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CHAPTER 11
FISCAL POLICY
In this chapter, you will find:
Learning Outcomes
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Solutions to Problems Appendix
Experiential Assignments
INTRODUCTION
This chapter brings government into the picture by analyzing how fiscal policy—including taxes, government
purchases, and transfer programs—influences the economy. (The impact of net exports on the aggregate
expenditure line and the algebra of the fiscal multipliers are covered here and in the chapter’s online
appendix.) The chapter then presents the historical evolution of fiscal policy, contrasting the classical view of
the economy with the Keynesian view. Classical economists believed that the economy would naturally tend
toward full employment, but Keynes argued that the economy could sometimes get stuck in a situation in
which output fell far short of the economy’s potential, as occurred during the Great Depression. From there,
the chapter presents a more complete description of aggregate demand with the aggregate supply curve
developed earlier. The objective is to show the pros and cons of discretionary fiscal policy and automatic
stabilizers as ways of addressing expansionary and recessionary gaps. The chapter closes with a description of
recent fiscal policy.
LEARNING OUTCOMES
11-1 Describe the discretionary fiscal policies to close a recessionary gap and an expansionary gap.
The tools of fiscal policy are automatic stabilizers and discretionary fiscal measures. Automatic stabilizers, such as the federal income tax, once implemented, operate year after year without congressional
action. Discretionary fiscal policy results from specific legislation about government spending, taxation,
and transfers. If that legislation becomes permanent, then discretionary fiscal policies often become automatic stabilizers.
An expansionary fiscal policy can close a recessionary gap by increasing government purchases,
reducing net taxes, or both. Because the short-run aggregate supply curve slopes upward, an increase in
aggregate demand raises both output and the price level in the short run. A contractionary fiscal policy
can close an expansionary gap by reducing government purchases, increasing net taxes, or both. Fiscal
policy that reduces aggregate demand to close an expansionary gap reduces both output and the price
level.
11-2 Summarize fiscal policy from the Great Depression to stagflation.
Fiscal policy from the Great Depression to the 1970s focused primarily on the demand side, not the supply side. This has been described as the Golden Age of Keynesian economics, when policymakers
believed they could tweak taxes and government spending to fine tune the economy.
11-3 Identify some reasons why discretionary fiscal policy may not work very well.
The problems of the 1970s, however, resulted more from a decline of aggregate supply than from a decline of aggregate demand, so demand-side remedies seemed less effective. A more fundamental problem
is that discretionary fiscal policy usually requires knowledge about aggregate supply, aggregate demand,
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
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162
potential output, and the natural rate of unemployment, but policymakers usually lack that information.
Without such knowledge, fiscal policy can be too little, too much, or too late.
11-4 Summarize fiscal policy from 1980 to the present and describe the most significant event during that
period, and the fiscal policy response.
The tax cuts of the early 1980s aimed to increase aggregate supply. But government spending grew faster
than tax revenue, creating budget deficits that stimulated aggregate demand. These huge deficits discouraged additional discretionary fiscal policy, but success in erasing deficits in the late 1990s spawned renewed interest in discretionary fiscal policy, as reflected by President Bush’s tax cuts in the face of the
2001 recession. Tax cuts and new spending increased deficits into 2004, but the economy added over 8
million jobs by 2007. The added output and income cut the federal deficit from about $400 billion in
2004 to about $160 billion in 2007.
After peaking in December 2007, the economy turned down, as consumers, firms, and financial
markets were spooked by falling home prices and rising foreclosure rates. Job losses increased sharply
after the financial crisis of September 2008. Government officials first tried to calm financial markets
with TARP, then tried to stimulate the economy with the largest spending program in history. The economy lost 8.4 million jobs between December 2007 and December 2009. Jobs started coming back in
2010, but the unemployment rate remained high for years.
CHAPTER OUTLINE WITH POWERPOINT SCRIPT
USE POWERPOINT SLIDE 2 FOR THE FOLLOWING SECTION
Theory of Fiscal Policy
Fiscal Policy: The use of government purchases, transfer payments, taxes, and borrowing to affect
macroeconomic variables such as real GDP, employment, the price level, and economic growth.
USE POWERPOINT SLIDES 3-4 FOR THE FOLLOWING SECTION
Fiscal Policy Tools:
 Automatic stabilizers: Revenue and spending programs in the federal budget that automatically adjust
with the ups and downs of the economy to stabilize disposable income.
 Discretionary fiscal policy: Deliberate manipulation of government purchases, transfer payments, and
taxes to promote macroeconomic goals like full employment, price stability, and economic growth.
