Download Fiscal Policy - Macmillan Learning

Fiscal Policy
20
20- 1
Overview
After studying this chapter, you should be able to:
• Describe the tools that governments use to influence
aggregate demand.
• Describe mandatory and discretionary government
spending.
• Describe the multiplier effect of increased government
spending on the equilibrium output of an economy.
• Explain expansionary and contractionary fiscal policy
• Describe why tax changes have a smaller impact on the
economy than changes in government.
• Describe the impact of automatic stabilizers, lag effects,
and the crowding out effects in fiscal policymaking.
• Describe the debate over the size of government and
economic policy.
20- 2
Food for Thought….
Some good blogs and other sites to get the juices flowing:
20- 3
Federal Government Budget,
2009
20- 4
Fiscal Policy
• Fiscal policy: one way the government
tries to manage the economy and tame
the business cycle.
• involves adjusting government spending
on:
• Goods and services
• Transfer payments
• Taxes
20- 5
Discretionary Spending
• The federal budget contains two types of
spending: discretionary and mandatory.
• Discretionary spending:
• The part of the budget that works its way
through the appropriations process of
Congress each year
• Includes:
•
•
•
•
•
National defense
Transportation
Science
Environment
Income security
20- 6
Mandatory Spending
• Mandatory spending:
• authorized by permanent laws and does
not go through the same appropriation
process as discretionary spending. To
change these entitlements, Congress
must change the law.
• Includes:
• Social Security
• Medicare
• Interest on the national debt
20- 7
Discretionary and Mandatory
Federal Spending
Getting
harder to
maneuver…
820-
8
Discretionary Fiscal Policy
• Discretionary fiscal policy:
• adjusting government spending and tax
policies
• with the express short-run goal of moving
the economy toward full employment,
encouraging economic growth, or
controlling inflation
20- 9
The Multiplier and Government
Spending
The Multiplier will
boost government
spending when
the economy is
below full
employment
But when we
reach full
employment,
more spending
will only create
inflation
20- 10
The Multiplier Effect
When government spending is injected into
the economy, the multiplier goes to work…
• $1 of additional spending in the economy will
create new income which will be spent (and respent many times by all who receive it as
income)
• Total new spending = Initial injection x Multiplier
20- 11
Taxes
• When taxes are increased, money is
withdrawn from the economy’s spending
stream.
• When taxes are reduced, consumers and
business have more to spend.
• A tax increase (or decrease) will have less
of a direct impact on income, employment,
and output than an equivalent change in
government spending.
20- 12
Taxes
GDP= C + I + G + (X - M)
• Let’s simplify for a moment…
• If GDP = C + I (no government or foreign
sector) and we know Y = GDP if there is no
taxes… so
• Y= C + I or
• Y – C = I and we know that (Y – C) = S so
•S=I
• At equilibrium, injections (I) are just
equal to withdrawals (S)
20- 13
Equilibrium
• Add in back in injections (G and X)
and subtract withdrawals (T and M)
and get
•I+ G+ X= S+ T+M
• Fiscal Policy works by changing G or
T to change the level of injections or
withdrawals in the economy
20- 14
Expansionary and
Contractionary Fiscal Policy
• Expansionary fiscal policy: increasing
government spending or decreasing taxes
to increase aggregate demand to expand
output.
20- 15
Expansionary Fiscal Policy
If the economy is below full employment, expansionary fiscal
policy can be used to boost AD to AD1.
Aggregate Price Level (P)
LRAS
SRAS0
P1
f
e
P0
AD1
AD0
Q0
Qf
Aggregate Output (Q)
20- 16
Contractionary Fiscal Policy
• If the economy is beyond the point of full
employment, contractionary fiscal policy
can be used to dampen inflationary
pressures.
• This requires an increase in taxes or a
decrease in government spending.
20- 17
Contractionary Fiscal Policy
A contractionary fiscal policy that shifts AD from AD0 to AD1
will lower the price level as it reduces aggregate output.
