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Did fiscal stimulus
end the recession?
In the global recession of
2008 and 2009 most
countries engaged in
massive fiscal stimulus
programs.
Did these policies help to
moderate the recession
and speed the recovery?
16
Fiscal Policy
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Describe the federal budget process and the recent
history of revenues, outlays, deficits, and debts.
2 Explain the supply-side effects of fiscal policy on
employment and potential GDP.
3 Explain the demand-side effects of fiscal policy on
employment and real GDP.
© 2011 Pearson Education
16.1 THE FEDERAL BUDGET
The federal budget is an annual statement of the
revenues, outlays, and surplus or deficit of the
government of the United States.
The federal budget has two purposes:
1. To finance the activities of the federal government
2. To achieve macroeconomic objectives
Fiscal policy is the use of the federal budget to achieve
the macroeconomic objectives of high and sustained
economic growth and full employment.
16.1 THE FEDERAL BUDGET
The Institutions and Laws
The President and the
Congress make the
budget and develop
fiscal policy on a fixed
annual time line.
Fiscal year is a year
that begins on October
1 and ends on
September 30 of the
next year.
16.1 THE FEDERAL BUDGET
Budget Surplus, Deficit
Budget balance = Tax revenues – Outlays
The government has a balanced budget when tax
revenues equal outlays (budget balance is zero).
The government has a budget surplus when tax
revenues exceed outlays (budget balance is positive).
The government has a budget deficit when outlays
exceed tax revenues budget balance is negative).
16.1 THE FEDERAL BUDGET
Surplus, Deficit, and Debt
The government borrows to finance a budget deficit
and repays its debt when it has a budget surplus.
The amount of debt outstanding that arises from past
budget deficits is called national debt.
Debt at end of 2010 = Debt at end of 2009 + Budget
deficit in 2010.
16.1 THE FEDERAL BUDGET
The Federal Budget 2010
16.1 THE FEDERAL BUDGET
On the tax revenues side of the budget:
The largest item is personal income taxes―taxes that
people pay on wages and salaries and on interest.
The second largest item is Social Security taxes―taxes
paid by workers and employers to fund Social Security
benefits.
Corporate income taxes, which are the taxes paid by
corporations on their profits, are much smaller.
Indirect taxes, the smallest revenue source, are sales
taxes and customs and excise taxes.
16.1 THE FEDERAL BUDGET
On the outlays side of the budget:
The largest item is transfer payments.
Transfer payments are Social Security benefits,
Medicare and Medicaid benefits, unemployment
benefits, and other cash benefits paid to individuals and
firms.
Expenditure on goods and services includes the
government’s defense and homeland security budgets.
Debt interest is the interest on the national debt.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Schools of Thought and Cracks in Today’s
Consensus
The three main schools of macroeconomic thought are
classical, Keynesian, and monetarist macroeconomics.
Today’s consensus as one that takes insights from each
of the schools.
While there is a consensus, the macroeconomic events
of 2008 and 2009 have placed the consensus under
some stress and cracks are emerging.
The main crack is between the views of Keynesian
economists and others.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
The Keynesian View
The Keynesian view is that fiscal stimulus—an increase
in government outlays or a decrease in tax revenues—
boosts real GDP and creates or saves jobs.
Fiscal stimulus boosts real GDP and employment by
increasing aggregate demand and the fiscal stimulus has a
multiplier effect.
Keynesians say that these positive effects of fiscal stimulus
make it a vital and powerful tool in the fight against deep
recession and depression.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
The Mainstream View
The mainstream view is that Keynesians overestimate
the multiplier effects of fiscal stimulus and their effects
are small, short-lived, and incapable of working fast
enough to be useful.
Mainstream economists say that government stimulus
“crowds out” investment.
The durable results of a fiscal stimulus are bigger
government, lower potential GDP, a slower real GDP
growth rate, and a greater burden of government debt
on future generations.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Fiscal Policy and Aggregate Demand
Fiscal policy is a change in government outlays or in tax
revenues.
Other things remaining the same, a change in any item
in the government budget changes aggregate demand.
The change in aggregate demand has a multiplier
effect— aggregate demand changes by a greater
amount than the initial change in the item in the
government budget.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Government Expenditure Multiplier
The government expenditure multiplier is the
effect of a change in government expenditure on goods
and services on aggregate demand.
An increase in aggregate expenditure increases
aggregate demand, which increases real GDP.
The increase in real GDP induces an increase in
consumption expenditure, which further increases
aggregate demand.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
The Tax Multiplier
The tax multiplier is the effect of a change in taxes on
aggregate demand.
