13e

Chapter 11:
Fiscal Policy

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Fiscal Policy
The Keynesian theory of macro
instability practically mandates
government intervention.
If AD is too little, unemployment arises.
If AD is too much, inflation arises.

If the market cannot correct these

imbalances, then the federal
government must.
11-2

Fiscal Policy
In this chapter we examine fiscal policy
tools.
Core issues are
Can government spending and tax policies
ensure full employment?
What policy actions will help fight inflation?
What are the risks of government intervention?

Fiscal policy: the use of government taxes

and spending to alter macroeconomic
outcomes.
11-3

Learning Objectives
11-01. Know what the real GDP gap and the
AD shortfall measure.
11-02. Know the desired scope and tools of
fiscal stimulus.
11-03. Know what AD excess measures and
the desired scope and tools of fiscal
restraint.
11-04. Know how the multiplier affects fiscal
policy.
11-4

Taxes and Spending

The federal government collects nearly $3
trillion a year in tax revenues, nearly half of
which comes from individual income taxes.
Less than half of government expenditures
go to government purchases of goods and
services; the rest are income transfers.
Income transfers: payments to individuals for
which no current goods or services are
exchanged.

11-5

Fiscal Policy
These tax and spending powers can
greatly influence AD.
Government can alter AD by
Purchasing more or fewer goods and
services.
Raising or lowering taxes.
Changing the level of income transfers.

11-6

Fiscal Policy Goals

First, we will explore fiscal policys
potential to ensure full employment.
Second, we will explore fiscal policys
potential to maintain price stability.

11-7

Fiscal Stimulus
If a recessionary
GDP gap exists, a
fiscal stimulus could
be used to deliver
the economy to fullemployment GDP.
Fiscal stimulus: tax
cuts or spending
hikes intended to
increase AD that
is, shift AD right.
11-8

The AD Shortfall
AS slopes upward, so an
AD shift right will induce
price level increases.
The fiscal stimulus needed
to close the GDP gap must
be larger than the gap.
AD shortfall: the amount
of additional AD needed to
achieve full employment
after allowing for price
level changes.
It is represented by the
distance between point a
and point e.
It becomes the fiscal
target.
11-9

Using Government Spending

Increased government spending is a
form of fiscal stimulus.
All new government spending will have a
multiplied impact on AD.
The multiplier effect will stimulate additional
rounds of increased consumer spending.

11-10

Desired Fiscal Stimulus

Too little fiscal stimulus? The
economy may stay in recession.
Too much fiscal stimulus? This may
rapidly lead to excessive spending
and inflation.

11-11

Tax Cuts
The fiscal stimulus can come from
inducing increased consumption or
investment spending.
Government can do this by lowering
taxes.
Individual income tax cut: disposable income
would increase, causing increased
consumption spending.
Corporate tax cut: profits would increase,
spurring increased investment spending.
11-12

Tax Cuts
A tax cut adds no more dollars to the
economy. It allows earners to keep more
of their current pretax income. How
much additional consumer spending is
controlled by the size of MPC.

11-13

Tax Cuts
Since there is no initial new input of
spending, a tax cut contains less
fiscal stimulus than a government
spending increase of the same size.
The initial spending injection can be less
than the size of the tax cut.

11-14

Balanced Budget Multiplier

Spending increases raise expenditures
(G), and tax cuts decrease revenues (T);
therefore, the budget deficit increases.
If the change in G and the change in T
are the same, the deficit would not
grow.
How would this affect AD?
Since the effect of a change in G is greater
than the effect of a change in T, AD would
shift by the size of the change.
11-15

Increased Transfers
Increasing transfer payments raises
recipients disposable income, and
spending increases.
The effect is much like a tax cut
since the recipients will save some of
the payment.

11-16

Fiscal Restraint
If an inflationary
GDP gap exists, a
fiscal restraint could
be used to return
the economy to fullemployment GDP.
Fiscal restraint: tax
hikes or spending
cuts intended to
decrease AD that
is, shift AD left.
11-17

The AD Excess
AS slopes upward, so an
AD shift left will induce
price level decreases.
The fiscal restraint needed
to close the GDP gap must
be larger than the gap.
AD excess: the amount by
which AD must be reduced
to achieve full
employment after allowing
for price level changes.
It is represented by the
distance between point
Q1 and point Q2.
It becomes the fiscal
target.

11-18

Desired Fiscal Restraint

Too little fiscal restraint? The
economy may continue to be
inflationary.
Too much fiscal restraint? This may
rapidly lead to decreased spending
and rising unemployment.

11-19

Budget Cuts
Decreased government spending is a
form of fiscal restraint.
Reduced government spending will
have a multiplied impact on AD.
The multiplier effect will generate
additional negative rounds of decreased
consumer spending.

