Download Fiscal Policy

Test Yourself: Fiscal Policy
Procrastination is the thief of time.
Edward Young
What is a discretionary fiscal policy?
A discretionary fiscal policy is the deliberate
use of changes in government spending or
taxation to alter aggregate demand.
What are some examples of
expansionary fiscal policy?
Some examples of expansionary fiscal policy
are to:

decrease government spending

increase taxes

decrease government spending and taxes
equally
Chart: Government Spending to
Combat a Recession
155
150
Price Level
AS
E2
E1
X
AD2
AD1
full
employment
Real GDP
$6
$6.10 $6.20
Diagram: Government
Spending to Combat a
Recession Increase in the price level
and the real GDP
Increase in the aggregate
demand curve
Increase in government
spending
What is the spending multiplier?
The concept of the spending multiplier holds
that any initial change in spending leads to a
chain reaction of more spending which causes
a greater change in demand.
The spending multiplier is calculated as the
ratio of the change in real GDP to an initial
change in aggregate expenditure.
What is the marginal propensity to
consume (MPC)?
The MPC is the change in consumption
resulting from a change in income.
What is the marginal propensity to save
(MPS)?
The MPS is the change in saving resulting
from a change in income.
If MPC is 0.75, what is MPS?
MPS = 0.25
Since MPC + MPS = 1 (always), if MPC = 0.75
then MPS = 0.25.
With an MPC of 0.75, what is the
spending multiplier?
The spending multiplier = 1 ÷ MPS (always).
If the MPC = 0.75, then the MPS = 0.25. (See
the previous slides.)
In this example, then, the spending multiplier
= 1 ÷ 0.25.
1 ÷ 0.25 = 4.
So, the spending multiplier = 4.
If the spending multiplier = 4, how much
will real GDP increase if government
spending increases by $50 billion?
The spending multiplier x
the increase in government spending =
the increase in real GDP.
So, 4 x $50 billion =
$200 billion increase in real GDP.
What is the
tax multiplier?
The tax multiplier is the change in aggregate
demand (total spending) resulting from an
initial change in taxes.
The formula for the tax multiplier is
1 – the spending multiplier.
What happens when government cuts
taxes by $50 billion?
A tax cut has a smaller multiplier effect on
aggregate demand than an equal increase in
government spending.
In the example given, the multiplier process is
less because initial spending increases only by
$38 billion instead of by $50 billion.
With a spending multiplier of 4 what is
the tax multiplier?
The tax multiplier = 1 – the spending multiplier.
So, the tax multiplier = 1 – 4 = -3.
How much does real GDP increase by
with a cut in taxes of $50 billion?
The tax multiplier x the cut in taxes =
the increase in real GDP.
So, -3 x -$50 billion = $150 billion increase in
real GDP.
[The tax multiplier is a negative number. The $50
billion is negative because it’s a tax decrease. (A tax
increase would be positive.) And, in case you’ve not
had math in a while, a negative number times a
negative number equals a positive number ... the
$150 billion.]
Can we assume that the MPC will remain
fixed?
No, we can’t assume that the MPC will always
be the same. It can change from one time
period to another for a variety of reasons.
Can fiscal policy be used to combat
inflation?
Yes, fiscal policy can be used to combat
inflation.
This would happen when the economy is
operating in the intermediate range of the
aggregate supply curve.
Chart: Using Fiscal Policy to Combat
Inflation
AS
$160
E1
E´
E2
$155
AD1
AD2
$6
$6.10
Real GDP
full
employment
Diagram: Using
Fiscal Policy to
Combat Inflation
Decrease in the price
level
Decrease in the
aggregate demand
curve
Decrease in
government spending
or increase in taxes
What will happen to aggregate demand
(AD)with a cut in government spending
of $25 billion?
The cut in government spending x the
spending multiplier = the change in AD.
So, -$25 billion x 4 = -$100 billion decrease in
AD.
What will happen to aggregate demand
with a cut in taxes of $33.3 billion?
The cut in taxes x the tax multiplier = the
change in AD
So, -$33.3 billion x -3 = $100 billion increase
in AD.
What is the balanced budget multiplier?
The balanced budget multiplier holds that an
equal change in government spending and
taxes (hence, balanced budget), will change
aggregate demand by the amount of the
change in government spending.
What is an
automatic stabilizer?
Federal expenditures and tax revenues that
automatically change levels in order to
stabilize an economic expansion or
contraction are called automatic stabilizers.
Some examples of automatic stabilizers are:

transfer payments

unemployment compensation

welfare
Chart: Automatic Stabilizers
$1,250
$500
$250
Budget
deficit
$750
Government Spending and Taxes
$1,000
T
G
Real GDP
$4 billion
$6 billion
$8 billion
What is a
budget surplus?
A budget surplus occurs in a budget in which
government revenues exceed government
expenditures in a given time period.
What is a
budget deficit?
A budget deficit occurs in a budget in which
government expenditures exceed government
revenues in a given time period.
Diagram: Budget
Surplus
Budget surplus offsets
inflation
Tax collections rise
and government
transfer payments fall
Increase in real GDP
Diagram: Budget
Deficit
Budget deficit offsets
recession
Tax collections fall and
government transfer
payments rise
Decrease in real GDP
What is supply-side fiscal policy?
Supply-side fiscal policy is a fiscal policy that
emphasizes government actions that increase
aggregate supply.
The purpose of supply-side fiscal policies is to
achieve long-run growth in real output, full
employment and a lower price level.
Chart: Demand-Side Fiscal Policy
AS
$250
E2
$200
E1
$150
AD2
full
employment
$100
AD1
Real GDP
2
4
6
8
10
12
Diagram: Demand-Side Fiscal Policy
Increase in the aggregate
demand curve
Increase in government
spending; decrease in net taxes
Chart: Supply-Side Fiscal Policy
AS1
$250
AS2
$200
E1
$150
E2
$100
full
employment
AD
0
2
4
6
Real GDP
8
10
12
Diagram: Supply-Side Fiscal Policy
Increase in the aggregate
supply curve
Decrease in resource prices;
technological advances;
subsidies; decrease in
regulations
Chart: Supply-Side Policies Affect
Labor Markets
Before tax-cut After tax-cut labor
labor supply
supply
E1
W1
E2
Wage rate
W2
Labor
Demand
Q of Labor
L1
L2
What is the
Laffer Curve?
The Laffer Curve puts forth the idea that
increasing taxes from zero will increase tax
revenues up to a certain point.
Chart: The Laffer Curve
Rmax
R
Federal Tax Revenue
B
A
0
C
Federal Tax Rate
Tmax
T
D
100%
Will an increase in taxes lead to higher
government revenues?
Whether or not an increase in taxes will lead to higher
government revenues depends on where the economy is
on the Laffer Curve.
If tax rates increase beyond a certain point, tax revenues
begin to decline as the economy begins to contract
(shrink).
According to Laffer, when taxes increase beyond a
certain level, workers have less incentive to work and
investors have less incentive to invest. The drop in
productivity and investment result in an economy that
contracts rather than grows. Taxpayers wind up paying
higher rates but on less money so tax revenue declines.
[Keep in mind that this doesn’t apply to every tax rate
increase ... only those past a certain point on the curve.]
The End