A decrease in taxes increases disposable income.
The increase in disposable income increases
consumption expenditure and aggregate demand.
With increased aggregate demand, employment and
real GDP increase and consumption expenditure
increases yet further.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
So a decrease in taxes works like an increase in
government expenditure.
Both actions increase aggregate demand and have a
multiplier effect.
The magnitude of the tax multiplier is smaller than the
government expenditure multiplier.
The reason: A $1 tax cut increases aggregate
expenditure by less than $1 whereas a $1 increase in
government expenditure increases aggregate
expenditure by $1.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
The Transfer Payments Multiplier
The transfer payments multiplier is the effect of a
change in transfer payments on aggregate demand.
This multiplier works like the tax multiplier but in the
opposite direction.
An increase in transfer payments increases disposable
income, which increases consumption expenditure.
With increased consumption expenditure, employment
and real GDP increase and consumption expenditure
increases yet further.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
The Balanced Budget Multiplier
The balanced budget multiplier is the effect on
aggregate demand of a simultaneous change in
government expenditure and taxes that leaves the
budget balance unchanged.
The balanced budget multiplier is not zero—it is
positive—because the government expenditure
multiplier is larger than the tax multiplier.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
A Successful Fiscal Stimulus
If real GDP is below potential GDP,
the government might pursue a fiscal
stimulus by:
• Increasing government expenditure
on goods and services,
• Increasing transfer payments,
• Cutting taxes, or
• A combination of all three.
Cash for Clunkers
was a fiscal stimulus.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Figure 16.2 illustrates a fiscal
stimulus.
Potential GDP is $13 trillion,
real GDP is $12 trillion, and
1. There is a $1 trillion
recessionary gap.
2. An increase in government
expenditure or a tax cut
increases expenditure by ∆E.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
3. The multiplier increases
induced expenditure. The
AD curve shifts rightward to
AD1.
The price level rises to 110,
real GDP increases to $13
trillion, and the recessionary
gap is eliminated.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
A Successful Contractionary Fiscal Policy
If real GDP is above potential GDP, the government
might pursue a contractionary fiscal policy in an attempt
to restore full employment.
Contractionary fiscal policy is a decrease in
government expenditure on goods and services, a
decrease in transfer payments, or an increase in taxes
designed to decrease aggregate demand.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Figure 16.3 illustrates
contractionary fiscal policy.
Potential GDP is $13 trillion,
real GDP is $14 trillion, and
1. There is a $1 trillion
inflationary gap.
2. A decrease in government
expenditure or a tax rise
decreases expenditure
by ∆E.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
3. The multiplier decreases
induced expenditure.
The AD curve shifts
leftward to AD1.
The price level falls to 110,
real GDP decreases to
$13 trillion, and the
inflationary gap is eliminated.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Automatic and Discretionary Fiscal Stimulus
Fiscal policy action that are aimed at stimulating
aggregate demand can be automatic or discretionary.
Automatic Fiscal Policy
Automatic fiscal policy is a fiscal policy action that
is triggered by the state of the economy.
For example, an increase in unemployment induces an
increase in payments to the unemployed or in a
recession tax receipts decrease as incomes fall.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Discretionary Fiscal Policy
Discretionary fiscal policy is a fiscal policy action
that is initiated by an act of Congress.
For example, an increase in defense spending or a cut
in the income tax rate.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Automatic Fiscal Policy
A consequence of tax revenues and outlays that
fluctuate with real GDP.
Automatic stabilizers are features of fiscal policy
that stabilize real GDP without explicit action by the
government.
Induced Taxes
Induced taxes are taxes that vary with real GDP.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Needs-Tested Spending
Needs-tested spending is spending on programs
that entitle suitably qualified people and businesses to
receive benefits— benefits that vary with need and with
the state of the economy.
Induced taxes and needs-tested spending decrease the
multiplier effects of change in autonomous expenditure
and moderate both expansions and recessions and
make real GDP more stable.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Discretionary Fiscal Policy
The use of discretionary fiscal policy is seriously
hampered by four factors:
•
•
•
•
Law-making time lag
Shrinking area of law-maker discretion
Estimating potential GDP
Economic forecasting
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Law-Making Time Lag
The amount of time it takes Congress to pass the laws
needed to change taxes or spending.
This process takes time because each member of
Congress has a different idea about what is the best tax
or spending program to change, so long debates and
committee meetings are needed to reconcile conflicting
views.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Shrinking Area of Law-Maker Discretion
Expenditure on the military and on homeland security and
very large expansion in expenditure on entitlement
programs such as Medicare has increased.
