Chapter 12 Fiscal Policy COMMON STUDENT ERRORS Students often believe the following statements are true. This same list is included in the student study guide. The correct answer is explained after the incorrect statement is presented. 1. Government deficits always lead to inflation. WRONG! Government deficits may result from government spending to reach full employment with price stability. RIGHT! You should focus on what is happening to aggregate supply and demand, not just deficits, when looking for the sources of inflation. By looking at the deficit, you cannot tell if there is adequate aggregate demand in the economy. If there is a shortfall in aggregate demand, government spending and the resulting deficits may restore full employment with price stability. If there is an excess aggregate demand, demand-pull inflation can result from increased consumption, investment, or export expenditures, just as much as from increased government spending. It is all too easy to point the finger at the government and forget the contribution to inflation from all the other sectors of the economy. 2. When a person invests in stocks, investment expenditures are increased. WRONG! Purchase of stocks has only an indirect relationship to investment expenditure in the economy. RIGHT! Investment expenditure refers to purchases of new capital goods (plant, machinery, etc.) or inventories. A purchase of stock represents a transfer of ownership from one person to another. Sometimes such purchases are called “financial investments,” but they do no represent economic investment. 3. Aggregate demand rises when people buy more imports. WRONG! Aggregate demand falls when people buy more imports, ceteris paribus. RIGHT! Students often think of imports as expenditures and therefore believe that increased spending on imports will have the same effects on the economy as an increase in consumption. Expenditures on imports, however, do not generate domestic income. If imports increase, they do so at the expense of purchases of U.S. goods, meaning fewer jobs in the United States. Because employment declines, there is less income with which to consume goods; consumption falls and so does aggregate demand. 4. Macro equilibrium and full employment are always the same. WRONG! Macro equilibrium and full employment are determined in different ways. RIGHT! Macro equilibrium occurs where aggregate demand and aggregate supply intersect. Full employment refers to the use of all available resources in production. If macro equilibrium does not occur at full employment, there is a GDP gap. 5. If the government increases spending and taxes by the same amount, there will be no effect on income. WRONG! An increase of government spending and taxes by the same amount will expand the economy. RIGHT! The full impact of the increased government spending turns into income for the people who provide goods and services to the government. Part of the increased taxes, however, comes from people’s savings, which had been leakages from the economy. Therefore, consumption decreases by less than the loss of taxes. This in turn means that income generated by consumption spending is not cut back by the amount of taxes. Therefore, the economy experiences a smaller cutback in incomes because of increased taxes than from the stimulus from increased government spending. The net effect is an increase in income. HEADLINES There are three Headline boxes in this chapter. Their titles and the concepts they highlight are: “Consumer Confidence Plunges to Two-Year Low” (Expectations) Consumer confidence plunged to its lowest level in two years as the holiday season failed to lift the spirit of Americans rattled by stock-market volatility and mounting fears of a significant economic slowdown. Expectations for jobs and income affect current spending decisions. When expectations diminish, the rate of spending typically slows down. “Retailers see results from child tax credit checks” (Fiscal Stimulus) Rebate checks for the 2003 income tax child credit caused a sudden jump in retail sales. When 24 million families received checks averaging $583, spending increased. For example, sales of apparel and furniture jumped 14 percent in one week. “Tax cuts could improve growth” (Boosting C, I) The tax cut package passed in 2003 was expected to increase consumer spending relatively quickly whereas investment spending was not expected to pick up until the next year. ANNOTATED CONTENTS IN DETAIL I. Fiscal Policy Definition: Fiscal Policy - The use of government taxes and spending to alter macroeconomic outcomes. II. Components of Aggregate Demand A. Aggregate Demand Definition: Aggregate Demand - The total quantity of output demanded at alternative price levels in a given time period, ceteris paribus. B. Four major components of aggregate demand. (Figure 12.1) 1. Consumption 2. Investment 3. Government spending 4. Net exports (exports minus imports) C. Consumption (Figure 12.1) Definition: Consumption - Expenditure by consumers on final goods and services. Note: Consumption expenditures such as tax services, concert tickets, tuition, sporting event tickets, cars, etc., account for about two- thirds of total spending in U.S. economy. D. Headline: “Consumer Confidence Plunges to Two-Year Low” (Expectations) Consumer confidence plunged to its lowest level in two years as the holiday season failed to lift the spirit of Americans rattled by stock-market volatility and mounting fears of a significant economic slowdown. Expectations for jobs and income affect current spending decisions. When expectations diminish, the rate of spending typically slows down. E. Investment (Figure 12.1) Definition: Investment - Expenditures on (production of) new plant and equipment (capital) in a given time period, plus changes in business inventories. Note: Investment expenditures, such as farmers replacing old tractors, factories installing robotics or new computers, etc., accounts for 15% of U.S. spending. F. Government Spending (Figure 12.1) 1. Includes federal, state and local spending on highways, schools, police, national defense and all other goods and services provided by public sector. 2. Government expenditures account for 18% of total spending. 3. Income transfers are not counted because they are counted in consumption expenditures when recipients spend their payments. G. Net exports (Figure 12.1) Definition: Net Exports - Exports minus imports (X - M) Note: In 2000 the U.S. bought more goods from abroad than foreigners bought from U.S. H. Equilibrium (Macro) (Figure 12.2) Definition: Equilibrium - The combination of price level and real output that is compatible with both aggregate demand and aggregate supply. 