USE POWERPOINT SLIDES 5 FOR THE FOLLOWING SECTION
Changes in Government Purchases: At any given price level, an increase in government purchases or
transfer payments increases real GDP demanded.
For a given price level, assuming only consumption varies with income:
 Change in real GDP = change in government spending  1 / (1 MPC) other things constant.
 Simple Spending Multiplier = 1 / (1  MPC)
USE POWERPOINT SLIDES 6 FOR THE FOLLOWING SECTION
Changes in Net Taxes: A decrease (increase) in net taxes increases (decreases) disposable income at each
level of real GDP, so consumption increases (decreases). The change in real GDP demanded is equal to the
resulting shift of the aggregate expenditure line times the simple spending multiplier.
 Change in real GDP = (MPC  change in NT)  1 / (1 – MPC) or simplified,
 Change in real GDP = change in NT  -MPC/(1-MPC)
 Simple tax multiplier = MPC / (1 – MPC)
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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USE POWERPOINT SLIDES 7-8 FOR THE FOLLOWING SECTION
Discretionary Fiscal Policy to Close a Recessionary Gap: Expansionary fiscal policy, such as an increase in
government purchases, a decrease in net taxes, or a combination of the two:
 Could increase aggregate demand just enough to return the economy to its potential output.
 Causes a higher price level and may cause a budget deficit.
USE POWERPOINT SLIDES 9-11 FOR THE FOLLOWING SECTION
Discretionary Fiscal Policy to Close an Expansionary Gap: Contractionary fiscal policy to reduce
aggregate demand by reducing government purchases, increasing net taxes, or a combination of the two:
 Could move the economy to potential output without the resulting inflation.
 Causes a lower price level and a lower deficit or even a surplus.
USE POWERPOINT SLIDE 12 FOR THE FOLLOWING SECTION
The Multiplier and the Time Horizon: The steeper the short-run aggregate supply curve, the less impact a
given shift of the aggregate demand curve has on real GDP and the more impact it has on the price level, so the
smaller the spending multiplier. At potential output, the spending multiplier in the long run is zero.
USE POWERPOINT SLIDES 13-14 FOR THE FOLLOWING SECTION
The Evolution of Fiscal Policy: Classical economists, who advocated laissez-faire, believed that natural
market forces—by way of flexible prices, wages, and interest rates—would move the economy toward
potential GDP. There was no need for government intervention.
USE POWERPOINT SLIDES 15-16 FOR THE FOLLOWING SECTION
The Great Depression and World War II
 The Great Depression strained belief in the economy’s ability to correct itself, which was the view of the
classical economists.
 Keynesian theory challenged the classical view:
 Prices and wages did not appear flexible enough to ensure the full employment of resources.
 Prices and wages were relatively inflexible, or “sticky” in the downward direction.
 Business expectations might at times become so grim that even very low interest rates would not spur firms
to invest all that consumers might save.
 After the Great Depression, the use of discretionary fiscal policy was bolstered by:
 The influence of Keynes “General Theory.”
 Impact of WWII on output and employment.
 Passage of the Employment Act of 1946, giving the government the responsibility for promoting full employment and price stability.
USE POWERPOINT SLIDE 17 FOR THE FOLLOWING SECTION
Automatic Stabilizers: The progressive federal income tax, unemployment insurance, and welfare spending
smooth fluctuations in disposable income over the business cycle by:
Stimulating aggregate demand during recessions; and,
Dampening aggregate demand during expansions.
USE POWERPOINT SLIDES 18-19 FOR THE FOLLOWING SECTION
From the Golden Age to Stagflation
 1960s Golden Age of fiscal policy: Increasing or decreasing aggregate demand to smooth economic
fluctuations.
 1970s Stagflation (high inflation and high unemployment due to adverse supply shocks):
 Fiscal policy is ill-suited to solving stagflation.
 Increasing aggregate demand would increase inflation, and decreasing aggregate demand would increase
unemployment.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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USE POWERPOINT SLIDES 20-21 FOR THE FOLLOWING SECTION
Fiscal Policy and the Natural Rate of Unemployment
Natural rate of unemployment: The unemployment rate that occurs when the economy is producing its
potential GDP.
 For discretionary policy purposes, officials must correctly estimate this natural rate.
USE POWERPOINT SLIDE 22 FOR THE FOLLOWING SECTION
Lags in Fiscal Policy: Time required to approve and implement fiscal legislation can weaken the effectiveness
of discretionary fiscal policy as a tool for macroeconomic stabilization.
