Chapter 13
Fiscal Policy
Introduction
Countries belonging to the European Monetary
Union have agreed to follow a path of fiscal
discipline, keeping government spending in line
with tax receipts.
Under what conditions would a government be
tempted to allow expenditures to exceed
receipts?
Slide 13-2
Learning Objectives
 Use traditional Keynesian analysis to
evaluate the effects of discretionary
fiscal policy
 Discuss ways in which indirect
crowding out and direct expenditure
offsets can reduce the effectiveness of
fiscal policy actions
Slide 13-3
Learning Objectives
 Explain why the Ricardian equivalence
theorem calls into question the
usefulness of tax changes
 List and define fiscal policy time lags
and explain why they complicate efforts
to engage in fiscal “fine tuning”
Slide 13-4
Learning Objectives
 Describe how certain aspects of fiscal
policy function as automatic stabilizers
for the country
Slide 13-5
Chapter Outline
 Fiscal Policy
 Possible Offsets to Fiscal Policy
 Discretionary Fiscal Policy in Practice
 Automatic Stabilizers
 What Do We Really Know About Fiscal
Policy?
Slide 13-6
Did You Know That...
 Federal government dollars are used
to fund a variety of endeavors, such as
the Rock and Roll Hall of Fame and
the National Cowgirl Museum?
 There are economy-wide effects from
changes in the level of government
spending.
Slide 13-7
Fiscal Policy
 Discretionary Fiscal Policy
– The discretionary changes in government
expenditures and/or taxes in order to
achieve certain national economic goals
•
•
•
•
High employment
Price stability
Economic growth
Improvement of international payments
balance
Slide 13-8
Fiscal Policy
 An increase in government spending
will stimulate economic activity
 Changes in government spending
– Military spending
– Education spending
– Budgets for government agencies
Slide 13-9
Expansionary Fiscal Policy:
Changes in G
Price Level
LRAS
SRAS
• The recessionary gap is
caused by insufficient AD
• To increase AD, use
expansionary fiscal policy to
increase government spending
• With an increase in G,
AD increases and real GDP
increases to full employment
120
E1
AD1
0
Figure 13-1, Panel (a)
11.5 12.0
Real GDP per Year
($ trillions)
Slide 13-10
Expansionary Fiscal Policy:
Changes in G
Price Level
LRAS
SRAS
• The recessionary gap is
caused by insufficient AD
• To increase AD, use
expansionary fiscal policy to
increase government spending
• With an increase in G,
AD increases and real GDP
increases to full employment
E2
130
120
E1
AD2
AD1
0
Figure 13-1, Panel (a)
11.5 12.0
Real GDP per Year
($ trillions)
Slide 13-11
Fiscal Policy
 Questions
– Would the increase in government
spending equal the size of the gap?
– What impact did the expansionary fiscal
policy have on the price level?
Slide 13-12
Contractionary Fiscal Policy:
Changes in Government Spending
LRAS
Price Level
SRAS1
130
E1
• The inflationary gap is caused
by SR equilibrium > full
employment
• To decrease AD, use
contractionary fiscal policy to
decrease government
spending
• With a decrease in G, AD
decreases and real GDP
decreases to full employment
AD1
0
Figure 13-1, Panel (b)
12.0 12.5
Real GDP per Year
($ trillions)
Slide 13-13
Contractionary Fiscal Policy:
Changes in Government Spending
LRAS
Price Level
SRAS1
E1
130
120
E2
• The inflationary gap is caused
by SR equilibrium > full
employment
• To decrease AD, use
contractionary fiscal policy to
decrease government
spending
• With a decrease in G, AD
decreases and real GDP
decreases to full employment
AD1
AD2
0
Figure 13-1, Panel (b)
11.5 12.0
Real GDP per Year
($ trillions)
Slide 13-14
Fiscal Policy
 Change in taxes
– A rise in taxes causes a reduction in
aggregate demand because it can reduce
consumption spending, investment
expenditures, and net exports
Slide 13-15
Expansionary Fiscal Policy:
Changes in Taxes
LRAS
Price Level
SRAS1
• The recessionary gap is
caused by insufficient AD
• To increase AD, use
expansionary fiscal policy
to decrease taxes
• With a decrease in taxes,
AD increases and real
GDP increases to full
employment
AD1
0
Figure 13-3, Panel (b)
12.0
Real GDP per Year
($ trillions)
Slide 13-16
Expansionary Fiscal Policy:
Changes in Taxes
LRAS
Price Level
SRAS1
E2
120
110
E1
• The recessionary gap is
caused by insufficient AD
• To increase AD, use
expansionary fiscal policy
to decrease taxes
• With a decrease in taxes,
AD increases and real
GDP increases to full
employment
AD2
AD1
0
Figure 13-3, Panel (b)
11.5 12.0
Real GDP per Year
($ trillions)
Slide 13-17
Expansionary Fiscal Policy:
Changes in Taxes
LRAS
• The inflationary gap is caused
by SR equilibrium > full
employment
• To decrease AD, use
contractionary fiscal policy to
increase taxes
• With an increase in taxes AD
decreases and real GDP
decreases to full employment
Price Level
SRAS1
E1
120
100
E2
AD1
AD2
0
Figure 13-3, Panel (a)
12.0 12.5
Real GDP per Year
($ trillions)
Slide 13-18
Fiscal Policy
 Question
– What would be the long-run impact on of
a tax cut on real GDP if the economy is at
full-employment equilibrium?
