Fiscal Policy

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					Fiscal policy Changes in federal taxes and purchases that
are intended to achieve macroeconomic policy objectives

   •high employment

   •price stability

   •high rates of economic growth.

      Automatic Stabilizers versus Discretionary Fiscal Policy
Automatic stabilizers Government spending and taxes that
automatically increase or decrease along with the business cycle

   •progressive income tax

   •unemployment benefits

   •food stamps / other entitlements
The Federal Government’s Share
of Total Government
Expenditures, 1929–2006
Federal Purchases and
Federal Expenditures as a
Percentage of GDP, 1950–2006
An Overview of Government Spending and Taxes

 Federal Government
 Expenditures, 2006

                                               Federal Government
                                               Revenue, 2006
  The Effects of Fiscal Policy
  on Real GDP and the Price Level
Looks a lot like expansionary and contractionary monetary policy
    …except for impacts on interest rates and investment spending
How Fiscal Policy Affects Aggregate Demand, Real
GDP and the Price Level

         Countercyclical Fiscal Policy

                                       ACTIONS BY CONGRESS
        Recession     Expansionary     Increase government       Real GDP and the
                                       spending or cut taxes     price level rise.

        Rising        Contractionary   Decrease government       Real GDP and the
        Inflation                      spending or raise taxes   price level fall.

Don’t Let This Happen to YOU!
Don’t Confuse Fiscal Policy and Monetary Policy!
Government Purchase and Tax Multipliers

The Multiplier Effect
and Aggregate Demand
  Government Purchase Multiplier

   The Multiplier Effect
   of an Increase in
   Government Purchases

This spending multiplier is
analogous but not the same
as the deposit multiplier
     The Government Tax Multiplier
A cut in tax rates affects equilibrium real GDP in two ways:
 (1) disposable income rises  consumption spending rises
 (2) the rate at which purchasing power leaks from the spending
     stream declines  the spending multiplier increases
    The less the marginal propensity to leak, the greater the
     spending multiplier.

 Spending Multiplier = 1/[Marginal Propensity to Leak]
 = 1/[Propensity Not to Respend Additional Income Domestically]
 =1/[Propensity to pay taxes, save and buy things from abroad]
The Government Purchases and Tax Multipliers

   Taking into Account the Effects of Aggregate Supply

                                   Because the Price Level rises,
                                   Real GDP does not increase as much
                                   as it otherwise would
                                    The multiplier effect is reduced
The Limits of Using Fiscal Policy   Crowding out A decline in
to Stabilize the Economy            private expenditures as a
                                    result of an increase in
      Money market                  government purchases.

                                        An Expansionary Fiscal Policy
                                        Increases Interest Rates
The Limits of Using Fiscal Policy
to Stabilize the Economy
 Crowding Out in the Short Run
Deficits, Surpluses, and Federal Government Debt

                                   The Federal Budget Deficit,

                             Cyclically adjusted budget deficit
                             or surplus The deficit or surplus in
                             the federal government’s budget if
                             the economy were at potential GDP.
                the     Did Fiscal Policy Fail during
                        the Great Depression?
                                                                       CYCLICALLY       CYCLICALLY
                                       FEDERAL      ACTUALFEDERAL       ADJUSTED         ADJUSTED
                                    GOVERNMENT      BUDGET DEFICIT   BUDGET DEFICIT   BUDGET DEFICIT
                                    EXPENDITURES      OR SURPLUS      OR SURPLUS      OR SURPLUS AS
                                     (BILLIONS OF    (BILLIONS OF     (BILLIONS OF    A PERCENTAGE
                                       DOLLARS         DOLLARS)         DOLLARS)          OF GDP

                             1929      $2.6            $1.0            $1.24             1.20%
                             1930        2.7            0.2              0.81            0.89
                             1931        4.0            -2.1            -0.41            -0.54
                             1932        3.0            -1.3             0.50            0.85
                             1933        3.4            -0.9             1.06            1.88
                             1934        5.5            -2.2             0.09            0.14
                             1935        5.6            -1.9             0.54            0.74
Although government          1936        7.8            -3.2             0.47            0.56
spending increased during
the Great Depression, the    1937        6.4            0.2              2.55            2.77
cyclically adjusted budget   1938        7.3            -1.3             2.47            2.87
was in surplus most years.   1939        8.4            -2.1             2.00            2.17
 Deficits, Surpluses, and Federal Government Debt
   The Federal Government Debt: Is it a problem?
Vicious circle: Deficit  Debt  i Interest expense Deficit
 The Effects of Fiscal Policy in the Long Run

Tax wedge The difference between the pre-tax and post-tax
return to an economic activity.

 Disincentive to work???
      Impacts of supply-side tax cuts

         • Individual income tax.

         • Corporate income tax.
         • Taxes on dividends and capital gains:
           double taxation.
   Tax Simplification: A flat–tax???
   —pros and cons
The Effects of Fiscal Policy in the Long Run
 The Economic Effect of “Supply Side” Tax Reform
Key Terms

            Automatic stabilizers
            Budget deficit
            Budget surplus
            Crowding out
            Cyclically adjusted budget
              deficit or surplus
            Fiscal policy
            Multiplier effect
            Tax wedge

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