Download contractionary fiscal policy

Chapter 10
Fiscal Policy
CoreEconomics 2nd edition by Gerald W. Stone
Slides By: Debbie
© 2011 Worth Publishers ▪ CoreEconomics
▪ Stone
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Chapter Outline
• Fiscal Policy and Aggregate Demand
• Fiscal Policy and Aggregate Supply
• Implementing Fiscal Policy
© 2011 Worth Publishers ▪ CoreEconomics
▪ Stone
Learning Objectives
• At the end of this chapter, the student will be
able to:
– Describe the tools that governments use to
influence aggregate demand
– Describe mandatory and discretionary fiscal
policy
– Describe the multiplier effect of increased
government spending on the equilibrium output
of an economy
© 2011 Worth Publishers ▪ CoreEconomics
▪ Stone
Learning Objectives
• At the end of this chapter, the student will be
able to:
– Discuss drawbacks of discretionary fiscal policy
– Describe expansionary and contractionary fiscal
policy
– Describe why tax changes have a smaller impact
on the economy than changes in government
spending
© 2011 Worth Publishers ▪ CoreEconomics
▪ Stone
Learning Objectives
• At the end of this chapter, the student will be
able to:
– Describe the fiscal policies that governments use
to influence aggregate supply
– 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
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Fiscal Policy
• Fiscal policy is one way the government tries
to manage the economy and to tame the
business cycle.
• Fiscal policy involves a trade-off.
– In a recessionary environment, higher output can
be achieved at the expense of rising prices.
– During times of inflation, the price level can be
lowered at the expense of increased
unemployment.
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Discretionary Spending
• The federal budget can be split into two
distinct types of spending: discretionary and
mandatory.
– Discretionary spending is that part of the budget
that works its way through the appropriations
process of Congress each year.
– It includes such programs as national defense,
transportation, science, environment, income
security (some welfare programs like Medicaid),
education, and veterans benefits and services.
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Mandatory Spending
• Mandatory spending is 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.
– Mandatory spending includes such programs as
Social Security and interest on the national debt.
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Discretionary Fiscal Policy
• The exercise of discretionary fiscal policy
involves 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.
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Discretionary Fiscal Policy
• Some examples of the use of discretionary fiscal
policy include tax cuts enacted during the Kennedy,
Reagan, and George W. Bush administrations.
• These tax cuts were designed to expand the
economy, both in the near term and in the long run.
They were meant to influence both aggregate
demand and aggregate supply.
The check is in the mail!
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The Multiplier Effect
• When government spending is injected into
the economy, the total level of economic
activity will expand by an amount equal to
the amount of the new expenditure times
the multiplier.
• Because the short-run aggregate supply
curve is upward-sloping, some of the increase
in output is absorbed by rising prices.
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▪ Stone
Aggregate Price Level
The Multiplier Effect
LRAS
SRAS
When government spending
shifts aggregate demand to
the right, the equilibrium level
of output will increase along
with the price level.
AD
P1
P0
1
AD0
Q0
Q1
Aggregate Output
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How Big is the Multiplier?
• In order to determine the amount of the
2009 stimulus package, policy makers needed
an estimate for the value of the multiplier.
– Studies suggest that the spending multiplier is
somewhere between 1 and 2.
– There is evidence that the long-run tax multiplier
may approach 3 because tax reductions have a
longer running impact on the economy than
short-run spending increases.
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▪ Stone
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, for that matter)
will have less of a direct impact on income,
employment, and output than will an
equivalent change in government spending.
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Expansionary Fiscal Policy
• Expansionary fiscal policy can be used to shift
aggregate demand to the right and close a
recessionary gap.
– Employment will
increase as output
expands.
– The aggregate
price level will rise.
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Expansionary Fiscal Policy
Aggregate Price Level (P)
LRAS
AS0
P1
f
e
P0
If the economy begins at point e
below full employment,
expansionary fiscal policy can
be implemented so as to boost
aggregate demand to AD1.
AD1
AD0
Q0
Qf
Aggregate Output (Q)
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Contractionary Fiscal Policy
• When an economy moves to a point beyond full
employment, an inflationary spiral has set in.
• One way to reduce such inflationary pressures is
by a contractionary fiscal policy: reducing
government spending, transfer payments, or
raising taxes (increasing withdrawals from the
economy).
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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.
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Contractionary Fiscal Policy
Aggregate Price Level (P)
LRAS
AS0
P0
e
P1
a
A contractionary fiscal policy
that would shift aggregate demand
from AD0 to AD1 will lower the price
level as it reduces aggregate output.
AD0
AD1
Qf
Q0
Aggregate Output (Q)
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Supply-Side Fiscal Policies
• Supply-side fiscal policies are different from
policies to influence aggregate demand in
that they do not always require such
tradeoffs between price levels and output.
• Supply-side policies require more time to
work than do demand-side policies.
