ECONOMICS
What does it mean to me?
FISCAL POLICY
READ Krugman Sec 4, Mod 21
Mankiw Ch 34
DO Morton Unit 3
READ
Krugman Section 4, Module 21
Mankiw Chapter 33, 34, 35,
Module 21
Fiscal Policy
and the Multiplier
•KRUGMAN'S
•MACROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• Why fiscal policy has a multiplier effect
• How the multiplier effect is influenced by
automatic stabilizers
Krugman, Sec 4 Mod 21
Fear the Boom and Bust
What you will learn in this chapter:
What fiscal policy is and why it is an important tool in
managing economic fluctuations
Which policies constitute an expansionary fiscal policy and
which constitute a contractionary fiscal policy
Why fiscal policy has a multiplier effect and how this effect
is influenced by automatic stabilizers
How to measure the government budget balance and how
it is affected by economic fluctuations
Why a large public debt may be a cause for concern
Why implicit liabilities of the government are also a cause
for concern
*Krugman
MONETARY POLICY
(Federal Reserve)
FISCAL POLICY
Expansionary:
(Federal Government)
1) Lower discount rate
Expansionary:
2) Lower reserve
requirement
1) Lower taxes
2) Increase spending
3) Buy T-bills
Contractionary:
Contractionary:
•
Raise discount rate
•
Raise taxes
•
Raise reserve
requirement
•
Decrease spending
•
Sell T-bills
Fiscal Policy: The Basics
*Krugman
Sources of Tax Revenue in the
United States, 2004
*Krugman
Government Spending in the
United States, 2004
*Krugman
The Government Budget and
Total Spending
Fiscal policy is the use of taxes, government transfers, or
government purchases of goods and services to shift the
aggregate demand curve.
Unemployment and
inflation are forms
of economic
instability closely
tied to long-term
economic growth.
The INSTABILITY
carries an
enormous cost-one that can be
measured in
economic as well
as human terms.
On one level,
unemployment and
inflation are simply
numbers that are
collected, reported in
the press, or plotted
on a graph.
On another level, they
represent enormous
economic failures that
waste the resources of
the nation and its
people.
•In the early 1980s, the U.S. reduced personal income
tax rates by some 25 percent, without offsetting
decreases in government spending. By expanding the
aggregate demand, this tax cut helped end the
recession of 1980-81 and promoted growth of output
and employment
•Earlier, during the Vietnam War, the U.S. placed a 10
percent surcharge--a tax added to taxes otherwise
owed--on both corporate and personal income taxes.
The idea was to reduce private spending and contain the
demand-pull inflation it caused.
•In the mid-1990s, Japan instituted a massive
government spending program to help move its
economy out of recession.
Why doesn’t government always
match it’s increase in spending
with its increase in taxes?
Under what circumstances might
government change spending and
taxation--or engage in FISCAL
POLICY.
Do these policies work?
FISCAL POLICY is the
manipulation of government
spending and taxes to
stabilize domestic output,
employment, and the price
level.
When Congressional leaders make changes
in the money circulation by adjusting taxes
and spending, they shift the aggregatedemand by influencing the spending
decisions of businesses and consumers.
For instance, suppose the U.S. Department of Defense
places a $25B order for fighter jets from Lockheed
Martin. The order raises demand for workers and other
resources to produce the jets. This results in an
increase in the total quantity of goods and services
demanded at each price level. This shifts the
aggregate-demand curve to the right.
The first emergence of fiscal actions on
the economy came during the
depression of the 1930s.
The EMPLOYMENT ACT OF 1946
committed the Federal government to the
promotion of fiscal responsibility and
economic stability by providing efforts to
promote employment.
The act also created the COUNCIL OF
ECONOMIC ADVISORS to assist the
President on economic matters.
DISCRETIONARY FISCAL POLICY is the
deliberate manipulation of taxes and government
spending by Congress to alter real GDP and
employment, control inflation, and stimulate economic
growth.
“Discretionary” means that the change in taxes and
government spending are at the option of the Federal
government.
•We assume government spending does not in any way
affect planned private spending
•We assume fiscal policy affects only the aggregate
demand side of the macroeconomy; it has no intended or
unintended effects on aggregate supply.
There are 2 types of Discretionary
Fiscal Policy used to control inflation,
employment, and stimulate economic
growth.
