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Chapter 13
Fiscal Policy
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
When U.S. economic activity began to weaken in early
2008, the U.S. government gave lower- and middleincome households one-time payments called tax
rebates.
During the depths of the Great Recession in 2009, the
government authorized another round of tax rebates.
Why and how does the U.S. government sometimes
seek to influence economic activity by varying
expenditures and tax receipts?
Reading this chapter will help you answer this
questions.
Learning Objectives
• Use traditional Keynesian analysis to evaluate the effects of
discretionary fiscal policy
• Discuss ways in which indirect crowding out and direct
expenditure offsets can reduce the effectiveness of fiscal
policy actions
• Explain why the Ricardian equivalence theorem calls into
question the usefulness of tax changes
Learning Objectives (cont'd)
• List and define fiscal policy time lags and
explain why they complicate efforts to engage
in fiscal “fine tuning”
• Describe how certain aspects of fiscal policy
function as automatic stabilizers for the
country
Chapter Outline
• Discretionary Fiscal Policy
• Possible Offsets to Fiscal Policy
• Discretionary Fiscal Policy in Practice: Coping
with Time Lags
• Automatic Stabilizers
• What Do We Really Know About Fiscal Policy?
Did You Know That ...
• A massive fiscal stimulus package approved by the U.S.
Congress in early 2009 allocated nearly $600 billion directly to
state governments during 2009 and 2010?
• In this chapter, you will learn about how variations in government
spending and taxes affect real GDP and the price level.
Discretionary Fiscal Policy
• Fiscal Policy
– The discretionary changing of government
expenditures or taxes in order to achieve national
economic goals, such as:
• High employment (low unemployment)
• Price stability
• Economic growth
Discretionary Fiscal Policy (cont'd)
• An increase in government spending will
stimulate economic activity
• Changes in government spending:
– Military spending
– Education spending
– Budgets for government agencies
Figure 13-1 Expansionary and Contractionary Fiscal Policy:
Changes in Government Spending, Panel (a)
If there is a recessionary gap
in panel (a), fiscal policy can
presumably increase
aggregate demand
Figure 13-1 Expansionary and Contractionary Fiscal Policy:
Changes in Government Spending, Panel (b)
If there is an inflationary gap,
fiscal policy can presumably
decrease aggregate demand
Discretionary Fiscal Policy (cont'd)
• Questions
– Would the increase in government spending equal
the size of the gap?
– What impact would expansionary fiscal policy
have on the price level?
Why Not … end our economic troubles by borrowing to finance
additional discretionary government spending?
• Almost all of the federal government’s revenues go toward
funding nondiscretionary programs such as Social Security,
Medicare, and Medicaid.
• Thus, since 2009, on average, the federal government has had
to borrow more than 90 cents of every single dollar that it has
committed to discretionary spending intended to stimulate
economic activity.
Discretionary Fiscal Policy (cont'd)
• Change in taxes
– A rise in taxes causes a reduction in aggregate
demand because it can reduce consumption
spending, investment expenditures, and net
exports
Figure 13-2 Contractionary and Expansionary Fiscal Policy:
Changes in Taxes, Panel (a)
• In panel (a), the economy is
initially at E1, where real GDP
exceeds long-run equilibrium
• Contractionary fiscal policy can
move aggregate demand to
AD2 via a tax increase
• A new equilibrium is at E2 at a
lower price level
• Real GDP is now consistent
with LRAS
Figure 13-2 Contractionary and Expansionary Fiscal Policy:
Changes in Taxes, Panel (b)
• In panel (b) with a
recessionary gap (in this case
$500 billion) taxes are cut
• AD1 moves to AD2
• The economy moves from E1
to E2, and real GDP is now at
$12 trillion per year
• We are at the long-run
equilibrium level
Discretionary Fiscal Policy (cont'd)
• Question
– What would be the long-run impact of a tax cut on
real GDP if the economy is at full-employment
equilibrium?
Possible Offsets to Fiscal Policy
• Fiscal policy does not operate in a vacuum and
important questions must be answered
– How are expenditures financed and by whom?
– If taxes are increased what does government do
with the taxes?
