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CHAPTER 12
FISCAL POLICY
In this chapter, you will find:
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Answers to the End-of-Book Questions and Problems for Chapter 12
Supplemental Cases, Exercises, and Problems
INTRODUCTION
This chapter brings government into the picture by analyzing how fiscal policy—including taxes, government
purchases, and transfer programs—influences the economy. (The impact of net exports on the aggregate
expenditure line and the algebra of the fiscal multipliers are covered here and in the chapter’s online
appendix.) The chapter then presents the historical evolution of fiscal policy, contrasting the classical view of
the economy with the Keynesian view. Classical economists believed that the economy would naturally tend
toward full employment, but Keynes argued that the economy could sometimes get stuck in a situation in
which output fell far short of the economy’s potential, as occurred during the Great Depression. From there,
the chapter presents a more complete description of aggregate demand with the aggregate supply curve
developed earlier. The objective is to show the pros and cons of discretionary fiscal policy and automatic
stabilizers as ways of addressing expansionary and recessionary gaps. The chapter closes with a description of
recent fiscal policy.
LEARNING OUTCOMES
1
Explain the theory of fiscal policy
The tools of fiscal policy are automatic stabilizers and discretionary fiscal measures. Automatic stabilizers, such as
the federal income tax, once implemented, operate year after year without congressional action. Discretionary fiscal
policy results from specific legislation about government spending, taxation, and transfers. If that legislation becomes permanent, then discretionary fiscal policies often become automatic stabilizers.
The effect of an increase in government purchases on aggregate demand is the same as that of an increase in any
other type of spending. Thus, the simple multiplier for a change in government purchases is 1/(1 - MPC). A decrease
in net taxes (taxes minus transfer payments) affects consumption by increasing disposable income, but does not increase spending as much as would an identical increase in government purchases. The multiplier for a change in autonomous net taxes is -MPC/(1 - MPC).
2
Describe how aggregate supply affects fiscal policy
An expansionary fiscal policy can close a recessionary gap by increasing government purchases, reducing net taxes,
or both. Because the short-run aggregate supply curve slopes upward, an increase in aggregate demand raises both
output and the price level in the short run. A contractionary fiscal policy can close an expansionary gap by reducing
government purchases, increasing net taxes, or both. Fiscal policy that reduces aggregate demand to close an expansionary gap reduces both output and the price level.
3
Discuss the evolution of fiscal policy
Fiscal policy focuses primarily on the demand side, not the supply side. The problems of the 1970s, however, resulted more from a decline of aggregate supply than from a decline of aggregate demand, so demand-side remedies
seemed less effective.
The tax cuts of the early 1980s aimed to increase aggregate supply. But government spending grew faster than
tax revenue, creating budget deficits that stimulated aggregate demand. These huge deficits discouraged additional
discretionary fiscal policy, but success in erasing deficits in the late 1990s spawned renewed interest in discretionary
fiscal policy, as reflected by President Bush’s tax cuts in the face of the 2001 recession.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 12
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162
Tax cuts and new spending increased deficits into 2004, but the economy added over 8 million jobs by 2007.
The added output and income cut the federal deficit from about $400 billion in 2004 to about $160 billion in 2007.
The recession that began officially in December 2007 reversed those recent gains, leading to increases in the deficit.
After peaking in December 2007, the economy turned down, as consumers, firms, and financial markets were
spooked by falling home prices and rising foreclosure rates. Job losses increased sharply after the financial crisis of
September 2008. Government officials first tried to calm financial markets with TARP, then tried to stimulate the
economy with the largest program in history. The economy lost 8.4 million jobs between December 2007 and December 2009. Jobs started coming back in 2010, but the unemployment rate remained high.
CHAPTER OUTLINE WITH POWERPOINT SCRIPT
USE POWERPOINT SLIDE 2 FOR THE FOLLOWING SECTION
Theory of Fiscal Policy
Fiscal Policy: The use of government purchases, transfer payments, taxes, and borrowing to affect
macroeconomic variables such as real GDP, employment, the price level, and economic growth.
USE POWERPOINT SLIDES 3-4 FOR THE FOLLOWING SECTION
Fiscal Policy Tools:
 Automatic stabilizers: Revenue and spending programs in the federal budget that automatically adjust
with the ups and downs of the economy to stabilize disposable income.
 Discretionary fiscal policy: Deliberate manipulation of government purchases, transfer payments, and
taxes to promote macroeconomic goals like full employment, price stability, and economic growth.
USE POWERPOINT SLIDES 5-6 FOR THE FOLLOWING SECTION
Changes in Government Purchases: At any given price level, an increase in government purchases or
transfer payments increases real GDP demanded.
For a given price level, assuming only consumption varies with income:
 Change in real GDP = change in government spending  1 / (1 MPC) other things constant.
 Simple Spending Multiplier = 1 / (1  MPC)
USE POWERPOINT SLIDES 7-8 FOR THE FOLLOWING SECTION
Changes in Net Taxes: A decrease (increase) in net taxes increases (decreases) disposable income at each
level of real GDP, so consumption increases (decreases). The change in real GDP demanded is equal to the
resulting shift of the aggregate expenditure line times the simple spending multiplier.
 Change in real GDP = (MPC  change in NT)  1 / (1 – MPC) or simplified,
 Change in real GDP = change in NT  -MPC/(1-MPC)
 Simple tax multiplier = MPC / (1 – MPC)
Including Aggregate Supply
USE POWERPOINT SLIDES 9-10 FOR THE FOLLOWING SECTION
Discretionary Fiscal Policy to Close a Recessionary Gap: Expansionary fiscal policy, such as an increase in
government purchases, a decrease in net taxes, or a combination of the two:
 Could increase aggregate demand just enough to return the economy to its potential output.
 Causes a higher price level and may cause a budget deficit.
USE POWERPOINT SLIDES 11-13 FOR THE FOLLOWING SECTION
Discretionary Fiscal Policy to Close an Expansionary Gap: Contractionary fiscal policy to reduce
aggregate demand by reducing government purchases, increasing net taxes, or a combination of the two:
 Could move the economy to potential output without the resulting inflation.
 Causes a lower price level and a lower deficit or even a surplus.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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USE POWERPOINT SLIDE 14 FOR THE FOLLOWING SECTION
The Multiplier and the Time Horizon: The steeper the short-run aggregate supply curve, the less impact a
given shift of the aggregate demand curve has on real GDP and the more impact it has on the price level, so the
smaller the spending multiplier. At potential output, the spending multiplier in the long run is zero.
USE POWERPOINT SLIDES 15-16 FOR THE FOLLOWING SECTION
The Evolution of Fiscal Policy: Classical economists, who advocated laissez-faire, believed that natural
market forces—by way of flexible prices, wages, and interest rates—would move the economy toward
potential GDP. There was no need for government intervention.
USE POWERPOINT SLIDES 17-18 FOR THE FOLLOWING SECTION
The Great Depression and World War II
 The Great Depression strained belief in the economy’s ability to correct itself, which was the view of the
classical economists.
 Keynesian theory challenged the classical view:
 Prices and wages did not appear flexible enough to ensure the full employment of resources.
 Prices and wages were relatively inflexible, or “sticky” in the downward direction.
 Business expectations might at times become so grim that even very low interest rates would not spur firms
to invest all that consumers might save.
 After the Great Depression, the use of discretionary fiscal policy was bolstered by:
 The influence of Keynes “General Theory.”
 Impact of WWII on output and employment.
 Passage of the Employment Act of 1946, giving the government the responsibility for promoting full employment and price stability.
USE POWERPOINT SLIDE 19 FOR THE FOLLOWING SECTION
Automatic Stabilizers: The progressive federal income tax, unemployment insurance, and welfare spending
smooth fluctuations in disposable income over the business cycle by:
Stimulating aggregate demand during recessions; and,
Dampening aggregate demand during expansions.
USE POWERPOINT SLIDES 20-21 FOR THE FOLLOWING SECTION
From the Golden Age to Stagflation
 1960s Golden Age of fiscal policy: Increasing or decreasing aggregate demand to smooth economic
fluctuations.
 1970s Stagflation (high inflation and high unemployment due to adverse supply shocks):
 Fiscal policy is ill-suited to solving stagflation.
 Increasing aggregate demand would increase inflation, and decreasing aggregate demand would increase
unemployment.
USE POWERPOINT SLIDES 22-23 FOR THE FOLLOWING SECTION
Fiscal Policy and the Natural Rate of Unemployment
Natural rate of unemployment: The unemployment rate that occurs when the economy is producing its
potential GDP.
 For discretionary policy purposes, officials must correctly estimate this natural rate.
USE POWERPOINT SLIDE 24 FOR THE FOLLOWING SECTION
Lags in Fiscal Policy: Time required to approve and implement fiscal legislation can weaken the effectiveness
of discretionary fiscal policy as a tool for macroeconomic stabilization.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 12
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USE POWERPOINT SLIDE 25 FOR THE FOLLOWING SECTION
Discretionary Fiscal Policy and Permanent Income: Because consumers base their spending decisions on
their permanent income, temporary tax changes are less effective.
USE POWERPOINT SLIDES 26-27 FOR THE FOLLOWING SECTION
The Feedback Effects of Fiscal Policy on Aggregate Supply: Automatic stabilizers and discretionary fiscal
policy may inadvertently affect individual incentives to work, spend, save, and invest.
USE POWERPOINT SLIDES 28-30 FOR THE FOLLOWING SECTION
1990 to 2007: From Deficits to Surpluses Back to Deficits: Higher tax revenue and spending discipline
created surpluses from 1998 to 2000. Recession and terrorist attacks in 2001 caused deficits to return.
USE POWERPOINT SLIDES 31-40 FOR THE FOLLOWING SECTION
Fiscal Policy and the 2007-2009 Recession: Crisis in the housing market led to a financial crisis and a deep
recession. Tax cuts and increased spending caused ballooning deficits. The American Recovery and
Reinvestment Act had an estimated cost of $862 billion.
Appendix: The Algebra of Demand-Side Equilibrium
USE POWERPOINT SLIDE 41 FOR THE FOLLOWING SECTION
Change in GDP demanded from a change in government purchases = G  1 / (1  MPC).
USE POWERPOINT SLIDE 42 FOR THE FOLLOWING SECTION
Net-Tax Multiplier = MPC / (1  MPC)
USE POWERPOINT SLIDE 43 FOR THE FOLLOWING SECTION
The Multiplier When Both G and NT Change: Y = (G (b NT) / 1b)
USE POWERPOINT SLIDES 44-45 FOR THE FOLLOWING SECTION
The Multiplier with a Proportional Income Tax
Y = a+I+G+(X-M)/[1b (1t)]
The higher the proportional tax rate, the smaller the spending multiplier.
USE POWERPOINT SLIDE 46 FOR THE FOLLOWING SECTION
Including Variable Net Exports
 Y = a+I+G+X/[1b+m+t(b-m)]
The higher the proportional tax rate, or the higher the MPM, the smaller the spending multiplier.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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CHAPTER SUMMARY
The tools of fiscal policy are automatic stabilizers and discretionary fiscal measures. Automatic stabilizers,
such as the federal income tax, once implemented, operate year after year without congressional action.
Discretionary fiscal policy results from specific legislation about government spending, taxation, and transfers.
If that legislation becomes permanent, then discretionary fiscal policies often become automatic stabilizers.
The effect of an increase in government purchases on aggregate demand is the same as that of an increase in
any other type of spending. Thus, the simple spending multiplier for a change in government purchases is
1/(1−MPC).
A decrease in net taxes (taxes minus transfer payments) affects consumption by increasing disposable income.
A decrease in net taxes does not increase spending as much as would an identical increase in government
purchases because some of the tax cut is saved. The multiplier for a change in autonomous net taxes is
−MPC/(1-MPC).
An expansionary fiscal policy can close a recessionary gap by increasing government purchases, reducing net
taxes, or both. Because the short-run aggregate supply curve slopes upward, an increase in aggregate demand
raises both output and the price level in the short run. A contractionary fiscal policy can close an expansionary
gap by reducing government purchases, increasing net taxes, or both. Fiscal policy that reduces aggregate
demand to close an expansionary gap reduces both output and the price level.
Fiscal policy focuses primarily on the demand side, not the supply side. The problems of the 1970s, however,
resulted more from a decline of aggregate supply than from a decline of aggregate demand, so demand-side
remedies seemed less effective.
The tax cuts of the early 1980s aimed to increase aggregate supply. But government spending grew faster than
tax revenue, creating budget deficits that stimulated aggregate demand, leading to the longest peacetime
expansion to that point in the nation’s history. These huge deficits discouraged additional discretionary fiscal
policy as a way of stimulating aggregate demand further, but success in erasing deficits in the late 1990s
spawned renewed interest in discretionary fiscal policy, as reflected by President Bush’s tax cuts in the face of
the 2001 recession.
Tax cuts and new spending increased deficits into 2004, but the economy added over 8 million jobs by 2007.
The added output and income cut the federal deficit from about $400 billion in 2004 to about $160 billion in
2007. The recession that began officially in December 2007 reversed those recent gains, leading to increases in
the deficit.