Slide 13-19
Fiscal Policy
 Tax rates and tax revenues
– Will an increase in tax rates always raise
tax revenue?
Slide 13-20
Possible Offsets to Fiscal Policy
 Indirect crowding out
– Increases in government spending without
raising taxes creates additional borrowing
Slide 13-21
Possible Offsets to Fiscal Policy
 Crowding-Out Effect
– The tendency of expansionary fiscal
policy to cause a decrease in planned
investment or planned consumption; this
decrease normally results from the rise of
interest rates
Slide 13-22
The Crowding-Out Effect
LRAS
Price Level
SRAS
Expansionary policy
causing deficit spending
initially shifts from AD to AD2
E2
140
130
Equilibrium GDP
below full-employment
GDP—recessionary gap
E1
AD2
AD1
0
Figure 13-5
11.5 12.0
Real GDP per Year
($ trillions)
Slide 13-23
The Crowding-Out Effect
Price Level
LRAS
SRAS
E2
140
135
130
Expansionary policy
causing deficit spending
initially shifts from AD to AD2
E3
Due to crowding out,
AD shifts inward to AD3
Equilibrium GDP
below full-employment
GDP—recessionary gap
E1
AD2
AD3
AD1
0
Figure 13-5
11.5 12.0
11.75
Real GDP per Year
($ trillions)
Slide 13-24
The Crowding-Out Effect,
Step-By-Step
Figure 13-4
Slide 13-25
Possible Offsets to Fiscal Policy
 Direct crowding out
– Direct Expenditures Offsets
• Actions on the part of the private sector in
spending money that offset government fiscal
policy actions
• Any increase in government spending in an
area that competes with the private sector
Slide 13-26
Possible Offsets to Fiscal Policy
 Planning for the future:
The Ricardian equivalence theorem
– Ricardian Equivalence Theorem
• The proposition that an increase in the
government budget deficit has no effect on
aggregate demand
Slide 13-27
Possible Offsets to Fiscal Policy
 Planning for the future:
The Ricardian equivalence theorem
– The reason for the offset
• People anticipate that a larger deficit today will
mean higher taxes in the future and adjust
their spending accordingly
Slide 13-28
Policy Example:
The Direct Offset of Government Grants
 Some scientific and engineering
research is conducted by private
companies that receive government
grants as part of their funding.
 To the extent that this research would
be conducted anyway, even without the
grant, then the public expenditure is
simply replacing a private one.
Slide 13-29
Possible Offsets to Fiscal Policy
 The supply-side effects of changes in
taxes
– Expansionary fiscal policy involving the
reduction of marginal tax rates in order to:
• increase productivity, since individuals will
work harder and longer, save more, and invest
more
• increase productivity, which will lead to more
economic growth
Slide 13-30
Possible Offsets to Fiscal Policy
 Supply-Side Economics
– Creating incentives for individuals and
firms to work more or to increase
productivity will shift the aggregate supply
curve to the right.
Slide 13-31
Possible Offsets to Fiscal Policy
 Question
– Would a tax increase cause you to work
more or less?
Slide 13-32
Possible Offsets to Fiscal Policy
Laffer Curve
Tax rates and
tax revenues
rise together
Tax revenues
are at a maximum
Tax rates and tax
revenues fall
together
Figure 13-6
Slide 13-33
Discretionary Fiscal Policy
in Practice
 Question
– Is fiscal policy as precise as it appears?
