Chapter 15 Fiscal Policy Lecture Slides Survey of

Chapter 15 Fiscal Policy Lecture Slides Survey of Economics Irvin B. Tucker © 2016 south-Western, a part of Cengage Learning 1

What will I learn in this chapter? • How the federal government uses discretionary fiscal policy to influence the economy’s performance 2 © 2016 south-Western, a part of Cengage Learning

What is discretionary fiscal policy? • The deliberate use of changes in government spending or taxes to alter aggregate demand 3 © 2016 south-Western, a part of Cengage Learning

Exhibit 15 -1 Expansionary Fiscal Policy • Increase government spending • Decrease taxes • Increase government spending and taxes equally © 2016 south-Western, a part of Cengage Learning 4

Exhibit 15 -1 Contractionary Fiscal Policy • Decrease government spending • Increase taxes • Decrease government spending and taxes equally © 2016 south-Western, a part of Cengage Learning 5

Increase in price level and real GDP Increase in aggregate demand curve Increase in government spending or decrease in taxes © 2016 south-Western, a part of Cengage Learning 6

Exhibit 15 -2 Using Government Spending to Combat a Recession AS E 2 215 Price Level (CPI) E 1 X 210 AD 2 AD 1 Full employment 13 © 2016 south-Western, a part of Cengage Learning 14 Real GDP 15 (trillions of dollars per year) 7

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 © 2016 south-Western, a part of Cengage Learning 8

How is the spending multiplier calculated? • The ratio of the change in real GDP to an initial change in any component of aggregate expenditures 9 © 2016 south-Western, a part of Cengage Learning

What is the marginal propensity to consume (MPC)? • MPC is the change in consumption resulting from a change in income 10 © 2016 south-Western, a part of Cengage Learning

The spending multiplier formula Spending multiplier (SM) = 1/(1 -MPC) 11 © 2016 south-Western, a part of Cengage Learning

With an MPC of 0. 50, what is the spending multiplier? 1/MPC = 1/1/2 = 2 12 © 2016 south-Western, a part of Cengage Learning

How much will real GDP increase with an increase in government spending of $1, 000 billion? ∆G X SM = ∆Y $1, 000 Bn x 2 = $2, 000 Bn 13 © 2016 south-Western, a part of Cengage Learning

Exhibit 15 -3 The Spending Multiplier Effect Round 1 Component of Total New Consumption Spending Sending (billions of dollars) Government spending $1, 000 2 Consumption 500 3 Consumption 250 . . . Consumption 4 All other rounds . . . 125 Consumption 125 Total spending . . . $2, 000 14 © 2016 south-Western, a part of Cengage Learning

Exhibit 15 -4 Relation Between MPC and the Spending Multiplier (1) Marginal Propensity to Consume (MPC) (2) Marginal Propensity to Save (MPS) (3) Spending Multiplier (SM) 0. 90 0. 80 0. 10 0. 20 10 5 0. 75 0. 25 4 0. 67 0. 50 0. 33 0. 50 3 2 0. 33 0. 67 1. 5 15 © 2016 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 16 © 2016 south-Western, a part of Cengage Learning

What is the tax multiplier formula? TM = 1 – spending multiplier 17 © 2016 south-Western, a part of Cengage Learning

With a spending multiplier of 2 what is the tax multiplier (TX)? 1 – spending multiplier = – 1 18 © 2016 south-Western, a part of Cengage Learning

How much does real GDP increase by with a cut in taxes of $1, 000 Bn? ∆ T x TM = ∆Y 1 x $1, 000 B = $1, 000 Bn 19 © 2016 south-Western, a part of Cengage Learning

What will happen to AD if both government spending (G) and taxes are increased by $1, 000 Bn? 20 © 2016 south-Western, a part of Cengage Learning

Exhibit 15 -5 Comparison of the Spending and Multipliers Increase in Aggregate Demand from a Round Component of Total Sending (1) (2) $1 Trillion increase in Government Spending (x∆G) $1 Trillion Cut in Taxes (T) ∆ 1 Government spending 2 Consumption 500 3 Consumption 250 . . . Consumption . . . 125 Consumption 125 $2, 000 $1, 000 4 All other rounds Total spending $1, 000 $ 0 . . . 21 © 2016 south-Western, a part of Cengage Learning

What is the conclusion? • A tax cut has a smaller multiplier effect on aggregate demand than an equal increase in government spending 22 © 2016 south-Western, a part of Cengage Learning

Can we assume that the MPC will remain fixed? • No, it can change from one time period to another 23 © 2016 south-Western, a part of Cengage Learning

Can fiscal policy be used to combat inflation? • Yes, this would happen when the economy is operating in the intermediate or classical ranges of the aggregate supply curve 24 © 2016 south-Western, a part of Cengage Learning

Decrease in price level and real GDP Decrease in aggregate demand curve Decrease in government spending or increase in taxes © 2016 south-Western, a part of Cengage Learning 25

Exhibit 15 -6 Using Fiscal Policy to Combat Inflation Price Level (CPI) AS 220 E´ E 1 E 2 215 AD 1 AD 2 Full employment 13 © 2016 south-Western, a part of Cengage Learning 14 Real GDP (trillions of dollars per year) 26

What is an automatic stabilizer? • Federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction 27 © 2016 south-Western, a part of Cengage Learning

What are examples of automatic stabilizers? • Transfer payments • Unemployment compensation • Welfare • Tax collections 28 © 2016 south-Western, a part of Cengage Learning

Budget surplus offsets inflation Tax collections rise and government transfer payments fall Increase in real GDP © 2016 south-Western, a part of Cengage Learning 29

What is a budget surplus? • A budget in which government revenues exceed government expenditures in a given time period 30 © 2016 south-Western, a part of Cengage Learning

Budget deficit offsets recession Tax collections fall and government transfer payments rise Decrease in real GDP 31 © 2016 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 32 © 2016 south-Western, a part of Cengage Learning

2. 0 T G Budget deficit (trillions of dollars per year) 2. 5 Budget surplus Government Spending and Taxes Exhibit 15 -7 Automatic Stabilizers 1. 5 1. 0 0. 5 T G 2 © 2016 south-Western, a part of Cengage Learning 1 14 Real GDP 16 (trillions of dollars per year) 33

END 34