Fiscal Policy

Prof. Sunny Mondal

Fiscal Policy Tools
Fiscal Policy Tools
Four Desirable
Attributes of
Tax Policy
 Fiscal Multiplier
• The fiscal multiplier is important in macroeconomics because it tells us how much output
changes as exogenous changes occur in government spending or taxation. The recipients of
the increase in government spending will typically save a proportion (1 – c) of each
additional dollar of disposable income, where c is the marginal propensity to consume
(MPC) this additional income.
• Ignoring income taxes, we can see that $c will, in turn, be spent by these recipients on more
goods and services. The recipients of this $c will themselves spend a proportion c of this
additional income (i.e., $c × c, or c-squared).
• This process continues with income and spending growing at a constant rate of c as it
passes from hand to hand through the economy. This is the familiar geometric progression
with constant factor c, where 0 < c < 1. The sum of this geometric series is 1/(1 – c).
• We define s as the marginal propensity to save (MPS), the amount saved out of an
additional dollar of disposable income. Because c + s = 1, hence s =1 – c.
 Fiscal Multiplier
• The overall final impact on aggregate demand and output will
effectively be the sum of this decreasing geometric series with common
ratio c(1 – t), and this sums to 1/[1 – c(1 – t)]. This is known as the fiscal
multiplier and is very relevant to studies of fiscal policy as changes in G
or tax rates will affect output in an economy through the value of the
multiplier.
• For example, if the tax rate is 20 percent, or 0.2, and the marginal
propensity to consume is 90 percent, or 0.9, then the fiscal multiplier
will be: 1/[1 – 0.9(1 – 0.2)] or 1/0.28 = 3.57. In other words, if the
government raises G by $1 billion, total incomes and spending rise by
$3.57 billion.
 Difficulties in Executing Fiscal Policy
• First, the policymaker does not have complete information on how the economy
functions. It may take several months for policymakers to realize that an
economy is slowing because data appear with a considerable time lag and even
then are subject to substantial revision. This is often called recognition lag and
has been likened to the problem of driving with the rearview mirror.
• Then, when policy changes are finally decided on, they may take many months to
implement. This is the action lag. If a government decides to raise spending on
capital projects to increase employment and incomes, for example, these may
take many months to plan and put into action.
• Finally, the result of these actions on the economy will take additional time to
become evident; this is the impact lag. These types of policy lags also occur in
the case of discretionary monetary policy.
 Relationship between Monetary & Fiscal
• Easy fiscal policy/tight monetary policy: If taxes are cut or government
spending rises, the expansionary fiscal policy will lead to a rise in
aggregate output. If this is accompanied by a reduction in money
supply to offset the fiscal expansion, then interest rates will rise and
have a negative effect on private sector demand. We have a higher
output and higher interest rates, and government spending will be a
larger proportion of overall national income.
• Tight fiscal policy/easy monetary policy: If a fiscal contraction is
accompanied by expansionary monetary policy and low-interest rates,
then the private sector will be stimulated and will rise as a share of
GDP, while the public sector will shrink.
 Relationship between Monetary & Fiscal
• Tight fiscal policy/easy monetary policy: If a fiscal contraction is
accompanied by expansionary monetary policy and low interest rates,
then the private sector will be stimulated and will rise as a share of
GDP, while the public sector will shrink.

• Tight monetary policy/tight fiscal policy: Interest rates rise (at least if
the monetary impact on interest rates is larger) and reduce private
demand. At the same time, higher taxes and falling government
spending lead to a drop in aggregate demand from both public and
private sectors.