Download Discretionary fiscal policy

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
Theory of Fiscal Policy

–
–
–
–
Fiscal policy
Government purchases, G
Transfer payment, TP
Taxes, T
Borrowing
LO1
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
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
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 in
e’’
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
LO2
Exhibit 4
Discretionary Fiscal Policy to Close an
Expansionary Gap
Price
level
Potential output
LRAS
e’’
SRAS130
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.
e’
135
Discretionary fiscal policy aimed at
AD’
reducing aggregate demand by just
e*
the right amount could close this gap
without inflation. An increase in net
AD*
taxes, a decrease in government
purchases, or some combination
could shift aggregate demand back to
14.0
14.5 Real GDP AD* and move the economy back to
(trillions of dollars) its potential output at e*.
130
0
Chapter 12
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.

–
–
–
•
•
•
•
LO3
–
Chapter 12
Prior to the Great Depression
Classical economists
Laissez-faire; Free markets
Balanced budget
Natural market forces
Flexible:
Prices
Wages
Interest rates
No need for government intervention
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Evolution of Fiscal Policy
2.
–
•
•
–
•
•
–
•
LO•3
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

–
–

–


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.
–
•
–
•
•
•
•
•
LO•3
Chapter 12
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
Higher OPEC-driven oil prices
Adverse supply shocks
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Lags in Fiscal Policy

–
•
•
–
–
–
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.


–


–
–
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.
–
–
–
–
–
–
–
–
–
–
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
Federal deficit increased to $450 billion in 2008; now
3
LO forecast between $1 trillion and $2 trillion
Chapter 12
Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved