Download Fiscal Policy

Fiscal Policy
Fiscal economic
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 nation’s money supply.
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
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.
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.
Yd  Y  T
Adding Net Taxes (T) and Government Purchases (G) to the
Circular Flow of Income
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:
Yd  Y  T
Yd  C  S
Y  T  C S
Y  C S  T
• And aggregate expenditure (AE) equals:
AE  C  I  G
The Budget Deficit

A government’s budget deficit is the
difference between what it spends (G)
and what it collects in taxes (T) in a given
period:
Budget deficit  G  T
• 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.
Adding Taxes to the
Consumption Function
C  a  bYd
Yd  Y  T

C  a  b( Y  T )
The aggregate consumption
function is now a function of
disposable, or after-tax, income.
Equilibrium Output: Y = C + I + G
C  100 .75Yd
C  100.75(Y  T )
Finding Equilibrium for I = 100, G = 100, and T = 100
(All Figures in Billions of Dollars)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
PLANNED
INVESTMENT GOVERNMENT
SPENDING
PURCHASES
I
G
(8)
(9)
(10)
PLANNED
AGGREGATE
EXPENDITURE
C+I+G
UNPLANNED
INVENTORY
CHANGE
Y  (C + I +
G)
ADJUSTMENT
TO
DISEQUILIBRIUM
NET
TAXES
T
DISPOSABLE
INCOME
Yd / Y  T
300
100
200
250
 50
100
100
450
 150
Output8
500
100
400
400
0
100
100
600
 100
Output8
700
100
600
550
50
100
100
750
 50
Output8
900
100
800
700
100
100
100
900
0
1,100
100
1,000
850
150
100
100
1,050
+ 50
Output9
1,300
100
1,200
1,000
200
100
100
1,200
+ 100
Output9
1,500
100
1,400
1,150
250
100
100
1,350
+ 150
Output9
OUTPUT
(INCOME)
Y
CONSUMPTION
SPENDING
(C = 100 + .75 Yd)
SAVING
S
(Yd – C)
Equilibrium
Finding Equilibrium
Output/Income Graphically
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.
1
Government spending multiplier 
MPS
The Government Spending
Multiplier
Finding Equilibrium After a $50 Billion Government Spending Increase
(All Figures in Billions of Dollars; G Has Increased From 100 in Table 25.1 to 150 Here)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
OUTPUT
(INCOME)
Y
NET
TAXES
T
DISPOSABLE
INCOME
Yd / Y  T
CONSUMPTION
SPENDING
(C = 100 + .75 Yd)
SAVING
S
(Yd – C)
PLANNED
INVESTMENT
SPENDING
I
GOVERNMENT
PURCHASES
G
(8)
(9)
(10)
PLANNED
UNPLANNED
AGGREGATE
INVENTORY
ADJUSTMENT
EXPENDITURE
CHANGE
TO
C+I+G
Y  (C + I + G) DISEQUILIBRIUM
300
100
200
250
 50
100
150
500
 200
Output8
500
100
400
400
0
100
150
650
 150
Output8
700
100
600
550
50
100
150
800
 100
Output8
900
100
800
700
100
100
150
950
 50
Output8
1,100
100
1,000
850
150
100
150
1,100
0
1,300
100
1,200
1,000
200
100
150
1,250
+ 50
Equilibrium
Output9
The Effect on GDP of an Increase
in Government Spending
$
45o
C+I+G’+(X-M)
C+I+G+(X-M)
G
Simple government expenditures multiplier =
GDP/G = 1/(1-MPC)
GDP
Real GDP
The Government Spending
Multiplier
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.
The Tax Multiplier
 1 
 Y  (initial increase in aggregate expenditure)  

 MPS 
 1 
 MPC 
 Y  (   T  MPC )  
   T  

 MPS 
 MPS 
 MPC 
Tax multiplier   

 MPS 
The Effect on GDP of a Decrease
in Taxes
$
45o
C’+I+G+(X-M)
C+I+G+(X-M)
Simple tax multiplier =
GDP/T = -MPC/(1-MPC)
GDP
Real GDP
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.
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
1 

