FISCAL POLICY-MODULES 20/21
J.A.SACCO
2
Introduction
One major government policy tool is fiscal policy,
which involves changes in government spending,
changes in taxes, or both.
During periods when the economy is doing poorly,
policymakers in Washington, D.C., have at times
recommended and enacted tax cuts. At other
times, when the federal government was spending
much more that it was receiving in taxes,
policymakers have recommended and enacted tax
increases.
3
Preview Questions
• What is fiscal policy?
• What is automatic fiscal policy, and how does it lend
stability to an economy?
• How does the crowding-out effect offset expansionary
fiscal policy?
• What types of time lags exists between the need for fiscal
stimulus and the time when such stimulus actually affects
the national economy?
4
Did You Know That...
• The first type of income tax was probably established in
the 1200s and 1300s during times of war in the Italian
city-states?
• America’s first income tax, enacted in 1861 to help pay for
the Civil War, was 3 percent on incomes over $800 a year.
5
Fiscal Policy
• 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
6
FISCAL POLICY
• Types of Fiscal Policy
• Fiscal policy can be either
• Discretionary
• Automatic
7
FISCAL POLICY
• Discretionary fiscal policy
• A fiscal policy action that is initiated by an act of
Congress.
• Automatic fiscal policy
• A fiscal policy action that is triggered by the state of the
economy
• For example, an increase in unemployment induces an
increase in payments to the unemployed or in a
recession marginal taxes decrease as incomes fall.
8
FISCAL POLICY
• Discretionary Fiscal Policy: Demand-Side Effects
The Government Expenditure Multiplier
• The government expenditure multiplier is
magnification effect of a change in government
expenditure on goods and services on aggregate
demand.
• It works like the autonomous expenditure multiplier.
9
FISCAL POLICY
The Tax Multiplier
• The
tax multiplier magnification effect of a change
in taxes on aggregate demand.
• A decrease in taxes increases disposable income.
And an increase in disposable income increases
consumption expenditure.
• With increased consumption expenditure,
employment and incomes rise and consumption
expenditure increases yet further.
10
FISCAL POLICY
• So a decrease in taxes works like an increase in government
expenditure.
• Both actions increase aggregate demand and have a multiplier
effect.
• The magnitude of the tax multiplier is smaller than the government
expenditure multiplier.
11
Expansionary Fiscal Policy
LRAS
1)
Price Level
SRAS
2)
3)
E1
130
E2
4)
120
Economy begins at E1, which is
_________.
There is a decrease in aggregate
demand to AD2 resulting in a
______.
According to the “classical
economists”, how does the
economy adjust to this situation?
According to Keynes how does
this economy recover?
What is this ?
AD1
AD2
0
6.5 7.0
Real National Income per Year
($ trillions)
12
Expansionary Fiscal Policy
LRAS
Price Level
SRAS
E2
130
E1
120
Contractionary
gap
AD2
AD1
0
6.5 7.0
Real National Income per Year
($ trillions)
1) The contractionary
gap is caused by
insufficient AD
2) To increase AD- use
expansionary fiscal
policy to increase
government
spending/ reduce
taxes
3) With an increase in
G/decrease in taxes
AD increases and
real GDP increases
to full employment
13
Fiscal Policy
• Questions
• Would the increase in government spending/ decrease in taxes
have to equal the size of the gap ($.5 trillion)?
• What impact did the expansionary fiscal policy have on the price
level?
14
Expansionary Fiscal Policy and the Multiplier
Potential GDP is $10
trillion, real GDP is $9
trillion, and
1. There is a $1 trillion
recessionary gap.
2. An increase in
government
expenditure or a tax cut
increases expenditure
by ∆E.
15
Expansionary Fiscal Policy
3. The multiplier increases
induced expenditure.
The AD curve shifts
rightward to AD1.
The price level rises to
110, real GDP increases
to $10 trillion, and the
recessionary gap is
eliminated.
16
Contractionary Fiscal Policy:
LRAS
SRAS
1)
2)
Price Level
3)
120
E1
AD1
What is this?
0
Explain the state of this economy.
If nothing is done, what will
eventually happen in this
economy?
Keynesian view on this situation?
7.0 7.5
Real National Income per Year
($ trillions)
17
Contractionary Fiscal Policy:
Price Level
LRAS
120
100
E2
Expansionary
gap
0
1) The expansionary
gap is caused by SR
SRAS
equilibrium > fullemployment
2) To decrease AD, use
contractionary fiscal
policy to decrease
E1
government spending
or increase taxes
3) With a decrease in
G or increase in taxes
AD decreases and
real GDP decreases
AD1
to full employment and the
AD2
price level drops
7.0 7.5
Real National Income per Year
($ trillions)
18
Contractionary Fiscal Policy
Potential GDP is $10
trillion, real GDP is
$11 trillion, and
1. There is a $1 trillion
inflationary gap.
2. A decrease in
government
expenditure or a tax
rise decreases
expenditure by ∆E.
19
Contractionary Fiscal Policy
3. The multiplier
decreases
induced
expenditure.
The AD curve
shifts leftward
to AD1.
The price level falls
to 110, real GDP
decreases to
$10 trillion, and the
inflationary gap is
eliminated.
20
Fiscal Policy
• Question
• What would be the long-run impact on real GDP of a tax cut if the
economy is at full-employment equilibrium?