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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. 11-11 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.