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Chapter 12
The Fiscal Policy
Approach to
Stabilization
Learning Objectives
• Describe the relationship between an
individual’s current disposable income and
that individual’s planned consumption.
• List three non-interest-rate-variables whose
changes might influence investment
decisions.
• Describe two ways in which the government
can engage in discretionary fiscal policy.
• Define an automatic stabilizer and give two
examples.
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Fiscal Policy
• Fiscal policy involves either changing
our tax structure or changing the rate of
growth of government spending.
• A fiscal policy approach to short-run
stabilization is often associated with a
twentieth-century economist named
John Maynard Keynes.
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The Life and Times of
Mr. Keynes
• John Maynard Keynes (1883–1946)
originated the school of economic thought
referred to as Keynesian economics, which
supports the use of government spending
and taxing to help stabilize the economy.
• Keynes believed that there was a need for
government intervention, in part because an
economy may reach an equilibrium level of
real GDP per year that generates less than
full employment.
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The Life and Times of
Mr. Keynes (cont.)
• Keynes developed his fiscal policy theories
during The Great Depression in the 1930s.
• He observed that the forces of aggregate
supply and aggregate demand operated
too slowly on their own in such a serious
recession.
• His idea was that the government could step
in to stimulate aggregate demand.
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12-5
Inflexible Prices—The Culprit
• Keynes argued that prices, especially the
price of labor (wages) were inflexible
downward due to the existence of unions and
of long-term contracts between businesses
and workers.
• In such a world, when there are large
amounts of excess capacity and
unemployment, an increase in aggregate
demand would not raise the price level.
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12-6
Figure 12-1: Changes in Aggregate
Demand Do Not Alter the Price Level
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Keynes Sought to Understand
Why People Spend
• Consumer spending, called consumption, is a
key aspect of aggregate demand.
• Keynes focused much of his research on
what determines how much you and I decide
to spend each year.
• He focused on the relationship between how
much people earn and their willingness to
engage in personal consumption
expenditures.
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12-8
Relating Consumption to Saving
• You can only do two things with a dollar of
disposable income (income net of taxes):
either you can consume it or you can save it.
• If you consume a dollar in disposable income,
it is gone.
• If you save the entire dollar, however, you will
be able to consume it (and perhaps more if it
earns interest) at some future time.
• That is the distinction between consumption
and saving.
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12-9
Relating Consumption to Saving
(cont.)
• A dollar of take-home income can either
be consumed or not consumed.
Therefore, the relationship between
disposal income, saving, and
consumption is:
Consumption + saving = disposable income
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12-10
Planned Consumption and Actual
Income
• Keynes chose to ignore all of the
psychological factors that might explain
people’s planned consumption and
planned saving.
• Keynes argued that consumption and
saving decisions depend primarily on an
individual’s current disposable
income.
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Marginal Propensity to Consume
(MPC)
• Marginal refers to a small incremental
change. Propensity is a tendency to do
something. So, your marginal propensity to
consume is defined as:
Change in consumption
Marginal Propensity

to Consume (MPC) Change in disposable income
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12-12
Marginal Propensity to Save (MPS)
Change in saving
Marginal Propensity

to Save (MPS)
Change in disposable income
• MPC + MPS = 1
• The marginal propensities to consume
and to save tell you what percentage of
a given increase in income will go
toward consumption and saving,
respectively.
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12-13
Investment
• Keynes also believed that the equilibrium
level of employment depends on the level of
investment. He argued that if the level of
investment is low, full employment can’t be
achieved.
• In economic analysis, investment is defined
as expenditures by firms on new machines
and buildings that are expected to yield a
future stream of income.
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12-14
Investment and Interest Rates
• When the cost of borrowing falls,
businesspeople can undertake more
investment projects, and vice versa.
• Therefore, planned investment rises as
interest rates fall, all other things held
constant. Planned investment falls as
interest rates rise, all other things held
constant.
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Other Factors that Cause Planned
Investment to Change
• Expectations of business people.
• Any change in productive technology
can potentially shift businesspersons’
investment plans.
• Changes in business taxes can change
a businessperson’s investment plans.
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Changes in Investment Can Cause
a Multiplier Effect
• When a businessperson decides to spend
more on an investment, his spending decision
has ramifications throughout the economy.
The extra income of the workers who are
hired to build a new plant is spent.
• If the marginal propensity to consume is 80
percent, or 0.8, all those workers who get the
extra income will spend 80¢ out of every
extra dollar earned.
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12-17
Changes in Investment Can Cause
a Multiplier Effect (cont.)
• Then there are others who will receive this
80¢ as income. They will in turn spend 80
percent of that additional income. This
process goes on and on. It turns out, then,
that an increase in investment spending will
lead to a multiple increase in the equilibrium
level of national income.
• What is operating here is the multiplier
effect of changes in investment spending.
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Multiplier Formula
• There is a relationship between the
marginal propensity to consume and the
size of the multiplier. The formula is:
1
Multiplier =
1 - MPC
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The MPC and the Multiplier
• The larger the marginal propensity to
consume (MPC), the larger the
multiplier. This fact has implications for
the effectiveness of changes in
government spending or taxes—what
we call the realm of fiscal policy.
• The multiplier formula applies to
changes in government spending too.
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Discretionary Fiscal Policy
• Fiscal policy can be thought of as a
deliberate attempt via changes in
government spending or taxes to cause
the economy to move to full
employment and price level stability
more quickly than it otherwise might.
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Discretionary Fiscal Policy (cont.)
• To John Maynard Keynes and his followers,
during recessions and especially
depressions, the government has to step in to
increase aggregate demand.
• Expansionary fiscal policy—increases in
government spending or tax reductions—
initiated by the federal government is a way
to ward off recessions.
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Figure 12-3: The Effects of Tax Cuts
on the Equilibrium Level of Real GDP
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Figure 12-4: The Effects of Increased
Government Spending on Aggregate
Demand
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Financing of Increased
Government Spending
• The effectiveness of increasing
government spending (or tax
reductions) depends in large part on
how such increased spending (or tax
reduction) is financed.
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Financing of Increased
Government Spending (cont.)
• If the government simultaneously raises
taxes to finance the increased
spending, there will not be much net
impact on the economy.
• If the government finances the
increased spending by borrowing from
the private sector, it may crowd out
private investment. This is called the
crowding out effect.
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Automatic Stabilizers
• Our federal tax system is an automatic
stabilizer because when incomes fall,
government tax revenues fall, too, thereby
softening the reduction in nationwide
economic activity.
• Unemployment compensation and welfare
benefits also act as automatic stabilizers.
They help people not to experience as
dramatic a drop in disposable income as they
would otherwise.
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Federal Budget Deficit
• When the federal government spends
more than it receives in revenues it has
a budget deficit. The reverse situation
generates a budget surplus.
• Since 1960, there have only been a few
years of budget surpluses. The rest of
the time, the federal government has
run a deficit.
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Government Borrowing
• Our governments—federal, state, and local—
borrow funds to finance their budget deficits.
• The federal government typically borrows by
selling U.S. Treasury bonds.
• The sale of these federal government bonds
to corporations, private individuals, pension
plans, foreign governments, foreign
businesses, and foreign individuals add to
this nation’s public debt.
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Key Terms and Concepts
• automatic stabilizers
• budget surpluses
• consumption
• crowding out effect
• disposable income
• fiscal policy
• Investment
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• Keynesian
economics
• marginal propensity
to consume (MPC)
• marginal propensity
to save (MPS)
• multiplier effect
• saving
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