Slide 13-34
Discretionary Fiscal Policy
in Practice
 Time lags
– Recognition Time Lag
• The time required to gather information about
the current state of the economy
Slide 13-35
Discretionary Fiscal Policy
in Practice
 Time lags
– Action Time Lag
• The time required between recognizing an
economic problem and putting policy into
effect
– Particularly long for fiscal policy
Slide 13-36
Discretionary Fiscal Policy
in Practice
 Time lags
– Effect Time Lag
• The time it takes for a fiscal policy to affect
the economy
Slide 13-37
Discretionary Fiscal Policy
in Practice
 Fiscal policy time lags are long.
A policy designed to correct a
recession may not produce results until
the economy is experiencing inflation.
 Fiscal policy time lags are variable in
length (1–3 years). The timing of the
desired effect cannot be predicted.
Slide 13-38
Policy Example: An Unexpected
Leak in the Stream of Tax Revenues
 Federal income taxes are collected
based on the dollar amount of wages
and salaries.
 As employees have accepted more of
their compensation in the form of
health benefits, this has dampened
growth of the tax base.
Slide 13-39
Automatic Stabilizers
 Automatic Stabilizers
– Changes in government spending and
taxation that occur automatically without
deliberate action of Congress
• Examples:
– The tax system
– Unemployment compensation
– Welfare spending
Slide 13-40
Automatic Stabilizers
Government Transfers
and Tax Revenues
Unemployment
compensation and welfare
Tax
revenues
Budget surplus
Budget
deficit
The automatic changes tend
to drive the economy back
toward its full-employment
output level
0
Figure 13-7
Y2
Y1
Real GDP per Year
($ trillions)
Slide 13-41
Automatic Stabilizers
Government Transfers
and Tax Revenues
Unemployment
compensation and welfare
Tax
revenues
Budget surplus
Budget
deficit
0
Figure 13-7
Y2
Yf
Y1
Real GDP per Year
($ trillions)
Slide 13-42
What Do We Really Know
About Fiscal Policy?
 Fiscal policy during normal times
– Congress ends up doing too little too late
to help in a minor recession.
– Fiscal policy that generates repeated tax
changes (as it has done) creates
uncertainty.
Slide 13-43
What Do We Really Know
About Fiscal Policy?
 Fiscal policy during abnormal times
– Fiscal policy can be effective
• The Great Depression
• Wartime
Slide 13-44
What Do We Really Know
About Fiscal Policy?
 The “soothing” effect of Keynesian
fiscal policy
– Assume
• We know how to use fiscal policy to prevent
another depression
– Results
• Stable expectations encourage a smoothing of
investment spending
Slide 13-45
Issues and Applications:
U.S. Government Budget Projections
 Despite having agreed to certain terms of fiscal
discipline, both France and Germany have allowed
government spending to exceed tax receipts.
 Marginal tax rates were reduced in order to
stimulate aggregate demand and to boost
productivity.
 Because nether government reduced spending in
the short term, both countries found that
expenditures were exceeding tax receipts.
 This stimulative effect led to higher growth in real
GDP and a reduction in unemployment.
Slide 13-46
Summary Discussion
of Learning Objectives
 The effects of discretionary fiscal policy
using traditional Keynesian analysis
– Increases in government spending and
decreases in taxes increase aggregate
demand.
– Decreases in government spending and
increases in taxes decrease aggregate
demand.
Slide 13-47
Summary Discussion
of Learning Objectives
 How indirect crowding out and direct
expenditure offsets reduce the effectiveness
of fiscal policy
– Deficits increase interest rates
– Some government spending replaces
private spending
 The Ricardian equivalence theorem states
that government borrowing to finance
deficits causes people in anticipation of
higher interest rates to repay the loans.
Slide 13-48
Summary Discussion
of Learning Objectives
 Fiscal policy time lags and the effectiveness
of fiscal “fine tuning”
– The time lags for fiscal policy are the recognition
time lag, action time lag, and the effect time lag.
– The time lags are long and variable.
 Automatic stabilizers are changes in tax
payments, unemployment compensation,
and welfare payments that automatically
change with the level of economic activity.
Slide 13-49
End of
Chapter 13
Fiscal Policy