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Fiscal Policy
Chapter 11
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies,
All Rights Reserved
Taxes and Spending
In 1902, the federal government
employed fewer than 350,000 people
and spent about $650 million.
Today, the federal government
employs over 4 million and spends
roughly $3 trillion a year.
2
Government Revenue
Government expansion started with
the 16th Amendment to the U.S.
Constitution (1913) which extended
the taxing power to incomes.
Today, the federal government
collects nearly $3 trillion a year in
taxes.
3
Government Expenditure
Government spending directly
affects aggregate demand.
Aggregate demand is the total quantity
of output demanded at alternative price
levels in a given time period, ceteris
paribus.
4
Purchases vs. Transfers
Income transfers are payments to
individuals for which no current goods
or services are exchanged.
Government purchases are part of
aggregate demand, income transfers
are not.
5
Fiscal Policy
The federal government can alter
aggregate demand by:
Purchasing more or fewer goods and
services.
Raising or lowering taxes.
Changing the level of income transfers.
6
Fiscal Policy
The federal budget is a tool that can
shift aggregate demand and thereby
alter macroeconomic outcomes.
Fiscal policy is the use of
government taxes and spending to
alter macroeconomic outcomes.
7
Fiscal Policy
DETERMINANTS
Internal market
forces
OUTCOMES
AS
Output
Jobs
Prices
External
shocks
Growth
Policy levers:
Fiscal policy
AD
International
balances
8
Fiscal Stimulus
Suppose the economy is
experiencing a recessionary GDP
gap of $400 billion.
The recessionary GDP gap is the
difference between full-employment
GDP and equilibrium GDP.
9
Price Level (average price)
The Policy Goal
AS
Full-employment GDP
AD1
a
PE
b
The goal is to
close GDP gaps
GDP Equilibrium
GDP gap
QE = 5.6
6.0 = QF
Real GDP (trillions of dollars per year)
10
Keynesian Strategy
From a Keynesian perspective, the
way out of recession is to get
someone to spend more on goods
and services.
A fiscal stimulus is tax cuts or
spending hikes intended to increase
(shift) aggregate demand.
11
Keynesian Strategy
Two strategic policy questions must
be answered:
By how much do we want to shift the AD
curve to the right?
How can we induce the desired shift?
12
The Fiscal Target
If GDP gap is $400 billion, why not
just increase AD by that much?
13
The Naive Keynesian Model
In the naive Keynesian model an
increase in AD by $400 billion will
achieve full employment.
This is only possible if the aggregate
supply curve is horizontal.
Aggregate supply is the total quantity
of output producers are willing to supply
at alternative price levels in a given time
period, ceteris paribus.
14
Price Level Changes
When the AD curve shifts to the right,
the economy moves up the AS curve,
not horizontally to the right.
Both real output and prices change.
15
Price Level Changes
Shifting (increasing) aggregate
demand by the amount of the GDP
gap will achieve full employment only
if the price level doesn’t rise.
16
The AD Shortfall
So long as the AS curve slopes
upward, AD must increase by more
than the size of the recessionary
GDP gap to achieve full employment.
LO1
17
The AD Shortfall
The AD shortfall is the fiscal target.
The AD shortfall is the amount of
additional aggregate demand needed
to achieve full employment after
allowing for price level changes.
LO1
18
Price Level (average price)
The AD Shortfall
AS
AD3
AD2
d
AD1
c
a
PE
b
e
Recessionary
GDP gap
AD shortfall
QE = 5.6
QF = 6.0
6.4
Real GDP (trillions of dollars per year)
LO1
19
More Government Spending
Increased government spending is a
form of fiscal stimulus.
LO3
20
Multiplier Effects
Every dollar of new government
spending has a multiplied impact on
aggregate demand.
LO3
21
Multiplier Effects
How much of a boost the economy
gets depends on the value of the
multiplier.
The multiplier is the multiple by which
an initial change in aggregate spending
will alter total expenditure after an
infinite number of spending cycles.
LO3
22
Multiplier Effects
The total spending change equals the
multiplier times the new spending
injections.
Total change
new spending
 multiplier 
in spending
injection
LO3
23
Multiplier Effects
The impact of fiscal stimulus on
aggregate demand includes:
The new government spending, plus
All subsequent increases in consumer
spending triggered by multiplier effects.
LO3
24
Multiplier Effects
Cumulative
increase
(horizontal
shift) in AD

new spending
injection (fiscal
stimulus)