– They aim to shift the long-run aggregate supply
curve to the right.
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Supply-Side Outcomes
• Modern growth theory suggests
governments can do a lot to create the right
environment to encourage economic growth.
– Provide infrastructure
– Create a fair and efficient legal system
– Establish a stable financial system
– Provide for the development of human capital
– Encourage the diffusion of technology
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The Laffer Curve
• Lower tax rates may increase productivity.
• The Laffer Curve shows that tax revenues can
sometimes be increased by lowering tax
rates.
– Reducing tax rates should encourage risk-taking
by entrepreneurs since lower taxes mean higher
after-tax returns on investments. Similarly,
cutting taxes should encourage private saving
and business investment.
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Supply-Side Outcomes
• Another aspect of supply-side policy focuses
on the incentive effects associated with
income tax rates.
• At times, marginal tax rates have been
reduced to stimulate incentives for business
formation.
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Encouraging Investment
• Investment can be encouraged by such
policies as investment tax credits and more
rapid depreciation schedules for plant and
equipment.
– When a firm can expense its capital equipment
over a shorter period of time, it cuts taxes now
rather than later, and so earns a higher net
return.
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Encouraging Investment
• Similarly, government
grants for basic research
help firms increase their
budgets for research and
development, which
results in new products
brought to market.
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Curbing Regulation
• Another way of increasing supply without
raising prices involves repealing unnecessarily
onerous regulations that simply hamper
business and add to costs.
• Examples of excessively regulated industries
have included trucking and the airlines.
– When these industries were deregulated in the
1980s, prices fell and productivity improved.
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Automatic Stabilizers
• Tax revenues and transfer payments are the
two principal automatic stabilizers.
• Without any overt action by Congress or
other policy makers, these components of
the federal budget will expand or contract in
ways that help counter movements of the
business cycle.
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Automatic Stabilizers
• The income tax is a powerful stabilizer
because of its progressivity.
– When incomes fall, tax revenues fall faster since
people do not just pay taxes on smaller incomes,
but they also pay at lower rates as their incomes
fall. Disposable income, in other words, falls
more slowly than aggregate income.
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Automatic Stabilizers
• The key point to remember here is that
automatic stabilizers reduce the intensity of
business fluctuations.
• Automatic stabilizers do not eliminate
fluctuations in the business cycle, but they
render business cycles smoother and less
chaotic.
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Fiscal Policy Timing Lags
• Information lag
– Most of the macroeconomic data that policy
makers need to enact the proper fiscal policies
are not available until at least one quarter after
the fact.
• Recognition lag
– Even if the most recent data suggest the
economy is trending into a recession, it may take
several quarters to confirm the record.
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Fiscal Policy Timing Lags
• Decision lag
– Congress and the White House must agree on an
approach.
• Implementation lag
– Fiscal policy requires a long and often
contentious legislative and implementation
process.
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The Crowding-Out Effect
• The crowding-out effect of fiscal policy arises
from deficit spending, which requires the
government to borrow. This borrowing can
drive up interest rates.
• A higher cost of borrowing will dampen
consumer spending on durable goods such as
cars or refrigerators. It will also discourage
business investment.
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▪ Stone
The Crowding-Out Effect
• While deficit spending
is usually expansionary,
its impact can be
partially offset by
reductions in
private spending.
© 2011 Worth Publishers ▪ CoreEconomics
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Chapter Summary
• Governments try to influence aggregate demand
by using fiscal policy. The government’s main
fiscal policy tools are spending on goods and
services, transfer payments, and taxes.
• Fiscal policy is powerful because of the
multiplier effect, which tells us that added
government spending will raise equilibrium
income and output by the multiplier times the
added expenditure.
© 2011 Worth Publishers ▪ CoreEconomics
▪ Stone
Chapter Summary
• Expansionary fiscal policies include increasing
government spending; increasing transfer
payments such as social security, unemployment
compensation, and welfare payments; and
decreasing taxes. These policies put more
money into the hands of consumers and
businesses.
– The opposite policies are contractionary.
• The size of the spending multiplier will depend
on how much slack there is in the economy.
© 2011 Worth Publishers ▪ CoreEconomics
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Chapter Summary
• Supply-side policies do not require such
tradeoffs; they can expand output without
raising prices.
- The goal of supply-side economics is to shift the long-run
aggregate supply curve to the right.
• Automatic stabilizers such as transfer
payments and the progressive income tax
counteract fluctuations of the business cycle.
© 2011 Worth Publishers ▪ CoreEconomics
▪ Stone
Chapter Summary
• Using fiscal policy to smooth out the short-term
business cycle is difficult because of several lags
associated with implementing it.
• The crowding-out effect arises when the government
engages in deficit spending, thereby driving up
interest rates. This action can reduce spending on
durable goods and business investment.
• Deficit spending has an expansionary effect on the
economy, but this effect can be diminished by
offsetting reductions in private spending.
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▪ Stone