Download No Slide Title

The
President
Congress
BUDGET
Taxes
Spending
Fiscal
Policy
Fiscal Policy
• A tool of macroeconomic policy that seeks to
influence the level of economic activity
through control of government expenditure
and taxation.
• There are two types of fiscal policy:
– Automatic Stabilizers
– Discretionary Policy
Fiscal Policy: Automatic Stabilizers
• Automatic stabilizers
– Built in, non-discretionary elements in fiscal
policy that serve to reduce the impact of economic
events automatically. For example,
• A fall in output and national income reduces tax burdens
as income falls and increases unemployment and
welfare payments.
– Lower tax payments and higher transfer payments increase the
government’s budget deficit and restore some of the income
lost by people.
Fiscal Policy: Discretionary Policy
• Discretionary Fiscal Policy
– Expansionary Fiscal Policy
• Decreases in taxes and/or increases in spending which
tend to increase economic activity.
– Contractionary Fiscal Policy
• Increases in taxes and/or decreases in spending which
tend to dampen economic activity.
Fiscal Policy: Demand Side
Transmission Mechanism
Government
Spending
Rises
Interest Rates
Rise
Deficit
Increases
Aggregate
Spending
Increases
Export
Spending is
Crowded Out
Imports Rise
Exports Fall
Taxes
Decrease
Price Level
Rises
Expansionary Fiscal Policy
Investment
Spending is
Crowded Out
Spending
Decreases
AE
AS
2
AE2(P1)
AE3(P2)
AE1(P1)
3
Y1
Y2
AS*
P1
Y3
Y
AS
2
The rising price level causes AE2 to
AD2 shift down to AE3. Equilibrium is
established at Y2 and P2.
1
AD1
0
Y1
Y2
Aggregate demand shifts from AD1 to
AD2.
At point 2, AD > AS*. As the price
level rises, AD decreases along the
aggregate demand curve.
3
P2
To close the gap, the government
engages in expansionary fiscal policy.
The increase in government spending
and/or decrease in taxes causes
aggregate expenditures to increase
from AE1 to AE2.
1
0
P
We begin at Y1, where AD< AS*. The
economy is in a recessionary gap.
Y3
Y
Fiscal Policy: Demand Side
Transmission Mechanism
Investment
Spending Rises
Government
Spending
Falls
Interest Rates
Fall
Deficit
Decreases
Aggregate
Spending
Decreases
Imports Fall
Exports Rise
Taxes
Increase
Price Level
Falls
Contractionary Fiscal Policy
Export
Spending
Rises
Spending
Increases
AE
AS
1
AE1(P1)
AE3(P2)
AE2(P1)
3
P1
Y1
Y2
Y3
Y
Aggregate expenditures decrease from
AE1(P1) to AE2 (P1).
AS
At point 2, AS* > AD. As the price
level falls, AD increases along the
aggregate demand curve.
AS*r
2
1
3
P2
AD2
0
To close the gap, the government
engages in contractionary fiscal policy.
The decrease in government spending
and/or increase in taxes causes
aggregate demand to shift from AD1 to
AD2.
2
0
P
We begin at Y3, where AD> AS*. The
economy is in an inflationary gap.
Y1
Y2
Y3
Y
The falling price level causes AE2(P1)
AD1 to shift up to AE3(P2). Equilibrium is
established at Y2 and P2.
Demand-Side Fiscal Policy Problems
• Expansionary fiscal policy can be used to push
the economy to a higher level of output, but it
also results in a higher price level.
• Fiscal policy actions often miss the target.
– We have only estimates of the size of the
multiplier.
• Fiscal policy actions often are timed poorly.
• Fiscal policy affects GDP with a lag.
• Fiscal policy can get mired down in politics.
Fiscal Policy: Supply Side
Transmission Mechanism
Inflation Falls
Unemployment Falls
After-tax Wage
Higher
Increase in
Labor Supply
Savings Rise
Interest Rates
Fall
After-tax ROR
Rises
Investment Rises
Aggregate Supply
Rises
Lower Personal
Tax Rates
Lower Business
Tax Rates
Productivity
Rises
Fiscal Policy: Supply Side
• Expansionary Fiscal Policy
– The federal government decreases taxes.
