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Chapter 34

Fiscal Policy

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Objective
• Understand how Fiscal Policy can help to
stabilize the economy

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Macro Outcome
• The basic macro outcomes include:
– Output - the total volume of goods and
services produced (real GDP).
– Jobs - the levels of employment and
unemployment.
– Prices - the average prices of goods and
services.

John Maynard Keynes and

Fiscal Policy
• John Maynard Keynes explained how a
deficiency in demand could arise in a
market economy.
• He showed how and why the government
should intervene to achieve
macroeconomic goals.
• He also advocated aggressive use of fiscal
policy to alter market outcomes.

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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 for goods and services
will not always be compatible with
economic stability.

Components of Aggregate Demand

• Aggregate demand is the total quantity of

output demanded at alternative price levels
in a given time period, ceteris paribus.

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Components of Aggregate Demand

• The four major components of aggregate
demand are:
– Consumption (C)
– Investment (I)
– Government spending (G)
– Net exports (exports minus imports) (X- IM)

AD = C + I + G + (X - IM)

Components of Aggregate Demand

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Consumption (C)
• Consumption refers to expenditures by
consumers on final goods and services.
• Consumption spending accounts for
approximately two-thirds of total spending
in the U.S. economy.
• Consumers often change their spending
behavior.

Investment (I)
• Investment refers to expenditures on
(production of) new plant and equipment in
a given time period, plus changes in
business inventories.

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Government Spending (G)

• Government spending includes
expenditures on all goods and services
provided by the public sector.
• Income transfers are not included:
– Income transfers are payments to individuals
for which no services are exchanged.

Net Exports (X-IM)

• Net exports is the difference between
export and import spending.
• Currently Americans are buying more
goods from abroad than foreigners are
buying from us.
• This means that U.S. net exports are
negative.

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Equilibrium
• Aggregate demand is not a single number
but instead a schedule of planned
purchases.
• Macro equilibrium is the combination of
price level and real output that is
compatible with both aggregate demand
and aggregate supply.

Equilibrium
• 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.

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Inadequate Demand
• AD could fall short of the full-employment
equilibrium, leaving some potential output
unsold at the equilibrium point.

Excessive Demand
• AD could generate too much spending,
causing the economy to produce at more
than the full-employment equilibrium.

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The Desired Equilibrium

The Nature of Fiscal Policy

• C + I + G + (X - IM) seldom adds up to
exactly the right amount of aggregate
demand.
• The use of government spending and
taxes to adjust aggregate demand is the
essence of fiscal policy.

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Fiscal Policy

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
full-employment output and the amount of
output demanded at current price levels.

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Deficient Demand

More Government Spending

• Increased government spending is a form
of fiscal stimulus:
– Fiscal stimulus - tax cuts or spending hikes
intended to increase (shift) aggregate demand.

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Multiplier Effects
• An increase in spending results in
increased incomes.
• All income is either spent or saved:
– Saving - Income minus consumption or that
part of disposable income not spent.

Multiplier Effects
• Each dollar spent is re-spent several times.
• As a result, every dollar has a multiplied
impact on aggregate income.

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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

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

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Multiplier Effects
• Spending and saving decisions are
connected:

MPS = 1 – MPC
or
MPC + MPS = 1

https://www.youtube.com/watch?v=is6qg7
iimx8

MPC and MPS

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Multiplier Effects and the

Circular Flow
• The fiscal stimulus to aggregate demand
includes:
– The initial increase in government spending.
– All subsequent increases in consumer
spending triggered by the government outlays.

Multiplier Effects and the

Circular Flow
• Income gets spent and respent in the
circular flow.

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The Circular Flow

Spending Cycles
• The demand stimulus initiated by increased
government spending is a multiple of the
initial expenditure.

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The Multiplier Process at Work

Multiplier Formula
• The multiplier is the multiple by which an
initial change in aggregate spending will
alter total expenditure after an infinite
number of spending cycles:
Multiplier = 1/(MPC)
or
Multiplier = 1/(1-MPS)

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Multiplier Formula
• The multiplier process at work:

Initial change
Total change in
= Multiplier x in government
spending
spending

• Every dollar of fiscal stimulus has a

multiplied impact on aggregate demand.

Multiplier Effects

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Tax Cuts
• Rather than increasing its own spending,
government can cut taxes to increase
consumption or investment spending.
• A tax cut directly increases disposable
income:
– Disposable income is the after-tax income of
consumers.

Taxes and Consumption

• So long as the MPC is greater than zero, a
tax cut will stimulate more consumer
spending:

Initial increase in consumption =

MPC x tax cut

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Taxes and Consumption

• The cumulative increase in aggregate
demand equals a multiple of the tax
induced change in consumption.

Cumulative change in spending =

multiplier x initial change in consumption

Taxes and Consumption

• A tax cut that increases disposable
incomes stimulates consumer spending.
• The cumulative increase in aggregate
demand is a multiple of the initial tax
cut.

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Taxes and Investment

• Tax cuts can increase investment spending
by increasing the expectations of after-tax
profits.
• Taxes were reduced in 1964 and in 1981 to
stimulate spending.
• President Bush pushed even larger tax cuts
in 2001, 2002, and 2003.

Inflation Worries
• Whenever the aggregate supply curve is
upward-sloping, an increase in aggregate
demand increases prices as well as output.
• President Clinton raised taxes partly
because he feared inflationary pressures
were building.

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Fiscal Restraint
• Fiscal restraint may be the proper policy
when inflation threatens:
– Fiscal restraint - tax hikes or spending cuts
intended to reduce (shift) aggregate demand.

Fiscal Restraint

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Budget Cuts
• Cutbacks in government spending directly
reduce aggregate demand.
• As with spending increases, the impact of
spending cuts is magnified by the multiplier.

Multiplier Cycles
• Government cutbacks have a multiplied
effect on aggregate demand:

Cumulative reduction in spending = multiplier

x initial budget cut

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Tax Hikes
• Tax increases reduce disposable income
and thus reduce consumption.
• This shifts the aggregate demand curve to
the left.
• Tax increases have been used to “cool
down” the economy.

Tax Hikes
• The Equity and Fiscal Responsibility Act of
1982 increased taxes to reduce inflationary
pressures.
• President Clinton restrained aggregate
demand in 1993 with a tax increase, but
increased AD in 1997 with a five-year
package of tax cuts.

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Fiscal Guidelines
• The policy goal is to match aggregate
demand with the full-employment potential
of the economy.
• The fiscal strategy for attaining that goal is
to shift the aggregate demand curve.

Fiscal Policy Guidelines

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Unbalanced Budgets
• The use of the budget to manage
aggregate demand implies that the budget
will often be unbalanced.

Budget Deficit
• Budget deficit - the amount by which
government expenditures exceed
government revenues in a given time
period:

Budget deficit = Government spending >

Tax revenues

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Budget Deficit
• The government borrows money to pay for
deficit spending.
• The federal government ran significant
budget deficits between 1970 and 1997.

Budget Surplus
• Budget surplus - an excess of
government revenues over government
expenditures in a given time period:

Budget surplus =Government spending

< Tax revenues

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Unbalanced Budgets

Budget Surplus
• By 1998, a combination of growing tax
revenues and slower government spending
created a budget surplus.
• Starting in 2003, however, the budget
returned to a deficit.

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Countercyclical Policy
• In Keynes’ view, an unbalanced budget is
perfectly appropriate if macro conditions
call for a deficit or surplus.
• A balanced budget is appropriate only if the
resulting AD is consistent with full-
employment equilibrium.

Measures to Control
Unemployment
• Fiscal Policy the government may practice
expansionary fiscal policy through taxation and
public expenditure
1. Decrease in Taxes: reduction in sales tax, service
tax will increase consumption. Reduction in
business and corporate tax will promote an
increase investmentè employment will rise
2. Increase in government expenditure: create more
project developmentsè employment will rise

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Measures to Control
Unemployment
• Direct Control
1.Providing Training: for example
unemployed graduates are given free short
courses to learn computer skills or
language
2.Development of New Land
3.Job Creation in various sectors in an
economy

To Control Inflation:
Fiscal Policy
• Increase Taxes: it will reduce the
disposable incomeè reduce the
consumptionè lead to a fall in prices
• Decrease in Government Spending: It
will directly affect Aggregate Demand.
Govè postpone development project, cut
salary of civil servantè reduce the
purchasing power of the public

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To Control Inflation:
Direct Control
• Price Control: use floor and ceiling price
• Anti hoarding campaign: against the
producers and consumer who store goods
unnecessarily.
• Compulsory saving: deduct the worker
salary can only be withdrawn upon
retirement

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