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Chapter 13
Fiscal Policy
Introduction
In the early 2000s the Japanese
government sought to cut taxes and
increase spending. By early 2004 it
launched plans for increasing taxes then
in 2005 contemplated cutting them again.
In this chapter, you will learn about
policy time lags, which contributed to the
Japanese government’s on-again, offagain tax policies.
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13-2
Learning Objectives
• Use traditional Keynesian analysis to
evaluate the effects of discretionary
fiscal policy
• Discuss ways in which indirect crowding out
and direct expenditure offsets can reduce the
effectiveness of fiscal policy actions
• Explain why the Ricardian equivalence
theorem calls into question the usefulness
of tax changes
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13-3
Learning Objectives (cont'd)
• List and define fiscal policy time lags
and explain why they complicate efforts
to engage in fiscal “fine tuning”
• Describe how certain aspects of fiscal
policy function as automatic stabilizers
for the country
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13-4
Chapter Outline
• Discretionary Fiscal Policy
• Possible Offsets to Fiscal Policy
• Discretionary Fiscal Policy in Practice:
Coping with Time Lags
• Automatic Stabilizers
• What Do We Really Know About
Fiscal Policy?
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13-5
Did You Know That...
• Since the early 2000s, total government
spending has increased at a rate of
about 8% per year?
• This is the largest annual rate of growth
since the 1940s and 1950s?
• There are consequences of higher
government spending for equilibrium
real GDP and the price level?
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13-6
Discretionary Fiscal Policy
• Discretionary Fiscal Policy
 The discretionary changes in government
expenditures and/or taxes in order to achieve
certain national economic goals is the realm of
fiscal policy.

High employment (low unemployment)

