Download chapter overview

Fiscal Policy
CHAPTER TWELVE
FISCAL POLICY
CHAPTER OVERVIEW
This chapter looks briefly at the legislative mandates given to government to pursue stabilization of the
economy; it then explores the tools of government stabilization policy in terms of the aggregate demandaggregate (AD-AS) model. Next, fiscal policy measures that automatically adjust government
expenditures and tax revenues when the economy moves through the business cycle phases are examined.
The recent use and resurgence of fiscal policy as a tool are discussed, as are problems, criticism, and
complications of fiscal policy. Finally, the workings of fiscal policy in an open economy are addressed.
WHAT’S NEW
While the organizational structure of this chapter remains relatively untouched, the content has been
revised significantly. With the long record of success by the Federal Reserve and the inability of
Congress and the President to successfully manage the U.S. budget, fiscal policy was seen as impotent
for many years. However, with the recent economic downturn in the U.S., monetary policy’s failure to
correct it, and the increased use of spending and tax measures, fiscal policy appears to be regaining some
of its lost popularity.
The graphical analysis of expansionary and contractionary fiscal policy has been revised to reflect the
new treatment of the AS curve, as presented in Chapter 11. The graphical separation between the “initial
change in spending” and the final change after multiplier effects is also carried through into this chapter.
The section on “Supply-Side Fiscal Policy” has been replaced with “Current Thinking on Fiscal Policy,”
and offers a more up-to-date perspective. Discussion of the “political business cycle” has been revised.
The section on “Recent U.S. Fiscal Policy” has been revised and expanded to include responses to the
U.S. recession in 2001. The section covering fiscal policy and the price level has been eliminated as
other coverage makes it redundant.
There is a new graphical presentation of the crowding-out and net export effects of fiscal policy.
Tables, figures, and questions have been updated.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to
1. Identify the Employment Act of 1946 and the roles of the CEA and JEC.
2. Distinguish between discretionary and nondiscretionary fiscal policy.
3. Differentiate between expansionary and contractionary fiscal policy.
4. Recognize the conditions for recommending an expansionary or contractionary fiscal policy.
5. Explain expansionary fiscal policy and its effects on the economy and Federal budget.
6. Explain contractionary fiscal policy and its effects on the economy and Federal budget.
7. Describe the two ways to finance a government budget deficit and how each affects the economy.
8. Describe the two ways to handle a government budget surplus and how each affects the economy.
182
Fiscal Policy
9. Give two examples of how built-in stabilizers help eliminate recession or inflation.
10. Explain the differential impacts of progressive, proportional, and regressive taxes in terms of
stabilization policy.
11. Explain the significance of the “full-employment budget” concept.
12. Describe recent U.S. fiscal policy actions and the motivation behind them.
13. List three timing problems encountered with fiscal policy.
14. State political problems that limit effective fiscal policy.
15. Identify actions by households, and by state and local governments that can frustrate fiscal policy.
16. Explain and recognize graphically how crowding out can reduce the effectiveness of fiscal policy.
17. Give two examples of complications that may arise when fiscal policy interacts with international
trade.
18. Explain the purpose and structure of the Leading Economic Indicators (Last Word).
19. Define and identify terms and concepts at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. Fiscal policy, especially tax policy, is one of the subjects that students usually find very
interesting. The chapter provides an excellent opportunity to establish the ties between theory and
real-world applications.
2. To give a more human dimension to this chapter, students may identify current members of the
Council of Economic Advisers (end-of-chapter question #1). You could assign excerpts from the
latest Economic Report of the President, which the Council helps to prepare.
3. Current federal tax or spending issues can illustrate the timing, administrative, and political
problems with discretionary fiscal policy. The 2001 tax cut proposal illustrated many of these
issues.
4. Current data on the federal budget can be obtained from the Federal Reserve Bulletin, Economic
Indicators, the Survey of Current Business, or the Economic Report of the President or website
given in web-based question #17.
5. Remind students of the multiplier impact that results from changes in government spending and/or
taxes. Most students can understand these concepts without reference to the numerical examples.
Numbers often confuse those with “math anxiety,” and if you skipped Chapter 10, they will benefit
from a brief overview of the concept.
