Fiscal Policy

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Fiscal Policy
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Government in the Economy

• Nothing arouses as much controversy as the role
  of government in the economy.
• Government can affect the macroeconomy in two
  ways
• Fiscal policy is the manipulation of government
  spending and taxation.
• Monetary policy refers to the behavior of the
  Federal Reserve regarding the nations money
  supply.

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What is Fiscal Policy?

• Fiscal policy is the deliberate manipulation of
  government purchases, transfer payments, taxes,
  and borrowing in order to influence macroeconomic
  variables such as employment, the price level,
  and the level of GDP

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Government in the Economy

• Discretionary fiscal policy refers to deliberate
  changes in taxes or spending.
• The government can not control certain aspects of
  the economy related to fiscal policy. For
  example
• The government can control tax rates but not tax
  revenue. Tax revenue depends on household income
  and the size of corporate profits.
• Government spending depends on government
  decisions and the state of the economy.

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Net Taxes (T), and Disposable Income (Yd)

• Net taxes are taxes paid by firms and households
  to the government minus transfer payments made to
  households by the government.
• Disposable, or after-tax, income (Yd ) equals
  total income minus taxes.

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Adding Net Taxes (T) and Government Purchases (G)
to the Circular Flow of Income
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Adding Net Taxes (T) and Government Purchases (G)
to the Circular Flow of Income

• When government enters the picture, the aggregate
  income identity gets cut into three pieces

• And aggregate expenditure (AE) equals

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The Budget Deficit

• A governments budget deficit is the difference
  between what it spends (G) and what it collects
  in taxes (T) in a given period

• If G exceeds T, the government must borrow from
  the public to finance the deficit. It does so by
  selling Treasury bonds and bills. In this case,
  a part of household saving (S) goes to the
  government.

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Adding Taxes to theConsumption Function

• The aggregate consumption function is now a
  function of disposable, or after-tax, income.

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Equilibrium Output Y C I G
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Finding EquilibriumOutput/Income Graphically
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The Government Spending Multiplier

• The government spending multiplier is the ratio
  of the change in the equilibrium level of output
  to a change in government spending.

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The Government Spending Multiplier
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The Effect on GDP of an Increase in Government
Spending

CIG(X-M)
45o
CIG(X-M)
Simple government expenditures multiplier
?GDP/?G 1/(1-MPC)
?G
Real GDP
?GDP
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The Government Spending Multiplier
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The Tax Multiplier

• A tax cut increases disposable income, and leads
  to added consumption spending. Income will
  increase by a multiple of the decrease in taxes.
• A tax cut has no direct impact on spending. The
  multiplier for a change in taxes is smaller than
  the multiplier for a change in government
  spending.

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The Tax Multiplier
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The Effect on GDP of a Decrease in Taxes

CIG(X-M)
45o
CIG(X-M)
Simple tax multiplier ?GDP/?T -MPC/(1-MPC)
Real GDP
?GDP
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The Balanced-Budget Multiplier

• The balanced-budget multiplier is the ratio of
  change in the equilibrium level of output to a
  change in government spending where the change in
  government spending is balanced by a change in
  taxes so as not to create any deficit.

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The Balanced Budget Multiplier

• A factor that show that identical changes in
  government purchases and net taxes change real
  GDP demanded by that same amount

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The Balanced-Budget Multiplier
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Fiscal Policy Multipliers
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Fiscal Policy in Practice
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Introduction

• Before the 1930s, fiscal policy was not
  explicitly used to influence the macroeconomy
• The classical approach implied that natural
  market forces, by way of flexible prices, wages,
  and interest rates, would move the economy toward
  its potential GDP
• Thus there appeared to be no need for government
  intervention in the economy
• Before the onset of the Great Depression, most
  economists believed that active fiscal policy
  would do more harm than good

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The Great Depression and World War II

• Three developments bolstered the use of fiscal
  policy
• The publication of Keynes General Theory
• War-time demand on production helped pull the
  U.S. out of the Great Depression
• The Full Employment Act of 1946, which gave the
  federal government responsibility for promoting
  full employment and price stability

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Automatic Stabilizers

• Structural features of government spending and
  taxation that smooth fluctuations in disposable
  income over the business cycle
• Examples include,
• Our progressive income system with its increasing
  marginal income tax rates
• Unemployment insurance
• Welfare spending

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The Economys Influenceon the Government Budget

• Fiscal drag is the negative effect on the economy
  that occurs when average tax rates increase
  because taxpayers have moved into higher income
  brackets during an expansion.