Price stability

Economic growth

Improvement of international payments balance
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13-7
Discretionary Fiscal Policy (cont'd)
• Fiscal Policy
 The discretionary changing of government
expenditures or taxes to achieve national
economic goals, such as high employment
with price stability
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13-8
Discretionary Fiscal Policy (cont'd)
• An increase in government spending
will stimulate economic activity
• Changes in government spending
 Military spending
 Education spending
 Budgets for government agencies
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13-9
Figure 13-1 Expansionary and
Contractionary Fiscal Policy: Changes in
Government Spending, Panel (a)
If there is a recessionary gap
in panel (a), fiscal policy can
presumably increase
aggregate demand
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13-10
Figure 13-1 Expansionary and
Contractionary Fiscal Policy: Changes in
Government Spending, Panel (b)
If there is an inflationary gap,
fiscal policy can presumably
decrease aggregate demand
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13-11
Discretionary Fiscal Policy (cont'd)
• Questions
 Would the increase in government
spending equal the size of the gap?
 What impact would expansionary fiscal
policy have on the price level?
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13-12
Figure 13-2 Contractionary and
Expansionary Fiscal Policy: Changes
in Taxes, Panel (a)
• In panel (a), the economy is
initially at E1, where real GDP
exceeds long-run equilibrium
• Contractionary fiscal policy can
move aggregate demand to
AD2 via a tax increase
• A new equilibrium is at E2 at a
lower price level
• Real GDP is now consistent
with LRAS
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13-13
Figure 13-2 Contractionary and
Expansionary Fiscal Policy: Changes
in Taxes, Panel (b)
• In panel (b) with a
recessionary gap (in this case
$500 billion) taxes are cut
• AD1 moves to AD2
• The economy moves from E1
to E2, and real GDP is now at
$12 trillion per year
• We are at the long-run
equilibrium level
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13-14
Discretionary Fiscal Policy (cont'd)
• Change in taxes
 A rise in taxes causes a reduction in
aggregate demand because it can reduce
consumption spending, investment
expenditures, and net exports.
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13-15
Discretionary Fiscal Policy (cont'd)
• Question
 What would be the long-run impact of a tax
cut on real GDP if the economy is at fullemployment equilibrium?
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13-16
Possible Offsets to Fiscal Policy
• Fiscal policy does not operate in a
vacuum and important questions must
be answered.
 How are expenditures financed and
by whom?
 If taxes are increased what does
government do with the taxes?
 What will happen if individuals worry about
increases in future taxes?
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13-17
Possible Offsets
to Fiscal Policy (cont'd)
• Crowding-Out Effect
 The tendency of expansionary fiscal policy
to cause a decrease in planned investment
or planned consumption in the private
sector; this decrease normally results from
the rise of interest rates.
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13-18
Figure 13-3 The Crowding-Out
Effect, Step by Step
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Figure 13-4
The Crowding-Out Effect
Expansionary policy causing
deficit spending initially shifts
from AD1 to AD2
Due to crowding out,
AD shifts inward to AD3
Equilibrium GDP
below full-employment
GDP—recessionary gap
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13-20
Possible Offsets
to Fiscal Policy (cont'd)
• Planning for the future:
the Ricardian equivalence theorem
 Ricardian Equivalence Theorem
 The
proposition that an increase in the
government budget deficit has no effect on
aggregate demand
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13-21
Possible Offsets
to Fiscal Policy (cont'd)
• Planning for the future:
The Ricardian equivalence theorem
 The reason for the offset
 People
anticipate that a larger deficit today will
mean higher taxes in the future and adjust their
spending accordingly.
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13-22
Possible Offsets
to Fiscal Policy (cont'd)
• Direct Expenditure Offsets
 Actions on the part of the private sector in
spending income that offset government
fiscal policy actions
 Any increase in government spending
in an area that competes with the
private sector will have some direct
expenditure offset.
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13-23
International Policy Example: Britain Pays
Up but Receives Little Economic Payoff
• The United Kingdom makes the third highest
net contribution to the EU budget, even
though EU expenditures contribute so little to
total planned spending in that nation.
• How do taxes that British residents pay to
fund their government’s contribution to the
EU budget affect aggregate demand in the
United Kingdom?
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13-24
Possible Offsets
to Fiscal Policy (cont'd)
• The supply-side effects of changes
in taxes
 Expansionary fiscal policy could involve
reducing marginal tax rates.
 Advocates
argue this increases productivity
since individuals will work harder and longer,
save more, and invest more.
 The
increased productivity will lead to more
economic growth.
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13-25
Possible Offsets
to Fiscal Policy (cont'd)
• Supply-Side Economics
 The suggestion that creating incentives for
individuals and firms to increase
productivity will cause the aggregate
supply curve to shift outward
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13-26
Possible Offsets
to Fiscal Policy (cont'd)
• Question
 Would a tax increase cause you to work
more or less?
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13-27
Figure 13-5 Laffer Curve
Tax rates and
tax revenues
rise together
Tax revenues
are at a maximum
Tax rates and tax
revenues fall
together
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13-28
Policy Example: A Laffer Curve in the
Mid-2000s?
• In 2003 Congress reduced the top tax
rate on corporate dividends and the tax
rate on capital gains along with cutting
personal income tax rates slightly.
• Many critics predicted that the federal
government’s tax revenues would
plummet after these rates were cut.
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13-29
Policy Example: A Laffer Curve in the
Mid-2000s? (cont'd)
• By the middle of 2006, after three years
of higher real GDP growth, total federal
income tax receipts from corporations
and individuals had increased by
nearly 40%.
• Why do you suppose it is difficult to
determine exactly which factors are
most responsible for the increase?
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13-30
Discretionary Fiscal Policy in Practice:
Coping with Time Lags
• Question
 Is fiscal policy as precise as it appears?
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13-31
Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Time lags
 Recognition Time Lag
 The
time required to gather information about
the current state of the economy
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13-32
Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Time lags
 Action Time Lag
 The
time required between recognizing an
economic problem and putting policy into effect