1) Expansionary Fiscal Policy: used
to reverse recession.
2) Contractionary Fiscal Policy: used
to control demand-pull inflation.
In order to explain DISCRETIONARY FISCAL POLICY,
we must first learn about:
MULTIPLIER EFFECT
CROWDING OUT EFFECT
MARGINAL PROPENSITY to
CONSUME
MARGINAL PROPENSITY to
SAVE
Multiplier Effects of an Increase in Government
Purchases of Goods and Services
• Initial increase in spending
• Indirect effect of increased spending
• Remember the multiplier
Krugman, Sec 4 Mod 21
The MULTIPLIER is a change in a component of
aggregate expenditures leading to a larger change
in equilibrium GDP.
Stated generally:
Multiplier =
change in real GDP
initial change in spending
By rearranging the above equation, we can also
say that:
Change in GDP = multiplier X initial change in spending
The reduction in AD that results when a fiscal
expansion raises the interest rate is called the
CROWDING OUT EFFECT.
This happens as a result of rising incomes in
households. As incomes rise, people plan to
buy more goods and services, resulting in
those people holding more of their wealth in
liquid form. The combination of fiscal
expansion causing the rise in incomes raises
the demand for money.
When an increase in government purchases increases AD….
The increase in spending increases money demand….
Which increases the equilibrium interest rate……
Which in turn partly offsets the initial increase in AD.
MS
MS
r2
AD2
r1
MD2
MD1
Quantity of Money
AD3
AD1
Quantity of Output
The MARGINAL PROPENSITY to CONSUME (MPC) is
the change in consumption as related to a change in
income.
MPC =
change in consumption
change in income
The MARGINAL PROPENSITY to SAVE (MPS) is the
ratio of saving as related to a change in income.
MPS =
change in saving
change in income
The sum of MPC and MPS must always
equal 1.
There is also a relationship between Marginal
Propensities (MPC and MPS) and the multiplier.
The initial change
in investment
spending of $5B
creates an equal
$5B of new
income in the first
round.
20
15.25
13.67
11.56
8.75
5
1
2
3
4 5 +
Assume this economy has an MPC = .75.
In the 2nd round,
households spend
$3.75 (=.75 x 5)
Round 3, spending
increase by $2.81
(=.75 x 3.75)
Round 4, by $2.11
(=.75 x 2.81)
Round 5, by $1.58
(=.75 x 2.81)
20
15.25
13.67
11.56
8.75
5
1
2
3
4 5 +
Assume this economy has an MPC = .75.
Once the entire
process is complete,
the cumulation results
in total change in
income of $20B
Using the equation
Multiplier =
1
1 - MPC
we find that the
multiplier is 4.
20
15.25
13.67
11.56
8.75
5
1
2
3
4 5 +
Three points about the multiplier must be made:
1) “Initial change in spending” is usually associated with
investment spending because of its volatility. But
changes in consumption, net exports, and government
purchases can also lead to the multiplier effect.
2) “Initial change in spending” refers to an upshift or
downshift of the aggregate expenditures schedule due to
an upshift or downshift of one of its components.
3) The multiplier works in both directions….an increase
in initial spending can create a multiple increase in GDP
or a decrease in spending can be multiplied into a larger
decrease in GDP.
Module 20
Economic Policy and
the Aggregate
Demand-Aggregate
Supply Model
•KRUGMAN'S
•MACROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• How the AD-AS model is used to
formulate macroeconomic policy
• The rationale for stabilization policy
• Why fiscal policy is an important tool for
managing economic fluctuations
• Which policies constitute expansionary
fiscal policy and which constitute
contractionary fiscal policy
Macroeconomic Policy
• Self-correction?
• Stabilization Policy
Policy in the Face of Demand
Shocks
• Negative Demand
Shocks & Positive
Demand Shocks
• Why are they bad?
• Should policymakers
counteract?