USE POWERPOINT SLIDE 23 FOR THE FOLLOWING SECTION
Discretionary Fiscal Policy and Permanent Income: Because consumers base their spending decisions on
their permanent income, temporary tax changes are less effective.
USE POWERPOINT SLIDES 24-25 FOR THE FOLLOWING SECTION
The Feedback Effects of Fiscal Policy on Aggregate Supply: Automatic stabilizers and discretionary fiscal
policy may inadvertently affect individual incentives to work, spend, save, and invest.
USE POWERPOINT SLIDES 26-28 FOR THE FOLLOWING SECTION
1990 to 2007: From Deficits to Surpluses Back to Deficits: Higher tax revenue and spending discipline
created surpluses from 1998 to 2000. Recession and terrorist attacks in 2001 caused deficits to return.
USE POWERPOINT SLIDES 29-38 FOR THE FOLLOWING SECTION
Fiscal Policy and the 2007-2009 Recession: Crisis in the housing market led to a financial crisis and a deep
recession. Tax cuts and increased spending caused ballooning deficits. The American Recovery and
Reinvestment Act had an estimated cost of $862 billion.
CHAPTER SUMMARY
The tools of fiscal policy are automatic stabilizers and discretionary fiscal measures. Automatic stabilizers,
such as the federal income tax, once implemented, operate year after year without congressional action.
Discretionary fiscal policy results from specific legislation about government spending, taxation, and transfers.
If that legislation becomes permanent, then discretionary fiscal policies often become automatic stabilizers.
The effect of an increase in government purchases on aggregate demand is the same as that of an increase in
any other type of spending. Thus, the simple spending multiplier for a change in government purchases is
1/(1−MPC).
A decrease in net taxes (taxes minus transfer payments) affects consumption by increasing disposable income.
A decrease in net taxes does not increase spending as much as would an identical increase in government
purchases because some of the tax cut is saved. The multiplier for a change in autonomous net taxes is
−MPC/(1-MPC).
An expansionary fiscal policy can close a recessionary gap by increasing government purchases, reducing net
taxes, or both. Because the short-run aggregate supply curve slopes upward, an increase in aggregate demand
raises both output and the price level in the short run. A contractionary fiscal policy can close an expansionary
gap by reducing government purchases, increasing net taxes, or both. Fiscal policy that reduces aggregate
demand to close an expansionary gap reduces both output and the price level.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 12
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165
Fiscal policy focuses primarily on the demand side, not the supply side. The problems of the 1970s, however,
resulted more from a decline of aggregate supply than from a decline of aggregate demand, so demand-side
remedies seemed less effective.
The tax cuts of the early 1980s aimed to increase aggregate supply. But government spending grew faster than
tax revenue, creating budget deficits that stimulated aggregate demand, leading to the longest peacetime
expansion to that point in the nation’s history. These huge deficits discouraged additional discretionary fiscal
policy as a way of stimulating aggregate demand further, but success in erasing deficits in the late 1990s
spawned renewed interest in discretionary fiscal policy, as reflected by President Bush’s tax cuts in the face of
the 2001 recession.
Tax cuts and new spending increased deficits into 2004, but the economy added over 8 million jobs by 2007.
The added output and income cut the federal deficit from about $400 billion in 2004 to about $160 billion in
2007. The recession that began officially in December 2007 reversed those recent gains, leading to increases in
the deficit.
After peaking in December 2007, the economy turned down, as consumers, firms, and financial markets were
spooked by falling home prices and rising foreclosure rates. Job losses increased sharply after the financial
crisis of September 2008. Government officials first tried to calm financial markets with TARP, then tried to
stimulate the economy with the largest program in history. The economy lost 8.4 million jobs between
December 2007 and De-cember 2009. Jobs started coming back in 2010, but the unemployment rate remained
high.
TEACHING POINTS
1. This chapter considers the effects of fiscal policy on equilibrium income and employment. It begins
with a discussion of multipliers and ends with a clear discussion of the aggregate demand curve and fiscal policy. Students should understand that there is a continuity to the presentations of the first and last
parts of this chapter.
2. You should link together the many parts of this chapter. First, you must again illustrate the multiplier
for the case of government spending. The multiplier has been discussed in previous chapters, so it should
not present any barriers to your students. Next, you must again discuss the aggregate demand curve. Reference should be made to Exhibit 9 in Chapter 9 for a graphical derivation of the aggregate demand
curve. Have your students review that section. Finally, there is a full discussion of the effects of fiscal
policy on aggregate demand, assuming a given aggregate supply curve.
3. The text works through examples of government spending changes and tax changes, making full use of
the multipliers. There is also an example using proportional taxes, as well as the “balanced budget multiplier” in the Appendix, which can be found online at 4ltrpress.cengage.com.
4. Having discussed the nature of fiscal policy and recessionary/expansionary gaps, you may find it useful to use a conventional aggregate demand–aggregate supply diagram with such a gap and to ask the
class how to determine the appropriate fiscal policy. It will be quickly evident that a great deal of information is required to make good policy. This includes knowledge of the size of the gap, the slopes of the
aggregate demand and aggregate supply curves, the size of the multipliers, and the adjustment time. This
will naturally lead into a discussion of the appropriateness and relative merits of using discretionary versus automatic stabilizers in fiscal policy.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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5. The tax cuts and stimulus spending in 2008–2010 will remain controversial for a long time. Ask the
students to research the latest studies of those policies and any currently proposed actions. Consider staging a classroom debate.
SOLUTIONS TO PROBLEMS APPENDIX
1.
(Fiscal Policy) Define fiscal policy. Determine whether each of the following, other factors held
constant, would lead to an increase, a decrease, or no change in the level of real GDP demanded:
a. A decrease in government purchases
b. An increase in net taxes
c. A reduction in transfer payments
d. A decrease in the marginal propensity to consume
a. decrease real GDP
b. decrease real GDP
c. decrease real GDP
d. decrease real GDP
2.
(Recessionary Gap) What is a recessionary gap? What fiscal policy might close that gap? Show
with a graph.
A recessionary gap is the extent to which actual output falls short of potential output. Expansionary fiscal policy should be utilized to increase aggregate demand.
3.
(Expansionary Gap) What is an expansionary gap? What fiscal policy might close that gap?
Show with a graph.
An expansionary gap is the extent to which actual output exceeds potential output. Contractionary fiscal policy should be utilized to decrease aggregate demand.
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Chapter 12
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(Changes in Government Purchases) Assume that government purchases decrease by $10 billion,
with other factors held constant, including the price level. Calculate the change in the level of real
GDP demanded for each of the following values of the MPC. Then, calculate the change if the
government, instead of reducing its purchases, increased autonomous net taxes by $10 billion.
a. 0.9
b. 0.8
c. 0.75
d. 0.6
The formula that should be used to solve the first part of this problem is ∆G*1/(1−MPC). The first
part indicates that there was a decrease in government purchases, so ∆G will equal −10. The
formula that should be used to solve the second part is ∆NT*−MPC/(1−MPC). The second part
indicates that there was an increase in autonomous net taxes, so ∆NT will equal +10.
a. −$100 billion = [−10*1/(1-0.9)]; −$90 billion = [10*−0.9/(1−0.9)]
b. −$50 billion = [−10*1/(1−0.8)]; −$40 billion = [10*−0.8/(1−0.8)]
c. −$40 billion = [−10*1/(1−0.75)]; −$30 billion = [10*−0.75/(1−0.75)]
d. −$25 billion = [−10*1/(1−0.6)]; −$15 billion = [10*−0.6/(1−0.6)]
5.
(Fiscal Multipliers) Explain the difference between the government purchases multiplier and the net
tax multiplier. If the MPC falls, what happens to the tax multiplier?
A change in government purchases directly affects aggregate expenditure by the amount of the
change in purchases, and its multiplier equals 1 / (1 − MPC). However, a change in net taxes has
no direct impact on aggregate expenditure. Rather, a change in net taxes affects disposable income,
therefore altering consumption by the change in net taxes times the net tax multiplier (−MPC /
1−MPC). Note the negative relationship between net taxes and consumption. Aggregate
expenditure initially shifts by the amount of the consumption change.
It may be best to use a numerical example to show what happens when MPC falls. If the MPC is
0.90, the tax multiplier will equal 9. If the MPC falls to 0.80, the tax multiplier will fall to 4. Thus, a
fall in the MPC reduces the tax multiplier.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
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Chapter 12
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168
(Multipliers) Suppose investment, in addition to having an autonomous component, also has a
component that varies directly with the level of real GDP. How would this affect the size of the
spending multiplier?
It would have the same impact on the spending multiplier as an increase in the MPC would,
injecting more spending at each stage in the multiplier process. Hence, the multiplier would be
larger in this case.
7.
(Fiscal Policy) Chapter 11 shows that increased government purchases, with taxes held constant,
can eliminate a recessionary gap. How could a tax cut achieve the same result?
A tax cut would increase disposable income. Individuals would in turn spend a portion of their tax
cuts, provided that they felt that the tax cuts were long lasting. This would raise aggregate
expenditure and aggregate demand.
To obtain a given effect, the tax cut must be larger than the increase in government purchases. We
know that the needed tax cut works on aggregate demand indirectly through the consumption
function. The size of the needed tax cut will depend on the tax multiplier, which is smaller than the
simple spending multiplier.
8.
(Fiscal Policy with an Expansionary Gap) Using the aggregate demand–aggregate supply model,
illustrate an economy with an expansionary gap. If the government is to close the gap by changing
government purchases, should it increase or decrease those purchases? In the long run, what
happens to the level of real GDP as a result of government intervention? What happens to the price
level? Illustrate this on an AD–AS diagram, assuming that the government changes its purchases by
exactly the amount necessary to close the gap.
Government purchases fall to reduce aggregate demand from AD1 to AD2 . When AD falls, both
real GDP and the price level fall. Equilibrium moves from e1 to e2 .
9.
(Evolution of Fiscal Policy) What did classical economists assume about the flexibility of prices,
wages, and interest rates? What did this assumption imply about the self-correcting tendencies in an
economy in recession? What disagreements did Keynes have with classical economists?
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Chapter 12
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The flexibility of prices was the most important point of the classical economists, since they
emphasized that flexible prices would restore any imbalance that might occur in the
macroeconomic markets. This implied that the natural market forces would move the economy
towards its potential GDP. Keynes attacked the ideas of the classical economists. First, he noted
that wages were seldom flexible downward. Next, he noted that even though interest rates might
fall, there could be such pessimism about the future that neither consumption nor investment would
increase very much. Thus, quantities of goods (and hence employment), not prices, would change to
equilibrate the markets.
10.
(Fiscal Policy) Why or why not was fiscal policy effective when the U.S. economy was experiencing stagflation during the 1970s?
The problems of the 1970s resulted from a decline of aggregate supply more than from a decline
of aggregate demand, so demand-side remedies seemed less effective. A more fundamental problem is that discretionary fiscal policy usually requires knowledge about aggregate supply, aggregate demand, potential output, and the natural rate of unemployment, but policymakers usually lack that information. Without such knowledge, fiscal policy can be too little, too much, or
too late.
11. (Fiscal Policy Effectiveness) Determine whether each of the following would make fiscal policy more
effective or less effective:
a. A decrease in the marginal propensity to consume
b. Shorter lags in the effect of fiscal policy
c. Consumers suddenly becoming more concerned about permanent income than about current income
d. More accurate measurement of the natural rate of unemployment
a.
b.
c.
d.
12.
Less effective
More effective
More effective
More effective
(Fiscal Policy During the Great Recession) Using the aggregate demand–aggregate supply
model, illustrate what President Obama was trying to accomplish with the $831 billion stimulus
program. What were some costs and benefits of this program?
After peaking in December 2007, the economy turned down, as consumers, firms, and financial
markets were spooked by falling home prices and rising foreclosure rates. Job losses increased
sharply after the financial crisis of September 2008. Government officials first tried to calm financial markets with TARP, then President Obama tried to stimulate the economy with the largest spending program in history. President Obama was trying to close a recessionary gap as
shown in the figure below. Unfortunately the economy remained weak due to the significant drop
in aggregate demand from private sector spending despite the fiscal stimulus. Nevertheless, jobs
started coming back in 2010, but the unemployment rate remained high for years. Perhaps the
fiscal stimulus was not large enough? The concern, however, with a fiscal stimulus of this size is
the growing national debt it creates.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 12
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170
Experiential Assignments
1. The University of Washington’s Fiscal Policy Center at
http://depts.washinton.edu/fpcweb/center/links.htm provides an extensive list of links about U.S. fiscal
policy. Ask students to visit the site and use the links to determine what tax and spending policies
have been proposed in Congress during the past year. Have students choose a proposal and apply the
AD–AS framework to figure out its likely impact.
2. In the United States, fiscal policy is determined jointly by the president and Congress. The Congressional Budget Office at http://www.cbo.gov/ provides analysis to Congress, and the Office of
Management and Budget at http://www.whitehouse.gov/omb does the same for the executive branch.
Suggest to students that they visit these Web sites to get a sense of the kinds of analyses these groups
undertake and how this analysis might be used in determining fiscal policy.
3. “Washington Wire” is a column that appears on the front page of the Wall Street Journal each Friday.
Have students review the latest column to determine what fiscal policy proposals are under consideration.
Do the proposals deal more with discretionary fiscal policy or with automatic stabilizers? Are they designed to affect aggregate demand or aggregate supply?
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.