(Combined Version) 5th Edition
Using Fiscal Stimulus to Fight Recession
 In this figure, a negative
output gap has developed at
E1.
 To reach the natural level of
real output at E2 , without
waiting for a downward shift
of the AS, the AD curve
could be shifted to the right,
from AD1 to AD2.
 That could be done either by
increasing real government
purchases or reducing net
taxes.
Introduction to Economics
(Combined Version) 5th Edition
Problems of Timing
 Lags in fiscal policy include
 delays of several months before it
is known that an output gap has
developed,
 delays while Congress passes
needed legislation, and
 delays after policy decision is made
before AD curve shifts.
Some kinds of spending, like military
procurement, involve long lead times
 Because of lags, action must be
taken based on forecasts, which are
not fully accurate.
 Fiscal stimulus that is applied too
late may take effect only after
recovery has already begun, in
which case it will cause
overshooting at the next cyclical
peak.
Introduction to Economics (Combined
Version) 5th Edition
How Large a Stimulus
 The amount of stimulus needed to
close the output gap depends on the
size of the multiplier effect.
 The effective fiscal multiplier means
the amount by which real GDP
increases in response to $1 of fiscal
stimulus.
 For the United States, the effective
fiscal multiplier is probably less than
2 and possibly less than 1.
 Example: With an effective fiscal
multiplier of 2, a fiscal stimulus of
$250 billion would be needed to
close the $500 billion output gap
shown in this figure.
Economists are still debating whether the economic
stimulus act of 2008 (ARRA) was too large or too small.
Introduction to Economics
(Combined Version) 5th Edition
Mathematics of the Multiplier
Review of Appendix to Chapter 5
 The Keynesian expenditure multiplier is equal to 1/(1-mpc)
where mpc is the marginal propensity to consume.
 The Keynesian expenditure multiplier measures the horizontal
shift in the AD curve as a result of $1 of added government
purchases.
 The Keynesian net tax multiplier is equal to mpc/(1-mpc).
 Note: The Keynesian expenditure multiplier is greater than the
“effective multiplier” reported in many statistical studies of
fiscal stimulus. The “effective multiplier” measures the amount
by which the output gap is reduced by a $1 stimulus, not the
amount of shift in the AD curve.
Introduction to Economics
(Combined Version) 5th Edition
The Crowding Out Effect
 Fiscal stimulus increases the
deficit and causes interest rates to
rise.
 Higher interest rates reduce
planned investment and
purchases of durable goods
bought on credit.
 The reduction in planned
investment and consumption
partly offsets the effect of the
fiscal stimulus.
 The tendency of an increased
government deficit to reduce
planned investment and
purchases of consumer durables is
called the crowding-out effect.
Monetary policy and the
crowding-out effect
• The crowding out effect is
minimized if the central bank
uses expansionary monetary
policy to hold interest rates
constant when fiscal stimulus
is applied
• Such coordinated use of
expansionary monetary
policy and fiscal stimulus is
called accommodating
monetary policy
Introduction to Economics
(Combined Version) 5th Edition
Reversibility
 Countercyclical fiscal policy
requires that fiscal stimulus
be applied at the start of a
contraction.
 The fiscal stimulus should be
reversed at the start of the
following expansion to avoid
overshooting.
 Politically motivated timeinconsistency may make it
hard to reverse fiscal
stimulus as an election
approaches.
Introduction to Economics
(Combined Version) 5th Edition
Apply fiscal
stimulus here
Reverse fiscal
stimulus here
 Fiscal stimulus is most effective if
the money can be spent
immediately. Following are
examples of fast-acting fiscal
stimulus:
 Subsidies to “shovel ready”
forms of spending like road
repairs
 Cash payments of tax rebates
to consumers
 The fastest-acting forms of fiscal
stimulus may not be the country’s
highest spending priorities.
 Projects like health-care reform or
infrastructure projects may have
long lags because of needed
planning, design, and permitting.
www.pdclipart.org
Fiscal Priorities
Every political group has its own set of
spending priorities
Introduction to Economics
(Combined Version) 5th Edition
Automatic vs. Discretionary Fiscal Policy
 Discretionary fiscal stimulus
means changes in laws to
increase government
purchases, increase transfer
payments, or cut taxes.
 Automatic fiscal stimulus
means changes in purchases,
transfers, or taxes that occur
because of changes in GDP and
the price level.
 Example: More is spent on
unemployment benefits when
the economy enters a
recession.
Discretionary stimulus requires the signing
of new laws
Introduction to Economics
(Combined Version) 5th Edition
Automatic Stabilizers
 Because automatic fiscal
policy like unemployment
benefits tends to increase
the deficit when the
economy enters recession,
they tend to moderate the
business cycle.
 The same can be said of
taxes that increase as the
economy enters an
expansion.
 Together, such taxes and
expenditures are known as
automatic stabilizers.
. . . and they
reverse the
stimulus here
Automatic
stabilizers
apply stimulus
here . . .
Introduction to Economics
(Combined Version) 5th Edition
A Cyclical Deficit
 In 2010, when the economy was in recession, the actual U.S. budget deficit was 8.4
percent of GDP.
 If real output had been at its natural level with the same tax and spending laws, the
structural budget deficit would have been just 6.3 percent of GDP.
 The difference between the two indicated a cyclical deficit of 2.1 percent of GDP.
Introduction to Economics
(Combined Version) 5th Edition
A Cyclical Surplus
•
•
•
In 2000, when the economy was at the peak of an expansion, the actual U.S. budget
surplus was 2.5 percent of GDP.
If real output had been at its natural level with the same tax and spending laws, the
structural budget surplus would have been just 0.9 percent of GDP.
The difference between the two (1.6 percent) indicated a cyclical surplus.
Introduction to Economics
(Combined Version) 5th Edition
The Budget Process
 The U.S. government operates on a fiscal
year from October 1 to September 30.
Example: Fiscal year 2014 starts October 1,
2013.
 In the winter before the fiscal year, the
President submits a budget message to
Congress.
 Congress passes a nonbinding budget
resolution in the spring.
 It should pass 12 appropriations bills to
authorize spending by the end of September.
 If it does not, the government has to operate
on the basis of a continuing resolution.
Introduction to Economics
(Combined Version) 5th Edition
Spending Not Subject to the
Annual Budget Cycle
 Entitlements: federal benefit programs such as social security and Medicare that are not
subject to the annual budget process
 Interest expenditures: interest payments on the national debt are another category of
expenditure that is not subject to annual review
 Discretionary spending includes all items subject to the annual appropriations process.
Introduction to Economics (Combined Version) 5th Edition
Tax Expenditures
 Tax expenditure is a
tax deduction or
other tax preference
intended to
encourage behavior
that serves some
purpose of public
policy.
 This table lists the
twelve largest tax
expenditures for
2012. Total tax
expenditures that
year were about $1.2
trillion, about onethird of the amount
of ordinary cash
expenditures.
Introduction to Economics
(Combined Version) 5th Edition
More Slideshows
More classroom-ready slideshows on fiscal policy:
•The Truth about Taxes: What are our Choices? These
slides were originally prepared for a presentation to a
local chapter of the League of Women Voters. They
focus on the issue of changes in tax rates vs. broader
tax reform that broadens the tax base.
• The Case against the Mortgage Interest Deduction is a
case study in tax expenditure.
If you have trouble with the links on this slide, check the
index of slideshows on Ed Dolan’s Econ Blog,
(dolanecon.blogspot.com)
Introduction to Economics
(Combined Version) 5th Edition