After peaking in December 2007, the economy turned down, as consumers, firms, and financial markets were
spooked by falling home prices and rising foreclosure rates. Job losses increased sharply after the financial
crisis of September 2008. Government officials first tried to calm financial markets with TARP, then tried to
stimulate the economy with the largest program in history. The economy lost 8.4 million jobs between
December 2007 and De-cember 2009. Jobs started coming back in 2010, but the unemployment rate remained
high.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 12
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TEACHING POINTS
1. This chapter considers the effects of fiscal policy on equilibrium income and employment. It begins with
a discussion of multipliers and ends with a clear discussion of the aggregate demand curve and fiscal
policy. Students should understand that there is a continuity to the presentations of the first and last parts
of this chapter.
2. You should link together the many parts of this chapter. First, you must again illustrate the multiplier for
the case of government spending. The multiplier has been discussed in previous chapters, so it should not
present any barriers to your students. Next, you must again discuss the aggregate demand curve.
Reference should be made to Exhibit 4 in Chapter 10 for a graphical derivation of the aggregate demand
curve. Have your students review that section. Finally, there is a full discussion of the effects of fiscal
policy on aggregate demand, assuming a given aggregate supply curve.
3. The text works through examples of government spending changes and tax changes, making full use of
the multipliers. There is also an example using proportional taxes, as well as the “balanced budget
multiplier” in the Appendix, which can be found online at http://4ltrpress.cengage.com/.
4. Having discussed the nature of fiscal policy and recessionary/expansionary gaps, you may find it very
useful to use a conventional aggregate demand–aggregate supply diagram with such a gap and to ask the
class how to determine the appropriate fiscal policy. It will be quickly evident that a great deal of
information is required to make good policy. This includes knowledge of the size of the gap, the slopes
of the aggregate demand and aggregate supply curves, the size of the multipliers, and the adjustment
time. This will naturally lead into a discussion of the appropriateness and relative merits of using
discretionary versus automatic stabilizers in fiscal policy.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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ANSWERS TO END-OF-BOOK QUESTIONS AND PROBLEMS
1.1. (Changes in Government Purchases) Assume that government purchases decrease by $10 billion, with
other factors held constant, including the price level. Calculate the change in the level of real GDP
demanded for each of the following values of the MPC. Then, calculate the change if the government,
instead of reducing its purchases, increased autonomous net taxes by $10 billion.
a. 0.9
b. 0.8
c. 0.75
d. 0.6
The formula that should be used to solve the first part of this problem is ∆G*1/(1−MPC). The first part
indicates that there was a decrease in government purchases, so ∆G will equal −10. The formula that
should be used to solve the second part is ∆NT*−MPC/(1−MPC). The second part indicates that there
was an increase in autonomous net taxes, so ∆NT will equal +10.
a. −$100 billion = [−10*1/(1-0.9)]; −$90 billion = [10*−0.9/(1−0.9)]
b. −$50 billion = [−10*1/(1−0.8)]; −$40 billion = [10*−0.8/(1−0.8)]
c. −$40 billion = [−10*1/(1−0.75)]; −$30 billion = [10*−0.75/(1−0.75)]
d. −$25 billion = [−10*1/(1−0.6)]; −$15 billion = [10*−0.6/(1−0.6)]
1.2
(Fiscal Multipliers) Explain the difference between the government purchases multiplier and the net tax
multiplier. If the MPC falls, what happens to the tax multiplier?
A change in government purchases directly affects aggregate expenditure by the amount of the change in
purchases, and its multiplier equals 1 / (1 − MPC). However, a change in net taxes has no direct impact
on aggregate expenditure. Rather, a change in net taxes affects disposable income, therefore altering
consumption by the change in net taxes times the net tax multiplier (−MPC / 1−MPC). Note the negative
relationship between net taxes and consumption. Aggregate expenditure initially shifts by the amount of
the consumption change.
It may be best to use a numerical example to show what happens when MPC falls. If the MPC is 0.90,
the tax multiplier will equal 9. If the MPC falls to 0.80, the tax multiplier will fall to 4. Thus, a fall in the
MPC reduces the tax multiplier.
1.3
(Changes in Net Taxes) Using the income-expenditure model, graphically illustrate the impact of a $15
billion drop in government transfer payments on aggregate expenditure if the MPC equals 0.75. Explain
why it has this impact. What is the impact on the level of real GDP demanded, assuming the price level
remains unchanged?