Responding to Supply Shocks
• Supply shock
• Policy dilemma
Fiscal Policy: The Basics
Taxes, Government Purchases of Goods and
Services, Transfers, and Borrowing
Taxes, Government Purchases of Goods and
Services, Transfers, and Borrowing
The Government Budget and Total Spending
• GDP = C + I + G + X - M
• The effect of taxes and transfers
• Effects on Investment
Expansionary and Contractionary
Fiscal Policy
• Expansionary Fiscal
Policy
• increase G
• decrease T
• increase transfers
Expansionary and Contractionary
Fiscal Policy
• Contractionary Fiscal
Policy
• decrease G
• increase T
• decrease transfers
A Cautionary Note: Lags in Fiscal Policy
• Time lags
• Recognition lag
• Decision lag
• Implementation lag
• Lags make decision making more difficult
When recession occurs, an
EXPANSIONARY
FISCAL POLICY
may be in order.
Suppose that a sharp
decline in investment
spending has shifted
AD from AD1 to AD2.
Perhaps profit
expectations on
investment projects
have dimmed,
curtailing much
investment spending
and reducing AD.
AS
P
R
I
C
E
AD2 AD1
$485 $505 GDPf
REAL GDP (billions)
Consequently, real GDP has fallen from $485b from its
near full-time level of $505b. Accompanying this $20b
decline in real output is an increase in unemployment
since fewer workers are needed to produce the
diminished output.
AS
This economy is
experiencing
recession and
cyclical
unemployment.
P
R
I
C
E
AD2 AD1
$485 $505 GDPf
REAL GDP (billions)
What should the government do?
There are 3 main options:
1) increase government spending,
2) reduce taxes,
3) use some combination of the two.
If the Federal budget is balanced at the onset, fiscal
policy during a recession or depression should create a
government BUDGET DEFICIT--or government
spending in excess of revenues.
All things being equal, an increase in government
spending will shift the AD curve to the right.
Suppose that recession
prompts government to
initiate $5b of new
spending on highways,
communications, and
prisons, represented by
the dashed line.
At EACH price level, the
amount of real output
demanded is now $5b
greater than that
demanded before the
increase.
$5 billion
initial
increase in
spending
P
R
I
C
E
AD2
REAL GDP (billions)
AS
But the AD curve shifts rightward to AD1; aggregate
demand increases by much more than the $5b in
government purchases.
This occurs because
the multiplier
process magnifies the
initial change in
spending into
successive rounds of
new consumption
spending.
$5 billion
initial
increase in
spending
P
R
I
C
E
AD2
REAL GDP (billions)
AS
If the economy’s MPC is .75 then the simple
multiplier is 4. The AD curve shifts right 4 times the
$5b increase.
Because this
particular increase in
AD occurs within the
horizontal range of
AS, real output rises
by the full extent of
the multiplier.
Unemployment falls
as firms call back laid
off workers.
$5 billion
initial
increase in
spending
P
R
I
C
E
AD1 AD2
AS
Full $20
billion
increase in
aggregate
demand
REAL GDP (billions)
Another option for expansionary fiscal policy would be
tax reductions to shift the aggregate demand curve
rightward.
Suppose government cuts
personal income taxes by
$6.7 billion, which increases
disposable income by the
same amount.
Consumption will rise by $5
billion (= MPC of .75 X $6.67
billion), and saving will go up
by $1.67 billion (= MPC of .25
X $6.67 billion). In this case
the horizontal distance
between AD2 and the dashed
line represents only the $5
billion initial increase in
consumption spending.
AS
P
R
I
C
E
AD2 AD1
REAL GDP (billions)
The aggregate demand curve eventually shifts rightward by four
times the $5 billion initial increase in consumption produced by
the tax cut. Real GDP rises by $20 billion, implying a multiplier
of 4. Employment also increases accordingly.
You may have also noted
that a tax cut must be
somewhat larger than the
proposed government
spending increase to
achieve the same amount
of rightward shift in the
aggregate demand curve.
This is part because part
of a tax reduction boosts
SAVINGS, not
consumption.
AS
P
R
I
C
E
AD2 AD1
$485b
$505b
REAL GDP (billions)
TO INCREASE INITIAL CONSUMPTION BY
A SPECIFIC AMOUNT, GOVERNMENT
MUST REDUCE TAXES BY MORE THAN
THAT AMOUNT.
With an MPC of .75, taxes must fall by $6.67 billion for
$5 billion of new consumption to be forthcoming,
because $1.67 billion is saved (not consumed).
If the MPC instead had been .6, then an $8.33b
reduction in tax collections would have been necessary
to increase initial consumption by $5b.
The smaller the MPC, the greater the tax cut needed to
accomplish a specific initial increase in consumption
and a shift in the AD curve.