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The Golden Age of Keynesian Fiscal Policy to
Stagflation

• The Early 1960s provided support for Keynesian
  theories
• In particular, President Kennedys 1964 income
  tax cut did much to boost the economy and reduce
  unemployment
• However, the 1970s were marked by significant
  supply-side shocks (increases in oil prices in
  addition to crop failures)
• The economic ills brought about by these
  supply-side shocks to the economy could not be
  remedied by demand-side Keynesian economic
  theories

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Lags in Fiscal Policy

• The time required to approve and implement fiscal
  legislation may hamper its effectiveness and
  weaken fiscal policy as a tool of economic
  stabilization
• In the case of an oncoming recession, it may take
  time to
• Recognize the coming recession
• Implement the policy
• Let the policy have its impact

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Discretionary Policy and Permanent Income

• Permanent income is income that individuals
  expect to receive on average over the long run
• To the extent that consumers base spending
  decisions on their permanent income, attempts to
  fine-tune the economy through discretionary
  fiscal policy will be less effective

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Budgets, Deficits,and Public Policy
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The Government Budget

• A plan for government expenditures and revenues
  for a specified period, usually a year

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The Federal Budget

• The federal budget is the budget of the federal
  government.
• The difference between the federal governments
  receipts and its expenditures is the federal
  surplus () or deficit (-).

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The Federal Budget
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Composition of Federal Expenditures Fiscal Year
1995
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The Presidential Role in the Budget Process

• Early in this century, the president had very
  little involvement in the development of the
  federal budget
• By the mid-1970s the president had been given the
  resources to translate policy into a budget
  proposal to be presented to Congress
• Office of Management and Budget (1921)
• Employment Act of 1946 (Council of Economic
  Advisers)

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The Presidential Role in the Budget Process
(continued)

• The development of the presidents budget begins
  a year before it is submitted to Congress
• The presidents proposed budget (The Budget of the
  United States Government) is supported by the
  Economic Report of the President
• The budget is submitted in January for the
  upcoming fiscal year October 1-September 30

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The Congressional Role in the Budget Process

• House and Senate budget committees review the
  presidents budget proposal
• An overall budget outline is approved by Congress
  (budget resolution) and given to the various
  congressional committees and subcommittees which
  authorize federal spending

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Budget Deficits and Surpluses

• When budgeted expenditures exceed projected tax
  revenues, the budget is projected to be in
  deficit
• When projected tax revenues exceed budgeted
  expenditures, the budget is projected to be in
  surplus

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The Federal Government Surplus () or Deficit
(-) as a Percentage of GDP, 1970 I-2003 II
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Problems with the Budget Process

• Continuing resolutions
• A continuing resolution is a budget agreement
  that allows agencies, in the absence of an
  approved budget, to spend at the rate of the
  previous years budget
• Continuing resolutions are implemented due to
  delays in the budget process or problems with
  content of the budget
• Overlapping committee authority
• Length of the budget process
• Uncontrollable budget items
• Overly detailed budget

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Entitlement Programs

• Guaranteed benefits for those who qualify under
  government transfer programs such as Social
  Security and Aid to Families with Dependent
  Children
• These programs represent a major fixed element
  of the budget, unless laws are passed to change
  eligibility requirements

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Suggestions for Budget Reform

• Biennial budget
• The elimination of line item details before
  Congress
• Congress would consider only the overall budget
  for a given agency, rather that detailed line
  items

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Rationale for Budget Deficits

• Large capital projects (highways, etc.)
• The benefits from these project will benefit more
  than current taxpayers, so deficit financing is
  appropriate
• Major Wars
• Keynesian economics points to the use of deficits
  to stimulate the economy during periods of
  economic slowdown
• Automatic stabilizers tend to increase deficits,
  since during times of recession, taxes are
  reduced while unemployment insurance and welfare
  payments are increased

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Budget Philosophies

• Annually balanced budgetBudget philosophy prior
  to the Great Depression aimed at equating
  revenues with expenditures, except during times
  of war
• Cyclically balanced budgetBudget philosophy
  calling for budget deficits during recessions to
  be financed by budget surpluses during expansions
• Functional FinanceA budget philosophy aiming
  fiscal policy at achieving potential GDP rather
  than balancing budgets either annually or over
  the business cycle

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Crowding Out and Crowding In

• Crowding out--When the government undertakes
  expansionary fiscal policy, interest rates
  increase due to competition for borrowed funds
  and increased transactions demand for money
• As a result, private investment is crowded out
  due to increases in public investment
• Crowding inIf expansionary fiscal policy raises
  the general level of prosperity in the economy,
  private investors may expect greater
  investment-related profits, causing private
  investment to increase

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Deficits and Interest Rates

• Financing Deficits
• Taxes
• Bonds (borrowing)
• Printing Money
• Ricardian Equivalence

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The Federal Deficit Versus the National Debt

• The federal deficit is a flow variable measuring
  the amount by which expenditures exceed revenues
  in a particular year
• The national debt is a stock variable measuring
  the accumulation of past deficits
• In the U.S., it took 200 years for the national
  debt to reach 1 trillion
• After the debt reached this level, it took only
  15 years for the debt to reach the 5 trillion
  level

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The Debt and Problems

• http//www.brillig.com/debt_clock/
• Arguments about the Debt
• We have to pay it back
• We owe it to ourselves (much less so than years
  ago).

