Chapter 12

Fiscal Policy

1. How does fiscal policy affect AD & AS?

2. Crowding-out & new classical models.
3. Timing of fiscal policy.
4. Synthesis view of fiscal policy.
5. Supply-side effects of fiscal polity.
• 4 alternative fiscal policy models:
(1) the Keynesian model
(2) crowding-out model
(3) new classical model
(4) supply-side model
 Budget Deficits & Surpluses
• Balanced budget:
A situation in which current government revenue from
taxes, fees, and other sources is just equal to current
government expenditures.
• Budget deficit:
A situation in which total government spending exceeds
total government revenue during a specific time period,
usually one year.
• Budget surplus:
A situation in which total government spending is less
than total government revenue during a time period,
usually a year.
• Changes in the size of the deficit or
surplus may merely reflect the state of the
economy.
• Changes in the deficit or surplus may
reflect discretionary fiscal policy.
• Discretionary fiscal policy:
A change in laws or appropriation levels
that alters government revenues and/or
expenditures.
 The Keynesian View of Fiscal Policy
• Keynesians argued that the federal budget
should be used to promote a level of aggregate
demand consistent with the full-employment rate
of output.
• Expansionary fiscal policy:
An increase in government expenditures and/or
a reduction in tax rates such that the expected
size of the budget deficit expands.
• Restrictive fiscal policy:
A reduction In government expenditures and/or
an increase in tax rates such that the expected
size of the budget deficit declines (or the budget
surplus increases).
• How to use budget to stimulate aggregate
demand?
• An increase in government purchases of
goods and services will directly increase
aggregate demand.
• Changes in tax policy will also influence
aggregate demand.
Expansionary Fiscal Policy

Expansionary fiscal policy

stimulates demand; directs
economy to full employment.

Initial income is less than

capacity

Y1 YF
 Self-corrective process:
• Initially, the economy is operating at c. Output is
below potential capacity and unemployment
exceeds its natural rate.
• If there is no change in policy, abnormally high
unemployment and excess supply in the
resource market will reduce real wages and
other resource prices, which will direct the
economy toward b.
• In addition, interest rates would decline as the
result of the weak demand for investment, and
increase aggregate demand.
• However, Keynesians believe this self-
corrective process will work slowly, if at all.
(1) Wages and prices are inflexible,
particularly in a downward direction.
(2) Lower interest rates may not stimulate
much additional spending in a
recessionary economy dominated by
consumer pessimism and excess
production capacity.
• Keynesians recommend government
action.
• When an economy is operating below its
potential capacity, the Keynesian
prescription calls for expansionary fiscal
policy---a deliberate change in
expenditures and/or taxes that will
increase the size of the government’s
budget deficit.
• The Keynesian revolution challenged the
view that a responsible government should
constrain spending within the bounds of its
revenues. Rather than balancing the
budget annually, Keynesians stressed the
importance of countercyclical policy.
Fiscal Policy & Crowding-Out Effect
• Crowding-out effect:
A reduction in private spending as a result
of higher interest rates generated by
budget deficits that are financed by
borrowing in the private loanable funds
market.
• The crowding-out effect suggests that budget
deficits will have less effect on aggregate
demand than the basic Keynesian model
implies. Because financing the deficit pushes up
interest rates, budget deficits will tend to retard
private spending, particularly spending on
investment and consumer durables.

• Thus, the expansionary fiscal policy will have

little, if any, effect on demand, output, and
employment.
• Keynesians argue that an increase in
government purchases financed by a deficit will
exert a strong multiplier effect on output,
employment, and real income.

• Moreover, when applied during a recession, the

demand stimulus may improve business profit
expectations and thereby stimulate additional
private investment.
• Restrictive fiscal policy will “crowd in” private
spending. If the government increases taxes
and/or reduces its spending , the budget will shift
toward a surplus. As a result, the government’s
demand for loanable funds will decrease, placing
downward pressure on the real interest rate. The
lower real interest rate will stimulate additional
private investment and consumption.

• So the fiscal policy restraint will be at least

partially offset by an expansion in private
spending.
 The New Classical View of Fiscal Policy

• New classical economists:

Economists who believe that there are
strong forces pushing a market economy
toward full-employment equilibrium and
that macroeconomic policy is an
ineffective tool with which to reduce
economic instability.
• Robert Lucas (University of Chicago)
Thomas Sargent (New York University)
Robert Barro (Harvard University):

“Budget deficits imply higher future taxes and tha

t taxpayers will reduce their current consumption
just as they would have if the taxes had been col
lected during the current period.”
Thus, new classical economists do not believe th
at budget deficits will stimulate additional consu
mption and aggregate demand.
• The new classical economists stress that debt fi
nancing simply substitutes higher future taxes fo
r lower current taxes. Thus, budget deficits affect
the timing of the taxes, but not their magnitude.
• Ricardian equivalence:
The view that a tax reduction financed with gover
nment debt will exert no effect on current consu
mption and aggregate demand because people
will fully recognize the higher future taxes implie
d by the additional debt.
example
• Suppose you knew that your taxes were
going to be cut by $1,000 this year, but
that next year they were going to be
increased by $1,000 plus the interest on
that figure.
Would you increase your consumption
spending this year?
 Higher expected future taxes crowd out private spending

Price Real
level interest S1
SRAS rate S2

e1
r1 e2
P1 E1 AD2

D2
AD1
D1

Y1 Q1 Q2

Goods & services (real GDP) Loanable funds

• New classical economists emphasize that budget deficits
merely substitute future taxes for current taxes.