Expansionary Fiscal Policy may also be initiated by a
combination of spending increases and tax reductions.
Government might increase its spending by
$1.25 billion while reducing taxes by $5 billion.
Can you ascertain why this combination will
produce the targeted $5b initial increase in
new spending.
If the government increases its
spending during recession to assist
the economy, the funds for such
expenditures must come from some
source. What source would have the
greatest expansionary effect?
Creating new money
Contractionary
Fiscal Policy
is used to control demand-pull
inflation.
AS
Suppose a shift of from AD3 to
AD4 occurs in the vertical range
of AS, and boosts the price level
from P3 to P4. This increase
may have resulted from a sharp
increase in investment or net
export spending.
Using fiscal policy, the remedy
used to control this is opposite
those used to control recession.
P4
P
R
I
C
E
AD4
P3
AD3
$515b
REAL GDP (billions)
What should the government do?
There are 3 main options:
1) decrease government spending,
2) increase taxes,
3) use some combination of the two.
When the economy faces demand-pull inflation, fiscal
policy should move toward a government BUDGET
SURPLUS--tax revenues in excess of government
spending.
Decreased government spending shifts the
AD curve leftward in its efforts to control
demand-pull inflation.
The dashed line represents $5
billion reduction in government
spending. Once the multiplier
effect is complete, the curve will
move from AD4 to AD3.
Assuming downward price
flexibility, the price level will return
to P3 and real output will remain
constant.
In the real world, prices are
“sticky” downward, so stopping
inflation is a matter of halting the
rise in the price level, not reducing
it to a previous level.
AS
P4
P
R
I
C
E
AD4
P3
AD3
$515b
REAL GDP (billions)
Increased taxes also shifts the AD curve
leftward in its efforts to control demand-pull
inflation by decreasing consumption.
If the economy has an MPC of
.75, government must raise taxes
by $6.67 billion to reduce
consumption by $5b. The $6.67
tax reduces saving by $1.67 ( =
the MPS of .25 X $6.67b) and this
$1.67b reduction in saving is not a
spending reduction.
But the $6.67b tax increase also
reduces consumption spending by
$5b (= the MPC of .75 x $6.67),
as shown by the dashed line.
After the multiplier process, AD
will shift left by $20b (= multiplier
of 4 X $5b).
AS
P4
P
R
I
C
E
AD4
P3
AD3
$515b
REAL GDP (billions)
Contractionary Fiscal Policy may also be
initiated by a combination of spending
decreases and tax increases
Why does a $2
billion decline in
government
spending paired
with a $4 billion
increase in taxes
shift the aggregate
.
demand curve from
AD4 to AD3.
AS
P4
P
R
I
C
E
AD4
P3
AD3
$515b
REAL GDP (billions)
Financing of Deficits and Disposing of Surpluses
The expansionary effect of deficit spending on the
economy depends on the method used to finance the
deficit. Similarly, the anti-inflationary impact of the
creation of a budget surplus depends on what is done
with the surplus.
There are two ways the government can FINANCE
THE DEFICIT:
1) Borrowing: When the government borrows money, it
competes with private business borrowers for the funds.
2) Money creation: Creation of new money is a more
expansionary (but potentially more inflationary) way of financing
deficit spending than is borrowing.
Demand-Pull inflation calls for fiscal action which will result in
a budget surplus. But the anti-inflationary effect of this
surplus depends on what government does with it.
There are two ways the government can DISPOSE OF
THE SURPLUS:
1) Debt Reduction: To retire the National Debt, the government
buys back some of its bonds; in doing so, it transfers its surplus tax
revenues back into the money market. This causes interest rates to
fall and thus private borrowing and spending to rise.
2) Impounding: Impounding the surplus funds and allowing them to
stand idle is a way for the government to extract and withhold
purchasing power from the economy.
Because there is no chance for the funds to be spent, the impounding
of a budget surplus is more anti-inflationary than the use of the
surplus to retire the public debt.
IS IT PREFERABLE TO USE GOVERNMENT
SPENDING OR TAXES TO ELIMINATE
RECESSION AND INFLATION?
The answer depends upon one’s view as to whether
the public sector is too large or too small.
“Liberal” economists, who think there are many unmet
social and infrastructure needs, usually recommend that
government spending be increased during recessions. In
times of demand-pull inflation, they tend to recommend tax
increases.
“Conservative” economists, who think the public sector
is too large and inefficient, usually advocate tax cuts during
recessions and cuts in government spending during times
of demand-pull inflation.
KRUGMAN’S
Contractionary v
Expansionary Policy
Expansionary and Contractionary Fiscal Policy
Expansionary Fiscal Policy Can Close a Recessionary
Gap
*Krugman
Expansionary and Contractionary Fiscal
Policy
Contractionary Fiscal Policy Can Eliminate an Inflationary Gap
*Krugman
The Multiplier Effect of an Increase in
Government Purchases of Goods and Services
*Krugman
How Taxes Affect the Multiplier
Automatic Stabilizers
Discretionary Fiscal Policy
The video on the next page is actually a Micro concept
but still applies here……….
Differences in the Effect of Expansionary Fiscal
Policies
The Budget Balance as a
Measure of Fiscal Policy
The budget balance is equal to government savings and is
defined by the following equation:
expansionary fiscal policies
contractionary fiscal policies
T= tax revenues
G=government
spending
TR=transfer
payments
The U.S. Federal Budget Deficit and the
Business Cycle
*Krugman
The U.S. Federal Budget Deficit and the
Unemployment Rate
*Krugman
What would the budget balance be if there
were neither a recessionary gap nor an
inflationary gap?
Cyclically adjusted budget balance is the estimate
of what the budget balance would be if real GDP
were exactly equal to potential output.
It takes into account the extra tax revenue the government
would collect and the transfers it would save if a
recessionary gap were eliminated-- or the revenue the
government would lose and the extra transfers it would
make if an inflationary gap were eliminated.
The Actual Budget Deficit Versus the
Cyclically Adjusted Budget Deficit
*Krugman
Government Debt as a Percentage of GDP
*Krugman
U.S. Federal Deficit and the Federal
Debt-GDP Ratio since 1939
*Krugman
Japanese Deficits and Debt
*Krugman
IMPLICIT LIABILITIES are spending promises
made by governments that are effectively a debt
despite the fact that they are not included in the
usual debt statistics.
Examples: Medicare & Social Security
The Implicit Liabilities of the U.S.
Government
*Krugman
Multiplier Effects of Changes in Government
Transfers and Taxes
Taxes and Transfers compared to Government
Spending
• Transfers (payments by the government to
households for which no good or service is provided
in return)
• Tax cuts
• Taxes
Krugman,
Sec 4 Mod
21
• Lump-sum taxes: (taxes that don’t depend on
the taxpayer’s income)
How Taxes Affect the Multiplier
• The reliance of taxes on real GDP (ie IncTax Rev
increases w/RGDP b/c depends on indiv income….Sales tax
Rev increases w/RGDP b/c people w/more money buy more
stuff…..Corp profit taxes increase w/RGDP b/c profits
increase w/people buying more stuff)
• Effect on the multiplier (effect= reduce the size of the
multiplier)
• Automatic stabilizers (affects RGDP as a consequence
of how tax laws are written)
• Discretionary Fiscal Policy
NONDISCRETIONARY
FISCAL POLICY:
BUILT-IN
STABILIZERS
Net tax revenues vary directly with GDP
because virtually any tax will yield more tax
revenue as GDP rises.
When GDP expands and more goods and
services are purchased, revenues from
corporate income taxes and sales and
excise taxes also increase.
Conversely, when GDP declines, tax
receipts from all those sources also decline.
Transfer payments (or “negative taxes”)
behave in the opposite way from tax
revenues.
Unemployment
compensation
payments, welfare
payments, and
subsidies to farmers
all DECREASE
during economic
expansion and
INCREASE during a
contraction.
This graph shows how the U.S. tax system creates built-in
stability. Tax revenues vary directly with GDP, and government
spending is assumed to be independent of GDP. As GDP falls
in a recession, deficits will occur automatically and will help
alleviate that recession. As GDP rise during expansion,
surpluses will occur automatically and will offset inflation.
Tax
Revenues
Surplus
Deficit
Real Domestic Output
Government
Spending
The economic importance of this direct relationship
between tax receipts and GDP is:
1) Taxes reduce spending and aggregate demand.
2) It is desirable from the standpoint of stability to reduce
spending when the economy is moving toward inflation
and to increase spending when the economy is
slumping.
A built-in stabilizer is anything which
increases the government’s budget deficit
(or reduces its budget surplus) during a
recession and increases its budget surplus
(or reduces its budget deficit) during
inflation without requiring explicit action by
policymakers.
As GDP rises during prosperity, tax revenues automatically
increase and, because they reduce spending, they restrain
the economic expansion. Put another way, as the
economy moves toward a higher GDP, tax revenues
automatically rise and move the budget from deficit toward
surplus.
Tax
Revenues
Surplus
Deficit
Real Domestic Output
Government
Spending
The steepness of T depends on the tax system itself. In a
PROGRESSIVE TAX SYSTEM, the average tax rate (=tax
revenue/GDP) rises with GDP.
In a PROPORTIONAL TAX SYSTEM, the average tax rate remains
constant as GDP rises.
In a REGRESSIVE TAX SYSTEM, the average tax rates falls as GDP rises.
T
THE MORE
a
PROGRESSIVE x
THE TAX
SYSTEM, THE
GREATER THE R
e
ECONOMY’S
v Deficit
BUILT-IN
e
STABILITY.
n
u
e
Real Domestic Output
s
(Tax Revenues)
T
Surplus
G
(Government
Spending)
Changes in public policies or laws which alter the
progressivity of the tax system affect the degree of
built-in stability.
For example: In 1993,
the Clinton
administration
increased the highest
marginal tax rate on
personal income from
31 to 39.6 percent and
boosted the corporate
income tax 1
percentage point to 35
percent.
These increases in tax rates raise the overall
progressivity of the tax system, slightly bolstering
the economy’s built-in stability.
However, built-in stabilizers can only diminish, NOT
correct, major changes in equilibrium GDP.
DISCRETIONARY
FISCAL POLICY
(changes in tax rates
and spending) may
be needed to correct
inflation or recession
of any appreciable
magnitude.
SO………………..
We have built-in stability because tax
revenues vary directly with GDP.
But those automatic increases or decreases
in tax revenues mean that the ACTUAL
BUDGET in any particular year does not tell
us whether government’s current
discretionary fiscal policy is expansionary,
neutral, or contractionary.
Here’s why…………….
Suppose and economy is achieving full-employment at GDPf.
Notice between spending line G and tax line T, there is an actual
budget deficit shown by vertical distance ab.
Assume that investment spending plummets, swamping the
expansionary effect of this budget deficit and causing a recession
to GDPr.
Full-employment
or structural deficit
E
x
G
p
o
e
v
n
e
d
r
it
n
u
m
r
e
e
n
s
t
T
a
x
a
R
e
v
e
n
u
e
&
s
b
T
G
GDP
GDPrr GDPf
(year 2) (year 1)
Assuming the government takes
no new discretionary action, line
G and T remain.
With the economy at GDPr, tax
revenues are lower than before,
while government spending
remains unaltered.
The budget deficit therefore rises to ec,
expanding from ab (=ed)
by amount dc.
The added deficit of dc is called CYCLICAL DEFICIT
because it relates to the business cycle.
Full-employment
or structural deficit
E
x
G
p
o
e
v
n
e
d
r
it
n
u
m
r
e
e
n
s
t
T
a
x
R
e
v
e
n
u
e
&
s
e
T
a
G
d
b
c
Cyclical
Deficit
GDP
GDPrr GDPf
(year 2) (year 1)
It is NOT the result of
discretionary fiscal
actions by government;
rather, it is the by-
product of the
economy’s slide into
recession.
So……
How do we resolve the
problem?
Economists do this by using the
FULL-EMPLOYMENT BUDGET.
Also called the STANDARDIZED
BUDGET, it measures what the
Federal budget deficit or surplus
would be with existing tax and
government spending structures if
the economy were at full
employment throughout the year.
Consider the graph once again. In full-employment year 1, the fullemployment deficit is ab, the amount of actual deficit.
In year 2, however, the actual budget deficit of ec overstates the fullemployment deficit.
Full-employment
or structural deficit
E
x
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Cyclical
Deficit
GDP
GDPrr GDPf
(year 2) (year 1)
Specifically, the cyclical part of
the deficit dc
must be subtracted from the actual
deficit ec
to obtain the full-employment
deficit, ed.
We note, then, that the fullemployment deficit for year 2 is the
same as year 1 (ed=ab).
By comparing these two fullemployment deficits, we see that
government did not change its fiscal
policy between years 1 and 2.
Proposed BALANCED BUDGET REQUIREMENT
The large annual budget deficits in the U.S. during the past two
decades have led many Congressional leaders to support a
constitutional amendment requiring the Federal government to
balance its budget each year.
Such a mandate would virtually eliminate discretionary fiscal policy
as a tool for stabilization, as it would force the government to reduce
spending or increase taxes during recession.
Let’s chart the effects of a requirement to
balance the budget……..
Suppose that in year 1, the economy is operating at
full-employment level of GDPf. At this point, the
budget is balanced.
T
a
G
deficit
b
GDPr
GDPf
(year 2)
(year 1)
In year 2, the economy
slides into recession
with real output
decreasing to
GDPr…automatically
decreasing tax
revenues, creating a
budget deficit of ab.
To comply with the balanced budget requirement, the
government must eliminate this defict in one of three
ways:
T2
a
T1
G1
b
GDPr
GDPf
(year 2)
(year 1)
1) Increasing tax
revenues so that the
tax line shifts
upward to T2,
intersecting the G1
line at point a.
OR
T1
a
G1
G2
b
GDPr
GDPf
(year 2)
(year 1)
2) Reducing
government
spending so that the
government
spending line shifts
downward to G2
intersecting with T1
at point b.
OR
T2
a
T1
G1
G2
b
GDPr
GDPf
(year 2)
(year 1)
3) Increasing taxes
and reducing
government
spending in some
combination to
eliminate the budget
deficit.
The problem with all three options is that they are
aspects of CONTRACTIONARY FISCAL POLICY.
They all reduce aggregate demand, which
decreases GDP. These actions further reduce real
GDP and tax revenues decline once again.
Rather than stabilizing the economy, a
strict balanced-budget requirement
may force government to take action
which worsen the economy.
PROBLEMS, CRITICISMS, COMPLICATIONS
1) Recognition Lag: time between
beginning of recession or inflation and the
certain awareness it is actually happening.
2) Administrative Lag: time that elapses
between recognition of need for fiscal action
and time action is taken.
3) Operational Lag: time between the action
taken and the time that action affects output,
employment, or price level.
POLITICAL PROBLEMS
1) Governmental goals also include concern with providing
public goods and services and redistributing income, not just
economic stability.
2) Fiscal policies of State and Local governments are
frequently pro-cyclical---they worsen, rather than correct
recession or inflation.
3) Deficits may be politically attractive and surpluses
politically painful.
4) Some economists contend that the goal of politicians is
not to act in the interests of the national economy but, rather,
to get reelected. Politicians might manipulate fiscal policy to
maximize voter support, even though their fiscal decisions
destabilize the economy.
The CROWDING-OUT Effect
An expansionary fiscal policy (deficit spending) will
increase the interest rate and reduce private
spending, weakening or canceling the stimulus of
the fiscal policy.
(i.e.) If the economy is in recession and government enacts
discretionary fiscal policy in the form of increased government
spending, it will borrow the needed funds from the money market.
This results in increased demand for money
The interest rate rises
Investment spending diminishes, as well as some consumption
spending (autos, boats on credit)
FISCAL POLICY and the NET EXPORT EFFECT
The net export effect may also work through
international trade to reduce the effectiveness of
fiscal policy.
If the crowding-out effect, during a period of
expansionary fiscal policy, boosts interest rates,
reduces investment, and weakens fiscal policy, then
what effect would these increased interest rates
have on a nation’s net exports?
Problem: RECESSION,
SLOW GROWTH
Problem: INFLATION
Expansionary Fiscal Policy
Contractionary Fiscal Policy
Higher domestic interest rate
Lower domestic interest rate
Increased foreign demand
for dollars
Decreased foreign demand
for dollars
Dollar appreciates
Net exports decline (aggregate
demand decreases, partially
offsetting the expansionary fiscal
policy)
Dollar depreciates
Net exports increase (aggregate
demand increases, partially
offsetting the contractionary fiscal
policy)
SUPPLY-SIDE FISCAL POLICY
“Supply-siders” contend that changes in aggregate
supply must be recognized as active forces in
determining levels of inflation and unemployment.
Supply-side economists argue that the huge growth of the
US tax-transfer system (welfare, subsidies, unemployment
compensation) negatively affects incentives to work,
invest, innovate, and assume entrepreneurial risk.
They believe that high taxes reduce the after-tax rewards of
workers and producers , making work, innovation, investing,
and risk bearing less financially attractive.
To induce aggregate inputs of labor
Reduce taxes on incomes
Work is more attractive because of the increasing
opportunity cost of leisure
Individuals choose to substitute work for leisure by:
More
hours
worked
per day
Postpone
retirement
More
people in
labor
force
Making
people
willing to
work
harder
Discouraging
long periods of
unemployment
The rewards for saving and investing are also reduced
by high tax rates.
A critical determinant of investment spending is the
expected after-tax return of that spending. (High
taxes on investment income will discourage
investment spending)
Therefore, if lower marginal tax rates encourage saving and
investing, workers will find themselves with more
technologically superior machinery and equipment.
Labor
productivity
rises
Expanding
aggregate
supply
Unemployment
and inflation low
TAX CUTS FOR THE RICH?? A different perspective….
Ten men go out to dinner and the bill for all
ten equals $100.
If they paid their bill the way we pay our taxes:
FIRST FOURpay nothing
FIFTH
pays $1
SIXTH
pays $3
SEVENTH
pays $7
EIGHTH
pays $12
NINTH
pays $18
TENTH
pays $59
TAX CUTS FOR THE RICH?? A different perspective….
They eat their dinner there every day until one day
the owner comes to them and says, “You are such
good customers, I’m going to reduce the daily cost
of your meal by $20.
The group still wanted to pay their bill the way we
pay our taxes do the first four men were
unaffected. Should the other 6 men divide the
$20 savings between them?
$20 divided by 6 is $3.33, but if they subtracted
that from everyone’s share, the fifth and sixth men
would each end up being paid to eat their meal.
TAX CUTS FOR THE RICH?? A different perspective….
So, the restaurant owner suggested:
Paying their bill the way we pay our taxes:
FIRST FOURpay nothing
pay nothing
FIFTH
pay $1
pay nothing
SIXTH
pays $3
$2
SEVENTH
pays $7
$5
EIGHTH
pays $12
$9
NINTH
pays $18
$14
TENTH
pays $59
$49
TAX CUTS FOR THE RICH?? A different perspective….
“I only got a dollar out of the $20” declared the
SIXTH man. He pointed to the TENTH man, “but
he got $10.”
“Yeah, that’s right,” exclaimed the FIFTH man, “I
only saved a dollar, too. The wealthy get all the
breaks!”
“Wait a minute,” yelled the first FOUR MEN, “We
didn’t get anything at all. The system exploits the
poor.”
The first 9 men surrounded the TENTH and beat
him up.
TAX CUTS FOR THE RICH?? A different perspective….
The next night, the TENTH man didn’t show up for
dinner, so the nine sat down and ate without him.
But when it came to pay the bill, they didn’t have
enough money between them for even half the
bill.
THE PEOPLE WHO PAY THE HIGHEST TAXES
GET THE MOST BENEFIT FROM A TAX
REDUCTION.
Tax them too much and they just might start eating
overseas where the atmosphere is somewhat
friendlier.
THE LAFFER
CURVE
Arthur Laffer suggested
that up to point m, higher
tax rates will result in
larger tax revenues.
Tax revenues decline
beyond some point (m)
because higher tax rates
discourage economic
activity which
diminishes the tax base.
n
100
m
m
l
0
Tax Revenue (dollars)
Supply-siders also claim that government’s
regulatory involvement in the economy has
adversely affected productivity and long-run
aggregate supply. They claim that government
regulation:
1) creates monopolies and cartels, especially in
transportation and communications, and
2) increases the cost of doing business when
imposing industry response to pollution, product
safety, worker health and safety, and equal access
to job opportunities.
The Laffer Curve
http://www.pbs.org/newshour/bb/business/janjune12/makingsense_01-11.html
Compiled by:
Virginia H. Meachum
Coral Springs High School
Sources:
Principles, Problems, and Policies, by Campbell
McConnell & Stanley Brue
Economics, by Krugman, Wells
Principles of Economics, by N. Gregory Mankiw
Notes by Florida Council on Economic Education
and FAU Center for Economic Education
Notes by Foundation for Teaching Economics