– What will happen if individuals worry about
increases in future taxes?
Possible Offsets to Fiscal Policy (cont'd)
• Crowding-out effect
– The tendency of expansionary fiscal policy to
cause a decrease in planned investment or
planned consumption in the private sector
– This decrease normally results from the rise of
interest rates
Figure 13-3 The Crowding-Out Effect,
Step by Step
Figure 13-4 The Crowding-Out Effect
Due to crowding out, AD shifts inward to AD3
Possible Offsets to Fiscal Policy (cont'd)
• Ricardian Equivalence Theorem
– The proposition that an increase in the
government budget deficit has no effect on
aggregate demand
– Reason: people anticipate that a larger deficit
today will mean higher taxes in the future and
adjust their spending accordingly
Possible Offsets to Fiscal Policy (cont'd)
• Direct Expenditure Offsets
– Actions on the part of the private sector in
spending income that offset government fiscal
policy actions
– Any increase in government spending in an area
that competes with the private sector will have
some direct expenditure offset
Possible Offsets to Fiscal Policy (cont'd)
• The supply-side effects of changes in taxes
– Expansionary fiscal policy could involve reducing
marginal tax rates
• Advocates argue this increases productivity since
individuals will work harder and longer, save more, and
invest more
• The increased productivity will lead to more economic
growth
Possible Offsets to Fiscal Policy (cont'd)
• Supply-side effects of changes in taxes
– Lower tax rates lead to an increase in productivity
because individuals will work harder and longer,
save more, and invest more
– Increased productivity will in turn lead to more
economic growth, thus higher real GDP
– Results: Lower marginal tax rates will not
necessarily reduce tax revenues due to a larger tax
base
Figure 13-5 Laffer Curve
Policy Example: Which Affects Real GDP More—Spending or Tax
Cuts?
• Several economists have found that discretionary increases in
government spending have significantly smaller effects on real GDP
than do discretionary tax cuts:
– Each $1 in real government purchases generates a net
increase in real GDP of only about $0.70
– Each $1 tax cut brings about an increase in real GDP
somewhere between $1.40 and $3.00
Discretionary Fiscal Policy in Practice: Coping with Time
Lags
• Question
– Is the conduct of fiscal policy as precise as it
appears?
• Answer
– The difficulty is that the conduct of fiscal policy
involves a variety of lags.
Discretionary Fiscal Policy in Practice: Coping with Time Lags
(cont'd)
• Time lags
– Recognition Time Lag
• The time required to gather information about the
current state of the economy
Discretionary Fiscal Policy in Practice: Coping with Time Lags
(cont'd)
• Time lags
– Action Time Lag
• The time required between recognizing an economic
problem and putting policy into effect
– Particularly long for fiscal policy which requires congressional
approval
Discretionary Fiscal Policy in Practice: Coping with Time Lags
(cont'd)
• Time lags
– Effect Time Lag
• The time it takes for a fiscal policy to affect the
economy
Discretionary Fiscal Policy in Practice: Coping with Time Lags
(cont'd)
• Fiscal policy time lags are:
– Long – a policy designed to correct a recession
may not produce results until the economy is
experiencing inflation
– Variable in length – they can be from 1-3 years,
and the timing of the desired effect cannot be
predicted
• Because fiscal policy time lags tend to be variable,
policymakers have a difficult time fine-tuning the
economy
Automatic Stabilizers
• Automatic or Built-In Stabilizers
– Changes in government spending and taxation
that occur automatically without deliberate action
of Congress
• The tax system
• Unemployment compensation
• Welfare spending
Automatic Stabilizers (cont’d)
• The Tax System
– Incomes and profits fall when business activity
slows down, and the government’s tax revenues
drop as well
– Some economists consider this an automatic tax
cut, which therefore stimulates aggregate demand
Automatic Stabilizers (cont’d)
• Unemployment Compensation and Income
Transfer Payments
– Unemployment compensation reduces changes in
people’s disposable income. Their disposable
income remains positive, although at a lower level
– In a recession, more people are eligible for income
transfer payments and do not experience as
dramatic a drop in disposable income
Automatic Stabilizers (cont’d)
• Stabilizing Impact
– The key impact of these systems is the ability to
mitigate changes in disposable income,
consumption, and the equilibrium level of GDP
– If disposable income is prevented from falling as
much as it otherwise would in a recession, the
downturn will be moderated
Figure 13-6 Automatic Stabilizers
The automatic changes
tend to drive the economy
back toward its fullemployment output level
What Do We Really Know About Fiscal
Policy?