6. The Last Word for the chapter is on the “leading indicators.” The stock market often reacts
immediately to changes in various indicators. One assignment could focus on the impact of the
latest report.
STUDENT STUMBLING BLOCKS
1. The biggest concern is with the magnitude of information in this chapter. Give students an
opportunity to focus on a few concepts at a time rather than assigning the entire chapter at once.
2. Although most students know this, some need to be reminded how Congress and the President
establish fiscal policy. This is particularly important when highlighting the different policymaking process for monetary policy.
183
Fiscal Policy
LECTURE NOTES
I.
Introduction
A. One major function of the government is to stabilize the economy (prevent unemployment or
inflation).
B. Stabilization can be achieved in part by manipulating the public budget—government
spending and tax collections—to increase output and employment or to reduce inflation.
C. This chapter will examine a number of topics.
1. It looks at the legislative mandates given government to pursue stabilization.
2. It explores the tools of government fiscal stabilization policy using AD-AS model.
3. It examines both discretionary and automatic fiscal adjustments.
4. It addresses the problems, criticisms, and complications of fiscal policy.
II.
Legislative mandates—The Employment Act of 1946
A. Congress proclaimed government’s role in promoting maximum employment, production,
and purchasing power.
B. The act created the Council of Economic Advisers to advise the President on economic
matters.
C. The act created the Joint Economic Committee of Congress to investigate economic
problems of national interest.
III.
Fiscal Policy and the AD/AS Model
A. Discretionary fiscal policy refers to the deliberate manipulation of taxes and government
spending by Congress to alter real domestic output and employment, control inflation, and
stimulate economic growth. “Discretionary” means the changes are at the option of the
Federal government.
B. Simplifying assumptions.
1. Assume initial government purchases don’t depress or stimulate private spending.
2. Assume fiscal policy affects only the demand, not the supply, side of the economy.
C. Fiscal policy choices: Expansionary fiscal policy is used to combat a recession (see examples
illustrated in Figure 12-1).
1. Expansionary Policy needed: In Figure 12-1, a decline in investment has decreased AD
from AD1 to AD2 so real GDP has fallen and employment has declined. Possible fiscal
policy solutions follow:
a. An increase in government spending (shifts AD to right by more than change in G
due to multiplier),
b. A decrease in taxes (raises income, and consumption rises by MPC  change in
income; AD shifts to right by a multiple of the change in consumption).
c. A combination of increased spending and reduced taxes.
d. If the budget was initially balanced, expansionary fiscal policy creates a budget
deficit.
184
Fiscal Policy
2. Contractionary fiscal policy needed: When demand-pull inflation occurs (as illustrated
by a shift from AD3 to AD4 in the vertical range of aggregate supply in Figure 12-2),
then contractionary policy is the remedy:
a. A decrease government spending shifts AD4 back to AD3 once the multiplier
process is complete. Here price level returns to its preinflationary level P 3 but GDP
remains at its full-employment level.
b. An increase in taxes will reduce income and then consumption at first by MPC  fall
in income, and then multiplier process leads AD to shift leftward still further. In
Figure 12-2 a tax increase of $6.67 billion decreases consumption by 5 and the
multiplier causes an eventual shift to AD3.
c. A combined spending decrease and tax increase could have the same effect with the
right combination ($2 billion decline in G and $4 billion rise in T will have this
effect).
D. Financing deficits or disposing of surpluses: The method used influences fiscal policy effect.
1. Financing deficits can be done in two ways.
a. Borrowing: The government competes with private borrowers for funds and could
drive up interest rates; the government may “crowd out” private borrowing, and this
offsets the government expansion.
b. Money creation: When the Federal Reserve loans directly to the government by
buying bonds, the expansionary effect is greater since private investors are not
buying bonds. (Note: Monetarists argue that this is monetary, not fiscal, policy that
is having the expansionary effect in such a situation.)
2. Disposing of surpluses can be handled two ways.
a. Debt reduction is good but may cause interest rates to fall and stimulate spending.
