Fiscal Policy
CHAPTER
27
© 2003 South-Western/Thomson Learning
1
Fiscal Policy
Fiscal policy refers to government
purchases, transfer payments, taxes, and
borrowing as they affect macroeconomic
variables such as real GDP, employment,
the price level, and economic growth
Two categories
Automatic stabilizers
Discretionary fiscal policy
2
Automatic Stabilizers
Refer to revenue and spending items in
the federal budget that automatically
change with the ups and downs of the
economy so as to stabilize disposable
income and, hence, consumption and
real GDP
Federal income tax
• Reduces the drop in disposable income during
recessions and reduces the jump in disposable
income during expansions
• Once adopted, it requires no congressional action
to operate year after year
3
Discretionary Fiscal Policy
Requires ongoing congressional
decisions involving the deliberate
manipulation of government purchases,
taxation, and transfers to promote
macroeconomic goals such as full
employment, price stability, and
economic growth
Clinton administration tax increases
Bush’s 2001 tax cut
4
Fiscal Policy
Using the income-expenditure
framework, we will initially focus on the
demand side to consider the effect of
changes in government purchases,
transfer payments, and taxes on real
GDP demanded
The short story is that at any given price
level, an increase in government
purchases or in transfer payments
increases real GDP, and an increase in
net taxes decreases real GDP, other
things constant
5
Government Purchases Multiplier
As long as consumption is the only
spending component that varies with
income, the multiplier for a change in
government purchases, other things
constant, equals
1
1  MPC
Thus, we can say that for a given price
level, and assuming that consumption
varies with income
1
realGDP  G (
)
1  MPC
6
Change in Net Taxes
A change in net taxes also affects real
GDP demanded, but the effect is less
direct
Specifically
A decrease in net taxes, other things
constant, increases disposable income at
each level of real GDP  consumption
increases
An increase in net taxes, other things
constant, reduces disposable income at each
level of real GDP  consumption decreases
7
Simple Tax Multiplier
The effect of a change in net taxes on
real GDP demanded equals the resulting
shift in the consumption function times
the simple spending multiplier 
 MPC
1  MPC
Therefore, the change in real GDP can be
determined as
 MPC
realGDP  NT (
)
1  MPC
8
Differences
Two differences between the
government-purchase multiplier and the
simple tax multiplier
The government-purchase multiplier is
positive  an increase in government
purchases leads to an increase in real GDP
demanded. The net tax multiplier is
negative  an increase in net taxes leads to
a decrease in real GDP demanded
The multiplier for a given change in
government purchases is larger by 1 than
the absolute value of the multiplier for an
identical change in net taxes
9
Differences
This latter difference occurs because
changes in government purchases affect
aggregate spending directly while the
simple tax multiplier increases
consumption indirectly by way of a
change in disposable income
In short, an increase in government
purchases has a greater impact than an
identical tax cut because some of the
tax cut is saved
10
Fiscal Policy: Contractionary Gap
What if policy makers overshoot the
mark and stimulate aggregate demand
more than needed to achieve potential
GDP?
