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Handout #24P
Fiscal Policy
Mr. Fix-It
So now let’s look at government’s tinkering with the economy.
Fiscal policy is when the government uses its spending or taxes to deliberately smooth out
the macroeconomic fluctuations of the business cycle or achieve other economic goals such
as stable price, low unemployment, and economic growth.
 Expansionary fiscal policy tries to raise aggregate demand (AD) or total expenditures
(TE). An increase in government spending (G) would increase AD/TE. A decrease in
taxes would raise disposable income which would increase consumption (C), which in
turn would increase AD/TE. This type of fiscal policy would be used for a recessionary
gap.
 Contractionary fiscal policy tries to decrease raise aggregate demand (AD) or total
expenditures (TE) by reducing government spending (G) or raising taxes which lowers
disposable income and decreases consumption (C), which in turn would increase AD/TE.
This type of fiscal policy would be used for an inflationary gap.
There two other ways to look at government fiscal policy. The first is automatic fiscal policy.
This happens when government spending automatically contracts without any action having to
be undertaken by anyone. The best example of this is when a recession starts to kick in,
workers lose their jobs. The workers go to the unemployment office and file unemployment
claims for benefits. The increase in benefits automatically increases government spending
which is precisely the expansionary fiscal policy that you would want to apply.
The second is discretionary fiscal policy which requires someone in government to do
something to initiate and implement policy action. In general, this means Congress has to act
because they control government expenditures through the budget and taxes.
There are three states of the government budget: surplus, deficit and balanced. A
government surplus exists when government tax revenues and other income exceeds
government expenditures. There is an excess of funds left over and government enters the
loanable funds market as a lender. A budget deficit occurs when government spending
outstrips the money it receives, and there is a shortage of funds. Government will operate as
a borrower in the loanable funds market to cover its budget shortfall. When the budget is
balanced, money in will equal money out for the government.
In recent times, the US government had operated “in the red” by running deficits. Continual
deficits have added to the growing public debt or what the government owes its creditors,
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now exceeding $16.7 trillion. This situation creates a generational imbalance where the
current generation is enjoying lower taxes and benefits while passing off the obligation to
fully cover those benefits to future generations.
There are two categories of budget deficits, structural and cyclical. Structured deficits are
planned to be deficits. This happens when Congress deliberately passes a budget where
expenditures exceed revenues. This type of deficit would occur even if the economy were
operating at full employment. A cyclical deficit is the part of the deficit that occurs when
the economy takes a downturn in economic activity, adding more to the total. So the total
deficit equals the structural plus the cyclical deficit.
There are three government multipliers that operate on fiscal policy changes.
 The expenditure multiplier is the multiplication effect of a change in government
spending on goods and services (G) on aggregate demand or total expenditures. When
G increases, real GDP (Y) increases, which in turn increases consumption (C) as the
spending works its way through the economy. If the expenditure multiplier is 5, then a
$100 increase in G, will raise AD/TE by $500.
 The autonomous tax multiplier is the multiplication effect of a change in taxes on
aggregate demand or total expenditures. A decrease in taxes will raises disposable
income (YD) which in turn raises consumption (C) and thus AD/TE. However, this fiscal
policy multiplier will have a smaller effect on AD/TE than the expenditure multiplier
because of the marginal propensity to consume (MPC). Since the change in YD will be
multiplied by the MPC which is less than 1, AD/TE will not increase by the whole
amount of the tax decrease. If the MPC is .8, the tax multiplier will be 5 calculated
by [1/(1-MPC)]. So if taxes are lowered by $100, YD will increase by $100 and C will
increase by .8*$100, or $80. Then AD/TE will rise by $80*5 or $400. Note this is
less than the $500 increase in AD/TE that the expenditure multiplier produced on
$100 change in government spending.
 The balanced budget multiplier is the multiplication effect on aggregate demand or
total expenditures from a simultaneous equal change in government spending and taxes
that does not crease a surplus or deficit. It will have a small positive or negative
effect because the expenditure multiplier has a larger impact than the offsetting tax
multiplier. If fiscal policy increased both G and taxes by $100, the increase in G would
result in +$500 in AD/TE while the increase in taxes would yield -$450. So the net
effect would be +$50.