Disposable income falls at each level of real GDP. Therefore, consumption drops by $11.25 billion ($15
billion reduction in transfer payments times the MPC of 0.75) at each level of real GDP, causing a
parallel shift in the aggregate expenditure line of –$11.25 billion. The initial drop in aggregate
expenditure leads to production cuts and falling income, and thus spending drops further. The total
change in equilibrium real GDP demanded equals $45 billion (tax multiplier of –3 times $15 billion).
Note that a drop in transfer payments means an increase in net taxes.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 12
1.4
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168
(Multipliers) Suppose investment, in addition to having an autonomous component, also has a
component that varies directly with the level of real GDP. How would this affect the size of the
government purchase and net tax multipliers?
It would have the same impact on the fiscal multipliers as an increase in the MPC would, injecting more
spending at each stage in the multiplier process. Hence, the multiplier would be larger in this case.
2.1
(Fiscal Policy) Chapter 12 shows that increased government purchases, with taxes held constant, can
eliminate a recessionary gap. How could a tax cut achieve the same result? Would the tax cut have to be
larger than the increase in government purchases? Why or why not?
A tax cut would increase disposable income. Individuals would in turn spend a portion of their tax cuts,
provided that they felt that the tax cuts were long lasting. This would raise aggregate expenditure and
aggregate demand.
To obtain a given effect, the tax cut must be larger than the increase in government purchases. We know
that the needed tax cut works on aggregate demand indirectly through the consumption function. The
size of the needed tax cut will depend on the tax multiplier, which is smaller than the simple spending
multiplier.
2.2
(Fiscal Policy with an Expansionary Gap) Using the aggregate demand–aggregate supply model,
illustrate an economy with an expansionary gap. If the government is to close the gap by changing
government purchases, should it increase or decrease those purchases? In the long run, what happens to
the level of real GDP as a result of government intervention? What happens to the price level? Illustrate
this on an AD–AS diagram, assuming that the government changes its purchases by exactly the amount
necessary to close the gap.
Government purchases fall to reduce aggregate demand from AD1 to AD2 . When AD falls, both real
GDP and the price level fall. Equilibrium moves from e1 to e2 .
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Chapter 12
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(Evolution of Fiscal Policy) What did classical economists assume about the flexibility of prices, wages,
and interest rates? What did this assumption imply about the self-correcting tendencies in an economy in
recession? What disagreements did Keynes have with classical economists?
The flexibility of prices was the most important point of the classical economists, since they emphasized
that flexible prices would restore any imbalance that might occur in the macroeconomic markets. This
implied that the natural market forces would move the economy towards its potential GDP. Keynes
attacked the ideas of the classical economists. First, he noted that wages were seldom flexible
downward. Next, he noted that even though interest rates might fall, there could be such pessimism
about the future that neither consumption nor investment would increase very much. Thus, quantities of
goods (and hence employment), not prices, would change to equilibrate the markets.
SUPPLEMENTAL CASES, EXERCISES, AND PROBLEMS
Case Studies
These cases are available to students online at www.cengagebrain.com.
Fiscal Policy and Presidential Elections
After the recession of 1990–1991, the economy was slow to recover. At the time of the 1992 presidential election, the unemployment rate still languished at 7.5 percent, up 2 percentage points from when President
George H. W. Bush had taken office in 1989. The higher unemployment rate was too much of a hurdle to
overcome, and Bush lost his reelection bid to challenger Bill Clinton. Clinton’s campaign slogan was: “It’s the
economy, stupid.”
The link between economic performance and reelection success has a long history. Ray Fair of Yale University examined presidential elections dating back to 1916 and found, not surprisingly, that the state of the
economy during the election year affected the outcome. Specifically, Fair found that a declining unemployment rate and strong growth rate in GDP per capita increased election prospects for the incumbent party. On
the other hand, the financial crisis just weeks before the presidential election of 2008 helped Barack Obama
defeat the incumbent party candidate, John McCain (before that crisis, the two were even in the polls). Another
Yale economist, William Nordhaus, developed a theory of political business cycles, arguing that incumbent
presidents, during an election year, use expansionary policies to stimulate the economy, often only temporarily.
For example, evidence suggests that President Nixon used expansionary policies to increase his chances for
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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reelection in 1972, even pressuring the Federal Reserve chairman to pursue an expansionary monetary policy.
There is also evidence of a political business cycle of sorts at the municipal level, where, prior to an election,
city officials spend more on those items most visible to the electorate, such as city parks.
The evidence to support the theory of political business cycles is not entirely convincing. One problem is
that the theory limits presidential motives to reelection, when in fact presidents may have other objectives. For
example, the first President Bush, in the election year of 1992, passed up an opportunity to sign a tax cut for
the middle class because that measure would also have increased taxes on a much smaller group—upperincome taxpayers.