• Fiscal policy during normal times
– Congress ends up doing too little too late to help
in a minor recession
– Fiscal policy that generates repeated tax changes
(as has happened) creates uncertainty
What Do We Really Know About Fiscal
Policy? (cont'd)
• Fiscal policy during abnormal times
– Fiscal policy can be effective
• The Great Depression—fiscal policy may be able to
stimulate aggregate demand
• Wartime—during World War II real GDP increased
dramatically
What Do We Really Know About Fiscal
Policy? (cont'd)
• The “soothing” effect of Keynesian fiscal policy
– Should we encounter a severe downturn, fiscal
policy is available
• Knowing this may reassure consumers and investors
– Stable expectations encourage a smoothing of investment
spending
You Are There: Raising Tax Rates While Emerging from a Severe
Recession
• In 2010, White House Budget Director Peter Orszag
anticipated that the government’s tax revenues would fall
short of its spending every year for the rest of the 2010s.
• Orszag also viewed that the only way to bring revenues and
spending back into closer balance was to raise federal tax
rates.
• He hoped that increased annual government spending would
stimulate the economy sufficiently to make up for the
contractionary effects of these higher tax rates.
Issues & Applications: Temporary Tax Rebates Prove to Be
Nonstimulating
• Figure 13-7 shows that real disposable income rose after the
one-time tax rebates in 2008 and 2009 but real consumption
expenditure did not.
Figure 13-7 U.S. Real Disposable Personal Income and Real
Personal Consumption Expenditures since January 2007
Issues & Applications: Temporary Tax Rebates Prove to Be
Nonstimulating (cont’d)
• Possible explanations:
– Many people who received the rebates used them to pay off debts
instead of spending the funds on goods and services
– The government financed the rebates by borrowing, so a number of
households responded by saving them (the Ricardian equivalence
theorem)
– The tax rebates were temporary lump sums, not permanent
reductions in income tax rates (supply-side economics)
Summary Discussion of Learning
Objectives
• The effects of discretionary fiscal policy using
traditional Keynesian analysis
– Increases in government spending and decreases
in taxes increase aggregate demand
– Decreases in government spending and increases
in taxes decrease aggregate demand
Summary Discussion of Learning
Objectives (cont'd)
• How indirect crowding out and direct
expenditure offsets can reduce the
effectiveness of fiscal policy actions
– Deficits increase interest rates
– Some government spending replaces private
spending
• If the Ricardian equivalence theorem is valid, a
tax cut has no effect on total planned
expenditures and aggregate demand
Summary Discussion of Learning
Objectives (cont'd)
• Fiscal policy time lags and the effectiveness of
fiscal “fine tuning”
– The time lags for fiscal policy are the recognition
time lag, action time lag, and the effect time lag
– The time lags are long and variable
• Automatic stabilizers are changes in tax
payments, unemployment compensation, and
welfare payments that automatically change
with the level of economic activity
Appendix D: Fiscal Policy: A Keynesian Perspective
• The traditional Keynesian approach to fiscal policy differs in
three ways from that presented in Chapter 13:
– It emphasizes the underpinnings of the components of aggregate
demand
– It assumes that government expenditures are not substitutes for
private expenditures and that current taxes are the only taxes taken
into account by consumers and firms
– It focuses on the short run and so assumes that as a first
approximation, the price level is constant
Figure D-1 The Impact of Higher Government Spending on
Aggregate Demand
Figure D-2 The Impact of Higher Taxes on Aggregate
Demand
Appendix D: The Balanced-Budget Multiplier
• Balanced-budget increase in real spending
– The government increases spending by $1 and
pays for it by raising current taxes by $1
• Balanced-budget multiplier is equal to 1