 - MPC 
Change in Y  Change in G  
 + Change in T  

 1- MPC 
 1- MPC 
Change in G  Change in T 
1
MPC 

Change in Y  Change in G  

 = Change in G
 1- MPC 1- MPC 
The Balanced-Budget Multiplier
Finding Equilibrium After a $200 Billion Balanced Budget Increase in G and T
(All Figures in Billions of Dollars; G and T Have Increased From 100 in Table 25.1 to 300 Here)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
OUTPUT
(INCOME)
Y
NET
TAXES
T
DISPOSABLE
INCOME
Yd / Y  T
CONSUMPTION
SPENDING
(C = 100 + .75 Yd)
PLANNED
INVESTMENT
SPENDING
I
GOVERNMENT
PURCHASES
G
PLANNED
AGGREGATE
EXPENDITURE
C+I+G
UNPLANNED
INVENTORY
CHANGE
Y  (C + I + G)
ADJUSTMENT
TO
DISEQUILIBRIUM
500
300
200
250
100
300
650
 150
Output8
700
300
400
400
100
300
800
 100
Output8
900
300
600
550
100
300
950
 50
Output8
1,100
300
800
700
100
300
1,100
0
1,300
300
1,000
850
100
300
1,250
+ 50
Output9
1,500
300
1,200
1,000
100
300
1,400
+ 100
Output9
Equilibrium
Fiscal Policy Multipliers
Summary of Fiscal Policy Multipliers
POLICY STIMULUS
Governmentspending
multiplier
Increase or decrease in the
level of government
purchases:
Tax multiplier
Increase or decrease in the
level of net taxes:
Balancedbudget
multiplier
Simultaneous balanced-budget
increase or decrease in the
level of government purchases
and net taxes:
MULTIPLIER
1
MPS
 MPC
MPS
FINAL IMPACT ON
EQUILIBRIUM Y
1
G
MPS
T 
 MPC
MPS
1
G
Fiscal Policy in Practice
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
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
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
The Economy’s Influence
on 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.
The Golden Age of Keynesian
Fiscal Policy to Stagflation

The Early 1960s provided support for
Keynesian theories


In particular, President Kennedy’s 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
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
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
Budgets, Deficits,
and Public Policy
The Government Budget

A plan for
government
expenditures and
revenues for a
specified period,
usually a year
The Federal Budget


The federal budget is the budget
of the federal government.
The difference between the federal
government’s receipts and its
expenditures is the federal surplus
(+) or deficit (-).
The Federal Budget
Federal Government Receipts and Expenditures, 2000 (Billions of Dollars)
AMOUNT
Receipts
Personal taxes
PERCENTAGE
OF TOTAL
1,010.1
49.6
193.2
111.0
720.6
2,034.9
9.5
5.5
35.4
100.0
Current Expenditures
Consumption
Transfer payments
Grants-in-aid to state and local governments
Net interest payments
Net subsidies of government enterprises
Total
514.1
831.9
274.2
236.9
52.5
1,909.6
26.9
43.6
14.4
12.4
2.7
100.0
Current Surplus (+) or deficit ()
+ 125.3
Corporate taxes
Indirect business taxes
Contributions for social insurance
Total
(Receipts  Current Expenditures)
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
Composition of Federal
Expenditures: Fiscal Year 1995
33.8%
15.3%
Welfare
Net interest
Social security &
medicare
National defense
14.5%
All other
18.0%
19.5%
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)
The Presidential Role in the
Budget Process (continued)

The development of the
president’s 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
The Congressional Role in the
Budget Process


House and Senate budget committees
review the president’s 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
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
The Federal Government Surplus (+) or
Deficit (-) as a Percentage of GDP, 1970 I2003 II
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 year’s 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
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
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
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
Budget Philosophies



Annually balanced budget—Budget
philosophy prior to the Great Depression;
aimed at equating revenues with
expenditures, except during times of war
Cyclically balanced budget—Budget
philosophy calling for budget deficits
during recessions to be financed by
budget surpluses during expansions
Functional Finance—A budget philosophy
aiming fiscal policy at achieving potential
GDP rather than balancing budgets either
annually or over the business cycle
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 in—If 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
Deficits and Interest Rates

