1 Fiscal Policy Key Concepts Key Concepts Summary ©2005 South-Western College Publishing.

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Fiscal Policy

• Key Concepts• Summary

©2005 South-Western College Publishing

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What does this chapter cover?

You will study demand-side and supply-side fiscal policies.

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What is a discretionary fiscal policy?

The deliberate use of changes in government spending or taxes to alter aggregate demand and stabilize the economy

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What are examples of expansionary

fiscal policy?• Increase government spending

• Decrease taxes• increase government spending and taxes equally

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What are examples of contractionary

fiscal policy?• Decrease government spending

• Increase taxes• Decrease government spending and taxes equally

6$6 $6.1 $6.2

AS

0

150

155

AD1

AD2

Real GDP

E2

XE1

155

Government Spending to Combat a Recession

Pri

ce L

evel

full employment

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Increase in government

spending

Increase in the aggregate

demand curve

Increase in the price

level and the real GDP

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With an MPC of 0.75, what is the spending

multiplier?

1/MPS = 1/1/4 = 4

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How much will real GDP increase by with

an increase in government spending

of $50 bil?4 x $50 bil = $200 bil

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What is thetax multiplier?

The change in aggregate demand (total spending) resulting from an initial change in taxes

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What happens when government cuts taxes by $50 bil?

The multiplier process is less because initial spending increases only by $38 bil instead of $50 bil

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What is the formula for the tax multiplier?

1 – spending multiplier

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How much does real GDP increase by with a cut in taxes of $50 bil?

3 x $50 bil = $150 bil

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Can we assume that the MPC will remain fixed?No, it can change from one time period to another

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Can fiscal policy be used to combat

inflation?Yes, this would happen when the economy is operating in the Classical or Intermediate range of the aggregate supply curve

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What will happen to AD with a cut in G spending of 25 bil?

-$25 bil x 4 = -$100 bil

17$6 $6.1

AS

0

155

160

Real GDP

E2

E1

Using Fiscal Policy to Combat Inflation

E´

Pri

ce L

evel

full employment

AD1

AD2

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Decrease in government

spending

Decrease in the aggregate

demand curve

Decrease in the price level

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What will happen to AD with a cut in taxes of 33.3 bil?

$33.3 x -3 = -$100 bil

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What is the balanced budget multiplier?

An equal change in government spending and taxes, which changes aggregate demand by the amount of the change in government spending

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What is anautomatic stabilizer?

Federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction

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What are examples of automatic stabilizers?

• Transfer payments• Unemployment compensation• Welfare

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What is abudget surplus?

A budget in which government revenues exceed government expenditures in a given time period

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What is abudget deficit?

A budget in which government expenditures exceed government revenues in a given time period

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$1,000

$750

$500

$250

$4 $6 $8

G

$2,500T

Real GDP

Bu

dg

et

def

icit

Bu

dg

et su

rplu

s

Automatic Stabilizers

Go

vern

men

t S

pen

din

g a

nd

Tax

es

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Increase in real GDP

Tax collections fall and government

transfer payments rise

Budget offsets inflation

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Decrease in real GDP

Tax collections fall and government

transfer payments rise

Budget offsets

recession

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What is supply-side fiscal policy?

A fiscal policy that emphasizes government policies that increase aggregate supply

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What is the purpose of supply-side fiscal

policies?To achieve long-run growth in real output, full employment, and a lower price level

302 4 6 8 10 12

AS

0

100

200

250

Demand-Side Fiscal Policy

Real GDPAD1

AD2

E1

E2

Pri

ce L

evel

150

full employment

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Increase in government spending; decrease in net taxes

Increase in the aggregate demand curve

322 4 6 8 10 120

100

200

250

Supply-Side Fiscal Policy

Real GDPAD

E1

Pri

ce L

evel

150

AS1

AS2

full employmentE2

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Decrease in resource prices; technological advances; subsidies;

decrease in regulations

Increase in the aggregate supply curve

34L1 L2

0

W2

W1

Labor DemandQ of Labor

Wag

e ra

te

E2

E1

Supply-Side Policies Affect Labor Markets

Before tax-cut labor supply

After tax-cut labor supply

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Will an increase in taxes lead to higher

government revenues?That depends on where the economy is on the Laffer Curve

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What is theLaffer Curve?

Puts forth the idea that increasing taxes from zero will increase tax revenues up to a certain point

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What happens beyond a certain point?

Tax revenues begin to decline as the economic pie begins to shrink

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Why does the economic pie begin to shrink?Workers have less incentive to work and investors have less of an incentive to invest

39Tmax

T0

R

Federal Tax Rate

Fed

eral

Tax

Rev

enu

e

A

The Laffer Curve

100%

B

C

D

Rmax

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Key Concepts

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• What is a discretionary fiscal policy?• What are examples of expansionary fiscal policy?• What are examples of contractionary fiscal policy?• With an MPC of 0.75, what is the multiplier?• How much will real GDP increase by with an increa

se in government spending of $50 bil?

• What is the tax multiplier?• What is the formula for the tax multiplier?• Can fiscal policy be used to combat inflation?

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• What will happen to ad with a cut in g spending of 25 bil?

• What is the balanced budget multiplier?• What is an automatic stabilizer?• What is a budget surplus?• What is a budget deficit?• What is supply side fiscal policy?• What is the Laffer Curve?

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Summary

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Fiscal policy is the use of government spending, taxes, and transfer payments for the purpose of stabilizing the economy.

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Discretionary fiscal policy follows the Keynesian argument that the federal government should manipulate aggregate demand in order to influence the output, employment, and price levels in the economy.

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Discretionary fiscal policy requires either new legislation to change government spending or taxes in order to stabilize the economy.

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Expansionary fiscal policy is a deliberate increase in government spending, a deliberate decrease in taxes, or some combination of these two options.

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Contractionary fiscal policy is a deliberate decrease in government spending, a deliberate increase in taxes, or some combination of these two options.

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Using either expansionary or contractionary fiscal policy, the government can shift the aggregate demand curve in order to combat recession, cool inflation, or achieve other macroeconomic goals.

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• Increase government spending• Decrease taxes• Increase government spending and taxes equally

Expansionary Contractionary

Discretionary Fiscal Policies

• Decrease government spending• Increase taxes• Decrease government spending and taxes equally

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The tax multiplier is the multiplier by which an initial change in taxes changes aggregate demand (total spending) after an infinite number of spending cycles.

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Expressed as a formula, the tax multiplier = 1 - spending multiplier.

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A balanced budget multiplier is not neutral. A dollar of government spending increases real GDP more than a dollar cut in taxes. Thus, even though the government does not spend more than it collects in taxes, it is still stimulating the economy.

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Combating recession and inflation can be accomplished by changing government spending or taxes.

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The total change in aggregate demand from a change in government spending is equal to the change in government spending times the spending multiplier. The total change in aggregate demand from a change in taxes is equal to the change in taxes times the tax multiplier.

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Increase in government

spending

Increase in the aggregate

demand curve

Increase in the price

level and the real GDP

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Decrease in government

spending

Decrease in the aggregate

demand curve

Decrease in the price level

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A budget surplus occurs when government revenues exceed government expenditures.

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A budget deficit occurs when government expenditures exceed government revenues.

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Automatic stabilizers are changes in taxes and government spending that occur automatically in response to changes in the level of real GDP.

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The business cycle creates braking power. A budget surplus slows down an expanding economy. A budget deficit reverses a downturn in the economy.

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$1,000

$750

$500

$250

$4 $6 $8

G

$2,500T

Real GDP

Bu

dg

et

def

icit

Bu

dg

et su

rplu

s

Automatic Stabilizers

Go

vern

men

t S

pen

din

g a

nd

Tax

es

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According to supply-side fiscal policy, lower taxes encourage work, saving, and investment, which shift the aggregate supply curve rightward. As a result, output and employment increase without inflation.

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The Laffer curve represents the relationship between the income tax rate and the amount of income tax revenue collected by the government.

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END