An alternative to the theory of political business cycles is that Democrats care more about unemployment
and less about inflation than do Republicans. This view is supported by evidence indicating that during Democratic administrations, unemployment is more likely to fall and inflation is more likely to rise than during Republican administrations. Republican presidents tend to pursue contractionary policies soon after taking office
and are more willing to endure a recession to reduce inflation. The country suffered a recession during the first
term of the last six Republican presidents. Democratic presidents tend to pursue expansionary policies to reduce unemployment and are willing to put up with higher inflation and higher deficits to do so. President
Barack Obama, for example, pushed through what would turn out to be an $862 billion stimulus package even
though it worsened what was already a huge federal deficit.
A final problem with the political-business-cycle theory is that other issues sometimes compete with the
economy for voter attention, particularly when the economy is doing well. For example, in the 2004 election,
President Bush’s handling of the war on terror, especially the war in Iraq, became at least as much of a campaign issue as his handling of the economy.
Sources: Linda Veiga and Francisco Veiga, “Political Business Cycles at the Municipal Level,” Public Choice,
131 (April 2007): 45–64; Burton Abrams, “How Richard Nixon Pressured Arthur Burns: Evidence from the
Nixon Tapes,” Journal of Economic Perspectives (Fall 2006): 177–188; Economic Report of the President,
February 2010; Ray Fair, Predicting Presidential Elections and Other Things (Stanford University Press,
2002); and William Nordhaus, “Alternative Approaches to the Political Business Cycle,” Brookings Papers on
Economic Activity, No. 2 (1989): 1–49.
Cash for Clunkers
On June 24, 2009, President Obama signed into law the Consumer Assistance to Recycle and Save (CARS)
Act, better known as the “cash-for-clunkers” program. The measure appropriated $1 billion to pay from $3,500
to $4,500 to each car buyer who traded a “clunker,” or an older car with gas mileage of 18 miles per gallon or
less, for a new one with better gas mileage. The clunker had to be “drivable,” and registered and insured by the
same person for at least a year prior to the sale (to prevent someone from buying a junk just as a trade-in).
Once car dealers began submitting paperwork for government reimbursement, it became clear the program
would soon burn through the $1 billion appropriation. So Congress put $2 billion more into the pot and limited
the program to a month (the $1 billion was originally expected to last four months). The 135 pages of
government rules were constantly changing, and the Web site dealers used often crashed. The 2,000 people
needed to process paperwork had trouble reimbursing dealers, so some dealers had to drop out of the program.
Still, nearly 680,000 new vehicles were sold during the month of the program. That spike in sales, some
argue, is clear evidence of the program’s success. For example, the Transportation Secretary claimed this “is
the one stimulus program that seems to be working better than just about any other program.” And the
program’s Web site said it was “wildly successful.” But evidence suggests that the overwhelming majority of
those car sales would have occurred anyway during the last half of 2009. For example, according to analysis by
the automotive Web site Edmunds.com, which tracks car sales, the net effect of the program was only 125,000
additional vehicle sales, implying a government cost of $24,000 per additional sale.
But even if the program was expensive on a per vehicle basis, didn’t the economy in general and car makers
in particular need a boost? First, the $3 billion spent on the program was money the government didn’t have;
the outlays increased the federal deficit, already at record levels. Ultimately, to pay for the program, taxes must
be raised or other government spending must be cut. Second, at least some of the stimulus benefited other
economies. Japanese manufacturers accounted for 41 percent of the program sales and the Big Three (General
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 12
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Motors, Ford, and Chrysler), 39 percent. Third, automakers already received the $83 billion in bailout funds
(and at least $34 billion would not likely ever be repaid). What about helping other sectors hit hard by the
recession such as furniture makers and the travel industry? Why not “cash for couches” or “cash for cruises”?
Proponents of cash for clunkers would point out that cars are a special case, because a second objective of
the program was to clear the air by replacing clunkers with cars that would get maybe 10 more miles to the
gallon. Christopher Knittel of the University of California, Davis, estimated that the government could have
gotten 10 times more carbon reduction by spending the $3 billion in the market for carbon offsets.