• People work more: People save more: Firms invest
more.
• Aggregate supply increases, unemployment falls,
inflation falls.
Tax Cuts: Labor Supply
• The decrease in marginal income tax rates
encourages people to work more.
– People are willing to work more because they now
keep more of their wages.
• More specifically, they get to keep more of the last
dollar earned.
– Therefore, the increased labor supply increases
output without putting upward pressure on wages.
Tax Cuts: Saving and Investment
• Business tax cuts increase business profits.
– Higher profits encourage investment in new
capital.
• Individual tax cuts stimulate household
savings.
– Increased savings contribute to lower interest rates
and increased investment in new capital.
• New capital increases productivity, thus,
lowering costs and inflationary pressures.
Fiscal Policy: Supply Side
• Contractionary Fiscal Policy
– The federal government increases taxes.
• People work less: People save less: Firms invest less.
• Aggregate supply decreases, unemployment rises,
inflation rises.
Supply Side Fiscal Policy
P
P1
P2
1
2
AS2 AS1
P
AS1 AS2
P2
P1
2
1
AD1
AD1
0
Y1 Y2
Expansionary
Y 0
Y2 Y1
Contractionary
Y
Supply-Side Fiscal Policy Problems
• Small Magnitude of the Supply-side Effects.
– Savings do not appear to respond to tax incentives.
• Demand Side Effects.
– People respond to tax cuts by spending more.
They may or may not respond by working more.
• Timing Problems
– The impact of increases in investment spending
occur much later as industrial capacity increases
Supply-Side Fiscal Policy Problems
• Effect on Income Distribution
– Supply-side tax cuts favor the wealthy
• Tax Cuts Increase the Budget Deficit
– But, so do demand-side tax cuts.
Are Deficits Bad?
• When the government runs a deficit, it must
borrow.
– The borrowing tends to cause interest rates to be
higher than they otherwise would be.
• Interest sensitive spending that occurs in the private
sector declines while government spending increases.
Are Deficits Bad?
• Government budget deficits are said to..
–
–
–
–
Reduce national saving
Create a flow of assets overseas
Slow rate of capital accumulation
Redistribute income and wealth
Output Effects of Deficits
• An economy’s output is determined by its
productive capacity.
• Productive capacity is determined in part by
the stock of capital.
• If deficits crowd out investment, the capital
stock grows more slowly.
• Over a decade or more, the economy’s
capacity to produce can be reduced.
• National income rises more slowly.
Wealth Effects of Deficits
• When foreigners increase their ownership of
domestic assets, more income from production
flows overseas in the form of rent, interest and
profits.
• National income may continue to rise, but the
amount that the citizens of the country actually
keep falls.
Wages and Profits and Deficits
• If deficits crowd out investment and
result in a smaller amount of available
capital, labor productivity and real
wages will fall.
• The productivity of capital and its
return, however, will rise.
Economists and the Balanced
Budget Amendment
• Most economists do not support a balanced
budget amendment because:
– Forecasting deficits requires an impossible degree
of accuracy.
– It is bad public policy to balance the budget in
every year. The budget should be balanced over
the business cycle.
• Deficits in recession cushion the economy
• Surplus in inflation cool off the economy
Economists and the Balanced
Budget Amendment
– Annual balancing would increase economic
instability and investor uncertainty adding to the
problem rather than fixing it.
– Distort budget policy causing a permanent
preference for spending cuts over tax increases.
– Preclude the development of capital budgeting
procedures.
– Give rise to inappropriate uses of government
mandates, regulations, tax breaks, and new forms
of “off-budget” spending designed to evade
restrictions on taxing and spending.
Economists and the Balanced
Budget Amendment
– Make international coordination of economic
policies more difficult.
– Postpone the day of reckoning until after
ratification of the amendment.
– Decrease the flexibility of economic policy
because the amendment would involve the courts,
whose function it is to interpret the Constitution.