Fiscal Policy CHAPTER 12 2003 SouthWesternThomson Learning 1

Fiscal Policy CHAPTER 12 © 2003 South-Western/Thomson Learning 1

Fiscal Policy Fiscal policy refers to government purchases, transfer payments, taxes, and borrowing as they affect macroeconomic variables such as real GDP, employment, the price level, and economic growth Two categories Automatic stabilizers Discretionary fiscal policy 2

Automatic Stabilizers Refer to revenue and spending items in the federal budget that automatically change with the ups and downs of the economy so as to stabilize disposable income and, hence, consumption and real GDP 3

Discretionary Fiscal Policy Requires ongoing congressional decisions involving the deliberate manipulation of government purchases, taxation, and transfers to promote macroeconomic goals such as full employment, price stability, and economic growth. 4

Aggregate expenditure (trillions of dollars) Exhibit 1: Increase in Government Purchases C + I + G' + (X – M) C + I + G + (X – M) b 10. 5 0. 1 10. 0 a 45º 0 10. 5 Real GDP (trillions of dollars) 5

Government Purchases Multiplier The simple multiplier for a change in government purchases, other things constant, equals Thus, we can say that for a given price level, and assuming that consumption varies with income 6

Change in Net Taxes A change in net taxes also affects real GDP demanded, but the effect is less direct A decrease in net taxes, other things constant, increases disposable income at each level of real GDP consumption increases An increase in net taxes, other things constant, reduces disposable income at each level of real GDP consumption decreases 7

Aggregate expenditure (trillions of dollars) Exhibit 2: Decrease in Autonomous Net Taxes C' + I + G + (X – M) C + I + G + (X – M) c 10. 4 10. 08 a 45º 0 10. 4 Real GDP (trillions of dollars) 8

Simple Tax Multiplier The effect of a change in net taxes on real GDP demanded equals the resulting shift in the consumption function times the simple spending multiplier - MPC 1 - MPC Therefore, the change in real GDP can be determined as 9

Exhibit 3: Contractionary Gap Potential output Price level SRAS 130 e* 130 125 e e" AD 0 9. 5 10. 0 Contractionary gap Real GDP (trillions of dollars) 10

Exhibit 3: Contractionary Gap Potential output Price level SRAS 130 e* 130 125 e e' AD* AD 0 9. 5 10. 0 Contractionary gap 10. 5 Real GDP (trillions of dollars) 11

Fiscal Policy: Contractionary Gap What if policy makers overshoot the mark and stimulate aggregate demand more than needed to achieve potential GDP? In the short run, real GDP will exceed potential output In the long run, firms and resource owners will adjust to the unexpectedly high price level The short-run supply curve will shift back until it intersects the aggregate demand curve at potential output, increasing the price still further but reducing real GDP to potential output 12

Exhibit 4: Expansionary Gap Potential output Price level SRAS 130 135 e' AD' * 0 10. 5 Expansionary gap Real GDP (trillions of dollars) 13

Exhibit 4: Expansionary Gap Potential output Price level e'' e' 135 130 SRAS 130 e* AD' AD* 0 10. 5 Expansionary gap Real GDP (trillions of dollars) 14

Problems with Fiscal Policy Precise expansionary and contractionary fiscal policies are difficult to achieve, for their proper execution assumes that The relevant spending multiplier can be predicted accurately Aggregate demand can be shifted by just the right amount The potential level of output is accurately gauged Various government entities can somehow coordinate their fiscal efforts The shape of the short-run aggregate supply curve is known and remains constant 15

Natural Rate of Unemployment The unemployment rate that occurs when the economy is producing its potential GDP is called the natural rate of unemployment Before adopting discretionary policies, public officials must correctly estimate this natural rate This problem is presented in Exhibit 5 16

Exhibit 5: When Discretionary Price level Fiscal Policy Overshoots 140 Potential output LRAS SRAS 140 SRAS 130 c b AD' 130 a AD 0 10. 2 (trillions of dollars) Real GDP 17

Lags in Fiscal Policy The time required approving and implementing fiscal legislation may hamper its effectiveness and weaken discretionary fiscal policy and may in fact do more harm than good Since a recession is not usually identified as such until at least six months after it begins, and since the eight recessions since 1949 lasted an average of 11 months, this leaves a narrow window in which to execute discretionary fiscal policy 18

Permanent Income Permanent income is the income a person expects to receive on average over the long run Thus, changes in taxes that are regarded as temporary will not stimulate consumption and may render fiscal policy ineffective 19

Feedback Effects Fiscal policy may unintentionally affect aggregate supply For example, suppose the government increases unemployment benefits and finances these transfer payments with higher taxes on current workers. If the marginal propensity to consume is the same for both groups, the reduction in spending by those whose taxes increase should just offset the increase in spending by transfer recipients 20

Feedback Effects But what of possible effects of these changes on the labor supply? The unemployed, who benefit from increased transfers, now have less incentive to find work 21

Feedback Effects Conversely, workers who find their aftertax wage reduced by the higher tax rates may be less willing to work The supply of labor could decrease as a result of offsetting changes in taxes and transfers with the result that aggregate supply would decline economy’s potential GDP would decline 22