Fiscal Policy

- Government Expenditure and Imposition of Tax, to stabilize the economy in terms of

expansion or contraction.

Structural Deficit - The part of the budget deficit that would exist even if the economy were
operating at full employment.

Cyclical Deficit - The part of the budget deficit that is a result of a downturn in economic
activity.

Expansionary Fiscal Policy - Increases in government expenditures and/or decreases in taxes to achieve
particular economic goals.

Contractionary Fiscal Policy - Decreases in government expenditures and/or increases in taxes to

achieve particular economic goals.

Discretionary Fiscal Policy- Deliberate changes of government expenditures and/or taxes to achieve
particular economic goals.

For example, Congress decide to increases government expenditure by, say

P10 billion in an attempt to lower unemployment rate, this is an act of
discretionary fiscal policy.

Automatic Fiscal Policy - Changes in government expenditures and/or taxes that occur automatically
without (additional) congressional action.

Demand-Side Fiscal Policy

 Fiscal policy can affect the demand side of the economy, that is aggregate demand (AD).

 This section focuses on how changes in government spending (G) and/or taxes (T) can affect
AD.

Complete Crowding Out - A decrease in one or more components of private spending completely offsets
the increase in government spending.

Incomplete Crowding Out - The decrease in one or more components of private spending only partially
offsets the increase in government spending.
Supply-Side Fiscal Policy

- Fiscal policy effects may be felt on the supply side as well as on the demand side of the
economy.

- For example, a reduction in tax rates may alter and individual’s incentive to work and produce,
thus altering aggregate supply.

In other words, when fiscal policy measures affect tax rates, they may affect both AD and AS

Marginal Tax rate and Aggregate Supply (AS)

 All other things held constant, lower marginal tax rates increase the incentive to engage in
productive activities (work) relative to leisure and tax-avoidance activities.

 As resources shift from leisure to work, short run AS increases.

 If the lower marginal tax rates are permanent, most economists predict that not only will the
short-run AS curve shift rightward, but the long-run AS curve will shift rightward too.

Sample Problem

1. Columns 1 and 2 in the table below are the aggregate supply schedule, and columns 1 and 3 are
the aggregate demand schedule.
1 2 3 4 5
Price Level Real GDP (1) AD (1) AD (2) Real GDP (2)
220 2,390 2,100 2,200 2,490
200 2,390 2,100 2,340 2,490
190 2,350 2,250 2,350 2,450
180 2,300 2,300 2,400 2,400
160 2,200 2,400 2,500 2,300

a. The equilibrium real GDP is 2,300 and price level is 180.

b. Suppose that expansionary fiscal policy increases aggregate demand from that is shown in
columns 1 and 3 to that shown in columns 1 and 4.
(1) If the price level remained constant, the equilibrium real GDP would increase to 2,400
(2) But the increase in aggregate demand does raise the price level to 190, and this rise in
the price level results in real GDP to only 2,300, and this rise in the price level results in
real GDP increasing to only 2350.
c. If the expansionary fiscal policy that increased aggregate demand also has supply effects
increased aggregate supply from that shown in the columns a 1 and 2 in column 1 and 5
(1) The equilibrium real GDP is would increase to 2,400
(2) The price level would remain constant.
2. The following table shows real GDP’s and the net tax revenues of the government at each level
of real GDP.

