Download Ch. 11 Fiscal Policy

Fiscal Policy
Ch. 11
•In this chapter we examine fiscal policy
tools.
•Core issues are
1) Can government spending and tax
policies ensure full employment?
2) What policy actions will help fight
inflation?
3) What are the risks of government
intervention?
Fiscal Policy
•
John Maynard Keynes (1883 – 1846):
British Economist. Considered the founder
of modern macroeconomics. One of the
most influential economists of the 20th
century
• Keynes believed the level of economic
activity is realized in aggregate demand
• The Keynesian theory of macro instability
practically mandates government
intervention.
– If AD is too little, unemployment
arises.
– If AD is too much, inflation arises.
•
If the market cannot correct these
imbalances, then the federal government
must.
• Fiscal policy: the use of government taxes
and spending to alter macroeconomic
outcomes.
Taxes and Spending
• The federal government collects nearly $3
trillion a year in tax revenues, nearly half of
which comes from individual income taxes.
• Less than half of government expenditures go
to government purchases of goods and
services.
• The rest are income transfers – payments to
individuals for which no current goods or
services are exchanged.
Fiscal Policy’s Influence
*These tax and spending powers can greatly influence AD.
(Keynesian Economists)
• Government can alter AD by
– Purchasing more or fewer goods and services.
– Raising or lowering taxes.
– Changing the level of income transfers.
Fiscal Policy Goals:
• First, we will explore fiscal policy’s potential to ensure full
employment.
• Second, we will explore fiscal policy’s potential to maintain
price stability.
*Fiscal Stimulus
• Keynesian economists
perceive the way out of a
recession is to increase
consumer spending
• If a recessionary GDP gap
exists, a fiscal stimulus could
shift the economy to fullemployment GDP.
• Fiscal stimulus: tax cuts or
spending hikes intended to
increase AD – that is, shift
AD right.
• AS slopes upward, so an AD
shift right will induce price
level increases
The AD Shortfall
• The fiscal stimulus needed to
close the GDP gap must be
larger than the gap.
*recessionary GDP gap differ
from AD shortfall when the
AS curve slopes upwards
• AD shortfall: the amount of
additional AD needed to
achieve full employment after
allowing for price level
changes.
– It is represented by the
distance between point a
and point e.
– It becomes the fiscal
target.
Using Government Spending
• Increased government spending is a form of
fiscal stimulus.
• All new government spending will have a
multiplied impact on AD.
• The multiplier effect will stimulate additional
rounds of increased consumer spending.
*The multiplier x fiscal stimulus
Horizontal shift in AD = Fiscal stimulus + Induced increases
in consumption
= Multiplier X Fiscal stimulus
Desired Fiscal Stimulus
• Too little fiscal stimulus? The economy may
stay in recession.
• Too much fiscal stimulus? This may rapidly
lead to excessive spending and inflation.
• We can use this formula to estimate how
much fiscal stimulus is needed:
AD shortfall
*Desired fiscal stimulus =
Multiplier
Tax Cuts
• The fiscal stimulus can come from inducing
increased autonomous consumption or
investment spending.
• Government can do this by lowering taxes.
– Individual income tax cut: disposable
income would increase, causing increased
consumption spending.
– Corporate tax cut: profits would increase,
spurring increased investment spending.
Tax Cuts
• A tax cut adds no more dollars to the
economy. It allows earners to keep more of
their current pretax income.
• How much additional consumer spending is
controlled by the size of MPC.
Initial increase in consumption = MPC X Tax cut
Cumulative change
in spending
=
Initial change in
Multiplier X consumption
Tax Cuts & Income Transfers
Tax Cuts
* Since there is no initial new input of spending, a tax cut
contains less fiscal stimulus than a government
spending increase of the same size.
• The initial spending injection can be less than the size
of the tax cut.
Income Transfers
• Increasing transfer payments raises recipients’
disposable income, and spending increases.
• The effect is much like a tax cut since the recipients will
save some of the payment.
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Balanced Budget Multiplier
• Spending increases raise expenditures (G), and
tax cuts decrease revenues (T); therefore, the
budget deficit increases.
• If the increase in G and the decrease in T are the
same size, the deficit would not grow.
• How would this affect AD?
– Since the effect of a change in G is greater than the
effect of a change in T, AD would shift by the size of
the change.
– The balanced budget multiplier, therefore, equals 1.
Fiscal Guidelines
• The goal of fiscal policy is to eliminate GDP gaps
by shifting AD.
• How much to shift is indicated by the AD shortfall
or the AD excess.
• The size of the fiscal initiative is equal to the
desired shift divided by the multiplier.
*The government should not increase spending by
the entire AD shortfall = inflationary gap
• What remains is to decide which policy tool to
use.
Fiscal Restraint
• If an inflationary GDP gap
exists, a fiscal restraint
could be used to return the
economy to fullemployment GDP.
• Fiscal restraint: tax hikes
or spending cuts intended
to decrease AD – that is,
shift AD left.
• AS slopes upward, so an
AD shift left will induce
price level decreases
*Keynesians would
recommend to rise taxes
if there is an excess in
AD
Crowding Out
*Crowding out: a reduction in private sector
borrowing (and spending) caused by increased
government borrowing.
– A fiscal stimulus would most likely be financed by
government borrowing.
– Less credit becomes available to the private sector,
which must reduce its borrowing and spending.
– This private sector spending reduction offsets the
government spending, reducing the impact of the
fiscal stimulus.