For most buyers, the clunker money served as the down payment on a new car, so more people could afford
one, and didn’t that stimulate the economy? From that stimulus effect must be subtracted the housing,
furniture, clothes, vacation trips, and other items that those consumers wouldn’t be buying in the future,
because they face additional monthly payments for car leases or car loans. Finally, by mandating the
destruction of each trade-in vehicle (a disposal facility had to crush or shred each clunker with evidence of
such supplied to the government), Congress removed up to 680,000 drivable cars from the used-car market,
inevitably raising the prices of the used cars that low-income households tend to buy. The destruction also
reduced the supply of salvageable used parts that are bought mostly by low-income drivers looking to keep
their cars running. Cash for clunkers was never that popular with the public. Polls show that most Americans
did not approve of the program.
Sources: Emily Maltby, “Used Car Dealers Feel Clunkers Pinch,” Wall Street Journal, 6 October 2009; Irwin
M. Stelzer, “Seven Lessons of Cash-for-Clunkers Failure,” Washington Examiner, 28 August 2009;
Christopher R. Knittel, “The Implied Cost of Carbon Dioxide Under the Cash for Clunkers Program,”
Working Paper (31 August 2009) at http://www.econ.ucdavis.edu/faculty/knittel/papers/CfC_final_latest.pdf;
and the government program’s site at http://www.cars.gov/.
Experiential Exercises
1. The University of Washington’s Fiscal Policy Center at http://depts.washington.edu/fpcweb/center/links.htm
provides an extensive list of links about U.S. fiscal policy. Ask students to visit the site and use the links to
determine what tax and spending proposals have been made in Congress during the past six months. Have
them choose one of the proposals and use the AD–AS framework to explain its likely impact.
2. In the United States, fiscal policy is determined jointly by the president and Congress. The Congressional
Budget Office at http://www.cbo.gov/ provides analysis to Congress, and the Office of Management and
Budget at http://www.whitehouse.gov/omb/ does the same for the executive branch. Suggest to students
that they visit these Web sites to get a sense of the kinds of analyses these groups do and how they might be
used in determining fiscal policy.
3. “Washington Wire” is a column that appears on the front page of the Wall Street Journal each Friday. Have
students review the latest column to determine what fiscal policy proposals are under consideration. Do the
proposals deal more with discretionary fiscal policy or with automatic stabilizers? Are they designed to
affect aggregate demand or aggregate supply?
4. (Global Economic Watch) Go to the Global Economic Crisis Resource Center. Select Global Issues in
Context. In the Basic Search box at the top of the page, enter the phrase "fiscal policy." On the Results
page, go to the Global Viewpoints Section. Click on the link for the August 29, 2010, editorial "Why We
Need a Second Stimulus." What are three reasons given for a second round of federal spending to follow
the 2009 stimulus plan?
Reasons given include the loss of one to two percentage points from the GDP growth rate as the 2009
stimulus runs out; spending on education by states would reduce cyclical and structural unemployment; infrastructure spending would increase productivity; and, in a time of slack resources, increased federal
government spending will not lead to crowding out, inflation, or dollar depreciation.
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5. (Global Economic Watch) Go to the Global Economic Crisis Resource Center. Select Global Issues in
Context. In the Basic Search box at the top of the page, enter the phrase "budget deficit." Use quotation
marks before and after the phrase to ensure finding articles about the economic concept of the budget deficit. Choose one article from the past two years. Does the article express concern about the budget deficit in
the country discussed?
Student answers will vary. The best answers will consider short-term and long-term effects of budget deficits.
Additional Questions and Problems
(From student Web site at www.cengagebrain.com)
1. (Fiscal Policy) Define fiscal policy. Determine whether each of the following, other factors held
constant, would lead to an increase, a decrease, or no change in the level of real GDP demanded:
a. A decrease in government purchases
b. An increase in net taxes
c. A reduction in transfer payments
d. A decrease in the marginal propensity to consume
Fiscal policy refers to government purchases, transfer payments, taxes, and borrowing as they affect
macroeconomic variables such as employment, price levels, and real GDP.
a. Decrease
b. Decrease
c. Decrease
d. Decrease
2. (The Multiplier and the Time Horizon) Explain how the steepness of the short-run aggregate supply
curve affects the government’s ability to use fiscal policy to change real GDP.
The steepness of the aggregate supply curve in the short run depends on how much production costs
increase as output expands. Therefore, the steeper the aggregate supply curve, the less impact a shift of
the aggregate demand curve will have on real GDP and the greater the impact on price levels. If the
economy is already at the natural rate of unemployment, any change in fiscal policy will affect the price
level, but not real output.
3. (Automatic Stabilizers) Often during recessions, the number of young people who volunteer for military
service increases. Could this rise be considered a type of automatic stabilizer? Why or why not?