Financing Deficits




Taxes
Bonds (borrowing)
Printing Money
Ricardian Equivalence
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
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).
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
Size of Government
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.
The Federal Government Debt as a
Percentage of GDP, 1970 I2003 II
The percentage began to fall in the
mid 1990s.
The Economy’s Influence
on 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.
The Economy’s Influence
on 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.
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
The Economy’s Influence
on 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.
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
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 economy’s
potential
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
Appendix: The Government
Expenditures and Tax Multipliers
Y
Y
G
G
1
 a  bNT  I  G  X  M

1 b
1
  bNT  G 

1 b
b
 NT
 0  Y  
1 b
1 b
 NT  NT
 T  Y  
1 b
Appendix: The Government
Multiplier with Income Taxes
C  a  b Y  tY  a  b1  t  Y
Y  a
b
1 t 
Y  I  G   X  M
C
Y1  b1  t    a  I  G   X  M 
a  I  G   X  M
Y
1  b1  t 
1
Y 
G
1  b1  t 
Appendix: The Multiplier with Income
Taxes and Variable Imports





Y  a
b
1 t 
Y  I  G   X  m
1

t
Y




C
M
Y1  b  m  t b  m   a  I  G  X
aIGX
Y
1  b  m  t b  m
1
Y 
G
1  b  m  t b  m
Appendix A:
Deriving the Fiscal Policy Multipliers
The government spending and tax multipliers
algebraically:
C  a  b(Y  T )
Y  C I  G
Y  a  b(Y  T )  I  G
Y  a  bY  bT  I  G
Y  bY  a  bT  I  G
Y (1 b)  a  bT  I  G
1
Y
(a  bT  I  G )
1 b
Appendix A:
Deriving the Fiscal Policy Multipliers
 The
balanced-budget multiplier is found by
combining the effects of government
spending and taxes:
increase in spending:
G
- decrease in spending:
C  T ( MPC )
= net increase in spending
G  T ( MPC )
G  T
 1 
Y  G ( MPS ) 
  G
 MPS 
• The balanced-budget multiplier
equals one. An increase in G
and T by one dollar each causes
a one-dollar increase in Y.
Appendix B: The Case In Which
Tax Revenues Depend on Income
Y  C I  G
T  T0  tY
Yd  Y  T
T  200  1 3Y
Appendix B: The Case In Which
Tax Revenues Depend on Income
Yd  Y  T
T  200  1 3Y
Yd  Y  (200  1 3Y )
Yd  Y  200  1 3Y )
C  a  bYd
C  100  .75(Y  200 1 3Y )
Y  C  I  G Y  900
I  100 G  100
Appendix B: The Case In Which
Tax Revenues Depend on Income
The Government Spending and Tax Multipliers Algebraically:
C  a  b(Y  T )
C  a  b(Y  T0  tY )
C  a  bY  bT0  btY
Y  C  I G
Y  a  bY  bT0  btY  I  G
1
Y
(a  bT0  I  G )
1  b  bt
Appendix B: The Case In Which
Tax Revenues Depend on Income

The government spending and tax multipliers when taxes
are a function of income are derived as follows:
Y  C I  G
C  a  b(Y  T )
C  a  b(Y  T0  tY )
1
Y
(a  bT0  I  G )
1  b  bt
C  a  bY  bT0  btY
Y  a  bY  bT0  btY  I  G
Y  bY  btY  a  bT0  I  G
Y (1  b  bt )  a  bT0  I  G
A Contractionary Gap Can be Closed
by Expansionary Fiscal Policy
Price
Level
Potential
output
SRAS
AD*
AD
contractionary
gap
Real GDP
An Expansionary Gap Can be Closed by
Contractionary Fiscal Policy
Price
Level
Potential
output
SRAS
AD*
AD
expansionary
gap
Real GDP
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,
AE  C  I  G
Y  C S  T
C S  T  C I  G
ST  IG