Download Fiscal Policy

Principles of Economics:
Macroeconomics - Econ101
Fiscal Policy
Chapter 11
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
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
11-2
Fiscal Policy
• Fiscal policy: The use of government taxes
and spending to alter macroeconomic
outcomes
• The federal budget is a tool that can shift
aggregate demand and thereby alter
macroeconomic outcomes
11-3
Fiscal Stimulus
• Suppose the economy is experiencing a
recessionary GDP gap of $400 billion
• From a Keynesian perspective, the solution is
to get someone to spend more on goods and
services
11-4
The Policy Goal
AS
Price Level
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
11-5
Keynesian Strategy
• Fiscal stimulus: Tax cuts or spending hikes
intended to increase (shift) aggregate demand
• Two strategic policy questions:
– By how much do we want to shift the AD curve to
the right?
– How can we induce the desired shift?
11-6
The Naive Keynesian Model
• An increase in AD by $400 billion will achieve
full employment only if AS curve is horizontal
• Assumption of a horizontal AS curve seems
naïve today
• Although not every AD shift will raise prices,
inflationary pressures increase as AD expands
11-7
The AD Shortfall
• So long as the AS curve slopes upward, AD
must increase by more than the size of the
recessionary gap to achieve full employment
• AD shortfall: The amount of additional
aggregate demand needed to achieve full
employment after allowing for price-level
changes
11-8
The AD Shortfall
AS
AD3
Price Level
AD2
d
AD1
c
a
PE
b
e
Recessionary
GDP gap
AD shortfall
QE = 5.6
QF = 6.0
Real GDP
6.4
The AD shortfall is the fiscal policy target for achieving full employment.
11-9
More Government Spending
• Increased government spending is a form of
fiscal stimulus
• Every dollar of new government spending has
a multiplied impact on aggregate demand
• How much of a boost the economy gets
depends on the value of the multiplier
11-10
Fiscal Restraint
• At times the economy is expanding too fast
and fiscal restraint is more appropriate
• Inflationary GDP gap: The amount by which
equilibrium GDP exceeds full-employment
• Fiscal restraint: Tax hikes or spending cuts
intended to reduce (shift) aggregate demand
11-11
The Fiscal Target
• AD excess: The amount by which aggregate
demand must be reduced to achieve fullemployment equilibrium after allowing for
price-level changes
• The AD excess exceeds the inflationary GDP
gap
11-12
Multiplier Effects
• Impact of fiscal stimulus on aggregate demand
includes both the new government spending
and all subsequent increases in consumer
spending triggered by multiplier effects
Total change
new spending
 multiplier 
in spending
injection
11-13
Multiplier Effects
new spending
Cumulative increase
induced increase

injection

(horizontal shift ) in AD
in consumption
( fiscal stimulus )
fiscal stimulus
 multiplier 
(new spending injection)
• The second equation is identical to the first but
expressed in the terminology of fiscal policy
11-14
Multiplier Effects
Price Level
Direct impact of rise in
government spending
+ $200 billion
P1
Indirect impact via
increased consumption
+ $600 billion
a
b
AD2
Current
price level
AD3
AD1
5.6
QE
5.8
6.4
Real GDP
11-15
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
11-16
Fiscal Guidelines
• The essence of fiscal policy is the deliberate
shifting of the aggregate demand curve
• Steps required to formulate fiscal policy:
– Specify the amount of the desired AD shift
– Select the policy tools needed to induce the desired
shift
11-17
Weak Economy: Fiscal Stimulus
AD shortfall
Desired fiscal stimulus 
the multiplier
Policy Tools
Increase government
purchases
Amount
desired fiscal stimulus
Cut taxes
desired fiscal stimulus
MPC
Increased transfers
desired fiscal stimulus
MPC
11-18
Overheated Economy: Fiscal Restraint
excess AD
Desired fiscal restraint 
the multiplier
Policy Tools
Reduce government
purchases
Amount
desired fiscal restraint
Increase taxes
desired fiscal restraint
MPC
Reduce transfers
desired fiscal restraint
MPC
11-19
A Warning: Crowding Out
• Some of the intended fiscal stimulus may be
offset by the crowding out of private
expenditure
• Crowding out: A reduction in private-sector
borrowing (and spending) caused by increased
government borrowing
11-20