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Chapter 12
Econ104 Parks
Fiscal Policy
Stabilization Policy
• Stabilization policy is an attempt to dampen the
fluctuations in the economy's level of output
through time to achieve low inflation and low
unemployment.
• The government's attempt to stabilize the
economy is know as fiscal policy, while the
Federal Reserve's attempt at stabilization is
called monetary policy.
Fiscal Policy
• Fiscal policy is the attempt by the government
to deliberately manipulate its budget position
with a goal of stabilizing prices, promoting
growth, and minimizing unemployment.
• Two scenarios that potentially leave room for
fiscal policy are recessionary gaps and
inflationary gaps.
Recessionary Gap
• A recessionary
gap occurs when
actual
equilibrium
output (YE) is
less than
potential output
(YP), or YE < YP.
• A recessionary gap, in economics, is the
amount by which the aggregate expenditures
schedule must shift upward to increase the real
GDP to its full-employment, noninflationary
level. A recessionary gap can also be referred
to as a deflationary gap. The GAP is actually
the amount on the prior diagram DIVIDED
by the multiplier!!! At times it is only defined
in the constant price simple model.
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Inflationary Gap
• An inflationary
gap occurs when
equilibrium
output exceeds
potential output,
or YE > YP.
Adding Government to the Fixed-Price
Model
•With inclusion of G
in the model,
equilibrium output
is Y = C + I + G.
• Adding G to the
equation simply
shifts the Aggregate
Demand curve to
the right.
Tools of Fiscal Policy
• The government has three "tools" to conduct
fiscal policy:
– change in the level of government expenditures,
– change in taxes, and
– change in transfer payments.
Tool #1: Change in Government
Expenditures
• An increase in
government
expenditures shifts
the Aggregate
Demand curve to
the right (from
AD0 to AD1),
which leads to the
usual multiplier
effects.
Tool #2: Change in Taxes
•An increase in
taxes, therefore,
shifts the
Aggregate
Demand curve to
the left.
•The change in
output is equal to
the tax change
times the tax
multiplier.
The Tax Multiplier
• For an increase in taxes, the initial decrease in
Aggregate Demand is not the amount of the tax
change, but the MPC times the tax change, or
• The term -MPC/(1-MPC) is the tax multiplier.
•
•
•
•
•
•
APE = C + I + G + (X-M)
C = CA + (Y-TA)*mpc
TA = autonomous taxes
APE = CA – TA*mpc + I + G + (X-M) + Y*mpc
Yeq = (CA–TA*mpc+I+G+(X-M))/(1-mpc)
Increase TA, decrease autonomous expenditures
by TA*mpc
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Tool #3: Change in Transfer Payments
•Transfer
payments (TR)
are distributions
of income to
individuals who
do not directly
work for the
income.
•An increase in
TR shifts the AD
curve to the right.
Expansionary Fiscal Policy
• Expansionary fiscal policy is desirable if
the economy is in a recessionary gap.
• The tools of expansionary fiscal policy include
– increase government expenditures
– decrease taxes
– increase transfer payments
Contractionary Fiscal Policy
• Contractionary fiscal policy is desirable if
the economy is in an inflationary gap.
• The tools of expansionary fiscal policy include
– decrease government expenditures
– increase taxes
– decrease transfer payments
Fiscal Policy with an upward-sloping AS
Curve
• If the Aggregate Supply curve is upward
sloping rather than horizontal (as we assume in
the fixed-price model), then two things are
different about fiscal policy:
– An increase in government expenditures increases
both output and the price level
– Output multiplier effects will be smaller because
some of the impact will be felt in higher prices
Discretionary Fiscal Policy vs. Automatic
Stabilizers
• Discretionary fiscal policy is policy that must
be deliberately enacted by Congress and/or the
President. Examples include tax cuts or a
change in rules governing unemployment
insurance or welfare benefits – and of course
the Stimulus Package.
Difficulties in conducting discretionary
fiscal policy
• Severe time lags
– Recognition lag: the time needed for legislators to recognize
that policy needs to be changed due to a change in the
business cycle.
– Implementation lag: the time needed to change the policy.
Decisions on taxes, transfer payments, and government
spending are usually made with more concern for politics
than for economics.
– Impact lag: the time elapsed between the implementation of
the changed policy and its impact on the economy.
• Affect on budget deficit
Automatic stabilizers
• Automatic stabilizers are policies that increase
government outlays and decrease taxes
automatically during recessions, and reduce
government outlays and increase taxes
automatically during inflationary periods.
– No deliberate government action is required.
– Examples are welfare payments, unemployment
insurance, and proportional income taxes.
– These policies are free from politics, recognition
and implementation lags.
Supply-Side Economics
•Supply-side economics
is a school of thought
that challenges the
emphasis of
Keynesian economics
on the demand side of
the economy.
•The goal is to achieve
growth by stimulating
the supply side of the
economy.
Unleashing Labor and Capital Resources
• A supply-side theme is that government
regulations and high taxes constrain the growth
of the supply-side of the economy.
• Policy reforms call for reductions in income
taxes and business taxes such as capital gains
taxes to encourage labor and capital formation.
The Laffer Curve
• Won’t tax cuts increase the budget deficit?
Yes, unless:
– government spending is also reduced in
conjunction with the tax cuts, or
– the economy is on the right side of the Laffer
curve. If the tax reductions stimulate enough
growth in GDP by increases in labor and capital
supply, then the tax base, and potentially tax
revenues, increase over time.
The Laffer Curve
•The Laffer curve
plots the tax rate
against tax revenues.
To the left of point
B, a tax cut results in
tax revenue declines.
But to the right of
point B, tax cuts
actually increase tax
revenue.
Supply-Side Economics: Is There
Consensus?
• Most economists do not argue about the theory of
supply-side economics.
– General consensus is that a reduction in labor and
capital taxes will stimulate the supply side of the
economy.
• The real disagreement is over the size of the
supply-side effects.
– Keynesian economists argue that the demand-side
effects of tax cuts swamp the (small) supply-side
effects.