Eco 200 – Principles of

Macroeconomics

Chapter 12:Fiscal Policy

Fiscal Policy – Keynesian
region
Fiscal policy – intermediate
region
Fiscal policy – classical region
Multipliers
 Government spending multiplier =
1 / (MPS + MPI)
 Lump-sum tax multiplier =
-(MPC-MPI) / (MPS + MPI)
 Balanced-budget multiplier = effect of
equal changes in G and T = 1
Government budget constraint
 Government spending = taxes +
change in government debt + change in
government-issued money
Tax finance of government
spending
 Balanced-budget multiplier = 1
 Offsetting effects:
 Incentive effects may reduce labor supply
and cause a reduction in AS
 Laffer curve
Deficit financing of
government spending
 Ricardian equivalence:
 Individuals may save more in response to
higher expected future taxes
 Crowding out:
 Increased borrowing leads to higher
interest rates; resulting in a reduction in I
and C (discussed more extensively shortly)
Monetary expansion used to
finance government spending
 Due to autonomy of Fed, this is less
likely to occur in the U.S. today.
 If used, tends to be inflationary,
resulting in a reduction in C.
Discretionary fiscal policy vs.
automatic stabilizers
 Discretionary fiscal policy: changes in government
spending, taxes, and/or transfer payments to
achieve a macroeconomic policy goal
 Automatic stabilizers: automatic increase in
transfers and tax reductions as income falls (the
reverse holds when income rises)
 Examples: unemployment compensation, income tax,
welfare programs.
 Automatic stabilizers reduce the value of the
multiplier.
Tax structures
 Proportional tax: Tax / income is
constant as income rises
 Progressive tax: Tax / income rises as
income rises
 Regressive tax: Tax / income declines
as income rises
Deficits and debt
 Deficit = G – T = amount by which
government spending exceeds net taxes
 Debt = total stock of outstanding
government bonds
 Deficit = a flow variable
 Debt = a stock variable
Deficits, interest rates, and
investment
 Loanable funds model
Demand for loans
Supply of loans
Equilibrium
Increase in deficit
Costs of deficit
 Crowding out: higher interest rates result in
less investment
 Higher deficit results in currency appreciation
and a decline in net exports (X)
 Interest payments – redistribution of income
 Regressive?
 Foreign debt holdings
Foreign fiscal policy
 Share of GDP devoted to G is smaller in
the U.S. than in most developed
economies
 Value-added taxes are commonly used
in most other developed economies