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Chapter 11 Fiscal Policy

Lecture Slides Macro Economics
Irvin B. Tucker
© 2011 South-Western, a part of Cengage Learning

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What is fiscal policy?
• The use of government spending and taxes to influence the nation’s output, employment, and price level.
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What is fiscal policy?
• Fiscal policy also determines the distribution of resources between the public sector and the private sector and influences the distribution of wealth.
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What is discretionary fiscal policy?
• The deliberate use of changes in government spending or taxes to alter aggregate demand
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Exhibit 1 Expansionary Fiscal Policy • Increase government spending • Decrease taxes • Increase government spending and taxes equally © 2011 South-Western. a part of Cengage Learning 5 .

a part of Cengage Learning 6 .Exhibit 1 Contractionary Fiscal Policy • Decrease government spending • Increase taxes • Decrease government spending and taxes equally © 2011 South-Western.

a part of Cengage Learning 7 .Increase in the price level and the real GDP Increase in the aggregate demand curve Increase in government spending © 2011 South-Western.

a part of Cengage Learning 14 15 8 (trillions of dollars per year) Real GDP .Exhibit 2 Using Government Spending to Combat a Recession AS 215 Price Level (CPI) E2 E1 210 X AD2 AD1 Full employment 13 © 2011 South-Western.

a part of Cengage Learning 9 .What is the spending multiplier? • Any initial change in spending leads to a chain reaction of more spending which causes a greater change in demand © 2011 South-Western.

a part of Cengage Learning .How is the spending multiplier calculated? • The ratio of the change in real GDP to an initial change in any component of aggregate expenditures 10 © 2011 South-Western.

What is the marginal propensity to consume (MPC)? • MPC is the change in consumption resulting from a change in income 11 © 2011 South-Western. a part of Cengage Learning .

The spending multiplier formula Spending multiplier (SM) = 1/MPC 12 © 2011 South-Western. a part of Cengage Learning .

what is the spending multiplier? 1/MPC = 1/1/2 = 2 13 © 2011 South-Western.With an MPC of 0. a part of Cengage Learning .50.

000Bn x 2 = $2. a part of Cengage Learning .000Bn 14 © 2011 South-Western.How much will real GDP increase with an increase in government spending of $1.000 billion? ∆G X SM = ∆Y $1.

.Exhibit 3 The Spending Multiplier Effect Round 1 2 3 4 Component of Total Sending Consumption Consumption Consumption New Consumption Spending (billions of dollars) $1. a part of Cengage Learning . . . .000 15 © 2011 South-Western.000 500 250 125 Government spending . All other rounds Consumption 125 Total spending $2. . . . .

Exhibit 4 Relation Between MPC and the Spending Multiplier (1) Marginal Propensity to Consume (MPC) (2) Spending Multiplier (SM) 0.75 0.67 0.80 0.33 10 5 4 3 2 1.90 0. a part of Cengage Learning .50 0.5 16 © 2011 South-Western.

a part of Cengage Learning .What is the tax multiplier? • The change in aggregate demand (total spending) resulting from an initial change in taxes 17 © 2011 South-Western.

What is the tax multiplier formula? TM = 1 – spending multiplier 18 © 2011 South-Western. a part of Cengage Learning .

With a spending multiplier of 2 what is the tax multiplier (TX)? 1 – spending multiplier = – 1 19 © 2011 South-Western. a part of Cengage Learning .

000Bn 20 © 2011 South-Western.How much does real GDP increase by with a cut in taxes of $1.000B = $1. a part of Cengage Learning .000Bn? ∆ T x TM = ∆Y 1 x $1.

000 Bn? 21 © 2011 South-Western.What will happen to AD if both government spending (G) and taxes are increased by $1. a part of Cengage Learning .

. . a part of Cengage Learning .Exhibit 5 Comparison of the Spending and Multipliers Increase in Aggregate Demand from a (1) (2) Round 1 2 3 4 Component of Total Sending Consumption Consumption Consumption $1 Trillion increase in Government Spending (x∆G) $1.000 22 © 2011 South-Western. . All other rounds . . . . .000 $1. . .000 500 250 125 $1 Trillion Cut in Taxes (T) ∆ $ 0 500 250 125 Government spending . . Consumption 125 125 Total spending $2.