This could be inflationary.
b. Impounding or letting the surplus funds remain idle would have greater
anti-inflationary impact. The government holds surplus tax revenues, which keeps
these funds from being spent.
E. Policy options: G or T?
1. Economists tend to favor higher G during recessions and higher T during inflationary
times if they are concerned about unmet social needs or infrastructure.
2. Others tend to favor lower T for recessions and lower G during inflationary periods when
they think government is too large and inefficient.
IV.
Built-In Stability
A. Built-in stability arises because net taxes (taxes minus transfers and subsidies) change with
GDP (recall that taxes reduce incomes and therefore, spending). It is desirable for spending
to rise when the economy is slumping and vice versa when the economy is becoming
inflationary. Figure 12-3 illustrates how the built-in stability system behaves.
1. Taxes automatically rise with GDP because incomes rise and tax revenues fall when
GDP falls.
2. Transfers and subsidies rise when GDP falls; when these government payments (welfare,
unemployment, etc.) rise, net tax revenues fall along with GDP.
185
Fiscal Policy
B. The size of automatic stability depends on responsiveness of changes in taxes to changes in
GDP: The more progressive the tax system, the greater the economy’s built-in stability. In
Figure 12-3 line T is steepest with a progressive tax system.
1. A 1993 law increased the highest marginal tax rate on personal income from 31 percent
to 39.6 percent and corporate income tax rate by 1 percentage to 35%. This helped
prevent demand-pull inflation.
2. Automatic stability reduces instability, but does not correct economic instability.
V.
Evaluating Fiscal Policy
A. A full-employment budget in Year 1 is illustrated in Figure 12-4(a) because budget revenues
equal expenditures when full-employment exists at GDP1.
B. At GDP2 there is unemployment and no discretionary government action is assumed, so lines
G and T remain as shown.
1. Because of built-in stability, the actual budget deficit will rise with the decline of GDP;
therefore, actual budget varies with GDP.
2. The government is not engaging in expansionary policy since the budget is balanced at
F.E. output.
3. The full-employment budget measures what the Federal budget deficit or surplus would
be with existing taxes and government spending if the economy is at full employment.
4. Actual budget deficit or surplus may differ greatly from full-employment budget deficit
or surplus estimates.
C. In Figure 12-4b, the government reduced tax rates from T1 to T2; now there is a F.E. deficit.
1. Structural deficits occur when there is a deficit in the full-employment budget as well as
the actual budget.
2. This is expansionary policy because true expansionary policy occurs when the
full-employment budget has a deficit.
D. If the F.E. deficit of zero was followed by a F.E. budget surplus, fiscal policy is
contractionary.
E. Recent U.S. fiscal policy is summarized in Table 12-1.
1. Observe that F.E. deficits are less than actual deficits.
2. Column 3 indicates that the expansionary fiscal policy of early 1990s became
contractionary in the later years shown.
3. Actual deficits have disappeared and the U.S. budget has actual surpluses since 1999.
(Key Question 7)
F. Global Perspectives 12-1 gives a fiscal policy snapshot for selected countries.
VI.
Problems, Criticisms and Complications
A. Problems of timing.
1. Recognition lag is the elapsed time between the beginning of recession or inflation and
awareness of this occurrence.
2. Administrative lag is the difficulty in changing policy once the problem has been
recognized.
186
Fiscal Policy
3. Operational lag is the time elapsed between change in policy and its impact on the
economy.
B. Political considerations: Government has other goals besides economic stability, and these
may conflict with stabilization policy.
1. A political business cycle may destabilize the economy: Election years have been
characterized by more expansionary policies regardless of economic conditions.
a. political business cycle?
2. State and local finance policies may offset federal stabilization policies. They are often
procyclical, because balanced-budget requirements cause states and local governments to
raise taxes in a recession or cut spending possibly making the recession worse. In an
inflationary period, they may increase spending or cut taxes as their budgets head for
surplus.
3. The crowding-out effect may be caused by fiscal policy.
a. “Crowding-out” may occur with government deficit spending. It may increase the
interest rate and reduce private spending which weakens or cancels the stimulus of
fiscal policy. (See Figure 12-5)
b. Some economists argue that little crowding out will occur during a recession.
c. Economists agree that government deficits should not occur at F.E.; it is also argued
that monetary authorities could counteract the crowding-out by increasing the money
supply to accommodate the expansionary fiscal policy.
