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Macro
McEachern
2011
ECON
2010-
12
CHAPTER
Fiscal Policy
Designed by
Amy McGuire, B-books, Ltd.
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Fiscal Policy Tools

–
–
•
Automatic stabilizers
Revenue and spending programs
Adjust automatically
E.g.: Federal income tax
LO1
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Fiscal Policy Tools

–
–
•
–
•
Discretionary fiscal policy
Deliberate manipulation of G, TP, and T
Increase in G or TP
Increases real GDP demanded
Increase in net taxes
Decreases real GDP demanded
LO1
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Changes in Government
Purchases

–
–
–
Increase government purchases
Stimulate the economy
Upward shift of AE line
Increase in GDP
LO1
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Exhibit 1
LO1
Aggregate expenditure (trillions of dollars)
Effect of a $0.1 Trillion Increase in Government
Purchases on Aggregate Expenditure and Real
GDP Demanded
C + I + G’ + (X - M)
b
14.5
C + I + G + (X - M)
0.1
14.0
Chapter 12
a
45°
0
14.0
As a result of a $0.1 trillion
increase in government
purchases, the aggregate
expenditure line shifts up by
$0.1 trillion, increasing the
real GDP demanded by $0.5
trillion. This model assumes
price level remains
unchanged.
Real GDP
14.5
(trillions of dollars)
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Changes in Net Taxes

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–
–
–
Decrease in net taxes
Increases DI by ∆NT
Increases C by MPC ×∆NT
Upward shift of AE line
Increase in GDP
LO1
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
LO1
Exhibit 2
Aggregate expenditure (trillions of dollars)
Effect of a $0.1 Trillion Decrease in Net Taxes on
Aggregate Expenditure and Real GDP Demanded
c
14.4
14.0
a
45°
0
Chapter 12
14.0
As a result of a decrease
C’ + I + G + (X - M) in NT of $0.1 trillion,
consumers, who are
assumed to have a MPC
C + I + G + (X - M)
of 0.8, spend $80 billion
more and save $20
0.08
billion at every level of
GDP. The consumption
function shifts up by $80
billion, as does the AE
line.
An $80 billion increase of AE line
eventually increases real GDP
demanded by $0.4 trillion. Keep in
mind that the price level is
Real GDP assumed to remain constant during
all this.
14.4
(trillions of dollars)
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Discretionary Fiscal Policy
LO2
Chapter 12

Expansionary fiscal policy

Contractionary gap

Price level < expected

Output < potential

Unemployment > natural rate

Increase G, decrease NT

Increase AD

Higher price level

Higher output
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Expansionary Fiscal Policy
LO2
Chapter 12

To close a contractionary gap

Output < potential

Unemployment > natural rate

Expansionary fiscal policy

Increase G

Decrease NT

Increase AD

Increase output

Increase price level

Close the contractionary gap
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
LO2
Exhibit 3
Discretionary Fiscal Policy to Close a
Contractionary Gap
Price
level
Potential output
LRAS
SRAS130
e*
130
e
125
0
13.5
The aggregate demand curve AD
and the short-run aggregate supply
curve SRAS130 intersect at point e.
Output falls short of the economy’s
potential. The resulting
contractionary gap is $0.5 trillion.
This gap could be closed by
discretionary fiscal policy that
increases aggregate demand by just
e’
the right amount. An increase in
AD*
government purchases, a decrease
e’’
in net taxes, or some combination
could shift aggregate demand out to
AD
AD*, moving the economy out to its
14.0
14.5 Real GDP potential output at e*.
(trillions of dollars)
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Contractionary Fiscal Policy
LO2
Chapter 12

To close an expansionary gap

Output > potential

Unemployment < natural rate

Contractionary fiscal policy

Decrease G

Increase NT

Decrease AD

Decrease output

Decrease price level

Close the expansionary gap
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Exhibit 4
LO2
Discretionary Fiscal Policy to Close an
Expansionary Gap
Price
level
Potential output
LRAS
e’’
SRAS130
e’
135
AD’
130
e*
AD*
0
Chapter 12
The aggregate demand curve AD’
and the short-run aggregate supply
curve SRAS130 intersect at point e’
resulting in an expansionary gap of
$0.5 trillion.
14.0
14.5 Real GDP
(trillions of dollars)
Discretionary fiscal policy aimed at
reducing aggregate demand by just
the right amount could close this gap
without inflation. An increase in net
taxes, a decrease in government
purchases, or some combination
could shift aggregate demand back to
AD* and move the economy back to
its potential output at e*.
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Contractionary & Expansionary
Fiscal Policy

Difficult to achieve

Potential output gauged accurately

Spending multiplier predicted
accurately

AD shifts by just the right amount

Government entities – coordinate
fiscal efforts

Shape of SRAS curve is known,
unaffected by the policy
LO2
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
The Multiplier and the Time
Horizon

Simple multiplier

Overstates ∆Real GDP

∆Real GDP depends

Steepness of SRAS curve

Production costs increase

The steeper SRAS curve

Less impact of an AD shift on real GDP

More impact on price level

The smaller the spending multiplier
LO2
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Evolution of Fiscal Policy
1.

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–
–
•
Prior to the Great Depression
Classical economists
Laissez-faire; Free markets
Balanced budget
Natural market forces
Flexible:
• Prices
• Wages
• Interest rates
LO3
– No need for government intervention
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Evolution of Fiscal Policy
2.
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•
•
–
•
•
–
•3
LO
•
Chapter 12
The Great Depression and World War II
Keynesian theory and policy
Prices and wages: ‘Sticky’ downward
Increase AD
WWII
Increase production
No cyclical unemployment
Employment Act of 1946, Government:
Full employment
Economic stability
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Automatic Stabilizers
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
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

Smooth out fluctuations DI
Stimulate AD (recessions)
Dampen AD (expansions)
Federal income tax
Progressive income tax
Unemployment insurance
Welfare payments
LO3
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Evolution of Fiscal Policy
3.
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•
•
•
From the Golden Age to Stagflation
1960s: demand-management policy
Increase or decrease AD
1970s: Stagflation
Higher inflation
Higher unemployment
From decreased AD
• Crop failures
•3 Higher OPEC-driven oil prices
LO• Adverse supply shocks
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Fiscal Policy and Natural UR
 Underestimate natural rate of unemployment
– Expansionary fiscal policy
• Increase AD; Short run:
• Increase output
• Decrease unemployment
• Expansionary gap; Long run:
• Decrease SRAS
• Inflation
• Decrease output
LO3
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
LO3
Exhibit 5
When Discretionary Fiscal Policy Overshoots
Potential Output
If public officials underestimate the
natural rate of unemployment, they may
attempt to stimulate AD even if the
SRAS140
economy is already producing at its
potential output, a.
SRAS130
c
This expansionary policy yields a shortrun equilibrium at b, where the price
level and output are higher and
b
unemployment is lower, so the policy
appears to succeed.
But the resulting expansionary gap will,
a
AD’
in the long-run, reduce the SRAS,
eventually reducing output to its
potential level of $14.0 trillion while
AD
increasing the price level to 140.
Thus, attempts to increase production
Real GDP beyond its potential GDP lead only to
14.0 14.2
(trillions of dollars) inflation in the long-run
Price
level
Potential output
LRAS
140
130
0
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Lags in Fiscal Policy

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•
•
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Fiscal policy
Time
Approve
Implement
Less effective
Too late
More harm than good
LO3
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Evolution of Fiscal Policy
4.
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Since 1990: from deficits to surpluses
1980s – mid-1990s: large deficits
1993 recovery under way
Increase tax on high-income households
1994: Decreased federal spending
1993 – 1998
Tax revenues: +8.3% per year
Federal outlays: +3.2% per year
LO3
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Evolution of Fiscal Policy
4.
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Since 1990: from deficits to surpluses back to deficits
1998: Federal surplus $70 billion
2000: Federal surplus $236 billion
Early 2001 – Recession: 10-year tax cut
September 11, 2001: Terrorist attack
2003 – 2007 Recovery
Employment: +8 million
Federal deficit (2004) $400 billion
Federal deficit (2007) under $200 billion
Recession beginning December 2007
deficit increased to $450 billion in 2008; now forecast
3
LOFederal
between $1 trillion and $2 trillion
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved