Macroeconomics

1
Macroeconomics

• Lecture 12
• Fiscal Policy

2
The Role of the Government

• Macroeconomics plays a key role in national
  politics.
• Fiscal policy is one tool that the government
  uses to guide the economy.
• Spending Taxation
• How does fiscal policy play a part in U.S.
  national politics?

3
Issues in this Chapter

• Examine how fiscal policy determines the
  equilibrium level of income in the economy.
• Examine the history of the budget process and
  fiscal policy in the U.S.

4
Fiscal Policy Aggregate Demand

• Recap What are the 4 components of aggregate
  demand?
• How does fiscal policy affect AD?
• Government Spending (direct affect)
• Taxes (indirect affect)

5
Shifting the AD Curve

• Changes in government spending and taxes will
  shift the aggregate demand curve.
• Which direction will the AD curve shift if the
  government increases spending on goods and
  services?
• How does this affect real GDP equilibrium price
  levels in the economy?
• Which direction will the AD curve shift if the
  government lowers taxes?

6
AD Real GDP

• How much the government increases/decreases
  spending influences how far the AD curve will
  shift.
• The affect on real GDP is also affected by
  aggregate supply (more specifically, where the AS
  curve the AD curve intersect).
• The results of a change in AD differ in a
  Keynesian model for real GDP.

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Keynesian Model
8
Real-World AD AS
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True Change in Real GDP

• If the price level remains constant, then real
  GDP changes by the shift of the curve in graph
  (a) Ye to Yp.
• In reality, because price levels will increase,
  in order for real GDP to increase from Ye to Yp,
  AD would have to increase much more, as indicated
  in graph (b).

10
Multiplier Effect

• Changes in government spending may also have a
  multiplier effect on real GDP.
• In other words, initially, a change of 1 in
  govt. spending will increase/decrease real GDP by
  a 1.
• Eventually (as we learned in Chapter 11) that 1
  would multiply in the economy, having a much
  larger impact on real GDP than the initial 1.

11
Multiplier Effect

• The magnitude of the multiplier effect is
  affected by different factors, including
• Price levels
• If price levels rise as real GDP rises, the
  multiplier effect will be smaller than they would
  be if the price levels had remained constant.
  Why?
• How the govt. pays for its spending
• The govt. must finance its spending through 1)
  taxing 2) borrowing and/or 3) creating money
  (govt. financing through created money is
  discussed more in Ch 14)

12
Govt. Spending Financed by Tax Increases

• What would happen if the government increased
  spending by 50 million and this change in
  spending was financed by an increase in taxes of
  50 million?
• What is the direct affect on AD?
• What is the indirect affect on AD?
• Does this change balance out or does real GDP
  change?

13
Govt. Spending Financed by Tax Increases

• Will a change in govt. spending (financed by tax
  increases) only affect aggregate demand, or will
  aggregate supply change also?
• Why or why not?

14
The Effect of Taxation on AD AS
Higher taxes will increase AD AD shifts to AD1
because the increase in govt. spending will not
be proportional to the decrease in consumption
caused by higher taxes.
The shift from AS to AS1 could be caused by a
reduced incentive to work due to higher taxes.
It is assumed that increased govt. spending
through taxation will always increase AD, but the
affects on AS are subject to debate among
economists.
15
Govt. Spending Financed by Borrowing

• Like govt. spending that is financed by taxation,
  if the govt. borrows to finance higher spending,
  this can limit the increase in AD.
• Why do you think this is?

16
Govt. Spending Financed by Borrowing

• Current govt. borrowing translates into higher
  taxes in the future.
• This can affect
• Consumer expectations spending/saving
• Business expectations
  spending/saving

17
Ricardian Equivalence

• The 19th century English economist, David
  Ricardo, was the 1st economist to suggest that
  govt. borrowing could function exactly like
  increased current taxes (reducing current
  household/business expenditures thus reducing the
  expansionary effect of increased govt. spending).
• The Ricardian Equivalence is debatable among
  economists today.

18
Crowding Out

• Like the Ricardian Equivalence, crowding out is a
  debatable theory among economists.
• Crowding out is related to govt. borrowing. It
  states that when the govt. increases spending
  through borrowing, this drives up the interest
  rate, causing private investment to fall
  (primarily in the bond market).

19
Supply-Side Economics

• In the 1980s (during Reagans presidency) a new
  economic theory was introduced, known as Supply
  Side Economics.
• Reagans economists believed that cutting taxes
  would stimulate the supply of goods and services
  to the point that tax revenues would actually
  increase (even though tax rates as a of income
  had been cut).
• This is illustrated in a Laffer Curve.

20
Laffer Curve

• Tax revenues are maximized at R2.
• If tax rates are already below R2, decreasing
  taxes will only decrease tax revenues.
• On the other hand, if the tax rate is above R2,
  decreasing the tax rate (until R2 is reached)
  will actually increase tax revenues.
• What was the situation during Reagans
  administration?

21
Review

• 1.Fiscal policy affects which two components of
  aggregate demand either directly or indirectly?
• a. Government spending and consumption
• b. Net exports and saving
• c. Investment and net exports
• d. Consumption and investment
• e. Taxes and consumption

22
Review

• 2. T F An increase in federal income tax rates
  is an example of fiscal policy that affects GDP
  indirectly.

23
Review

• 3. T F Changes in government spending and taxes
  represent movements along the aggregate demand
  curve.

24
Review

• 4. Supply-side economics, where the emphasis of
  fiscal policy is given to greater incentives to
  produce created by lower taxes, is most related
  to which of the following economic ideas?
• a. The Laffer curve
• b. The permanent income hypothesis
• c. The idea of the invisible hand
• d. The idea of the paradox of thrift
• e. Ricardian equivalence

25
Review

• 5. Refer to the figure. If you were a member of
  Congress who wanted to increase the amount of
  taxes collected, what would you recommend if the
  current tax rate were 80 percent?
• a. Increasing the tax rate to 100 percent
• b. Decreasing the tax rate to 30 percent
• c. Decreasing the tax rate to 70 percent
• d. Increasing the tax rate to 90 percent
• e. Decreasing the tax rate to zero percent

26
Fiscal Policy in the U.S.

• Fiscal policy in the U.S. is the result of an
  intricate process that involves both the
  executive legislative branches of govt.
• U.S. Fiscal Year
• October 1 - September 30
• The Budget process begins in the Spring
• Lasts approximately 18 months.

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U.S. Federal Budget Process

• The federal budget process is established and
  influenced as much by __________ as by
  economics.
• (In other words, what tends to prevail over
  sensible economic fiscal policy).

28
Political Power

• Politicians will often respond to different
  groups of constituents by supporting various
  government programs regardless of the need for
  tighter fiscal policy.
• In this sense, budget deficits are often caused
  by the political response to citizens
  desires/needs.

29
Historical Record

• The U.S govt. (revenues expenditures) have
  grown significantly over time.
• The difference between the expenditures
  revenues reflect the budget deficit or surplus.

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Components of Fiscal Policy

• Fiscal policy maintains 2 components
• Discretionary fiscal policy
• Changes in govt. spending and taxation aimed at
  achieving a policy goal (conscious decisions by
  policymakers).
• Automatic Stabilizers
• Elements of fiscal policy that change
  automatically as income changes.

31
Automatic Stabilizers

• Automatic stabilizers are designed to partially
  offset changes in income so that fluctuations in
  the business cycle are restrained (diminish the
  impact of the business cycle).
• Examples
• Income Taxes (Progressive)
• Transfer Payments
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  

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Progressive Income Taxes

• What is the difference between regressive,
  proportional progressive income taxes?
• U.S. federal income tax is a progressive tax as
  income rises, rate of taxation rises.
• This form of progressive tax is designed to
  offset the effects of lower income on spending
  (consumption) by allowing a greater of earned
  income to be spent (consumed).

33
Transfer Payments

• Transfer payments are payments to one person that
  is funded by taxing others.
• Food stamps
• Welfare benefits
• Unemployment benefits
• If income is used to establish eligibility for a
  transfer payment, then we know it is an automatic
  stabilizer of fiscal policy.
• Like progressive taxes, they are designed to
  offset the effects of lower income on spending in
  the economy.

34
Review

• The fiscal year for the United States government
• a. begins October 1 and ends the following
• September 30.
• b. begins January 1 and ends on December 31 of
• the same year.
• c. begins April 16 and ends the following April
  15.
• d. begins September 1 and ends the following
• August 31.
• e. begins June 1 and ends the following year.

35
Review

• 2. Economists define two components of fiscal
  policy. These are
• a. Obligatory fiscal policy and automatic fiscal
• actions.
• b. Discretionary fiscal policy and reflexive
  fiscal
• policy.
• c. Discretionary fiscal policy and automatic
  stabilizers.
• d. Automatic stabilizers and reflexive fiscal
  policy.
• e. Obligatory and reflexive fiscal policies.

36
Review

• 3. An automatic stabilizer is
• a. a change in government spending aimed at
• achieving a policy goal.
• b. an element of fiscal policy that
  automatically
• changes in value as income changes.
• c. an element of monetary policy that
  automatically
• changes in value as income changes.
• d. a deliberate change in taxation aimed at
  increasing real
• GDP.
• e. a decrease in tax rates as the economy moves
  into a
• recession.

37
Review

• 4. A progressive tax is
• a. a tax used by progressive governments around
• the world.
• b. a tax that is a flat dollar amount
  regardless of
• income.
• c. a tax whose rate falls as income rises.
• d. a tax that a business pays.
• e. an automatic stabilizer.

38
Review

• 5. A major benefit of automatic stabilizers is
  that they
• a. guarantee a balanced budget over the course
  of
• the business cycle.
• b. have the tendency to reduce the national
  debt.
• c. help increase recessionary gaps in the
  economy.
• d. moderate the effect of fluctuations in the
• business cycle.
• e. require legislative review by Congress before
• they can be implemented.

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Homework 9

• Page 296, 4, 9