C. With an upward sloping AS curve, some portion of the potential impact of an expansionary
fiscal policy on real output may be dissipated in the form of inflation. (See Figure 12-5c)
VI.
Fiscal Policy in an Open Economy (See Table 12-2)
A. Shocks or changes from abroad will cause changes in net exports, which can shift aggregate
demand leftward or rightward.
B. The net export effect reduces the effectiveness of fiscal policy: For example, expansionary
fiscal policy may affect interest rates, which can cause the dollar to appreciate and exports to
decline (or rise).
VII.
Supply-Side Fiscal Policy
A. Fiscal policy may affect aggregate supply as well as aggregate demand (see Figure 12-6
example).
B. Assume for simplicity that AS is upward sloping.
C. Tax changes may shift aggregate supply. An increase in business taxes raises costs and
shifts supply to left; a decrease shifts supply to the right.
1. Also, lower taxes could increase saving and investment.
2. Lower personal taxes may increase effort, productivity and, therefore, shift supply to the
right.
3. Lower personal taxes may also increase risk-taking and, therefore, shift supply to the
right.
D. If lower taxes raise GDP, tax revenues may actually rise.
E. Many economists are skeptical of supply-side theories.
187
Fiscal Policy
1. The effect of lower taxes on a supply is not supported by evidence.
2. Tax impact on supply takes some time, but demand impact is more immediate.
VIII.
LAST WORD: The Leading Indicators
A. This index comprises 10 variables that have indicated forthcoming changes in real GDP in
the past.
B. The variables are the foundation of this index, consisting of a weighted average of ten
economic measurements. A rise in the index predicts a rise in GDP; a fall predicts declining
GDP.
C. Ten components comprise the index:
1. Average workweek: A decrease signals future GDP decline.
2. Initial claims for unemployment insurance: An increase signals future GDP decline.
3. New orders for consumer goods: A decrease signals GDP decline.
4. Vendor performance: Better performance by suppliers in meeting business demand
indicates decline in GDP.
5. New orders for capital goods: A decrease signals GDP decline.
6. Building permits for houses: A decrease signals GDP decline.
7. Stock market prices: Declines signal GDP decline.
8. Money supply: A decrease is associated with falling GDP.
9. Interest-rate spread: when short-term rates rise, there is a smaller spread between shortterm and long-term rates which are usually higher. This indicates restrictive monetary
policy.
10. Index of consumer expectations: Declines in consumer confidence foreshadow declining
GDP.
D. None of these factors alone is sufficient to predict changes in GDP, but the composite index
has correctly predicted business fluctuations many times (although not perfectly). The index
is a useful signal, but is not totally reliable.
ANSWERS TO END-OF-CHAPTER QUESTIONS
12-1
What is the central thrust of the Employment Act of 1946? What is the role of the Council of
Economic Advisers (CEA) in response to this law? Class assignment: Determine the names and
educational backgrounds of the present members of the CEA.
The central thrust of the Employment Act of 1946 is that the government does have a role to play
in stabilizing economic conditions: prices (purchasing power), employment, and output.
The CEA advises the President on economic matters. Its members and staff gather and analyze
relevant economic data, make forecasts, formulate policy, and help to “educate” the public and
public officials on matters related to the nation’s economic health.
Try www.whitehouse.gov for information on the CEA.
12-2
(Key Question) Assume that a hypothetical economy with an MPC of .8 is experiencing severe
recession. By how much would government spending have to increase to shift the aggregate
demand curve rightward by $25 billion? How large a tax cut would be needed to achieve this
188
Fiscal Policy
same increase in aggregate demand? Why the difference? Determine one possible combination
of government spending increases and tax decreases that would accomplish this same goal.
In this problem, the multiplier is 1/.2 or 5 so, the increase in government spending = $5 billion.
For the tax cut question, initial spending of $5 billion is still required, but only .8 (= MPC) of a
tax cut will be spent. So .8 x tax cut = $5 billion or tax cut = $6.25 billion. Part of the tax
reduction ($1.25 billion) is saved, not spent.