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Expansionary fiscal policy applied to a recessionary gap in the AD/AS model would look like
the graph below. First, the initial fiscal policy would increase aggregate demand, shifting the
AD curve to the right. As the multiplier effects build, the AD curve shifts all the way out to
return the economy to full employment.
LRAS
Price
Level
SRAS
P2
P1
P
AD2
(After
multiplier)
AD1
AD
Qe
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Qn
(Expansionary
fiscal policy)
Real GDP
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Contractionary fiscal policy applied to an inflationary gap in the AD/AS model would work
the other way. First, the initial fiscal policy would decrease aggregate demand, shifting the
AD curve to the left. As the multiplier effects build, the AD curve shifts all the way in to
return the economy to full employment.
LRAS
Price
Level
SRAS
P
P1
P2
AD
AD1
(Contractionary
fiscal policy)
AD2
(After
multiplier)
Qn
Qe
Real GDP
If you know the amount of the gap of real GDP that is needed to bring the economy to full
employment, you can calculate the size of the fiscal policy you need to implement. The dollar
amount will be different if changing government spending is the method used or if tax
changes are used.
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In the TP/TP model, expansionary fiscal policy applied to a recessionary gap in the economy
would look like the graph below. If the economy is in a recessionary gap, Qe is less than Qn
and the TE line should shift up to the point where TP=TE=QN. Let’s say that the gap in Real
GDP is $5000. Using the MPC of .8 and multiplier of 5, we can calculate the change in G that
is need to bring the economy back to full employment by dividing the gap, $5000 by the
multiplier 5. That means we need to increase government spending by $1000 so when it is
multiplied by 5 , we will get the $5000 we need to close the gap.
TE, TP
$
TP
TE1
B
TE
A
$1000
G
QE
QN
Real GDP
$5000
In the TP/TP model, contractionary fiscal policy applied to an inflationary gap in the economy
would look like the graph below. If the economy is in an inflationary gap, Qe is greater than
Qn and the TE line should shift down to the point where TP=TE=QN. Let’s say that the gap in
Real GDP is again $5000. Using the MPC of .8 and multiplier of 5, we can calculate the
change in taxes that is need to bring the economy back to full employment by dividing the
gap, $5000 by the multiplier 5 and then dividing the result by the MPC. The tax increase
would thus need to be $1250, as compared to the $1000 ΔG above, A increase in taxes of
$1250 would give a decrease in consumption of .8*$1250 or $1000 which is what we need to
close the $5000 gap with a multiplier of 5
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TE, TP
$
TP
TE
A
TE1
$1000
C
From tax
$1250
B
QN
QE
Real GDP
$5000
There are real world problems with implementing fiscal policy, besides the fact that precise
knowledge of what should be done is not achievable. There are five “lag” problems that really
get in the way of effectively correcting the economy’s movements
 The data lag: Policymakers are not aware of changes in the economy as soon as they
happen because the data is not yet available. Data statistics take time to accumulate
and develop to measure what is happening in the economy.
 The wait-and-see lag: After the data indicates a change in the economy,
policymakers will usually wait to see if the change is temporary or ongoing. Data can
bounce up and down from month to month.
 The legislative lag: Once policymakers decide that there has been a change in the
economy, a decision has to be reached on whether or not to implement fiscal policy. If
policy is to be implemented, a particular plan of fiscal policy has to be proposed
(President or Congress), politically debated, amended, and passed by Congress. This
can take many months.
 The transmission lag: After the fiscal policy is passed, it has to move through the
bureaucratic process to be implemented. This might include bids, design, contracts
etc. and could take quick a long time—maybe years.
 The effectiveness lag: After the fiscal policy is actually implemented, it takes time
to work its way through the economy.
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The net effect of these lags is that by the time the fiscal policy actually takes effect, the
economic problem 1) may no longer exist, 2) may not exist to the degree it did, or 3) may
have changed altogether to another problem. So the fiscal policy may actually cause a new
problem such as over-correction.
