04/01/2009 201- 005: Principles of Macroeconomics

Dr. S. Ghosh
Spring 2009

Chapter 16: Fiscal Policy

Lecture Outline

Learning Goals:

„ To describe the federal budget process

„ To explain the effects of fiscal policy – both the demand-side effects of fiscal policy
and the supply-side effects of fiscal policy

1. The Federal Budget and Fiscal Policy

Fiscal policy is the use of the federal budget to encourage sustained economic
growth and smooth the business cycle.

The Federal Budget

• The federal budget is the annual statement of the expenditures and tax
revenues of the government of the United States.

• Budget balance = Tax revenues – Expenditures

− If tax receipts exceed expenditures, the government has a budget

surplus.
− If expenditures exceed tax receipts, the government has a budget
deficit.
− If tax receipts equal expenditures, the government has a balanced
budget.

• Discretionary fiscal policy is a fiscal action that is initiated by an act of

Congress.

• Automatic fiscal policy is a fiscal action that is triggered by the state of

the economy.

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04/01/2009 201- 005: Principles of Macroeconomics
Dr. S. Ghosh
Spring 2009

The Federal Budget Timeline for Fiscal Year 2009

Jan 1, 2008 The President submits a budget proposal to Congress

Feb 2, 2008

Congress debates, amends and enacts the budget.

The President signs the budget act into law.

Oct 1, 2008 Fiscal 2009 begins

Sept 30, 2009 Fiscal 2009 ends

2. The Supply Side Effects of Discretionary Fiscal Policy and Potential GDP

• Discretionary fiscal policy can have supply side effects in the economy

• Supply side impact of increased government expenditures on certain types

of goods and services:
− Some government services (law and order, public education) and some
government capital infrastructure (highways, airports) increase
production possibilities.
− Thus, an increase in government expenditures on these types of
spending increases potential GDP and aggregate supply.

• Supply side impact of raising income taxes:

− Income taxes create a disincentive to work, so income taxes decrease
the supply of labor

− The difference between the before-tax wage rate and the after-tax wage
rate is the tax wedge.

− The decrease in the supply of labor decreases employment, which

decreases potential GDP and aggregate supply.

− The higher the tax wedge, the smaller the level of employment and
potential GDP.

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04/01/2009 201- 005: Principles of Macroeconomics
Dr. S. Ghosh
Spring 2009

Graph: Labor Market

Production Function

The Laffer Curve

• As the tax rate rises, incomes decrease and so the total tax revenue
decreases.
• The relationship between the tax rate and total tax revenue is called the Laffer
curve.
• The Laffer curve shows that there is one tax rate that maximizes total tax
revenue.

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04/01/2009 201- 005: Principles of Macroeconomics
Dr. S. Ghosh
Spring 2009

3. The Demand Side Effects of Discretionary Fiscal Policy: Stabilizing Real GDP

The two examples of discretionary fiscal policy would be:

(i) The government changing its expenditures on goods and services (G)

• The government expenditure multiplier is the magnification effect of a

change in government expenditures on goods and services on aggregate
demand. An increase in government expenditures on goods and services
increases aggregate expenditures, which sets in motion the multiplier
process.

(ii) The government changing taxes

• The tax multiplier is the magnification effect of a change in taxes on

aggregate demand. A decrease in taxes increases disposable income and
hence consumption, setting in motion the multiplier process.

• The magnitude of the tax multiplier is less than the magnitude of the
government expenditure multiplier

• Why? Because a $1 tax cut generates less than a $1 increase in

consumption expenditure since only a fraction of the increase in disposable
income is spent on consumption expenditure.

A third possibility is for the government is to simultaneously change government

expenditures and taxes which leaves the budget balance unchanged. This leads to
the balanced budget multiplier.

• The balanced budget multiplier is the magnification effect on aggregate

demand of a simultaneous change in government expenditures and taxes
that leaves the budget balance unchanged.

• Because the government expenditure multiplier is larger than the tax

multiplier, the balanced budget multiplier is positive, so a balanced budget
increase in government expenditures and taxes increases aggregate
demand.

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04/01/2009 201- 005: Principles of Macroeconomics
Dr. S. Ghosh
Spring 2009

Discretionary Fiscal Stabilization

• If timed correctly and of the correct magnitude, discretionary fiscal policy can
be used to push the economy to potential GDP.

• Expansionary fiscal policy is a fiscal policy designed to increase aggregate

demand and seeks to eliminate a recessionary gap.
ƒ an increase in government expenditures
ƒ a decrease in taxes
ƒ an increase in transfer payments

• Contractionary fiscal policy, a fiscal policy designed to decrease aggregate

demand seeks to eliminate an inflationary gap.
ƒ a decrease in government expenditures
ƒ an increase in taxes
ƒ a decrease in transfer payments

• Example of contractionary fiscal policy (used when there is an inflationary

gap).

o The contractionary fiscal policy decreases aggregate demand and the

multiplied effect shifts the AD curve leftward from AD0 to AD1. The
inflationary gap is eliminated and the economy moves to its new
equilibrium (which equals potential GDP).

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04/01/2009 201- 005: Principles of Macroeconomics
Dr. S. Ghosh
Spring 2009

Combined Demand-Side and Supply-Side Effects of a Discretionary Tax Cut

• A tax cut increases both aggregate demand and aggregate supply. Both the
aggregate demand and aggregate supply curves shift rightward.

• Equilibrium real GDP definitely increases.

• But the impact on the equilibrium price level is uncertain.

− If the increase in aggregate demand exceeds the increase in aggregate
supply, the price level rises.
− If the increase in aggregate demand equals the increase in aggregate
supply, the price level does not change.
− If the increase in aggregate demand is less than the increase in
aggregate supply, the price level falls.

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04/01/2009 201- 005: Principles of Macroeconomics
Dr. S. Ghosh
Spring 2009

Limitations of Discretionary Fiscal Policy

• In practice, discretionary fiscal policy is hampered by four factors:

− Law-Making Time Lag: The law-making lag is the amount of time it takes
Congress to pass the laws needed to change taxes or spending.

− Shrinking Area of Law-Maker Discretion: An increasing large part of the

budget (such as Medicare) is effectively off limits for shrinkage.

− Estimating Potential GDP: It is not easy to tell whether real GDP is

below, above, or at potential GDP so it is not easy tell if a contractionary
or expansionary policy is needed.

− Economic Forecasting: Fiscal policy must target forecasts of where the

economy will be in the future. Economic forecasting has improved
enormously in recent years, but it remains inexact and subject to error.

Automatic Fiscal Policy

• Automatic stabilizers are features of fiscal policy that stabilize real GDP
without explicit action by the government. Induced taxes and needs-tested
spending are automatic stabilizers.

− Induced taxes are taxes that vary with real GDP. In an expansion, induced
taxes rise, helping to stabilize the economy and in a recession, induced
taxes fall, helping to stabilize the economy.

− Needs-tested spending is spending on programs that entitle suitably

qualified people and businesses to receive benefits -- benefits that vary with
need and with the state of the economy.

• Induced taxes and needs-tested spending decrease the multiplier effects of

changes in autonomous expenditure so they moderate both expansions and
recessions and make real GDP more stable.

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