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Chapter 29
Fiscal Policy
© 2014 by McGraw-Hill Education
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What will you learn in this chapter?
• What the difference is between contractionary
and expansionary fiscal policy.
• How fiscal policy can counteract short-run
fluctuations.
• What challenges are associated with fiscal
policies.
• How to calculate the fiscal multiplier.
• How revenue and spending determine a
government budget.
• What the difference is between government
deficit and debt.
• What the costs and benefits of government debt
are.
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Fiscal policy
• Fiscal policy refers to government decisions
about the level of taxation or government
spending.
• Fiscal policy affects the economy by
influencing aggregate demand (AD).
– Government spending.
– Tax policies directly affect consumption, which
impacts AD.
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Fiscal policy
Fiscal policy can be either expansionary or contractionary.
• Increased government spending and lower taxes have expansionary effects.
• Decreased government spending and higher taxes have contractionary effects.
Price level
Price level
LRAS
LRAS
SRAS
SRAS
P1
P2
P2
P1
AD1
AD2
Y1
AD2
AD1
Output
Y2
• Expansionary fiscal policy shifts the AD
curve to the right.
Y2
Y1 Output
• Contractionary fiscal policy shifts
the AD curve to the left.
– Output increases.
– Prices increase.
– Output decreases.
– Prices decrease.
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Policy response to economic fluctuations
• Policy-makers try to use fiscal policy to smooth
fluctuations in the economy.
• The AD/AS model illustrates how fiscal policy
can counteract the effects of economic shocks.
– The model predicts that the economy can
automatically correct itself.
– Lawmakers often intervene because automatic
correction can be a painful and slow process.
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Expansionary policy responses
Expansionary policy can counteract decreases in AD.
Initial market response to fall in AD
Price level
Expansionary fiscal policy restores some AD
Price level
LRAS
LRAS
SRAS
P1
SRAS
P3
AD 1
P2
AD1
P2
AD3
Y2
Y1
AD 2
Output
Y2
Y3
AD2
Output
• The government can spend more or tax less.
• Often called “Keynesian” economic policy.
• The expansionary policy increases aggregate demand.
• Output and price levels increase.
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Contractionary policy responses
Positive economic shocks may cause the economy to expand too
rapidly. Contractionary policy can counteract increases in AD.
Economy overheats from too much AD
Contractionary fiscal policy lowers prices and output
Price level
Price level
LRAS
LRAS
SRAS
P2
AD 2
P1
SRAS
P2
P3
AD2
AD3
Y1
Y2
AD 1
Output
Y3
Y2
AD1
Output
• The government can spend less or tax more.
• The contractionary policy decreases aggregate demand.
• Output and price levels decrease.
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Time lags
• Why should any government wait for the
economy to correct itself when it can do the
work much more quickly?
• Fiscal policies are often educated guesses.
• Time lags between when policies are chosen and
when they are implemented often cause fiscal
policy to be ineffective or even harmful:
1. Information lag: Understanding the current
economy.
2. Formulation lag: Deciding on and passing
legislation.
3. Implementation lag: Time to affect the economy.
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Policy tools: discretionary and automatic
• Automatic stabilizers are taxes and government
spending that affect fiscal policy without specific
action from policy-makers.
• Taxes work as automatic stabilizers because the
income tax system is progressive.
– As earnings rise, higher tax rates apply. This puts a
check on overall spending.
• Some types of government spending work as
automatic stabilizers.
– Unemployment insurance benefits and welfare
programs have eligibility criteria based on income or
unemployment status.
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Policy tools: discretionary and automatic
• Policy-makers can also use discretionary fiscal
policy, which refers to adjusting tax rates in
response to economic conditions.
– Information, formulation, and implementation lags
can reduce the effectiveness of such policy.
• Discretionary policy may be used when
automatic stabilizers are unsuccessful in
correcting the economy.
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Limits of fiscal policy: The money must
come from somewhere
• Politicians often cut taxes in response to
recessions.
• Tax cuts aren’t free because the government
must find a way to make up for lost tax
revenue.
• Ricardian equivalence predicts that if there are
tax cuts but no decrease in spending, people
will not change their behavior.
– People realize that the government will have to
borrow money and at some point taxes will
increase.
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The multiplier model
• Changes in tax rates and government spending
have different effects on the economy.
• Economists use a multiplier that measures the
effect of government spending or tax cuts on
national income.
• The multiplier effect is the increase in
consumer spending that occurs when spending
by one person causes others to spend more
too.
– This amplifies the impact of the initial government
policy on the economy.
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The multiplier model
• For example, consider what happens when
someone hires a builder to construct a deck for
$5,000.
– This decision adds $5,000 to national GDP.
• The builder may take his family on a $3,000
vacation that he couldn’t have afforded before he
built your deck.
– This decision adds $3,000 to national GDP.
• The decision to build a deck adds $8,000 to GDP,
more than the original amount of the deck.
– This is the multiplier effect.
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Deriving the multiplier
• To determine how much more GDP increases, the
multiplier uses the proportion of income people spend.
• Consumption is based on the amount of income left
after paying taxes.
– People usually consume part of their income and save the
rest.
• The amount consumption increases when after-tax
income increases by $1 is called the marginal
propensity to consume (MPC).
– The MPC is a number between 0 and 1.
– It equals the fraction of an additional dollar that is spent
when an individual receives an additional dollar of income.
• For example, a MPC of 0.8 means that 80% of an
additional dollar of income is spent and 20% is saved.
