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Chapter 12 Fiscal Policy Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fiscal Policy • Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes. • The premise of fiscal policy is that the aggregate demand (AD) for goods and services will not always be compatible with economic stability. 12-2 Fiscal Policy • Recessions occur when AD declines. • Recessions persist when AD remains below the economy’s capacity to produce. 12-3 Fiscal Policy • John Maynard Keynes explained how a deficiency in demand could arise in a market economy. • Keynes showed how and why the government should intervene to achieve macroeconomic goals. • Keynes also advocated aggressive use of fiscal policy to alter market outcomes. 12-4 Components of Aggregate Demand • The four major components of AD are: – Consumption (C) – Investment (I) – Government spending (G) – Net exports (exports minus imports) (X – IM) AD = C + I + G + (X – IM) 12-5 Figure 12.1 12-6 Equilibrium • Macro equilibrium is the combination of price level and real output that is compatible with both AD and AS. – There is no guarantee that AD will always produce an equilibrium at full employment and price stability. – Sometimes there will be too little demand, and sometimes there will be too much. 12-7 Figure 12.2 12-8 The Nature of Fiscal Policy • C + I + G + (X – IM) seldom adds up to exactly the right amount of AD. • The use of government spending and taxes to adjust AD is the essence of fiscal policy. 12-9 Figure 12.3 12-10 Fiscal Stimulus • If AD falls short, there is a gap between what the economy can produce and what people want to buy. – The GDP gap is the difference between fullemployment output and the amount of output demanded at current price levels. • The goal is to eliminate the GDP gap by shifting AD to the right. 12-11 Multiplier Effects • Any increase in spending results in increased incomes to someone else, who also increases spending. • All income is either spent or saved. – The saved portion is drained away and not recycled as added income to someone else. 12-12 Multiplier Effects • Part of each dollar spent is re-spent several times, creating new income and new spending. • As a result, every dollar has a multiplied impact on aggregate income. 12-13 Multiplier Effects • The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption: change in consumption MPC = change in disposable income 12-14 Multiplier Effects • The marginal propensity to save (MPS) is the fraction of each additional (marginal) dollar of disposable income not spent on consumption: change in saving MPS = change in disposable income 12-15 Multiplier Effects • Because all new income must be either spent or saved, spending and saving decisions are connected: MPS = 1 – MPC or MPC + MPS = 1 12-16 Multiplier Formula • The multiplier formula tells us how much total spending will change in response to an initial spending stimulus. It is governed by how much drains away into saving (MPS = 1 – MPC). Multiplier = 1 / (1 – MPC) 12-17 Multiplier Formula • Every dollar of fiscal stimulus has a multiplied impact on AD: Total change in spending = Multiplier x Initial change in government spending 12-18 Tax Cuts • Government can cut taxes to increase consumption or investment spending. • A tax cut directly increases disposable income and stimulates consumer spending (C). Initial increase in consumption = MPC x Tax cut 12-19 Taxes and Consumption • The cumulative increase in AD equals a multiple of the tax-induced change in consumption. Cumulative Initial change in = Multiplier x change in spending consumption 12-20 Fiscal Restraint • Fiscal restraint may be the proper policy when inflation threatens: – Fiscal restraint – tax hikes or spending cuts intended to reduce aggregate demand (shift AD left). 12-21 Figure 12.8 12-22 Multiplier Cycles • Government cutbacks have a multiplied effect on AD: Cumulative reduction in = Multiplier x spending Initial budget cut 12-23 Tax Hikes • Tax increases reduce disposable income and thus reduce consumption, shifting the AD curve to the left. • Tax increases have been used to “cool down” the economy; that is, they act as a fiscal restraint. 12-24 Fiscal Guidelines • Problem: unemployment. • Solution: increase AD. • Tools: – Increase government spending. – Cut taxes. • Problem: inflation. • Solution: decrease AD. • Tools: – Decrease government spending. – Raise taxes. 12-25 Must the Budget Be Balanced? • The use of the budget to manage aggregate demand implies that the budget will often be unbalanced, usually in deficit: – Government spending > Tax revenues • Recent deficits have been much larger than earlier deficits. 12-26 Figure 12.9 12-27 Must the Budget Be Balanced? • Budget deficit: the amount by which government expenditures exceed government revenues in a given time period. – The government must borrow to pay for deficit spending. – A fiscal stimulus increases the budget deficit. – A fiscal restraint decreases the budget deficit. 12-28