In the short run, real GDP will exceed
potential output
In the long run, firms and resource owners
will adjust to the unexpectedly high price
level
The short-run supply curve will shift back
until it intersects the aggregate demand
curve at potential output, increasing the
price still further but reducing real GDP to
potential output
11
Problems with Fiscal Policy
Precise expansionary and
contractionary fiscal policies are
difficult to achieve, for their proper
execution assumes that
The relevant spending multiplier can be
predicted accurately
Aggregate demand can be shifted by just
the right amount
The potential level of output is accurately
gauged
Various government entities can somehow
coordinate their fiscal efforts
The shape of the short-run aggregate supply
curve is known and remains constant
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Multiplier and Time Horizon
In the short run, the aggregate supply
curve slopes upward  a shift in
aggregate demand changes both the price
level and the level of output  the simple
multiplier overstates the amount by
which output changes
The exact change in equilibrium output
depends on the steepness of the
aggregate supply curve, which in turn
depends on how sharply production costs
increase as output expands
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Multiplier and Time Horizon
The steeper the short-run aggregate
supply curve
the less impact a given shift in the
aggregate demand curve has on output and
the more impact it has on the price level 
the smaller the spending multiplier
If the economy is already producing its
potential, then, in the long run, any
change in fiscal policy aimed at
stimulating demand will increase the
price level but will not affect output 
spending multiplier is zero
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Evolution of Fiscal Policy
Prior to the Great Depression, public
policy was shaped by the views of
classical economists who generally
believed that free markets were the best
way to achieve national economic
prosperity
Economists believed that natural market
forces, such as changes in prices, wages,
and interest rates, would correct the
problems of inflation and unemployment
 no need for government intervention in
the economy
15
Great Depression and World War II
Keynesian theory and policy were
developed to address the problem of
unemployment arising from the Great
Depression
Keynes’s main quarrel with the classical
economists was that prices and wages
did not appear flexible enough to
ensure the full employment of
resources, e.g, they were sticky 
natural forces would not return the
economy to full employment in a timely
fashion
16
Great Depression and World War II
Keynes also believed business
expectations might at times become so
bleak that even very low interest rates
would not spur firms to invest all that
consumers might save
The Great Depression continues to
influence economic thought and policy
solutions
17
Great Depression and World War II
Three developments following the Great
Depression bolstered the use of
discretionary fiscal policy in the United
States
The influence of Keynes’s General Theory in
which he argued that natural forces would
not necessarily close a contractionary gap 
government would have to increase
aggregate demand so as to boost output
and employment
The demands of World War II greatly
increased production and in the process
eliminated cyclical unemployment during
the war years
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Great Depression and World War II
The third development, largely a
consequence of the first two, was the
passage of the Employment Act of 1946,
which gave the federal government
responsibility for promoting full employment
and price stability
The combined impact of these factors led
policy makers grew more receptive to the
idea that fiscal policy could improve
economic stability
Additionally, the objective of fiscal policy was
no longer to balance the budget but to
promote full employment with price stability
even if deficits occurred in the process
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Automatic Stabilizers
Automatic stabilizers smooth fluctuations
in disposable income over the business
cycle, thereby boosting aggregate
demand during periods of recession and
dampening aggregate demand during
periods of expansion
Two good examples of automatic
stabilizers
Progressive income tax
Unemployment compensation
20
Progressive Income Tax
The progressive income tax relieves
some of the inflationary pressures that
might otherwise arise when output
increases above its potential during an
economic expansion
Conversely, when the economy is in a
recession, real GDP declines but taxes
decline faster, so disposable income
does not fall as much as real GDP  it
cushions declines in disposable income,
in consumption, and in aggregate
demand
21
Unemployment Insurance
During an economic expansion,
unemployment insurance taxes flow
from the income stream into the
insurance fund, thereby moderating
aggregate demand
During a recession, unemployment
payments automatically flow from the
insurance fund to those who have
become unemployed  increasing
disposable income and consumption
22
From the Golden Age to Stagflation
John F. Kennedy was the first president
to propose a federal budget deficit to
stimulate an economy by proposing a
tax cut for the purpose of stimulating
business investment, consumption, and
employment
Discretionary fiscal policy is a type of
demand-management policy because
the objective is to increase or decrease
aggregate demand to smooth
fluctuations
23
From the Golden Age to Stagflation
However, the 1970s were different
when the problem was stagflation 
the double trouble of higher inflation
and higher unemployment resulting
from a decrease in aggregate supply
Demand-management policies were ill
suited to solving these problems
because an increase in aggregate
demand would worsen inflation,
whereas a decrease in aggregate
demand would worsen unemployment
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Problems with Fiscal Policy
Other concerns also caused economists
and policy makers to question the
effectiveness of discretionary fiscal
policy
The difficulty of estimating the natural rate
of unemployment
The time lags involved in implementing
fiscal policy
The distinction between current and
permanent income
Possible feedback effects of fiscal policy on
aggregate supply
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Natural Rate of Unemployment
The unemployment rate that occurs
when the economy is producing its
potential GDP is called the natural rate
of unemployment
Before adopting discretionary policies,
public officials must correctly estimate
this natural rate
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Lags in Fiscal Policy
The time required approving and
implementing fiscal legislation may
hamper its effectiveness and weaken
discretionary fiscal policy and may in fact
do more harm than good
Since a recession is not usually identified
as such until at least six months after it
begins, and since the eight recessions
since 1949 lasted an average of 11
months, this leaves a narrow window in
which to execute discretionary fiscal
policy
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Permanent Income
The original belief was that given the
marginal propensity to consume, a
relationship that is among the most
stable in macroeconomics, tax changes
could increase or decrease disposable
income to bring about any desired
change in consumption
A more recent view is that people base
their consumption decisions not merely
on changes in their current income but
on changes in their permanent income
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Permanent Income
Permanent income is the income a
person expects to receive on average
over the long run
Thus, changes in taxes that are regarded
as temporary will not stimulate
consumption and may render fiscal policy
ineffective
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Feedback Effects
Fiscal policy may unintentionally affect
aggregate supply
For example, suppose the government
increases unemployment benefits and
finances these transfer payments with
higher taxes on current workers.
If the marginal propensity to consume is
the same for both groups, the reduction
in spending by those whose taxes
increase should just offset the increase in
spending by transfer recipients
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Feedback Effects
Thus, with a fiscal policy that focuses on
aggregate demand, there should be no
change in aggregate demand or on
equilibrium real GDP
But what of possible effects of these
changes on the labor supply?
The unemployed, who benefit from
increased transfers, now have less
incentive to find work
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Feedback Effects
Conversely, workers who find their aftertax wage reduced by the higher tax rates
may be less willing to work
In short, the supply of labor could
decrease as a result of offsetting changes
in taxes and transfers with the result that
aggregate supply would decline 
economy’s potential GDP would decline
32
Budget Deficits of the 1980s and 1990s
The Reagan tax rate cut reflected a
philosophy that reductions in tax rates
would make people more willing to work
and to invest because they could keep
more of what they earned
Lower taxes, would increase the supply
of labor and the supply of other
resources thereby increasing aggregate
supply and the economy’s potential GDP
33
Supply Side Economics
This supply-side theory held that
enough additional real GDP would be
generated by the tax cuts that total tax
revenue would actually increase
What actually happened?
Taking 1981 to 1988 as the time frame,
we can examine the effects of the 1981
federal income tax rate cut.
34
Supply Side Economics
After the tax cut was approved but before
it took effect, a recession hit the economy
and the unemployment rate increased
Between 1981 and 1988 employment
climbed by 15 million and real GDP per
capita increased by about 2.5% per year
The stimulus from the tax rate cut helped
sustain a continued expansion during the
1980s, the longest peacetime expansion
to that point in history
35
Supply Side Economics
Despite the growth in employment,
government revenues did not expand to
offset the combination of tax cuts and
increased government spending
Between 1981 and 1988, federal outlays
grew an average of 7.1% while federal
revenues averaged a 6.3% increase 
the deficits accumulated into a huge
national debt which doubled relative to
GDP from 33% in 1981 to 64% in 1992
36
Political Business Cycles
William Nordhaus developed a theory of
political business cycles, arguing that
incumbent presidents use expansionary
policies to stimulate the economy, often
only temporarily, during an election
year
That is, they try to increase their
changes of reelection by pursuing
policies that stimulate real GDP and
reduce unemployment
37
Political Business Cycles
The evidence to support the theory of
political business cycles is not entirely
convincing
One problem is that the theory limits
presidential motives to reelection, when
in fact presidents may have other
objectives
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Political Business Cycles
An alternative to this theory, and one
that is supported by some evidence, is
that Democrats care relatively more
about unemployment and relatively less
about inflation than do Republicans
Democrats tend to pursue expansionary
policies while Republicans tend to
pursue contractionary policies
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Balancing the Budget
The combination of increased taxes
imposed by the Clinton administration
and a vigorous recovery fueled by
growing consumer spending, rising
business optimism, and the strongest
stock market in history led to record
budget surpluses
However, by early 2001, U.S. economic
growth was slowing, so that President
George W. Bush pushed through across
the board tax cuts
40
Balancing the Budget
The terrorist attack on September 11,
2001 further depressed consumer
confidence with the result that
taxpayers spent only about one-fifth of
the tax rebate checks
Thus, additional stimulus programs
were put in place
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