One combination: a $1 billion increase in government spending and a $5 billion tax cut.
12-3
(Key Question) What are government’s fiscal policy options for ending severe demand-pull
inflation? Use the aggregate demand-aggregate supply model to show the impact of these
policies on the price level. Which of these fiscal policy options do you think might be favored by
a person who wants to preserve the size of government? A person who thinks the public sector is
too large?
Options are to reduce government spending, increase taxes, or some combination of both. See
Figure 12-2. If the price level is flexible downward, it will fall. In the real world, the goal is to
reduce inflation—to keep prices from rising so rapidly—not to reduce the price level. A person
wanting to preserve the size of government might favor a tax hike and would want to preserve
government spending programs. Someone who thinks that the public sector is too large might
favor cuts in government spending since this would reduce the size of government.
12-4
(For students who were assigned Chapter 10) Explain how equal-size increases in G and T
could eliminate a recessionary gap and how equal-size decreases in G and T could eliminate an
inflationary gap.
Equal-size increases (decreases) in G and T could eliminate a recessionary (inflationary) gap
because the multiplier effects of a change in government spending are greater than they are for a
change in taxes. The effect of a change in G is found by taking the change in G times the
spending multiplier. To find the effect of a change in T, the change must first be multiplied by
the MPC (because the tax change will affect both consumption and saving), and then by the
spending multiplier.
Example: Recessionary (inflationary) gap of $10 billion, MPC of 0.8. An increase (decrease) in
G of $10 billion will generate a $50-billion increase (decrease) in GDP [$50 = $10(1/[1-0.8])].
An increase (decrease) in T of $10 billion will generate a $40 billion decrease (increase) in GDP
[-$40 = ($10 x 0.8)(1/[1-0.8])]. Adding the effects of the two changes will result in a $10 billion
increase (decrease) in GDP, just sufficient to close the gap.
12-5
Designate each statement as true or false and justify your answer.
a. Expansionary fiscal policy during a depression will have a greater positive effect on real
GDP if government borrows the money to finance the budget deficit than if the central bank
creates new money to finance the deficit.
b. Contractionary fiscal policy during severe demand-pull inflation will be more effective if
government impounds the budget surplus rather than using the surplus to pay some of its past
debt.
(a) The statement is false. The truth is the opposite because when government creates new
money during a depression, there is little danger of inflation and all of the new expenditures
will be felt through increased aggregate demand as government’s net spending increases. If
the government finances its deficit by borrowing, there is danger that this will crowd out
some private borrowing and investment spending. The resulting reduction in private
spending offsets the expansionary effect of the fiscal deficit.
189
Fiscal Policy
(b) The statement is true. When the government impounds the surplus, these funds are removed
from the spending flow. If the government used the surplus to pay of some of its past debt,
money is returned to the private sector and at least a portion of it will be pumped into the
economy in new expenditures. These expenditures will offset the contractionary effect of the
budget surplus.
12-6
Explain how built-in (or automatic) stabilizers work. What are the differences between
proportional, progressive, and regressive tax systems as they relate to an economy’s built-in
stability?
In a phrase, “net tax revenues vary directly with GDP.” When GDP is rising so are tax
collections, both income taxes and sales taxes. At the same time, government payouts—transfer
payments such as unemployment compensation, and welfare—are decreasing. Since net taxes
are taxes less transfer payments, net taxes definitely rise with GDP, which dampens the rise in
GDP. On the other hand, when GDP drops in a recession, tax collections slow down or actually
diminish while transfer payments rise quickly. Thus, net taxes decrease along with GDP, which
softens the decline in GDP.
A progressive tax system would have the most stabilizing effect of the three tax systems and the
regressive tax would have the least built-in stability. This follows from the previous paragraph.
A progressive tax increases at an increasing rate as incomes rise, thus having more of a
dampening effect on rising incomes and expenditures than would either a proportional or
regressive tax. The latter rate would rise more slowly than the rate of increase in GDP with the
least effect of the three types. Conversely, in an economic slowdown, a progressive tax falls
faster because not only does it decline with income, it becomes proportionately less as incomes
fall. This acts as a cushion on declining incomes—the tax bite is less, which leaves more of the
lower income for spending. The reverse would be true of a regressive tax that falls, but more
slowly than the progressive tax, as incomes decline.
