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Chapter 32 Spending/Fiscal Policy
A. Fiscal Policy Re-Visited
-We have already covered the expenditure model and how to alleviate both a recessionary and
inflationary Gap.
1. Fiscal Policy – recall this is a change in Gov’t spending that is designed to stimulate the
economy. It could be an increase in spending or a decrease in taxes. It is an attempt to alter
spending overall to increase or decrease unemployment and produce high and sustained
output/growth.
-It is called discretionary fiscal policy when it is done deliberately. This is opposed to the notion
that the government simply changes G or Taxes without any real motivation of the economy’s
stability.
Terms:
a. Federal Budget – annual statement of revenues and outlays to finance activities of the federal
government and achieve macroeconomic objectives.
i. Budget Deficit – when they spend more than they take in; Taxes – Spending < 0
ii. Budget Surplus – when they spend less than they take in; Taxes – Spending > 0
iii. Balanced Budget – when Taxes = Spending
iv. National Debt – the accrued amount the federal government owes; Σdeficits/surpluses < 0. So
on average we run deficits.
b. Fiscal Year – this is the timeline for the budget. It runs from Oct 1 – Sept 30th.
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B. Supply-Side, Potential GDP, and Fiscal Policy
-these are the effects that end up affecting our potential output/GDP
1. Full-employment GDP with & without taxes
Recall in the LR Model we use the labor market and the aggregate production function to find
out what the FE GDP is. If we put a tax on workers (i.e. an income tax) then the labor supply
would shift backward. The result can be seen below
LS2 – with Tax
Wage (w)
LS1 –w/o tax
WE2
Tax Wedge
These are both FE- values since there is
no cyclical unemployment
WE1
Take-Home Wage-2
LD
# Workers
Output(GDP)
APF
GDPFE-2
GDPFE-1
# Workers
LF-1
LF-2
Note: If we shift the Ls in we get a lower amount of output b/c there are less workers working.
This can be seen in the graph. So the result of a tax serves to reduce our overall GDP and
workforce.
i-Tax Wedge – this the gap created by what you pay someone and what they actually get to
receive. If you look above we can see that the take-home pay per hour is less than the
equilibrium value since we must take out the tax. This effect is also seen in interest rates. We
must subtract the taxable rate as well as inflation to get real interest rate.
ii- Real Interest = Nominal Rate – inflation – tax rate
Example: what is the real interest rate when the nominal rate is 7%, inflation is 2% and you have
a table rate of 25% on the nominal rate. Since the taxable amount is 0.25 of 7% then it is
0.25*(0.07) = 0.0175 or 1.75%
So real interest rate = 7 – 2 – 1.75 = 3.25%
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C. Demand Side Fiscal Policy
1. Types of Fiscal Policy
a. Expansionary Policy – when there is an increase in G or drop in Taxes in order to get an
increase in GDP. It could also be that they use a mixture of both in order to achieve their goal of
a stable and growing economy.
b. Contractionary Policy – when there is a drop in G or increase in taxes (or a mixture of both in
order to get a drop in GDP.
Example and Illustration Graphically:
Suppose that there is a recessionary GAP of 500 Billion dollars and we have an MPC=.8,
Let’s do the following:
i-calculate the amount of spending that would be necessary to achieve FE-GDP
ii-show the results on the AE and AD/AS graphs
iii-show how the gov’t could implement a tax cut to achieve the same result
(i) Recall that we have Δ GDP = Δ spending * exp multiplier
So if we sub in the appropriate numbers we have:
500 Billion = 1/ (1 - 0.8) * Δ spending  Δ spending = 100 Billion
*so we need an increase of 100 Billion in spending to get rid of the recessionary gap.
(ii) Graph 1: AE-Line
45-Degree Line
AE
AE2
The increase in the AE
line is by 100 Billion
AE1
500 Billion
GDP
GDP
1
2
GDP
-So we can see above that the AE-Line shifts up because there is an increase in spending by the
government.
-We also see the same result in the graph below. Since there is a spending change it must be that
the AD line shifts. Since it is an increase it shifts outward (i.e. in the positive direction).
Consequently we get an increase in GDP and an increase in price level.
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Graph 2: Illustration in AD/AS
P-level
AS
P2
P1
500 Billion
AD2
GDP
GDP1 GDP2
AD1
GDP
(iii) The answer is different if the
government decided to engage in a tax cut since a tax cut
reduces taxes by putting money back in people’s hands as opposed to increasing spending. To
see the desired result we can show what would happen if taxes were cut by 100 Billion and see
the result.
This would increase spending initially by 100 Billion* MPC = 80 Billion
So, plugging this back into our equation of
Δ GDP = Δ spending * exp multiplier = 80 Billion (1 / 1- 0.80) = 400 Billion, which would NOT
cover the Gap. So to fill the gap we would need a greater tax cut than the change in spending
required in a.
**specifically we would need:
Billion change in GDP.
=
=125 Billion tax cut to get the 500
Note:
We are not going to re-introduce the notes on MPC, Expenditure Multiplier, and tax multiplier. If
we go back to chapter 8 & 9 notes the results and explanation are as previously shown.
3. Balance Budget Multiplier – this is the uses the idea of a mixture of fiscal policy in order to
get an increase in AD (and consequently GDP) without creating more debt. The public is taxed
at the same rate as the increase in G. So as G goes up, so too do taxes by the same amount as G.
S. there is no debt that is created.
-Since the spending multiplier is bigger than the tax effect we get an increase or decrease in AD
without having to go into debt.
4. Automatic Stabilizers – These are Government/Federal expenditures and taxes that
automatically change when the economy is in a recession or expansion in order to diminish the
overall effects in the economy.
i- induced taxes – taxes that vary with real GDP
ii- needs tested spending – programs that entitle qualified people to transfers.
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Recession  Taxes collections fall  increase in transfer payments (i.e. social security,
unemployment, Medicare, etc...)
Notice how this would reduce the impact of a recession due to increasing income to those who
need it and by decreasing the taxes that are collected. This generally causes a budget deficit. A
budget deficit is when spending is greater than tax income (i.e. G < T)
Expansion  Taxes collections increase  decrease in transfer payments
-this is an opposite reaction since there is an expansion. In this case we get a budget surplus, or
when G < T.
5. Supply-Side Fiscal Policy – this is the use of fiscal policy to procure changes in AS in order
to get a change in GDP. This is more of a LR solution since it generally takes a longer time for
these policies to cycle through in the economy.
Graphically:
P-level
AS
1
AS2
P1
P2
GDP
1
2
GDP GDP
AD
-if these policies are effective we get an increase in GDP, a lower price level, and a lower
GDP
unemployment rate. These are all
good things.
How can we get these?
-Government subsidies and regulations conduce to lowering costs
-Technological Advances
-Decrease in resource prices such as oil and other inputs
**issues with these policies are the length of time for them to take effect and AD will also adjust
due to some of the effects these policies have in the economy and on spending.
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