• If households did not anticipate the higher future taxes,

aggregate demand would increase to AD2. However,
demand remains unchanged at AD1 when households
fully anticipated the future increase in taxes.

• Simultaneously, the additional saving to meet the higher

future taxes will increase the supply of loanable funds to
S2 and allow the government to borrow the funds to
finance its deficit without pushing up the real interest rate.

• In this model, fiscal policy exerts no effect. The real

interest rate, real GDP, and level of employment all
remain unchanged.
Fiscal Policy Changes & Problems of Timing

• A change in fiscal policy will require legisla

tive action.
• A change in policy will not immediately imp
act the macroeconomy.
• Because of these delays, if fiscal policy is
going to exert a stabilizing influence, policy
makers need to know what economic cond
itions are going to be like twelve to eightee
n months in the future.
• In the real world, a discretionary change in
fiscal policy is like a two-edged sword----it
has the potential to do harm as well as
good. If timed correctly, it will reduce
economic instability. If timed incorrectly,
however, it will increase rather than
reduce economic instability.
 Automatic Stabilizers
• Automatic stabilizers:
Built-in features that tend automatically to
promote a budget deficit during a recession and
a budget surplus during an inflationary boom,
even without a change in policy.
The major advantage of automatic stabilizers is
that they institute countercyclical fiscal policy
without the delays associated with legislative
action.
 Unemployment Compensation
• When an economy begins to dip into a
recession, the government will pay out more
money in unemployment benefits as the number
of laid-off and unemployed workers expands.
Simultaneously, the receipts from the
employment tax that finances the unemployment
compensation system will decline because fewer
workers are paying into the system.
Therefore, the program will automatically run a
deficit during a business slowdown.
• Similarly, it will automatically tend to run a
surplus during an economic boom.
 The Corporate Profit Tax

• During a recession, corporate profits decline

sharply, so do corporate tax payments. In
turn, the decline in tax revenues will enlarge
the size of the budget deficit.
• In contrast, corporate tax payments will go
up during an expansion.
 The Progressive Income Tax
• When incomes grow rapidly, more people
will find their income above the “no tax
due” cutoff. Others will jump up into higher
tax brackets. Therefore, during an
economic expansion, personal income tax
revenues increase more rapidly than
income. Other things constant, the budget
moves toward a surplus, even though the
economy’s tax rate structure is unchanged.
 The major points of the modern synthesis
view of fiscal policy as a stabilization tool:
• Proper timing of discretionary fiscal policy is both
difficult to achieve and crucially important.
• Automatic stabilizers reduce fluctuations in
aggregate demand and help direct the economy
toward full employment.
• Fiscal policy is much less potent than the early
Keynesian view implied.
• Each of the three demand-side models of fiscal
policy is valid under some circumstances but not
others.
The Supply-side Effect of Fiscal Policy

• Supply-side economists:
– Modern economists who believe that changes in
marginal tax rates exert important effects on
aggregate supply.
– When fiscal policy changes marginal tax rates, it
influences aggregate supply by altering the
attractiveness of productive activity relative to leisure
and tax avoidance. Other things being constant, lower
marginal tax rates will increase aggregate supply.
Supply-side economics should be viewed as a
long-run strategy, not a countercyclical tool.
 Tax policy changes affect the supply side
of the economy differently than the
demand side of the economy.
• On the demand side, lower taxes stimulate
spending by consumers and increase
aggregate demand.
• On the supply side, lower taxes encourage
people to work more, increasing aggregate
supply.
 Why do high tax rates retard
output?
• High marginal tax rates discourage work
effort and productivity.
• High tax rates will adversely affect the rate
of capital formation and the efficiency of its
use.
• High marginal tax rates encourage people
to substitute less-desired tax-deductible
goods for more-desired non-deductible
goods.
 Thumbnail Sketch
• The impact of expansionary fiscal policy:
(1) The basic Keynesian view:
An increase in government spending and/or a
reduction in taxes will be magnified by the
multiplier process and lead to a substantial
increase in aggregate demand. When an
economy is operating below capacity, real output
and employment will also increase substantially.
(2) Crowding-out view:
Expansionary fiscal policy will exert little or no
effect on aggregate demand and employment
because borrowing to finance the budget deficit
will push up interest rates and crowd out private
spending, particularly investment. In an open
economy, the higher interest rates will lead to an
inflow of capital, a currency appreciation, and a
decline in net exports.
(3) New classical view:
Expansionary fiscal policy will exert little or no eff
ect on aggregate demand and employment beca
use households will anticipate the higher future t
axes that might result from the debt and reduce t
heir spending (and increase their saving) in orde
r to pay them. Like current taxes, debt (future tax
es) will crowd out private spending.
(4) Supply-side view:
lower marginal tax rates will increase the i
ncentive to earn (produce) and improve th
e efficiency of resource use, leading to an i
ncrease in aggregate supply (real output) i
n the long run.
 The Fiscal Policy of the United States
• During the 1980s, defense expenditures increased
substantially and large budget deficits resulted.
• Following the collapse of communism, defense spending
fell sharply during the 1990s, shifting the budget toward
a surplus.
• In the aftermath of Sept. 11, 2001, spending on defense
and homeland security increased sharply and large
budget deficits again were incurred.
• Even though fiscal policy was expansionary during the
1980s and restrictive during the 1990s, both decades
were characterized by a lengthy economic expansion
and strong economic growth.