Chapter 12
Fiscal Policy
Slides to Accompany “Economics: Public and Private Choice 9th ed.”
James Gwartney, Richard Stroup, and Russell Sobel
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1. Budget Deficits
and Surpluses
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Budget Deficits and Surpluses

Budget deficit:
-- Present when total government spending exceeds
total revenue from all sources.
 When the money supply is constant, deficits must
be covered with borrowing.
 The U.S. Treasury borrows funds by issuing bonds.

Budget surplus:
-- Present when total government spending exceeds
total revenue from all sources.
 Surpluses reduce the size of the government’s
outstanding debt.
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Budget Deficits and Surpluses


Changes in the size of the federal deficit or
surplus are often used to gauge whether fiscal
policy is adding additional demand stimulus or
imposing additional demand restraint.
Changes in the size of the budget deficit or
surplus may arise from either:


A change in the state of the economy, or,
A change in discretionary fiscal policy
-- that is, through either government spending
and/or changes in taxation.
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2. The Keynesian View
of Fiscal Policy
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The Keynesian View
of Fiscal Policy


Keynesian theory highlights the potential
of fiscal policy as a tool capable of
reducing fluctuations in demand.
When an economy is operating below its
potential output, the Keynesian model
suggests that the government should institute
expansionary fiscal policy -- it should either:


increase the government’s purchases
of goods & services, and/or,
cut taxes.
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Expansionary Fiscal Policy
to Promote Full-Employment
Price
level
LRAS
P2
P1
P3
SRAS1
SRAS3
E2
Expansionary fiscal policy
stimulates demand and
directs the economy to
full-employment
e1
E3
Keynesians believe that allowing
for the market to self-adjust may
be a lengthy and painful process.
AD1
Y1 YF

AD2
Goods & Services
(real GDP)
We begin in the short run at Y1, below the economy’s potential capacity (YF).
There are 2 routes to long-run full-employment equilibrium.

Policymakers could wait for both lower wages and resource prices to
reduce costs, increase supply to SRAS3 and restore equilibrium at YF.

Alternatively, expansionary fiscal policy could stimulate aggregate
demand (shift AD1 to AD2) and guide the economy back to E2, at YF.
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The Keynesian View
of Fiscal Policy


When inflation is a potential problem, the
Keynesian analysis suggests a shift toward
a more restrictive fiscal policy:
 reduce government spending, and/or,
 raise taxes.
Keynesians challenged the view that the
government’s should always be balance its
budget.

Rather than balancing the budget annually,
Keynesians argued that counter-cyclical
policy should be used to offset fluctuations
in aggregate demand.
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Restrictive Fiscal Policy
to Combat Inflation
Price
level
SRAS3
LRAS
P3
E3
P1
P2
SRAS1
Restrictive fiscal policy
restrains demand and
helps control inflation.
e1
E2
AD2
YF Y1

AD1
Goods & Services
(real GDP)
Strong demand such as AD1 will temporarily lead to an output rate beyond
the economy’s long-run potential (YF).

If maintained, the high level of demand will lead to the long-run
equilibrium E3 at a higher price level (as SRAS shifts back to SRAS3).

However, restrictive fiscal policy could restrain demand from expanding
to AD2 in the first place and guide the economy to a non-inflationary
equilibrium (E2).
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3. Fiscal Policy and the
Crowding-out Effect
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Fiscal Policy and the
Crowding-out Effect

The Crowding-out Effect:
-- indicates that the increased borrowing to finance
a budget deficit will push real interest rates up
and thereby retard private spending, reducing the
stimulus effect of expansionary fiscal policy.

The implications of the crowding-out analysis are
symmetrical.


Restrictive fiscal policy will reduce real interest
rates and "crowd in" private spending.
Crowding-out Effect in an open economy:
-- Larger budget deficits and higher real interest
rates also lead to an inflow of capital, appreciation
in the dollar, and a decline in net exports.
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A Visual Presentation of the Crowding-Out
Effect in an Open Economy
Decline in
Private
Investment
Increase
In Budget
Deficit






Higher Real
Interest Rates
Inflow of
An increase in govt.
Financial
borrowing to finance
Capital
an enlarged budget
from Abroad
Appreciation
deficit places upward
of the Dollar
pressure on real interest rates.
Decline in
Net Exports
This retards private investment
and thereby Aggregate Demand.
In an open economy, higher interest rates attract capital from abroad.
As foreigners buy more dollars to buy U.S. bonds and other financial
assets, the dollar appreciates.
In turn, the appreciation of the dollar causes net exports to fall.
Thus, as a result of increased budget deficits, higher interest rates
trigger reductions in both private investment and net exports, which
weaken the expansionary impact of a budget deficit.
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4. The New Classical
View of Fiscal Policy
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The New Classical View
of Fiscal Policy

The New classical view stresses that:



debt financing merely substitutes higher
future taxes for lower current taxes, and thus,
budget deficits affect the timing of taxes, but
not their magnitude.
New Classics argue that when debt is substituted
for taxes


people will save the increased income so they will
be able to pay the higher future taxes, thus,
the budget deficit does not stimulate aggregate
demand.
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The New Classical View
of Fiscal Policy


Similarly, the real interest rate is unaffected
by deficits since people will save more in
order to pay the higher future taxes.
According to the new classical view, fiscal
policy is completely impotent. It does not
effect output, employment, or real interest rates.
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New Classical View -- Higher Expected
Future Taxes Crowd-out Private Spending
Price
level
SRAS1
P1
AD1
Y1



AD2
Goods & Services
(real GDP)
New Classical economists emphasize that budget deficits merely
substitute future taxes for current taxes.
If households did not anticipate the higher future taxes, aggregate
demand would increase (from AD1 to AD2).
However, demand remains unchanged at AD1 when households
fully anticipate the future increase in taxes and, so, save for them.
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New Classical View -- Higher Expected
Future Taxes Crowd-out Private Spending
Price
level
S1
S2
r1
e1
e2
D1
Q1



Under this model, fiscal
policy exerts no effect -the interest rate, real GDP,
and level of unemployment
each remain unchanged.
Q2
D2
Loanable
Funds
In order to finance the budget deficit, the govt borrows from the loanable
funds market, increasing the demand (from D1 to D2).
According to the new classical view, people will save more in order to
pay the higher future taxes implied by the increases in debt. This will
increase the supply of loanable funds to S2.
This permits the government to borrow the funds to finance the deficit
without pushing up the interest rate.
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5. Fiscal Policy:
-- Problems of
Proper Timing
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Fiscal Policy:
-- Problems with Proper Timing


Various time lags make proper timing of
changes in discretionary fiscal policy difficult.
Discretionary fiscal policy is like a two-edged
sword; it can both harm and help.


If timed correctly, it may reduce
economic instability.
If timed incorrectly, however, it may
increase economic instability.
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Why Proper Timing of
Fiscal Policy is Difficult
Price
level
LRAS
SRAS
Consider that shifts in
AD are difficult to forecast.
P0
P1
E0
e1
AD1 AD0
Y1 YF



Goods & Services
(real GDP)
We begin long-run equilibrium (E0) at the price level P0 and output Y0.
At this output, only the natural rate of unemployment is present.
An investment slump and business pessimism result in an unanticipated
decline in AD (to AD1). Output falls and unemployment increases.
After a time, policymakers institute expansionary fiscal policy seeking
to shift AD back to AD0, but by the time fiscal policy begins to exert its
primary effect, private investment has recovered and decision makers
have become increasingly optimistic about the future.
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Why Proper Timing of
Fiscal Policy is Difficult
Price
level
LRAS
P3
e4
P2
P0
P1
SRAS2
SRAS
e2
E0
e1
AD2
AD
0
AD1
Goods & Services
(real GDP)
Y1 YF Y2



Thus, just as AD begins shifting back to AD0 by its own means,
the effects of fiscal policy over-shift AD to AD2.
The price level in the economy rises as the economy is now
overheated.
Unless the expansionary fiscal policy is reversed, wages and
other resource prices will eventually increase, shifting SRAS
back to SRAS2 (driving the price level up to P3).
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Why Proper Timing of
Fiscal Policy is Difficult
Price
level
LRAS
P2
P0
SRAS
e2
E0
AD0
YF Y2


AD2
Goods & Services
(real GDP)
Alternatively, suppose an investment boom disrupts the initial
equilibrium shifting aggregate demand out to AD2, placing upward
pressure on prices.
Policymakers respond by increasing taxes and cutting government
expenditures, but by the time that the restrictive fiscal policy has
had an opportunity to take effect, investment returns to its normal
rate (shifting AD2 back to AD0).
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Why Proper Timing of
Fiscal Policy is Difficult
Price
level
LRAS
P2
P0
P1
SRAS
e2
E0
e1
AD2
AD
0
AD1
Goods & Services
(real GDP)
Y1 YF Y2



Thus, just as AD begins shifting back to AD0 by its own means,
the effects of fiscal policy over-shift AD to AD1.
The price level in the economy falls as the economy is now
thrown into recession.
Because fiscal policy does not work instantaneously, and since
dynamic factors are constantly influencing private demand,
proper timing of fiscal policy is not an easy task.
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Fiscal Policy:
-- Problems with Proper Timing

Automatic Stabilizers:
-- without any new legislative action, they
tend to increase the budget deficit (or
reduce the surplus) during a recession and
increase the surplus (or reduce the deficit)
during an economic boom.

Examples of Automatic Stabilizers:



Unemployment Compensation
Corporate Profit Tax
A Progressive Income Tax
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6. Fiscal Policy
as a Tool:
-- A Modern Synthesis
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Fiscal Policy as a Tool:
-- A Modern Synthesis



The proper timing of discretionary fiscal
policy is both difficult to achieve and of
crucial importance.
Automatic stabilizers reduce the fluctuation
of aggregate demand and help to direct the
economy toward full-employment.
Fiscal policy is much less potent than the
early Keynesian view implied.
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Questions for Thought:
1. What is the Keynesian view of fiscal policy?
How do the crowding-out and new classical
models modify the basic Keynesian analysis?
2. Why is the proper timing of a change in fiscal
policy important?
3. "Budget deficits may stimulate aggregate
demand and output in the short run, but since
they divert funds away from capital formation
and toward current consumption, they will
retard the growth of output in the long run."
Do you agree with this statement?
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7. Supply-side Effects
of Fiscal Policy
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Supply-side Effects
of Fiscal Policy

From a supply-side viewpoint, the marginal tax
rate is of crucial importance:


A reduction in marginal tax rates increases the
reward derived from added work, investment,
saving, and other activities that become less
heavily taxed.
High marginal tax rates will tend to retard total
output because they will:



Discourage work effort and reduce the
productive efficiency of labor,
Adversely affect the rate of capital formation
and the efficiency of its use, and,
Encourage individuals to substitute less
desired tax-deductible goods for more desired
non-deductible goods.
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Supply-side Effects
of Fiscal Policy


Thus, changes in marginal tax rates, particularly
high marginal rates, may exert an impact on
aggregate supply because the changes will
influence the relative attractiveness of productive
activity in comparison to leisure and tax avoidance.
Impact of supply-side effects



Are likely to take place over a lengthy time period.
There is some evidence that countries with high
taxes grow more slowly—France and Germany
versus United Kingdom.
While the significance of supply-side effects are
controversial, there is evidence they are important
for taxpayers facing extremely high rate, say rates
of 40 percent and above.
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Tax Rate Effects
and Supply-Side Economics
Price
level
LRAS1 LRAS2
SRAS1
SRAS2
P0
E1
E2
AD1
YF1



YF2
With time, lower tax rates
will promote more rapid
growth (shifting LRAS
and SRAS to the right to
LRAS2 and SRAS2).
AD2
Goods & Services
(real GDP)
What are the supply-side effects of a reduction in marginal tax rates?
The lower marginal tax rates increase the incentive to earn and use
resources efficiently. AD1 shifts out to AD2, and as the effects of the tax
cut are long-run as well as short-run, both SRAS and LRAS shift out.
If the lower tax rates are financed by budget deficits, aggregate demand
may expand by a larger amount than aggregate supply, leading to an
increase in the price level.
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How Have Changes in Marginal Tax Rates
Affected the Share of Taxes Paid By The Rich?
Share of Personal Income Taxes
Paid by Top 0.5 Percent of Earners
.23
.22
1986
Top rate
cut from
50% to 30%
.21
1990–93
Top rate
raised from
30% to 39.6%
.20
This graphic illustrates that,
at least for this group of
high-income recipients,
there existed strong supplyside effects associated with
changes in marginal rates.
1964–65
Top rate
cut from
91% to 70%
.19
.18
.17
.16
1981
Top rate
cut from
70% to 50%
.15
.14
<
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996


Year
The above graph indicates the share of the personal income tax paid by
the top one-half percent of earners during 1960-1996. There were 3
major reductions in the top marginal tax rate during this period.
Note that the share of the tax bill paid by these “super-rich” earners
increased following each of the tax cuts and fell when inflation pushed
more and more taxpayers into higher tax brackets during the ‘70s and
when rates were raised again (to 39.6%) during the Bush/Clinton years.
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8. Empirical Evidence
on the Impact of
Fiscal Policy
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Empirical Evidence on
the Impact of Fiscal Policy
Percent
of Real GDP
26
Expenditures
24
22
Deficits
20
Revenues
18
<
1960
1965
1970
1975
1980
1985
1990
1995
2000
Year

Fiscal policy during the past 4 decades:


Since 1960 the federal budget as a % of GDP has
generally increased during recessions and declined
during periods of economic expansion.
Budget deficits and interest rates:


The year-to-year relationship is weak.
However, interest rates were high as the deficits
of the early 80’s rose.
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Empirical Evidence on
the Impact of Fiscal Policy
Component as a % of GDP
Time
Period
Real
Federal
I
nterest
Deficit
Rate A
% Of GDP
Gross
Net
Personal
Private
Foreign
Consumption Investment Investment
Gross
Investment
Less Net
Net
Foreign
Investment Exports
1976–1980
1983–1987
Differential B
2.9
5.1
+2.2
1.9
7.5
+5.6
62.3
65.0
+2.2
17.5
16.7
-0.8
0.0
2.6
+2.6
17.5
14.1
-3.4
- 0.8
- 2.6
-1.8
1960–1974
1981–1994
Differential B
0.9
4.0
+3.1
2.4
6.1
+3.7
62.0
65.8
+3.8
15.7
15.3
-0.4
- 0.5
1.6
+2.1
16.2
13.7
+2.5
0.2
- 1.6
-1.8
A
B Later
period minus earlier period. As the data of the
first column indicate, the federal deficits were larger
during the later period.
Source: Derived from the Economic Report of the President, 1996, Tables B-1, B-3, B-28, and B-73.

The real interest rate was derived by subtracting
the annual inflation rate as measured by the
GDP deflator from the AAA corporate bond rate.
Consumption and Investment:



As deficits rose from ‘83 to ‘87, consumption rose (from 62.2%
to 65%), consequently savings fell (also in ‘81-‘84 period).
This runs contrary to the new classical view.
Appreciation of the dollar, capital inflow and net exports:


As deficits rose from ‘83 to ‘87, net foreign investment rose
(from 0% to 2.6%), while net exports fell. (also in ‘81-‘84 period).
This is consistent with the crowding-out model.
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9. Current View
of Fiscal Policy
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Current View
of Fiscal Policy



Compared to two decades ago, there is
now greater awareness of the political
and economic factors that make the
proper timing of fiscal policy difficult.
There is now more concern about the
impact of budget deficits on interest rates
and capital formation.
In the 1990s, there has been more
emphasis on controlling the deficit and
balancing the budget.
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Questions for Thought:
1. The following quotation was made in the mid-1980s by Paul
Samuelson, perhaps the leading American Keynesian:
“In the early stages of the Keynesian revolution, macroeconomists emphasized fiscal policy as the most powerful
and balanced remedy for demand management. Gradually,
shortcomings of fiscal policy became apparent. The shortcomings stem from timing, politics, macroeconomic theory,
and the deficit itself."
What are the shortcomings Samuelson is referring to?
2. Outline the supply-side view of fiscal policy. How does
this view differ from the various demand-side theories?
3. The budget deficit decreased steadily during 1993-1998.
What factors accounted for the reduction in the deficit
during the period? Do you think a change in views toward
fiscal policy played any role? Did the deficit reduction
exert a positive or negative impact on the economy?
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End
Chapter 12
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