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Active Learning: Deriving the MPC
Consider the following situations where there is an
increase in income that leads to an increase in
consumption expenditures.
• Calculate the marginal propensity to consume (MPC).
Situation
Increase in Income ($)
Increase in Consumption
Expenditures ($)
A
1,000
900
B
500
400
C
300
100
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Marginal Propensity to
Consume (MPC)
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Multiplier effect of government spending
• The government-spending multiplier is the
amount that GDP increases when government
spending increases by $1.
Government−spending multiplier =
1
1 − MPC
• A smaller MPC results in a smaller governmentspending multiplier.
• A larger MPC results in a larger governmentspending multiplier.
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Active Learning: Government-multiplier effect
Consider a situation where the marginal propensity to
consume is 0.6.
• Calculate the government-spending multiplier.
• Use this to determine how much GDP will increase if
the government spends $10 million on federal
highway repairs.
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Multiplier effect of government transfers
and taxes
• The taxation multiplier is the amount that
GDP decreases by when taxes increase by
$1.
−MPC
Taxation multiplier =
1 − MPC
• The multiplier effect of tax cuts is smaller
than the effect of government spending.
• Tax cuts boost GDP indirectly through an
effect on consumption.
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Active Learning: Taxation multiplier effect
Consider a situation where the marginal
propensity to consume is 0.6.
• Calculate the taxation multiplier.
• Use this to determine how much GDP will
increase if there are $10 million in tax cuts.
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The government spending and taxation
multipliers
The impact of tax cuts and government spending
varies by the MPC.
Marginal
Government-
propensity to
spending multiplier
Consume (MPC)
1/(1 – MPC)
A $500 million
stimulus would
Taxation multiplier
MPC/(1 – MPC)
increase GDP by:
A $500 million
tax cut would
increase GDP by:
0.2
1.25
$625 million
–0.25
$125 million
0.4
1.67
$835 million
–0.67
$335 million
0.6
2.50
$1.25 billion
–1.50
$750 million
0.8
5.00
$2.50 billion
–4.00
$
2 billion
• Note that for the same MPC, the government spending
multiplier is higher than the taxation multiplier.
• The difference is greater as the MPC increases.
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The government budget
• The government may want to influence the
economy by changing the amount it spends or
taxes.
• In practice, this may require the government
going into debt.
• Governments’ budgets contain tax revenues as
their source of income and government purchases
and transfer payments as expenditures.
– Transfer payments are payments from the government
to individuals for programs that don’t involve a
purchase of goods or services.
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The government budget
• The government may budget expenditures greater than
income by issuing debt.
– The budget deficit is the amount of money a government spends
beyond its revenue.
– The budget surplus is the amount of revenue a government brings in
beyond what it spends.
U.S. government deficit since 1940
Billions of constant 2010 dollars
1,600
Percent of GDP
32
1,400
28
Billions of 2010 dollars
Percent of GDP
1,200
24
1,000
20
800
16
600
12
400
8
200
4
0
1940
1950
1960
1970
1980
1990
0
2010
2000
Since the 1940s, the U.S. has consistently maintained a budget deficit.
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The public debt
• Public debt is the total amount of money that a
government owes at a point in time.
– Public debt is the cumulative sum of deficits and surpluses.
U.S. government debt since 1940
Billions of 2010 U.S. dollars
15,000
Percent of GDP
125
Total debt in billions of 2010 dollars
12,000
100
Percent of GDP
9,000
75
6,000
50
25
3,000
0
1940
1950
1960
1970
1980
1990
2000
0
2010
U.S. government debt has risen rapidly in the last decade, with
larger budget deficits.
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The public debt
Almost every country in the world has some debt.
Debt in various OECD countries, 2010
Country (rank)
Japan (1)
183.5
Greece (2)
147.8
Italy (3)
109
France (10)
67.4
United States (11)
61.3
Ireland (12)
60.7
Korea (24)
31.9
0
50
100
150
200
Public debt as a percent of GDP
There is a wide discrepancy in the amount of debt owed among
countries.
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Is government debt good or bad?
Most economists believe that some debt is necessary to have a
smoothly functioning government. What are the costs and
benefits?
Costs of government debt
Benefits of government debt
• It allows the government to
• The direct cost associated
be flexible when something
with government debt is the
unexpected happens.
interest on borrowing.
• Government debt can pay
• There are indirect costs
for investments that lead to
associated with government
economic growth and
debt distorting credit
prosperity.
markets.
• The government must consider who bears the burden of the debt.
• People today benefit when the government borrows, but future
generations will have to repay the loans.
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Summary
• The level of taxation and government spending
is called fiscal policy.
– Expansionary fiscal policy can be used during a
recession to increase AD.
– Contractionary fiscal policy can be used during a
boom to decrease AD.
• The government might want to change fiscal
policies to counteract economic fluctuations.
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Summary
• The two main challenges the government faces
when implementing fiscal policy are time lags
and Ricardian equivalence.
• The government-spending multiplier measures
how much output increases when government
spending increases.
• The taxation multiplier measures how much
output increases when taxation falls.
• The government-spending multiplier is larger
than the taxation multiplier.
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Summary
• The government budget includes all of the
revenue it collects in taxes and the money it
spends on government programs.
– There is a deficit when the government spends
more than it collects.
– There is a surplus when the government collects
more than it spends.
• The public debt is the total amount of money
that the government has borrowed over time.
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