1. Aggregate demand is not a single number but instead a schedule of planned purchases. 2. Inadequate demand and excessive demand a. Formula: AD = C + I + G + (X - M) b. There is no evident reason why AD will always produce equilibrium at full employment. Sometimes there will be too little demand and sometimes there will be too much. III. The Nature of Fiscal Policy A. It would be a minor miracle if C + I + G + (X - M) added up to exactly the right amount of aggregate demand. B. The use of government spending and taxes to adjust aggregate demand is the essence of fiscal policy. (Figure 12.3) IV. Fiscal Stimulus A. GDP gap Definition: GDP gap - The difference between full-employment output and the amount of output demanded at current price levels. B. More Government Spending. 1. Increased government spending is a form of fiscal stimulus. 2. Definition: Fiscal Stimulus -Tax cuts or spending hikes intended to increase (shift) aggregate demand. 3. Multiplier effects (Figure 12.4) a. An increase in spending results in increased incomes. b. Each dollar is spent and respent several times. As a result, every dollar has a multiplied impact on aggregate income. c. All income is either spent or saved. d. Saving Definition: Saving - Income minus consumption: that part of disposable income not spent. 4. Marginal propensity to consume (MPC) Definition: Marginal Propensity to Consume (MPC) - The fraction of each additional (marginal) dollar of disposable income spent on consumption. 5. Marginal propensity to save (MPS) Definition: Marginal Propensity to Save (MPS) - The fraction of each additional (marginal) dollar of disposable income not spent on consumption; 1 - MPC. 6. Formula: MPS = (1 - MPC) 7. MPC and MPS are decisions that are connected (Figure 12.5) 8. The fiscal stimulus to aggregate demand includes both the initial increase in government spending and all subsequent increases in consumer spending triggered by the government outlays. 9. Income is spent and respent in the circular flow. (Figure 12.6) 10. Spending Cycles (Table 12.1) 11. Multiplier Formula a. Definition: Multiplier - The multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles. Formula: 1 Multiplier 1 mpc b. The multiplier process at work (Table 12.1) Formula: Total change in spending multiplier initial change in spending c. The circular flow process (Figure 12.6) d. Every dollar of fiscal stimulus has multiplied impact on aggregate demand. (Figure 12.7) 12. Headline: “Retailers see results from child tax credit checks” (Fiscal Stimulus) Rebate checks for the 2003 income tax child credit caused a sudden jump in retail sales. When 24 million families received checks averaging $583, spending increased. For example, sales of apparel and furniture jumped 14 percent in one week. B. Tax Cuts 1. Disposable income Definition: Disposable Income - After-tax income of consumers. 2. Taxes and consumption a. If MPC is greater than zero consumers spend some of the tax cut. How much of an AD shift we get from a personal tax cut depends on the MPC. b. Formula: Initial change in consumption = MPC x tax cut (increase) c. Formula: Cumulative change in spending=multiplier x initial change in consumption d. The effect of a tax cut, that increases disposable incomes, is to stimulate consumer spending. e. Cumulative increase in aggregate demand is a multiple of initial tax cut. 3. Taxes and investment a. Tax cuts for consumers or investors provide alternative to increased government spending for stimulating aggregate spending. b. President John F. Kennedy in 1963 reduced taxes to stimulate spending. c. President Ronald Reagan in 1981 - largest tax cut in history to pull U.S. economy out of recession. d. President Clinton in 1992 promised to cut taxes and increase government spending to create stimulus. e. Headline: “Tax cuts could improve growth” (Boosting C, I) The tax cut package passed in 2003 was expected to increase consumer spending relatively quickly whereas investment spending was not expected to pick up until the next year. D. Inflation Worries 1. Clinton raised taxes partly because he feared inflationary pressures were building. 2. Whenever the aggregate supply curve is upward sloping, an increase in aggregate demand increases prices as well as output. IV. Fiscal Restraint (Figure 12.8) A. Budget Cuts 1. Government cutbacks have multiplied effect on aggregate demand. B. Multiplier Cycles 1. Government cutbacks (expansions) have a multiplied effect on aggregate demand. 2. Formula: Cumulative change in spending multiplier initial budget change C. Tax Hikes 1. Shift aggregate demand curve to the left. 2. Tax hikes reduce disposable income and thus a reduction in consumption. 3. The Equity and Fiscal Responsibility Act of 1982 increased taxes, shifting the AD leftward and thus reducing inflationary pressures. 4. President Clinton restrained aggregate demand in 1993 with tax increase, but increased AD in 1997 with a five-year package of tax cuts. D. Fiscal Guidelines (Table 1.2) 1. The fiscal strategy for attaining the goal of full employment is to shift the aggregate demand curve. 2. Fiscal Policy Guidelines Problem Solution Policy Tools Unemployment Increase aggregate Increase government (Recession) demand spending and/or cut taxes Inflation Reduce aggregate Cut government spending demand and/or raise taxes V. Policy Perspectives A. Unbalanced budgets (Figure 12.9) 1. The use of the budget to manage aggregate demand implies that the budget will often be unbalanced. 2. Budget deficit a. Definition: Budget deficit - The amount by which government expenditures exceed government revenues in a given time period. b. Formula: Budget deficit government spending tax revenues c. In 1997, the federal budget deficit was $22 billion. To pay, the government had to borrow money. By 1992, the deficit had peaked at $300 billion. 3. Budget surplus a. Definition: Budget surplus - An excess of government revenues over government expenditures in a given time period. b. By 1998, the deficit had completely vanished and a budget surplus appeared. This occurred primarily because of an economic expansion and a stock market boom that swelled tax collections. c. budget surplus tax revenues government spending 4. Countercyclical Policy – In the Keynesian view, an unbalanced budget was perfectly appropriate if macro conditions called for a deficit or a surplus. Such a policy appears to have been followed by President Bush in 2001 – 2003.
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