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End of
ECON 151 – PRINCIPLES
OF MACROECONOMICS
Chapter
10
Chapter 13: Fiscal Policy
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
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1
Discretionary Fiscal Policy

Discretionary Fiscal Policy
 The
discretionary changes in government
expenditures and/or taxes in order to achieve certain
national economic goals is the realm of fiscal policy.

High employment (low unemployment)

Price stability

Economic growth

Improvement of international payments balance
Discretionary Fiscal Policy
(cont'd)

Fiscal Policy
 The
discretionary changing of government
expenditures or taxes to achieve national
economic goals, such as high employment
with price stability
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
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)

Change in taxes
A
rise in taxes causes a reduction in
aggregate demand because it can reduce
consumption spending, investment
expenditures, and net exports.
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
Expansionary policy causing
deficit spending initially shifts
from AD1 to AD2
Due to crowding out,
AD shifts inward to AD3
Equilibrium GDP
below full-employment
GDP—recessionary gap
Possible Offsets to Fiscal Policy (cont'd)

Planning for the future:
the Ricardian equivalence theorem
 Ricardian

The proposition that an increase in the government
budget deficit has no effect on aggregate demand
 The

Equivalence Theorem
reason for the offset
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 Economics
 The
suggestion that creating incentives for
individuals and firms to increase productivity
will cause the aggregate supply curve to shift
outward
Figure 13-5 Laffer Curve
Tax rates and
tax revenues
rise together
Tax revenues
are at a maximum
Tax rates and tax
revenues fall
together
Discretionary Fiscal Policy in Practice:
Coping with Time Lags
 Recognition

The time required to gather information about the
current state of the economy
 Action

Time Lag
The time required between recognizing an
economic problem and putting policy into effect
 Effect

Time Lag
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 and a policy designed to
correct a recession may not produce results until the
economy is experiencing inflation.

Fiscal policy time lags are variable in length (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
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.
End of
ECON 151 – PRINCIPLES
OF MACROECONOMICS
Chapter
10
Chapter 13: Fiscal Policy
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
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