Real GDP Net Tax Revenues Government Purchases Government

deficit/surplus
850 170 __ __
900 180 __ __
950 190 ___ __
1,000 200 __ __
1,150 230
Tax Rate = 20 Percent (170/850)
a. Looking at the two columns on the left side of the table, it can be seen that,
(1) When real GDP increases by 50 the net tax revenue (increase, decrease) by 10.
(2) When the real GDP decrease by 100, the net tax revenues (increase, decrease) by 20.
(3) The relationship between real GDP real GDP and net tax revenues (direct, indirect)
b. Assume that the multiplier has a value of 10 and the investment spending decrease by
PHP10 in the economy.
(1) If the net tax revenues remained constant, the equilibrium GDP will would decrease by
100.
(2) But when real GDP decreases, net tax revenues also decrease; and this decrease in the
net tax revenues will tend to (increase, decrease) the equilibrium level of GDP.
(3) And, therefore the decrease in real GDP brought about by the 10 decrease in the
investment will be (more, less) than 100.
(4) The direct relationship between net tax revenue and the real GDP has (lessened,
expanded) the impact of 10 decrease in investment spending on real GDP.
c. Suppose the simple multiplier is also 10 and the government wishes to increase the
equilibrium real GDP by 50.
(1) If the net tax revenues remain constant and the government would have to increases its
purchases of goods and services by 5.
(2) But when real GDP rises, net tax revenues also rise, and this rise in net tax revenues will
tend to (increase, decrease) the equilibrium real GDP.
(3) The effect, therefore, of the 5 increase in government purchases will also be to increase
the equilibrium real GDP by (more, less) than 50.
(4) The direct relationship between net tax revenues and real GDP (lessened, expanded)
the effect of the 5 increase in government purchases and to raise the equilibrium real
GDP by 50, the government will have to increase its purchases by (more, less) than 5.
d. Imagine that the full-employment real GDP of the economy is 1150 and that the
government purchases goods and services are 200.
(1) Complete the table by entering the government purchases and computing the budget
deficit or surplus at each of the real GDP’s (Show government deficit by placing negative
sign in front of the amount by which expenditures exceed net tax revenues)
Real GDP Net Tax Revenues Government Purchases Government
deficit/surplus
850 170 200 -30
900 180 200 -20
950 190 200 -10
1,000 200 200 0
1,150 230 200 30
 (2) Were the economy in a recession and producing a real GDP of 900, the budget would
show a (surplus, deficit) of 30.
(3) This budget deficit or surplus makes it appear that government is pursuing a(n)
expansionary, contractionary) fiscal policy, but the deficit or surplus is not a result of
countercyclical fiscal policy but the result of recession.
(4) If the government did not change its net tax rates, it could increase the equilibrium real
GDP from 900 to the full employment real GDP of 1150 by increasing its purchases by
approximately 70. At the full employment real GDP, the budget would show a (surplus,
deficit) of 40. (Net Tax revenue (230) – Government purchases (200 + 70)
(5) If the government did not change its purchases, it would increase the equilibrium level
real GDP from 900 to 1150 by decreasing next tax revenues at all real GDP by a lump
sum of approximately 80. The full-employment budget would have (surplus, deficit) of
50. (net tax revenues 230 – 80 = 150 – government purchases 200 = -50)
3. Complete the table below by stating whether the direction of discretionary policy was
contractionary or had no effect given the hypothetical data for an economy.

Year Actual Budget Full Employment Budget Direction of Fiscal

Surplus + surplus + Policy
Deficit - Deficit –
1 -10 billion +10 billion _______
2 +10 billion -20 billion _______
3 -20 billion +0 billion _______
4 -120 billion -120 billion _______
5 -150 billion -130 billion _______
Answer
Year Actual Budget Full Employment Budget Direction of Fiscal
Surplus + surplus + Policy
Deficit - Deficit –
1 -10 billion +10 billion Contractionary
2 +10 billion -20 billion Expansionary
3 -20 billion +0 billion no effect
4 -120 billion -120 billion Expansionary
5 -150 billion -130 billion Expansionary

a. The best gauge of the direction of fiscal policy is (actual, full-employment) budget
deficit or surplus because it removes the (cyclical, structural) component from the
discussion of the budget situation.

4. Suppose that the government of the Philippines is enjoying a fat budget surplus with fixed
government expenditures of G = 150 and fixed taxes of T = 200. Assume that consumers of the
Philippines behave as described in the following consumption function: C = 150 + 0.75(Y – T)
Suppose further that investment spending is fixed ay 100.
a. Calculate the equilibrium level of GDP in Philippines. Solve the equilibrium levels of Y,
and S.
 b. Assume that the Congress in Philippines reduces the tax by 20, calculate the equilibrium
level of using the tax multiplier. Solve for the equilibrium level of Y, C and S after the tax
cut and ensure that the multiplier.
Answer

a. Y = C + I + G

C = 150 + 0.75(Y-T) G = 150 I = 100

Y = 150 + [(0.75*Y) -(.75*200)] + 150 + 100

Y = 150 + 0.75Y - 150 + 150 + 100
Y – 0.75Y = 150 – 150 + 150 + 100
0.25Y = 250
(0.25Y / .25) = (250 / .25)
Y = 1000
Yd = Y – T = 1000 – 200 = 800
Consumption = 150 + 0.75 (1000 – 200) = 750
Savings = Yd (1000 – 200) - C (750) = 50
Yd = C + S = 750 + 50 = 800
Y- T = C+S
1000 – 200 = 750 + 50
Y = C+S+T
1000 = 750 + 50 + 200
1000 = 1000
AE = C+I+G
= 750 + 100 + 150
AE = 1000

b. Tax Multiplier = - (MPC / MPS)

= 0.75 / 0.25
=3
Government Spending multiplier = 1 / MPS
= 1 / 0.25
=4
Reduce by 20 tax
Impact = Tax multiplier 3 * 20 = 60 (increase the level of income in the economy by 80)
Y = 1000 + 60
= 1060
Yd = Y – T = 1060 – 180 = 880
Consumption = 150 + 0.75*880 = 810
Savings = 880 – 810 = 70
Y = C + S +T
1060 = 810 + 70 + 180
Y- T = C+S
1060 – 180 = 810 + 70
Y = C+S+T
1060 = 810 + 70 + 180
1060 = 1060