12-7
(Key Question) Define the “full-employment budget,” explain its significance, and state why it
may differ from the “actual budget.” Suppose the full-employment, noninflationary level of real
output is GDP3 (not GDP2) in the economy depicted in Figure 12-3. If the economy is operating
at GDP2 instead of GDP3, what is the status of its full-employment budget? Of its current fiscal
policy? What change in fiscal policy would you recommend? How would you accomplish that
in terms of the G and T lines in the figure?
The full-employment (also call standardized) budget measures what the Federal deficit or surplus
would be if the economy reached full-employment level of GDP with existing tax and spending
policies. If the full-employment budget is balanced, then the government is engaging in neither
expansionary nor contractionary policy, even if, for example, a deficit automatically results when
GDP declines. The “actual” budget is the deficit or surplus that results when revenues and
expenditures occur over a year if the economy is not operating at full-employment.
Looking at Figure 12-3, if full-employment GDP level was GDP3, then the full-employment
budget is contractionary since a surplus would exist. Even though the “actual” budget has no
deficit at GDP2, fiscal policy is contractionary. To move the economy to full-employment,
government should cut taxes or increase spending. You would raise the G line or lower the T
line or a combination of each until they intersect at GDP3.
12-8
As shown in Table 12-1, between 1990 and 1991 the actual budget deficit (as a percentage of
GDP) grew more rapidly than the full-employment budget deficit. What could explain this fact?
The explanation must be that the economy entered a recessionary phase during those years (it
did, in fact), and for that reason the deficit was greater than it would have been in a fullemployment economic situation. During a recession, tax revenues are lower than they would be
at full employment and government expenditures for entitlement programs rise more than they
190
Fiscal Policy
would at full employment. Therefore, the actual deficit is greater than the full-employment
budget deficit.
12-9
Some politicians have suggested that the United States enact a constitutional amendment
requiring that the Federal government balance its budget annually. Explain why such an
amendment, if strictly enforced, would force the government to enact a contractionary fiscal
policy whenever the economy experienced a severe recession.
When the economy enters a recession, net tax revenue falls. Specifically, revenues from income
and excise taxes decline as unemployment rises and consumer spending falls. At the same time,
transfer payments to help the poor and/or unemployed rise. If tax revenue falls and the
government is required to balance the budget, it will be forced to either cut spending or increase
taxes – both of which are contractionary policies likely to worsen the recession.
12-10 (Key Question) Briefly state and evaluate the problem of time lags in enacting and applying
fiscal policy. Explain the notion of a political business cycle. How might expectations of a nearterm policy reversal weaken fiscal policy based on changes in tax rates? What is the
crowding-out effect and why is it relevant to fiscal policy? In what respect is the net export
effect similar to the crowding-out effect?
It takes time to ascertain the direction in which the economy is moving (recognition lag), to get a
fiscal policy enacted into law (administrative lag); and for the policy to have its full effect on the
economy (operational lag). Meanwhile, other factors may change, rendering inappropriate a
particular fiscal policy. Nevertheless, discretionary fiscal policy is a valuable tool in preventing
severe recession or severe demand-pull inflation.
A political business cycle is the concept that politicians are more interested in reelection than in
stabilizing the economy. Before the election, they enact tax cuts and spending increases to
please voters even though this may fuel inflation. After the election, they apply the brakes to
restrain inflation; the economy will slow and unemployment will rise. In this view the political
process creates economic instability.
A decrease in tax rates might be enacted to stimulate consumer spending. If households receive
the tax cut but expect it to be reversed in the near future, they may hesitate to increase their
spending. Believing that tax rates will rise again (and possibly concerned that they will rise to
rates higher than before the tax cut), households may instead save their additional after-tax
income in anticipation of needing to pay taxes in the future.