What is the conclusion? • A tax cut has a smaller multiplier effect on aggregate demand than an equal increase in government spending 23 © 2011 South-Western. a part of Cengage Learning .

a part of Cengage Learning . it can change from one time period to another 24 © 2011 South-Western.Can we assume that the MPC will remain fixed? • No.

this would happen when the economy is operating in the intermediate or classical ranges of the aggregate supply curve 25 © 2011 South-Western. a part of Cengage Learning .Can fiscal policy be used to combat inflation? • Yes.

Decrease in the price level Decrease in the aggregate demand curve Decrease in government spending or increase in taxes © 2011 South-Western. a part of Cengage Learning 26 .

a part of Cengage Learning 14 Real GDP 27 (trillions of dollars per year) .Exhibit 6 Using Fiscal Policy to Combat Inflation AS Price Level (CPI) 220 215 E´ E1 E2 AD1 AD2 Full employment 13 © 2011 South-Western.

What is an automatic stabilizer? • Federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction 28 © 2011 South-Western. a part of Cengage Learning .

What are examples of automatic stabilizers? • Transfer payments • Unemployment compensation • Welfare • Tax collections 29 © 2011 South-Western. a part of Cengage Learning .

a part of Cengage Learning .Budget surplus offsets inflation Tax collections rise and government transfer payments fall Increase in real GDP 30 © 2011 South-Western.

a part of Cengage Learning .What is a budget surplus? • A budget in which government revenues exceed government expenditures in a given time period 31 © 2011 South-Western.

a part of Cengage Learning .Budget deficit offsets recession Tax collections fall and government transfer payments rise Decrease in real GDP 32 © 2011 South-Western.

a part of Cengage Learning .What is a budget deficit? • A budget in which government expenditures exceed government revenues in a given time period 33 © 2011 South-Western.

a part of Cengage Learning .0 1.0 0.5 1.Exhibit 7 Automatic Stabilizers Government Spending and Taxes 2.5 G (trillions of dollars per year) T Budget deficit 2.5 T 12 14 Real GDP (trillions of dollars per year) G 16 34 © 2011 South-Western.

What is supply-side fiscal policy? • A fiscal policy that emphasizes government policies that increase aggregate supply 35 © 2011 South-Western. a part of Cengage Learning .

and a lower price level 36 © 2011 South-Western. full employment. a part of Cengage Learning .What is the purpose of supply-side fiscal policies? • To achieve long-run growth in real output.

a part of Cengage Learning .Keynesian Demand-Side Fiscal Policy Increase in the aggregate demand curve Increase in government spending. decrease in net taxes 37 © 2011 South-Western.

a part of Cengage Learning 4 8 12 16 20 38 (trillions of dollars per year) Real GDP .Exhibit 8(a) Demand-Side Fiscal Policy AS 250 200 Price Level (CPI) E2 E 150 1 100 50 AD2 Full employment AD1 0 © 2011 South-Western.

Supply-Side Fiscal Policy Increase in the aggregate supply curve Decrease in resource prices. a part of Cengage Learning . technological advances. decrease in regulations 39 © 2011 South-Western. subsidies.

a part of Cengage Learning 4 8 12 16 20 40 (trillions of dollars per year) Real GDP .Exhibit 8(b) Supply-Side Fiscal Policy 250 AS1 200 Price Level AS2 E1 150 (CPI) E2 100 50 AD Full employment 0 © 2011 South-Western.

a part of Cengage Learning L1 L2 41 (hours per day) .Exhibit 9 How Supply-Side Policies Affect Labor Markets Before-tax-cut After-tax-cut labor supply labor supply (dollars per hour) Wage rate W1 W2 E1 E2 Labor Demand Quantity of Labor © 2011 South-Western.

42 © 2011 South-Western.What is the Laffer Curve? Arthur Laffer • A graph depicting the relationship between changes in the tax rate and total tax revenues. a part of Cengage Learning .

a part of Cengage Learning . 43 © 2011 South-Western.Will an increase in the tax rate lead to higher government total tax revenues? • The answer depends on the relationship between the tax rate and the corresponding total tax revenues along the Laffer Curve.

a part of Cengage Learning . 44 © 2011 South-Western.What happens if the tax rate increases beyond an optimal rate? • Tax revenues fall as the economic pie (GDP) shrinks.

a part of Cengage Learning Why does the economic pie begin to shrink? • Workers have less incentive to work and investors have less incentive to invest as their taxes increase beyond an optimal tax rate.© 2011 South-Western. 45 .

The Laffer Curve Rmax Federal Tax Revenue (Trillions of dollars) B C R A 0% © 2011 South-Western. a part of Cengage Learning D Tmax Federal Tax Rate (percent) T 100% 46 .

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