The increase in the number of volunteers during recession is caused by the increase in unemployment.
To the extent that unemployed individuals join the armed services, the unemployment rate will fall. Since
the entry into the armed forces of individuals who would otherwise be unemployed has the effect of
boosting aggregate demand and, in the process, helping to cure a recession, this does act as an
automatic stabilizer.
4. (Permanent Income) “If the federal government wants to stimulate consumption by means of a tax cut, it
should employ a permanent tax cut. If the government wants to stimulate saving in the short run, it
should employ a temporary tax cut.” Evaluate this statement.
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Chapter 12
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This argument is an interesting application of the theory of permanent income. If consumers believe that
the tax cut will be long lasting, they will increase their spending. If, on the other hand, they suspect that
the tax cut will be of only a year’s duration, consumption will not be affected as much. If consumers do
not spend their tax cut, they will save it.
5. (Fiscal Policy) Explain why effective discretionary fiscal policy requires information about each of the
following:
a. The slope of the short-run aggregate supply curve
b. The natural rate of unemployment
c. The size of the multiplier
d. The speed with which self-correcting forces operate
This question goes to the heart of the information problems with discretionary policy and hence the basis
of arguments made by many economists against “fine-tuning” the economy.
a. Information about the slope of the aggregate supply curve is required because the steeper the curve,
the greater the price change, and thus the greater the necessary fiscal stimulus.
b. The natural rate of unemployment must be known in order to determine potential GDP and therefore
the size of the output gap.
c. The size of the multiplier must be known in order to determine the extent of the stimulus needed.
d. The speed at which self-correcting forces operate is important because, if self-correction is fast,
policy may be correcting a problem that no longer exists by the time the fiscal stimulus kicks in.
6. (Automatic Stabilizers) Distinguish between discretionary fiscal policy and automatic stabilizers. Provide
examples of automatic stabilizers. What is the impact of automatic stabilizers on disposable income as
the economy moves through the business cycle?
Discretionary fiscal policy refers to deliberate decisions by the government to change government
purchases or net taxes in order to affect employment, prices, and output. Automatic stabilizers require
no government action once they are in place; they generate changes in government purchases and net
taxes automatically as income changes.
Automatic stabilizers include the progressive income tax, unemployment insurance, and welfare benefits.
As the economy moves into recession, the automatic stabilizers work to dampen the drop in disposable
income; taxes fall and transfer payments rise. As the economy moves into expansion, the automatic
stabilizers work to reduce the increases in disposable income; taxes rise and transfer payments fall.
Therefore, the fluctuations in disposable income are smoothed over the business cycle.
7. (Fiscal Policy Effectiveness) Determine whether each of the following would make fiscal policy more
effective or less effective:
a. A decrease in the marginal propensity to consume
b. Shorter lags in the effect of fiscal policy
c. Consumers suddenly becoming more concerned about permanent income than about current income
d. More accurate measurement of the natural rate of unemployment
a.
b.
c.
d.
Less effective
More effective
More effective
More effective
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Chapter 12
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8. (From Deficits to Surpluses to Deficits) What effect did the financial crisis of 2008 have on the federal
budget deficit?
The financial crisis and the subsequent recession caused decreases in federal tax revenues. In addition,
the Congress and the President passed tax cuts and increased spending in an attempt to stimulate the
economy. The net result was a great increase in the federal deficit from $161 billion in 2007 to $459
billion in 2008 to $1.4 trillion in 2009. Equally high deficits were projected for 2010 and 2011.
ANSWERS TO ONLINE CASE STUDIES
1.
(CaseStudy: Fiscal Policy and Presidential Elections) Suppose that fiscal policy changes output faster
than it changes the price level. How might such timing play a role in the theory of political business
cycles?
During election years, there may be an expansionary bias to fiscal policy because the benefits (to the
electorate) will accrue more rapidly than the costs. This increases the likelihood of a political business
cycle in which incumbent presidents stimulate the economy during election years. A reduction in
unemployment and an increase in output increase the incumbent’s chances for reelection. Inflation
would reduce those chances, but price level changes would more likely show up after the election.
2.
(CaseStudy: Cash for Clunkers) Studies suggest that the Cash for Clunkers only shifted sales to August
2009 from later in the year. Assuming that this is true, what was the spending multiplier for the Cash for
Clunkers program?
If government spending on the Cash for Clunkers program led to a zero increase in GDP, then the
spending multiplier must have been zero. At the best, the spending multiplier might have been greater
than zero but less than one.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.