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Reducing the Deficit

• Line-item veto (signed into law in April 1996
  struck by the Supreme Court in 1998)
• A provision to allow the president to reject
  particular portions of the budget rather than
  simply accept or reject the entire budget
• Balanced budget amendment
• Proposed amendment to the U.S. Constitution
  requiring a balanced federal budget

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Size of Government
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The Debt

• The federal debt is the total amount owed by the
  federal government. The debt is the sum of all
  accumulated deficits minus surpluses over time.
• Some of the federal debt is held by the U.S.
  government itself and some by private
  individuals. The privately held federal debt is
  the private (non-government-owned) portion of the
  federal debt.

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The Federal Government Debt as a Percentage of
GDP, 1970 I-2003 II

• The percentage began to fall in the mid 1990s.

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The Economys Influenceon the Government Budget

• The full-employment budget is what the federal
  budget would be if the economy were producing at
  a full-employment level of output.

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The Economys Influenceon the Government Budget

• The cyclical deficit is the deficit that occurs
  because of a downturn in the business cycle.
• The structural deficit is the deficit that
  remains at full employment.

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Review Terms and Concepts

• automatic stabilizers
• balanced-budget multiplier
• budget deficit
• cyclical deficit
• discretionary fiscal policy
• disposable, or after-tax, income
• federal budget
• federal debt
• federal surplus () or deficit (-)

• fiscal drag
• fiscal policy
• full-employment budget
• government spending multiplier
• monetary policy
• net taxes
• privately held federal debt
• structural deficit
• tax multiplier

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The Economys Influenceon the Government Budget

• Automatic stabilizers are revenue and expenditure
  items in the federal budget that automatically
  change with the state of the economy in such a
  way as to stabilize GDP.

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The Budget Deficits of the 1980s and 1990s

• The tax cuts of the early 1980s together with
  large increases government spending caused the
  annual government deficit and the national debt
  to grow significantly
• Although both fiscal policy measures stimulated
  the economy, the resulting tax revenues were not
  sufficient to manage the large government deficits

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Fiscal Policy and the Natural Rate of Unemployment

• If there is a natural rate of unemployment,
  fiscal policy that increases aggregate demand
  will appear to succeed in the short run because
  output and employment will both expand
• But stimulating aggregate demand will, in the
  long run, result only in a higher price level,
  while the level of output will fall back to the
  economys potential

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Feedback Effects of Fiscal Policy on Aggregate
Supply

• Both automatic stabilizers and discretionary
  fiscal policy may affect individual incentives to
  work spend, save, and invest, though these
  effects are usually unintended

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Appendix The Government Expenditures and Tax
Multipliers
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Appendix The Government Multiplier with Income
Taxes
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Appendix The Multiplier with Income Taxes and
Variable Imports
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Appendix ADeriving the Fiscal Policy
Multipliers

• The government spending and tax multipliers
  algebraically

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Appendix ADeriving the Fiscal Policy Multipliers

• The balanced-budget multiplier is found by
  combining the effects of government spending and
  taxes

• The balanced-budget multiplier equals one. An
  increase in G and T by one dollar each causes a
  one-dollar increase in Y.

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Appendix B The Case In WhichTax Revenues
Depend on Income
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Appendix B The Case In WhichTax Revenues
Depend on Income
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Appendix B The Case In WhichTax Revenues
Depend on Income

• The Government Spending and Tax Multipliers
  Algebraically

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Appendix B The Case In WhichTax Revenues
Depend on Income

• The government spending and tax multipliers when
  taxes are a function of income are derived as
  follows

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A Contractionary Gap Can be Closed by
Expansionary Fiscal Policy
Potential output
Price Level
SRAS
AD
AD
Real GDP
contractionary gap
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An Expansionary Gap Can be Closed by
Contractionary Fiscal Policy
Potential output
Price Level
SRAS
AD
AD
Real GDP
expansionary gap
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The Leakages/Injections Approach

• Taxes (T) are a leakage from the flow of income.
  Saving (S) is also a leakage.
• In equilibrium, aggregate output (income) (Y)
  equals planned aggregate expenditure (AE), and
  leakages (S T) must equal planned injections (I
  G). Algebraically,