Aggregate Price Level (P)
LRAS
SRAS0
P0
e
P1
a
AD0
AD1
Qf
Q0
Aggregate Output (Q)
20- 18
Supply-Side Fiscal Policies
• Supply-side fiscal policies:
• Goal: create growth, reduce
unemployment and stabilize prices
• They are designed to shift the long-run
aggregate supply curve to the right
• Do not always require such tradeoffs
between price levels and output
• Supply-side policies require more time to
work than do demand-side policies
20- 19
Supply-Side Outcomes
• Current examples of supply-side
technology:
• Spending on infrastructure and education
• Improvements in technology and
communications have increased
productivity.
• These have helped to keep interest rates
and inflation low for several decades.
20- 20
Supply-Side Policy
If successful, supply-side policies will create economic
growth, lower unemployment and lower prices
20- 21
Supply-Side Policy
• Supply-side policy ideas:
• Infrastructure Spending
• Reducing Tax Rates
• Expanding Investment and Reducing
Regulations
President Reagan arguing for a tax cut
20- 22
The Laffer Curve
• One recommendation of supply-side
economics: lower tax rates to increase
productivity.
• The Laffer Curve argues that tax revenues can
sometimes be increased by lowering tax rates
• Encourages risk-taking by entrepreneurs; lower
taxes mean higher after-tax returns on
investments
• Encourages private saving and business
investment
20- 23
The Laffer Curve
Art Laffer: Reduce the tax rate and watch the revenues
increase….
20- 24
Encouraging Investment
• Investment can be increased by:
• Investment tax credits
• More rapid depreciation schedules for plant and
equipment
• When a firm can expense its capital equipment over a
shorter period of time, it reduces tax payments now
rather than later, and so earns a higher net return.
• Repealing unnecessarily heavy regulation
• Government grants for basic research
20- 25
Implementing Fiscal Policy
• It takes time to recognize economic
problems and implement
solutions… some times too much
time.
20- 26
Automatic Stabilizers
• The solution? Automatic Stabilizers
• Automatic Stabilizers: Tax revenues and
transfer payments automatically adjust to
economic fluctuations without requiring
overt action by Congress.
• When the economy is growing tax receipts will
rise with rising income, and transfer payments
will decline because fewer people require
welfare or unemployment assistance.
20- 27
Automatic Stabilizers
• The income tax is a powerful stabilizer
because of its progressivity.
• When incomes fall, tax revenues fall
faster since people pay lower rates as
their incomes fall.
• Disposable income falls more slowly
than aggregate income.
20- 28
Fiscal Policy Timing Lags
• Information lag
• Most of the data that policy makers need are not available
until at least one quarter after the fact.
• Recognition lag
• It may take several quarters to confirm the economic
trends.
• Decision lag
• The time it takes Congress and the administration to
decide on a policy once a problem is recognized.
• Implementation lag
• Fiscal policy requires a long and often contentious
legislative and implementation process.
• It also takes time for the policy to affect the economy.
20- 29
The Crowding-Out Effect
• The crowding-out effect of fiscal policy:
deficit spending requires the government to
borrow from a the economy’s pool of funds.
• This borrowing can drive up interest rates.
• Higher interest rates:
• Dampen consumer spending
• Reduce business investment
20- 30
Ponder This
How big should the government be?
20- 31
Key Concepts
• Discretionary
•
spending
• Mandatory spending •
• Discretionary fiscal •
policy
•
• Expansionary fiscal •
policy
•
• Contractionary fiscal •
policy
•
Supply-side fiscal
policies
Laffer curve
Automatic stabilizers
Information lag
Recognition lag
Decision lag
Implementation lag
Crowding-out effect
20- 32
In a depressed economy with a lot of excess
capacity and a MPC of 0.75, what effect will a
$100 increase in government spending have
on equilibrium GDP?
a) Reduce it by $250
b) Raise it by $250
c) Raise it by $400
d) Raise it by $700
20- 33
Which of the following is a contractionary
fiscal policy?
a) Increasing government spending
b) Expanding transfer payments
c) Subsidizing basic research
d) Raising tax rates
20- 34
True or false: Supply-side fiscal policy
does not require tradeoffs between
output and prices and it works faster
than demand-side fiscal policy.
a) True
b) False
20- 35
True or false: Supply-side fiscal policy
does not require tradeoffs between
output and prices and it works faster
than demand-side fiscal policy.
a) True
b) False
20- 36