The crowding-out effect is the reduction in investment spending caused by the increase in
interest rates arising from an increase in government spending, financed by borrowing. The
increase in G was designed to increase AD but the resulting increase in interest rates may
decrease I. Thus the impact of the expansionary fiscal policy may be reduced.
The net export effect also arises from the higher interest rates accompanying expansionary fiscal
policy. The higher interest rates make U.S. bonds more attractive to foreign buyers. The inflow
of foreign currency to buy dollars to purchase the bonds drives up the international value of the
dollar, making imports less expensive for the United States, and U.S. exports more expensive for
people abroad. Net exports in the United States decline, and like the crowding-out effect,
diminish the expansionary fiscal policy.
12-11 In view of your answers to question 10, explain the following statement: “While fiscal policy
clearly is useful in combating the extremes of severe recession and demand-pull inflation, it is
impossible to use fiscal policy to fine-tune the economy to the full-employment, noninflationary
level of real GDP and keep the economy there indefinitely.”
As suggested, the answer to question 10 explains this quote. While fiscal policy is useful in
combating the extremes of severe recession with its built-in “safety nets” and stabilization tools,
191
Fiscal Policy
and while the built-in stabilizers can also dampen spending during inflationary periods, it is
undoubtedly not possible to keep the economy at its full-employment, noninflationary level of
real GDP indefinitely. There is the problem of timing. Each period is different, and the impact
of fiscal policy will affect the economy differently depending on the timing of the policy and the
severity of the situation. Fiscal policy operates in a political environment in which the
unpopularity of higher taxes and specific cuts in spending may dictate that the most appropriate
economic policies are ignored for political reasons. Finally, there are offsetting decisions that
may be made at any time in the private and/or international sectors. For example, efforts to
revive the economy with more government spending could result in reduced private investment
or lower net export levels.
Even if it were possible to do any fine tuning to get the economy to its ideal level in the first
place, it would be virtually impossible to design a continuing fiscal policy that would keep it
there, for all of the reasons mentioned above.
12-12 Suppose that government engages in deficit spending to push the economy away from recession
and that this spending is directed toward new “public capital” such as roads, bridges, dams,
harbors, office parks, and industrial sites. How might this spending increase the expected rate of
return on some types of potential private investment projects? What are the implications for the
crowding-out effect?
Government spending that is directed toward the improvement of the infrastructure (roads,
bridges, dams, and harbors) provides additional “public capital,” which increases the “production
possibilities” of the nation. Private business firms benefit from these improvements through
more convenient and reliable transportation systems and other amenities that lower production
costs and make their business locations more desirable. Business firms that benefit from these
public projects are, in effect, being subsidized by the government spending. These firms are
likely to find that the publicly funded improvements increase the expected rate of return on their
own investment projects. Other things equal, private investment spending would rise. Some
refer to this phenomenon as “crowding in,” and it is argued that this effect is strongest during a
recession, when expected rates of return are low (and thus easier to raise) and deficit spending
will produce less upward pressure on interest rates.
12-13 Use Figure 12-4(b) to explain why the deliberate increase of the full-employment budget
(resulting from the tax cut) will reduce the size of the actual budget deficit if the fiscal policy
succeeds in pushing the economy to its full-employment output of GDP3. In requesting a tax cut
in the early 1960s, President Kennedy said, “It is a paradoxical truth that tax rates are too high
today and tax revenues are too low, and the soundest way to raise tax revenues in the long run is
to cut tax rates now.” Relate this quotation to your previous answer.
To the extent that the deficit increase is successful in expanding the economy, equilibrium GDP
will be to the right of its original position in Figure 12-4. The higher GDP means greater income
and employment, which should raise total tax revenues despite lower rates and automatically
reduce government spending on many social programs as fewer recipients qualify for support.
The expansionary policy could have a beneficial effect on both the economy and the actual
budget deficit.
Especially in the relatively noninflationary early 1960s, President Kennedy was right. The cut in
tax rates, finally achieved under President Johnson, did indeed increase real GDP. The cut in
taxes boosted production, so that out of the increased real GDP, tax revenues became greater
than they had been before the tax cut—as Figure 12-4 would have predicted.
