•Keynesian view
•Discretionary versus non-discretionary fiscal policy
•The automatic stabilizers
•Fiscal policy to close a contractionary gap.
•The tax multiplier
•Fiscal policy to close an expansionary gap.
•Problems with fiscal policy
The use of the taxing and spending powers of
government to regulate aggregate expenditure,
and thereby to stabilize the economy
The economy needs to be
stabilized. The economy
can be stabilized. The
economy should be
stabilized. This is the
Keynesian view
This legislation
established a
responsibility for the
federal government to
promote “maximum
employment,
production, and
purchasing power.”
Discretionary fiscal policy is the deliberate
manipulation of government purchases, taxation, and
transfer payments to pursue macroeconomic goals
such as full employment and price stability.
The Bush tax stimulus package of
2008 is an example of
discretionary fiscal policy
Non-discretionary or “built-in” features of
government spending and taxation that reduce
fluctuations in disposable income, and thus
consumption, over the business cycle.
•Tax rates for various types of income are set by elected
officials. Tax collections depend on the employment
levels/incomes, profits, capital gains, retails sales, . . .
•Elected officials establish eligibility requirements and support
levels for needs-tested transfer payments—e.g., TANF, food
stamps, and unemployment compensation. Actual government
outlays for needs-tested transfer payments depend on (1) the
number of persons eligible; and (2) the number of those
eligible that actually file claims.
As the economy enters a recession,
federal revenues tend to decline
while at the same time transfer
payments rise. Thus recession
brings about an automatic decline
of net taxes (NT)
Remember that: DI = Y - NT
 Y  NT  DI
 Y  NT  DI
If a lack of aggregate expenditure is
the problem, why not use the
spending and taxing powers of the
federal government to stimulate
aggregate expenditure
YF is full-employment (potential) GDP.
AE
AE’
AE
•Increase in G
•Decrease in NT
a  bNT  I  G  X  M
Y
YF
Contractionary gap
Real GDP (Y)
Effect of a $0.1 trillion increase in G on AE and
real GDP demanded
Aggregate expenditure (trillions of dollars)
1
Y  G 
1 b
C+I+G’+(X-M)
b
14.5
C+I+G+(X-M)
0.1
14.0
a
45°
0
14.0
Real GDP
14.5
(trillions of dollars)
As a result of a$0.1 trillion
increase in government
purchases, the aggregate
expenditure line shifts up by
$0.1 trillion, increasing the
real GDP demanded by $0.5
trillion. This model assumes
price level remains
unchanged.
Aggregate expenditure (trillions of dollars)
Effect of a $0.1 trillion decrease in net taxes
on aggregate expenditure and real GDP
demanded
As a result of a decrease in
C’+I+G+(X-M)
b
14.5
C+I+G+(X-M)
0.08
14.0
a
45°
0
14.0
NT of $0.1 trillion,
consumers, who are assumed
to have a MPC of 0.8, spend
$80 billion more and save $20
billion at every level of GDP.
The consumption function
shifts up by $80 billion, as
does the AE line.
An $80 billion increase of AE line
eventually increases real GDP
demanded by $0.4 trillion. Keep in
mind that the price level is
Real GDP assumed to remain constant
14.5
(trillions of dollars) during all this.
10
Note: We assume imports are autonomous. Thus the
multiplier is given by:
1
1 b
1
Y  (b  NT ) 
1 b
[1]
We can rewrite [1] as:
b
Y  NT 
1 b
Tax multiplier
Discretionary fiscal policy: close a contractionary gap
Price
level
Potential output
LRAS
SRAS130
e*
130
e
e’
125
AD*
e’’
AD
0
13.5
14.0
The aggregate demand curve AD and
the short-run aggregate supply curve
SRAS130 intersect at point e. Output
falls short of the economy’s
potential. The resulting
contractionary gap is $0.5 trillion.
This gap could be closed by
discretionary fiscal policy that
increases aggregate demand by just
the right amount. An increase in
government purchases, a decrease in
net taxes, or some combination could
shift aggregate demand out to AD*,
moving the economy out to its
potential output at e*.
14.5 Real GDP
(trillions of dollars)
12
Discretionary fiscal policy: close expansionary
gap
The aggregate demand curve AD’
and the short-run aggregate supply
curve SRAS130 intersect at point e’
resulting in an expansionary gap of
$0.5 trillion.
Price
level
Potential output
LRAS
SRAS130
e’’
e’
135
AD’
130
e*
AD*
0
14.0
Discretionary fiscal policy aimed at
reducing aggregate demand by just
the right amount could close this gap
without inflation. An increase in net
taxes, a decrease in government
purchases, or some combination
could shift aggregate demand back to
AD* and move the economy back to
its potential output at e*.
14.5 Real GDP
(trillions of dollars)
13
1. Policy lags
2. Permanent income