The result is that around 80 percent of the federal budget
is effectively off limits for discretionary fiscal policy action.
The 20 percent that is available for discretionary change
include items such as education and the space program,
which are hard to cut.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Estimating Potential GDP
It is not easy to tell whether real GDP is below, above,
or at potential GDP.
So a discretionary fiscal action might move real GDP
away from potential GDP instead of toward it.
This problem is a serious one because too much fiscal
stimulation brings inflation and too little might bring
recession.
16.2 THE DEMAND SIDE: STABILIZING REAL GDP
Economic Forecasting
Fiscal policy changes take a long time to enact in
Congress and yet more time to become effective.
So fiscal policy must target forecasts of where the
economy will be in the future.
Economic forecasting has improved enormously in
recent years, but it remains inexact and subject to error.
So for a second reason, discretionary fiscal action might
move real GDP away from potential GDP and create the
very problems it seeks to correct.
EYE on FISCAL STIMULUS
Did Fiscal Stimulus End the Recession?
In February 2009, in the depths of the 2008–2009
recession, Congress passed the American Recovery and
Reinvestment Act, a $787 billion fiscal stimulus package.
This Act of Congress is an example of discretionary fiscal
policy.
Did this action by Congress contribute to ending the 2008–
2009 recession and making the recession less severe than
it might have been?
The Obama Administration economists are confident that
the stimulus package made a significant contribution to
easing and ending the recession.
EYE on FISCAL STIMULUS
Did Fiscal Stimulus End the Recession?
But many, and perhaps most, economists don’t agree.
They think that the stimulus package played a small role
and that the truly big story is not discretionary fiscal policy
but the role played by automatic stabilizers.
What were the fiscal policy actions and their likely effects?
President Obama promised that fiscal stimulus would save
or create 650,000 jobs by the end of the 2009 summer.
In October 2009, the Administration economists declared
that the fiscal stimulus had saved or created the promised
650,000 jobs.
EYE on FISCAL STIMULUS
Did Fiscal Stimulus End the Recession?
This claim of success might be correct, but it isn’t startling
and it isn’t a huge claim. Why?
How much GDP would 650,000 people produce?
In 2009, each employed person produced $100,000 of real
GDP on average. So 650,000 people would produce $65
billion of GDP.
But only 20 percent of the $787 billion stimulus package
had been spent (or taken in tax breaks), so the stimulus
was only about $160 billion.
If government outlays of $160 billion created $65 billion of
GDP, the multiplier was 0.4 (65/160 = 0.4).
EYE on FISCAL STIMULUS
Did Fiscal Stimulus End the Recession?
This multiplier is much smaller than the 1.6 that the Obama
economists say will eventually occur.
They believe, like Keynes, that the multiplier starts out small
and gets larger over time as spending plans respond to
rising incomes.
An initial increase in expenditure increases aggregate
expenditure.
But the increase in aggregate expenditure generates higher
incomes, which in turn induces greater consumption
expenditure.
EYE on FISCAL STIMULUS
Did Fiscal Stimulus End the Recession?
Automatic Fiscal Policy
Government revenue is sensitive to the state of the
economy.
When personal incomes and corporate profits fall, income
tax revenues fall too.
When unemployment increases, outlays on unemployment
benefits and other social welfare benefits increase.
These fiscal policy changes are automatic. They occur with
speed and without help from Congress.
EYE on FISCAL STIMULUS
Did Fiscal Stimulus End the Recession?
In 2009, real GDP fell to 6 percent below potential GDP—a
recessionary gap of $800 billion. Tax revenues crashed and
transfer payments skyrocketed.
The figure shows that the automatic stabilizers were much
larger than the discretionary actions.
Automatic action played the major role in limiting job losses.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
Fiscal policy influences the output gap by changing
aggregate demand and real GDP relative to potential
GDP.
But fiscal policy also influences potential GDP and the
growth rate of potential GDP.
These influences on potential GDP and economic growth
arise because
• The government provides public goods and services
that increase productivity and
• Taxes change the incentives the people face.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
Supply-side effects are the effects of fiscal policy
on potential GDP.
Supply-side effects operate more slowly than the
demand-side effects.
Supply-side effects are often ignored in times of
recession when the focus is on fiscal stimulus and
restoring full employment.
But in the long run, the supply-side effects of fiscal
policy dominate and determine potential GDP.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
Full Employment and Potential GDP
The higher the real wage rate, other things remaining the
same, the smaller is the quantity of labor demanded and the
greater is the quantity of labor supplied.
When the real wage rate has adjusted to make the quantity
of labor demanded equal to the quantity of labor supplied,
there is full employment.
When the quantity of labor is the full-employment quantity,
real GDP equals potential GDP.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
Fiscal Policy, Employment, and Potential GDP
Both sides of the government's budget influences
potential GDP.
Public Goods and Productivity
The expenditure side provides public goods and services
that enhance productivity.
The increase in productivity increases potential GDP.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
Taxes and Incentives
On the revenue side, taxes modify incentives and
change the full-employment quantity of labor, as well as
the amount of saving and investment.
An increase in taxes drives a wedge between the price
paid by the buyer and the price received by a seller.
In the labor market, tax wedge is the gap between
the before-tax wage rate and the after-tax wage rate.
The result is a decrease in the full-employment quantity
of labor and a decrease in potential GDP.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
Full Employment with
No Income Tax
The wage rate is $30 an
hour and 250 billion hours
of labor is employed.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
The economy is at full
employment with 250
billion hours of labor
employed.
The production function
shows that when 250
billion hours are employed,
potential GDP is $14
trillion.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
The Effects of the Income
Tax
The income tax
1. Decreases the supply of
labor.
2. Creates a tax wedge
between the wage rate
that firms pay and workers
receive.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
3. The before-tax wage rate
rises to $35 an hour.
4. The after-tax wage rate
falls to $20 an hour.
5. Full employment
decreases to 200 billion
hours.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
5. Full employment
decreases to 200 billion
hours.
6. Potential GDP decreases
to $14 trillion.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
Changes in the Tax Rate
A change in the income tax rate changes equilibrium
employment and potential GDP.
In the example that you’ve just worked through, the tax
rate is about 43 percent—a $15 tax on a $35 wage rate.
If the income tax rate is increased, the supply of labor
decreases yet more and the LS + tax curve shifts farther
leftward.
Equilibrium employment and potential GDP decrease.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
 Taxes, Deficits, and Economic Growth
Fiscal policy influences economic growth in two ways:
1. Taxes drive a wedge between the interest rate paid
by borrowers and the interest rate received by
lenders.
2. If there is a budget deficit, government borrowing to
finance the deficit competes with firms’ borrowing to
finance investment and to some degree, government
borrowing “crowds out” private investment.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
Interest Rate Tax Wedge
Lenders pay an income tax on the interest they receive
from borrowers, which creates an interest rate tax
wedge.
A tax on interest lowers the quantity of saving and
investment and slows the growth rate of real GDP.
A tax on interest income creates a Lucas wedge—an
ever widening gap between potential GDP and the
potential GDP that might have been.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
Investment and saving plans depend on the real aftertax interest rate.
The real interest rate equals the nominal interest rate
minus the inflation rate.
So the after-tax interest rate equals the real interest rate
minus the income tax paid on interest income.
But the nominal interest rate, not the real interest rate,
determines the amount of tax to be paid; and the higher
the inflation rate, the higher is the nominal interest rate,
and the higher is the true tax rate on interest income.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
Deficits and Crowding Out
A tax cut that increases the budget deficit brings an
increase in the demand of loanable funds to firms.
The interest rate rises and crowds out private investment.
But the lower income tax rate shrinks the tax wedge and
stimulates employment, saving, and investment.
But a higher budget deficit decreases investment.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
Combined Demand-Side and Supply-Side
Effects
A fiscal stimulus increases aggregate demand and
potential GDP.
When potential GDP increases aggregate supply
increases.
Equilibrium real GDP increases, but the price level might
rise, fall, or not change.
Figure 16.5 shows the combined effects of fiscal policy
when fiscal policy has no effect on the price level.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
1. A tax cut increases
disposable income, which
increases aggregate
demand from AD0 to AD1.
A tax cut also strengthens
the incentive to work,
save, and invest, which
increases aggregate
supply from AS0 to AS1.
2. Real GDP increases.
16.3 THE SUPPLY SIDE: POTENTIAL GDP AND GROWTH
Long-Run Fiscal Policy Effects
The long-run consequences are the most profound ones.
If investment is crowded out by a large budget deficit, the
economic growth rate slows and potential GDP gets ever
farther below what it might have been as the Lucas
wedge widens.
If a large budget deficit persists, debt increases,
confidence in the value of money is eroded, and inflation
erupts.
It is vital that government outlays and budget deficits be
kept under control.