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30 Fiscal Policy, Deficits, and Debt McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Fiscal Policy Recall; • AD = C + I + G + X - M • Changes in AD will have significant effects on the economy. • Economic problems such as inflation and unemployment • Changes in AD components leads to changes in AD LO1 30-2 Fiscal Policy • Recall that the government sector purchase goods and services (G) and collect taxes (T) • The government can use: G and T to affect AD • Fiscal policy: deliberate changes in G and/or T to achieve full employment, price stability, and economic growth. LO1 30-3 Fiscal Policy How to use fiscal policy? • Performed by the government via its tools: G and/or T • Note that G has a direct effect on AD while T has indirect effect (through C and S) • Two different fiscal policies: Expansionary Fiscal Policy and Contractionary Fiscal Policy LO1 30-4 Expansionary Fiscal Policy • • • • Used to face a recession When: GDP (or Y) < AE Need to increase the level of AE Increase level of G, and / or Reduce level of T • Both will increase the level of Y LO1 30-5 Expansionary Fiscal Policy Price level AS increase in aggregate demand P1 AD1 AD2 $510 Real GDP (billions) LO1 30-6 Expansionary Fiscal Policy Example; • Assume we have a sharp decline in I from I0 to I1. (show the graph? ) • Result: what will happen to AD(show the graph?) • This may cause a problem .………. • What is the solution? Use …………..fiscal policy. • What are the tools of such fiscal Policy to use? LO1 30-7 Expansionary Fiscal Policy • Assume that GDP0=$505, • When I falls, GDP1=$485 • This is accompanied by an increase unemployment. • How much we need ∆G, ∆ T, or both? Recall that MPC=75%, and Gm=4, Tm=3 • ∆G: • ∆T: LO1 ∆Y = ∆G . M 20 = ∆G . 4 ∆G = $5 ∆Y = - ∆T . M 20 = - ∆T . 3 ∆T = - $6.67 30-8 Expansionary Fiscal Policy Therefore; ∆C = MPC.T=(0.75)(6.67) = +5 ∆S = MPS.T=(0.25)(6.67) = +1.67 • What if we used both? ∆Y= ∆ G mg + ∆T mt 20 = ∆G(4)+ ∆T(3) 20 = 1.25(4)+ 5(3) 20 = 2(4)+ 4(3) 20 = 2.75(4)+ 3(3) LO1 30-9 Contractionary Fiscal Policy • • • • Used to face a demand-pull inflation When: GDP (or Y) > AE Need to reduce the level of AE Reduce level of G, or/ and Increase level of T • Both will reduce the level of Y LO1 30-10 Contractionary Fiscal Policy Price level AS P1 decrease in aggregate demand a P2 b AD1 AD2 $522 Real GDP (billions) LO1 30-11 Contractionary Fiscal Policy Example; • Assume we have a increase in I from I0 to I1. (show the graph? ) • Result: what will happen to AD(show the graph?) • This may cause a problem .………. • What is the solution? Use …………..fiscal policy. • What are the tools of such fiscal Policy to use? LO1 30-12 Contractionary Fiscal Policy • • • • Assume that GDP0=$505, When I falls, GDP1=$515 This is accompanied by an increase prices. How much we need ∆G, ∆ T, or both? Recall that MPC=75%, and Gm=4, Tm=3 • ∆G: • ∆T: LO1 ∆Y = ∆G . M -10 = ∆G . 4 ∆G = $2.5 ∆Y = - ∆T . M -10 = - ∆T . 3 ∆T = - $3.34 30-13 Contractionary Fiscal Policy Therefore; ∆C = MPC.T=(0.75)(3.34) = -2.505 ∆S = MPS.T=(0.25)(6.67) = -0.835 • What if we used both? ∆Y= ∆ G mg + ∆T mt 10 = ∆G(4)+ ∆T(3) 10 = 1 (4)+ 2(3) 10 = 1.75(4)+ 1(3) 10 = 0.25(4)+ 3(3) LO1 30-14 Policy Options: G or T? • To expand the size of government (if they are concerned about unmet social needs or infrastructure) • If recession, then increase government • spending If inflation, then increase taxes • To reduce the size of government (when they think government is too large and inefficient) • If recession, then decrease taxes • If inflation, then decrease government spending LO1 30-15 Other Considerations The crowding-out effect The crowding-out effect may be caused by fiscal policy. “Crowding-out” may occur with government deficit spending. It may increase the interest rate and reduce private spending (Private Investment Spending) which weakens or cancels the stimulus of fiscal policy. Standardized Budget (Full-Employment Budget) Public Budget = Total Revenue – Government Spending Total Revenue is coming usually from Tax Revenue Total Revenue >Government Spending…Budget Surplus Total Revenue < Government Spending….Budget Deficit If the budget was initially balanced, expansionary fiscal policy creates a budget deficit..How?? LO1 30-16