Particularly long for fiscal policy which requires
congressional approval
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13-33
Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Time lags
 Effect Time Lag
 The
time it takes for a fiscal policy to affect
the economy
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13-34
Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Fiscal policy time lags are long and a
policy designed to correct a recession
may not produce results until the
economy is experiencing inflation.
• Fiscal policy time lags are variable in
length (1–3 years), and the timing of the
desired effect cannot be predicted.
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13-35
Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
• Because fiscal policy time lags tend to
be variable, policymakers have a
difficult time fine-tuning the economy.
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13-36
Automatic Stabilizers
• Automatic or Built-In Stabilizers
 Changes in government spending and
taxation that occur automatically without
deliberate action of Congress
 The
tax system
 Unemployment
 Welfare
compensation
spending
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13-37
Figure 13-6 Automatic Stabilizers
The automatic changes
tend to drive the economy
back toward its fullemployment output level
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13-38
What Do We Really Know
About Fiscal Policy?
• Fiscal policy during normal times
 Congress ends up doing too little too late
to help in a minor recession.
 Fiscal policy that generates repeated
tax changes (as has happened)
creates uncertainty.
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13-39
What Do We Really Know
About Fiscal Policy? (cont'd)
• Fiscal policy during abnormal times
 Fiscal policy can be effective
 The
Great Depression—fiscal policy may be
able to stimulate aggregate demand.
 Wartime—during
World War II real GDP
increased dramatically.
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13-40
What Do We Really Know
About Fiscal Policy? (cont'd)
• The “soothing” effect of Keynesian
fiscal policy
 Should we encounter a severe downturn,
fiscal policy is available.
 Knowing
this may reassure consumers
and investors.

Stable expectations encourage a smoothing of
investment spending.
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13-41
Issues and Applications: The Roller
Coaster of Japanese Tax Policy
• Between 2000 and 2002, the average rate of growth
in total expenditures on goods and services in Japan
was 0%.
• In an effort to boost aggregate demand amid a
slumping economy the Japanese government cut
taxes to spur growth.
• By the end of 2004 the Japanese government
found it was spending nearly twice as much as
it was receiving in tax revenues, financing the rest
by borrowing.
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13-42
Figure 13-7 Government Spending
and Tax Revenues in Japan
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13-43
Issues and Applications: The Roller
Coaster of Japanese Tax Policy (cont'd)
• Recognition lag
 The period between 2003 when aggregate
demand began to pick up and 2004 when
the government recognized it is called a
recognition lag.
• Action lag
 In 2004 the government began a plan
to phase in tax increases between 2005
and 2007.
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13-44
Issues and Applications: The Roller
Coaster of Japanese Tax Policy (cont'd)
• The roller coaster ride continues
 In 2005, the Japanese government
gradually phased in the first scheduled
tax increase.
 Spending fell and new information showed
total expenditures had increased at a rate
of less than 1% in 2005.
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13-45
Issues and Applications: The Roller
Coaster of Japanese Tax Policy (cont'd)
• The roller coaster ride continues
 Tax increases slated for 2006 and 2007
threatened to reduce aggregate demand
even further.
 During 2006 the Japanese government
began rethinking its policy options once
more and the cycle began anew.
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13-46
Summary Discussion
of Learning Objectives
• The effects of discretionary fiscal policy
using traditional Keynesian analysis
 Increases in government spending
and decreases in taxes increase
aggregate demand.
 Decreases in government spending
and increases in taxes decrease
aggregate demand.
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13-47
Summary Discussion
of Learning Objectives (cont'd)
• How indirect crowding out and direct
expenditure offsets can reduce the
effectiveness of fiscal policy actions
 Deficits increase interest rates.
 Some government spending replaces
private spending.
• On net, if the Ricardian equivalence
theorem is valid, a tax cut has no effect
on total planned expenditures and
aggregate demand.
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13-48
Summary Discussion
of Learning Objectives (cont'd)
• Fiscal policy time lags and the effectiveness
of fiscal “fine tuning”
 The time lags for fiscal policy are the recognition
time lag, action time lag, and the effect time lag.
 The time lags are long and variable.
• Automatic stabilizers are changes in tax
payments, unemployment compensation, and
welfare payments that automatically change
with the level of economic activity.
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13-49
End of
Chapter 13
Fiscal Policy