11-20

Budget Cuts
Cut government expenditures to
initiate a multiplier process to achieve
the desired fiscal restraint.
For example, decreased military spending
would cause layoffs at defense plants.
Incomes would decrease and consumer
spending would also decrease, triggering
the negative multiplier rounds.

11-21

Tax Hikes
The direct effect of a tax hike is
reduced disposable income.
People must reduce consumption and
saving to pay the added taxes.
This will trigger the negative
multiplier effect.
AD will shift to the left.
11-22

Reduced Transfers
If transfer payments decrease,
recipients disposable income falls
and spending decreases.
The effect is much like a tax hike.
This option is politically unpopular.

11-23

Fiscal Guidelines
The goal of fiscal policy is to
eliminate GDP gaps by shifting AD.
How much to shift is indicated by the
AD shortfall or the AD excess.
The size of the fiscal initiative is less
than the desired shift.
What remains is to decide which
policy tool to use.
11-24

Crowding Out
Crowding out: a reduction in private
sector borrowing (and spending) caused
by increased government borrowing.
A fiscal stimulus would most likely be
financed by government borrowing.
Less credit becomes available to the private
sector, which must reduce its borrowing and
spending.
This private sector spending reduction offsets
the government spending, reducing the
impact of the fiscal stimulus.
11-25

Fiscal Policy Problems

Time lags: it takes time to

Recognize that a problem exists.

Develop a policy strategy.
Pass the required legislation.
Implement the policy.
Generate the many steps in the multiplier
process.

This might take months.

Other impacts on the economy may have
occurred before the impact of the policy
takes place.
11-26

Fiscal Policy Problems

Pork barrel politics: Congress
members might
Channel spending to their own districts.
Protect favored projects from cuts.
Steer away from tax hikes or spending
cuts before an election.

These political moves can alter the

content and timing of fiscal policy.
11-27

Public vs. Private Spending

Two camps have emerged:
One camp favors government solutions to
problems.
The other camp is concerned about
excessively large government and asserts
that solutions are better left to the
private sector.

If government is divided between the

two groups, fiscal policy will be delayed
by arguments on these policy issues.
11-28

Public vs. Private Spending

One camp favors government solutions to
problems.
They would increase government spending to
cover an AD shortfall.
They would hike taxes to cover an AD excess.

The other camp is concerned about

excessively large government and thinks
that solutions are better left to the private
sector.
They would cut taxes to cover an AD shortfall.
They would reduce government spending to
cover an AD excess.
11-29

The Economy Tomorrow

The concern for content.
To move out of recession to full-employment
GDP, the primary concern is how much
spending (or tax cuts) should be involved.
Another concern is the content of the
spending.
Public sector or private sector?
A boost for businesses or more for the needy?

11-30

The Economy Tomorrow

Each policy tool would alter the
economys mix of consumption and
investment and a different distribution of
income.
One side: smaller tax cut for the rich, more tax
relief for the poor, and more social programs.
The other side: cut taxes for businesses and
entrepreneurs, reduce the size and scope of
government programs.

11-31

The Economy Tomorrow

There is usually some form of
compromise on issues like these.
However, you can expect to continue
to see major political conflicts over
the differing views of these two sets
of politicians in the economy
tomorrow.

11-32

Revisiting the Learning

Objectives
11-01. Know what the real GDP gap and
the AD shortfall measure.
The real GDP gap is the difference between
existing GDP and full-employment GDP.
The AD shortfall measures how much
cumulative spending is required to move the
economy back to full-employment GDP.
The scope of the stimulus is determined by
the AD shortfall divided by the multiplier.

11-33

Revisiting the Learning

Objectives
11-02. Know the desired scope and
the tools of fiscal stimulus.
Fiscal stimulus should be designed to
move the economy from its existing GDP
in recession to full-employment GDP.
The tools of fiscal stimulus are
Increasing government purchases.
Reducing taxes.
Raising income transfers.

11-34

Revisiting the Learning

Objectives
11-03. Know what the AD excess
measures and the desired scope and
tools of fiscal restraint.
The AD excess measures how much
cumulative reduction in spending is
required to move the economy back to
full-employment GDP.
The scope of the restraint is determined
by the AD excess divided by the
multiplier.
11-35

Revisiting the Learning

Objectives
11-04. Know how the multiplier affects
fiscal policy.
Initial changes in spending, taxes, or
transfer payments begin a cycle in which,
for example, an increase in government
spending becomes income to another. This
income is mainly spent, which becomes
income to yet another, etc.
This repetitive cycle generates a multiplier
effect.

11-36