Fiscal Policy

1
Fiscal Policy

• Fiscal policy changes in government
  expenditures and taxation to achieve
  macroeconomic goals.
• Fiscal policy may affect whether the economy
  produces at Natural Real GDP in the short run.
• Fiscal policy may affect the level of economic
  growth in the long run.

2
Fiscal Policy and the Budget

• Changes in fiscal policy affect the federal
  governments budget.
• Budget deficit when government expenditures are
  greater than tax revenues.
• Budget surplus when tax revenues are greater
  than government expenditures.

3
Keynesian Fiscal Policy

• According to Keynesian theory, the level of Real
  GDP is determined by the level of Total
  Expenditures.
• The level of Total Expenditures may not be the
  level that will cause the economy to achieve
  Natural Real GDP.

4
Keynesian Fiscal Policy

• The federal government may be able to move the
  level of TE toward the ideal level (and move Real
  GDP toward Natural Real GDP) by using fiscal
  policy.

5
Keynesian Fiscal Policy and a Recessionary Gap

• To close a recessionary gap, Keynesian theory
  calls for the use of expansionary fiscal policy
  (an increase in government expenditures or a
  decrease in taxation).
• Keynesian theory calls for the use of deficit
  spending to close a recessionary gap.

6
Keynesian Fiscal Policy and a Recessionary Gap

• Example 1 If Real GDP is 15,000 billion and
  Natural Real GDP is 15,500 billion, the economy
  is in a recessionary gap. If the MPC is .80, an
  increase in government purchases of 100 billion
  would cause an eventual increase in Real GDP of
  500 billion, closing the recessionary gap.

7
Recessionary Gap
8
Return to Natural Real GDP
9
Keynesian Fiscal Policy and an Inflationary Gap

• To close an inflationary gap, Keynesian theory
  calls for the use of contractionary fiscal policy
  (a decrease in government expenditures or an
  increase in taxation).
• Keynesian theory calls for the use of budget
  surpluses to close an inflationary gap.

10
Keynesian Fiscal Policy and an Inflationary Gap

• Example 2 If Real GDP is 16,000 billion and
  Natural Real GDP is 15,500 billion, the economy
  is in an inflationary gap. If the MPC is .80, a
  decrease in government purchases of 100 billion
  would cause an eventual decrease in Real GDP of
  500 billion, closing the inflationary gap.

11
Inflationary Gap
12
Return to Natural Real GDP
13
Automatic Stabilizers

• Certain transfer payments (e.g. unemployment
  compensation) will automatically increase during
  a recessionary gap and decrease during an
  inflationary gap.
• Certain taxes (e.g. income tax) will
  automatically decrease during a recessionary gap
  and increase during an inflationary gap.

14
Automatic Stabilizers

• Automatic stabilizers taxes and transfer
  payments that automatically tend to move
  equilibrium Real GDP toward Natural Real GDP.
• Example 3 The unemployment rate increased from
  4 in 2000 to 6 in 2003. Unemployment
  compensation increased from 23 billion in 2000
  to 57 billion in 2003. Corporate income taxes
  decreased from 207 billion in 2000 to 132
  billion in 2003.

15
Potential Problems with Fiscal Policy

• 1. There may be a political bias toward
  expansionary fiscal policy at all times.
• Contractionary fiscal policy may be politically
  unpopular.
• Since Keynesian theory was introduced in 1936,
  the federal government has had budget deficits in
  all but 12 years.

16
Potential Problems with Fiscal Policy

• 2. Crowding out increases in government
  spending lead to decreases in private spending.
• a. If increased government spending is paid for
  with increased taxes, this will mainly reduce
  consumption.
• b. If increased government spending is paid for
  with deficit spending, this will mainly reduce
  investment.

17
Potential Problems with Fiscal Policy

• 3. Fiscal policy may be mistimed because of
  lags
• a. The information lag. Government policy
  makers have access to information about the
  business cycle only after some time has passed.
• See Example 6A on page 9-6.

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Potential Problems with Fiscal Policy

• 3. Fiscal policy may be mistimed because of
  lags
• b. The policy lag. Enacting a change fiscal
  policy (e.g. a tax cut, a new spending program)
  takes time.
• See Example 6B on page 9-6.

19
Potential Problems with Fiscal Policy

• 3. Fiscal policy may be mistimed because of
  lags
• c. The impact lag. Once a change in fiscal
  policy is enacted, it takes time before the new
  policy has its full effect on Real GDP.
• See Example 6C on page 9-7.

20
Potential Problems with Fiscal Policy

• 4. Fiscal policy may be miscalculated.
• The government doesnt really know how large the
  multiplier will be, what Natural Real GDP is, or
  even what the current level of Real GDP is.

21
Supply-side Fiscal Policy

• Supply-side economists argue that Keynesian
  fiscal policy has had a harmful effect on the
  supply side of the economy.
• Deficit spending has led to a growing federal
  government.
• See Examples 7A and 7B on page 9-8.

22
Supply-side Fiscal Policy

• The growing federal government has led to high
  marginal tax rates.
• High marginal tax rates reduce incentives, and
  can thus reduce both SRAS and, especially, LRAS.
• See Example 8 on page 9-8.

23
Lower Marginal Tax Rates

• Supply-side economists support lowering marginal
  tax rates.
• Lowering marginal tax rates would increase
  incentives, and would thus increase production in
  both the short run and the long run.

24
The Laffer Curve

• The relationship between tax rates and tax
  revenue can be illustrated on a Laffer curve.
• The Laffer curve indicates that lowering tax
  rates might increase tax revenue.

25
The Laffer Curve
26
Supply-side Tax Cuts

• During the Reagan presidency, the top marginal
  tax rate was lowered from 70 to 28.
• The supply-side tax cuts of the 1980s led to an
  increase in real federal tax paid by higher
  income taxpayers.
• See Example 10A and 10B on page 9-9.

27
History of the Federal Governments Budget

• Since Keynesian theory was introduced in 1936,
  the federal government has had budget deficits in
  all but 12 years.
• See the Table on page 9-10.

28
Appendix The Importance of Incentives

• A fundamental assumption of economic reasoning is
  that people respond to incentives.
• See the Appendix on page 9-11.