fiscal stimulus
multiplier X (new spending
injection)
+
induced
increase in
consumption
The second equation is identical to the first
but expressed in the terminology of fiscal
policy.
LO3
25
Price Level (average price)
Multiplier Effects
Direct impact of rise
in government
spending + $200
billion
P1
Indirect impact via
increased consumption
+ $600 billion
a
b
AD1
5.6
QE
LO3
5.8
AD2
Current
price level
AD3
6.4
Real GDP
($ trillions per year)
26
The Desired Stimulus
The general formula for computing
the desired stimulus is a simple
rearrangement of the earlier formula:
AD shortfall
Desired fiscal stimulus =
the multiplier
LO3
27
Tax Cuts
By lowering taxes, the government
increases the disposable income of
the private sector.
Disposable income is the after-tax
income of consumers; personal income
less personal taxes.
LO2
28
Taxes and Consumption
Tax cuts directly increase the
disposable income of consumers.
The amount consumption increases
depends on the marginal propensity
to consume.
Initial increase
MPC  tax cut

in consumption
LO2
29
Taxes and Consumption
An AD shortfall can be closed with a
tax cut.
A dollar of tax cut contains less fiscal
stimulus than an increase of
government purchase of the same
size.
Desired fiscal stimulus
Desired tax cut =
MPC
LO2
30
The Tax Cut Multiplier
Tax Cut
First round of spending:
Second round of spending:
More consumption
= MPC X tax cut
More saving
= MPS X tax cut
More income
More saving
More consumption
More income
Third round of spending:
More saving
More consumption
Cumulative change in
saving: = tax cut
LO2
31
Taxes and Investment
A tax cut may also be an effective
mechanism for increasing investment
spending.
Tax cuts have been used numerous
times to stimulate the economy.
LO2
32
Increased Transfers
Increasing transfer payments
stimulates the economy.
The initial fiscal stimulus of increased
transfer payments is:
Initial fiscal
stimulus
(injection)
LO3

MPC X
increase in
transfer
payments
33
Fiscal Restraint
There are times when the economy is
expanding too fast and fiscal restraint
is more appropriate.
Fiscal restraint is using tax hikes or
spending cuts intended to reduce
(shift) aggregate demand.
LO1
34
The Fiscal Target
The AD excess is the amount by
which aggregate demand must be
reduced to achieve price stability
after allowing for price-level changes.
The AD excess exceeds the
inflationary GDP gap.
LO1
35
The Fiscal Target
The first task is to determine how
much AD needs to fall:
desired AD reduction
Desired fiscal restraint =
the multiplier
excess AD
=
the multiplier
LO1
36
Price Level (average price)
Excess Aggregate Demand
AS
PE
f
E1
E2
PF
Inflationary
GDP gap
Excess AD
Q2 = 5.8
QF = 6.0
AD1
AD2
Q1 = 6.2
Real Output (trillions of dollars per year)
LO1
37
Budget Cuts
Budget cuts reduce government
spending and induces cutbacks in
consumer spending.
Cumulative reduction
in spending
LO3

Initial
multiplier X budget cut
38
Tax Hikes
Tax hikes can be used to shift the AD
curve to the left.
The direct effect of tax increases is a
reduction in disposable income.
LO2
39
Tax Hikes
Taxes must be increased more than a
dollar to get a dollar of fiscal restraint.
Desired increase
in taxes
LO2
=
Desired fiscal restraint
MPC
40
Reduced Transfers
A cut in transfer payments works like
a tax hike, reducing the disposable
income of transfer recipients.
The desired reduction in transfers is
the same as a desired tax increase.
LO3
41
Fiscal Guidelines
The essence of fiscal policy is the
deliberate shifting of the aggregate
demand curve.
LO3
42
A Primer: Simple Rules
The steps required to formulate fiscal
policy are:
Specify the amount of the desired AD
shift.
Select the policy tools needed to induce
the desired shift.
LO3
43
Weak Economy:
Fiscal Stimulus
AD shortfall
Desired fiscal stimulus 
the multiplier
Policy Tools
LO3
Amount
Increase government purchases
desired fiscal stimulus
Cut taxes
desired fiscal stimulus
MPC
Increased transfers
desired fiscal stimulus
MPC
44
Overheated Economy:
Fiscal Restraint
Desired fiscal restraint 
Policy Tools
LO3
excess AD
the multiplier
Amount
Reduce government purchases
desired fiscal restraint
Increase taxes
desired fiscal restraint
MPC
Reduce transfers
desired fiscal restraint
MPC
45
A Warning: Crowding Out
Some of the intended fiscal stimulus
may be offset by the crowding out of
private expenditure.
Crowding out is a reduction in
private-sector borrowing (and
spending) caused by increased
government borrowing.
46
Time Lags
It takes time to recognize that a
problem exists and then formulate
policy to address the problem.
The very nature of the macro
problems could change if the
economy is hit with other internal or
external shocks.
47
Pork-Barrel Politics
Members of Congress want their
constituents to get the biggest tax
savings.
They don’t want spending cuts in
their own districts.
They don’t want a tax hike or
spending cut before the election.
48
Fiscal Policy
End of Chapter 11
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies,
All Rights Reserved