12-14 Advanced analysis: (For students assigned Chapter 10) Assume that, without taxes, the
consumption schedule for an economy is as shown below:
192
Fiscal Policy
GDP,
billions
Consumption,
billions
$100
200
300
400
500
600
700
$120
200
280
360
440
520
600
a. Graph this consumption schedule and determine the size of the MPC.
b. Assume that a lump-sum (regressive) tax of $10 billion is imposed at all levels of GDP.
Calculate the tax rate at each level of GDP. Graph the resulting consumption schedule, and
compare the MPC and the multiplier with those of the pretax consumption schedule.
c. Now suppose a proportional tax with a 10 percent tax rate is imposed instead of the
regressive tax. Calculate and graph the new consumption schedule, and note the MPC and
the multiplier.
d. Finally, impose a progressive tax system such that the tax rate is zero percent when GDP is
$100, 5 percent at $200, 10 percent at $300, 15 percent at $400, and so forth. Determine and
graph the new consumption schedule, noting the effect of this tax system on the MPC and
multiplier.
e. Explain why proportional and progressive tax systems contribute to greater economic
stability, while a regressive tax does not. Demonstrate using a graph similar to Figure 12-3.
(a) The MPC  $200  $120  billion / $200  $100  billion  80 / 100  0.8
(b)
GDP,
billions
$100
200
300
400
500
600
700
Tax,
billions
$10
10
10
10
10
10
10
DI,
billions
$ 90
190
290
390
490
590
690
Consumption
after tax
$112
192
272
352
432
512
592
Tax rate,
percent
billions
10%
5.0
3.33
2.5
2.0
1.67
1.43
The MPC is 0.8 [= ($192-$112) billion / ($200-$100) billion = 80/100], as before the tax
increase. The spending multiplier remains 5 [= 1/(1-0.8) = 1/0.2]
(c)
193
Fiscal Policy
GDP,
billions
$100
200
300
400
500
600
700
Tax,
billions
DIs
billions
Consumption
after tax,
billions
10%
10
10
10
10
10
10
$90
180
270
360
450
540
630
$112
184
256
328
400
472
544
The MPC is 0.72 $184  $112 billion /$200  $100 billion  72 / 100.
And the spending multiplier is now 3.57 1 / 1  .072   1 / 0.28.
(d)
GDP
billions
$100
200
300
400
500
600
700
Tax,
billions
DI,
billions
$ 0
10
30
60
100
150
210
$100
190
270
340
400
450
490
Consumption
after tax
Tax rate,
percent
billions
MPC
$120
192
256
312
360
400
432
0%
5
10
15
20
25
30
undefined
0.72
0.64
0.56
0.48
0.40
0.32
(e) The MPC decreases as shown in the right-hand column above. Proportional and (especially)
progressive tax systems reduce the size of the MPC and, therefore, the size of the multiplier.
A lump-sum tax does not alter the MPC or the multiplier.
NOTE: For instructors who assign the graphs, the following would be true. For each graph (a) through
(d), plot the consumption schedule against the GDP. Graph (a) will have a slope of .8 and will
cross the 45 degree line at C = GDP = 200. Graph (b) is parallel to (a) but $10 billion below it
and will cross the 45 degree line at C = GDP = 150, indicating the multiplier of 5 ($10 billion
loss in income leads to $50 billion drop in equilibrium GDP). Graph (c) will not be as steep as
(a) or (b) with a slope of .72 and equilibrium between GDP = 200 and GDP = 300 on the
diagram. Graph (d) has a decreasing slope so it will not be a straight line. Equilibrium is just
beyond GDP = 200. The multiplier is illustrated by noting the change in equilibrium GDP if any
curve were to be shifted by a given amount. The multiplier is the ratio of change in equilibrium
GDP to the vertical shift.
12-15 (Last Word) What is the index of leading economic indicators, and how does it relate to
discretionary fiscal policy?
194
Fiscal Policy
The index of leading indicators is a monthly composite index of a group of variables that in the
past has provided advance notice of changes in GDP. Changes in the index provide a clue to the
future direction of the economy and may shorten the length of the “recognition lag” associated
with the implementation of discretionary fiscal policy.
195