Govt
trying to
go here
Price
Level
Economy
starts here
LRAS
SRAS
SRAS1
2
4
1
Ends up here after
economy selfcorrected
3
AD1
During lags,
economy moves
here on its own
AD
Qn
(Expansionary
Fiscal Policy
Real GDP
One other issue with fiscal policy is crowding-out. Crowding-out occurs when an action by the
government, quite often taken to implement fiscal policy, causes an opposite movement in the
private sector. For example, when government spending (G) increases, any budget deficit will
also increase, and the government enters the loanable funds market as a borrower. Real
interest rates are driven up to a higher level because of the increase in the demand for
loanable funds. The increase in the real interest rate in turn, decreases both consumption
and investment which offsets the expansionary effects on real GDP from the increase in
government spending. Another example would be if government spends more on building
public libraries, private sector spending on books could decrease, causing consumption to fall.
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There can be no crowding-out, partial crowding-out, or complete crowding-out. With no
crowding-out, fiscal policy has its full impact on real GDP. Partial crowding-out causes fiscal
policy to have a smaller impact on real GDP because of the offset by the private sector.
Complete crowding out results in no change in real GDP when fiscal policy is implemented by
the government.
For a recessionary gap, you can see the three different effects of crowding-out below.
LRAS
Price
SRAS
Level
P2
P1
P
1 no private offset
AD1
(Full impact of fiscal policy with
no crowding out)
total private offset 3
2 some private offset
AD2
AD
(Smaller impact of fiscal policy
with partial crowding out)
AD3
(No impact of fiscal policy with
complete crowding out)
Q3
Q1
Q2
no
total
partial
crowding crowding crowding
out
out
out
out
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Real GDP
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In an inflationary gap, just the opposite occurs.
LRAS
Price
Level
SRAS
P2
P1
P
1 no private offset
AD AD3
total private offset 3
(No impact of fiscal policy with
complete crowding out)
AD2
some private offset 2
(Smaller impact of fiscal policy
with partial crowding out)
AD1
(Full impact of fiscal policy with
no crowding out)
Q1
Q2
Q3
no
partial
total
crowding crowding crowding
out
out
out
out
Real GDP
Fiscal policy can have effects on the supply side of the economy as well as on aggregate
demand. Imposing a tax on income—labor, interest, and capital—has an effect on the
economy in several ways. First, a tax on labor income reduces the supply of labor. That
reduction in the supply of labor causes potential GDP to decrease and reduces output in the
short-run and long-run. The before-tax wages rise but the after-tax wages fall—referred to
as the income tax wedge. Since employers are paying the higher before-tax wages, they
employ less labor and since workers are only receiving the lower after-tax wage, less labor is
supplied.
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LS1
Real
Wage
Rate
LS
Higher
Before-Tax
Wages
Income Tax
Wedge
We
Lower
After-Tax
Wages
Lower Employment
LD
QL1
QL
Labor Hours
Real GDP
Potential
GDP
PF
Lower
Potential
GDP1
QL1
QL
Labor Hours
A decrease in potential real GDP along the production function will shift the LRAS and the
SRAS into the left causing a decrease in QN and an increase in the price level.
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Price Level
LRAS1
LRAS
SRAS1
SRAS
P1
Pe
D
QN1
QN
Q
Taxes on consumption add to the tax wedge. Taxes on consumption raise the prices worker
have to pay for goods and services which is equivalent to a drop in the real wage rate. The
higher are the taxes on goods and services, the lower is the after-tax wage rate, and the
lower the incentive to supply labor.
Taxes on interest income and capital earnings also affect the incentive to save and invest. A
tax on interest income decreases the supply of loanable funds. The leftward shift in the
supply of loanable funds increases the before-tax real interest rate but also creates a tax
wedge so that the after-tax real interest rate falls. Investors would pay a higher interest
rate on funds borrowed and savers would earn a small amount on funds saved.
Because of the tax wedge effects of taxes on employment and saving, a higher tax rate does
not always result in higher tax revenues. Tax revenues are calculated by the tax rate times
the tax base or earnings. But if a higher tax rate causes reduced labor hours, the tax base
could actually decrease more than the increase in the tax rate and tax revenues would go
down rather than up. The Laffer curve shows this relationship between tax rates and tax
revenues.
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Tax
Revenues
Maximum Tax Revenues
0%
100%
 Tax Rate   Revenues
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Tax Rate
 Tax Rate   Revenues
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