Download Fiscal Policy Chapter 11

Fiscal Policy
Chapter 11

Discretionary Fiscal Policy (active):
• Tax or spending changes that are
enacted by choice
• Example: 2007 stimulus checks and the
2001 tax cuts (income, estate, and gift)

Expansionary Fiscal Policy
• Tax or spending changes that are
intended to increase Aggregate Demand
• Tax cuts, spending increases, or both
Fiscal Policy Chapter 11
(cont.)

Contractionary Fiscal Policy
• Tax or spending changes that are intended to
decrease Aggregate Demand
• Tax increase, spending decrease, or both

Fiscal policy is a source of a great deal of
political strife
• Traditionally Republicans have advocated tax
cuts while Democrats have supported spending
increases
• This clear distinction has changed in recent
times
Fiscal Policy Chapter 11
(cont.)

Non-Discretionary Fiscal Policy
• A.K.A.—Passive, built-in, or automatic
stabilizers
• These are taxes or spending that
automatically change depending on the
economy
• Progressive tax system
• Transfer payments—unemployment
payments, welfare
Fiscal Policy Chapter 11
(cont.)

Various types of tax
• Progressive, average tax increases as
income rises—ex. Tax brackets (our
income tax system)
• Proportional, average tax is the same at
all income levels—ex. Flat income tax
• Regressive, average tax decreases as
income rises—ex. $1 tax on a pack of
cigarettes
Problems With Fiscal Policy

Timing:
• Recognition Lag—The it takes for policy
makers to realize economic problems
• Administrative Lag—The time it takes to
decide on a particular policy
• Operational Lag—The time it takes for a
given policy to impact the economy

Changes in taxes are typically faster than
spending changes
Problems With Fiscal Policy
(cont.)

Political considerations:
• Fiscal policy can be used for the wrong
reasons

Crowding-Out Effect:
• When the government borrows $ for
increased spending, resulting in higher
interest rates that slow Investment
Demand
• This may blunt the increase in AD that
was intended
You’re the Politician

What should you do if we are in a
recession or if we are having high
inflation?:
• Recession


Cut taxes
Increase spending
• Inflation



Increase taxes
Decrease spending
But by how much?
Fixing The Problem Using the “3 Amigos”
(∆ in spending) (Multiplier) = ∆ in GDP
LRAS
PL
SRAS1
1.
MPC=.8
2.
PL1
3.
AD1
Y1
650B
Yfe
900B
RGDP
Determine if
we are in a
recession or if
we are having
inflation
Determine if
you should use
expansionary
or
contractionary
fiscal policy
Determine the
size of the
GDP gap
(∆ in spending) (5) = 250B
LRAS
PL
SRAS1
MPC=.8
PL1
AD1
Y1
650B
Yfe
900B
RGDP
4.
Fill in what
you know
∆ in spending = 50B
LRAS
PL
SRAS1
MPC=.8
PL1
AD1
Y1
650B
Yfe
900B
RGDP
5.
Solve
∆ in spending = 50B
LRAS
PL
SRAS1
MPC=.8

50B
PL1
AD2
AD1
Y1
650B
Yfe
900B
RGDP
AD will shift
by the initial
change in
spending and
eventually
reach the full
employment
level of output
due to the
multiplier
How about using a tax change?
(∆ in tax) (tax multiplier) = ∆ in GDP
LRAS
PL
SRAS1
MPC=.8
PL1
AD1
Y1
650B
Yfe
900B
RGDP
1.
Fill in what
you know
(∆ in tax) (4) = 250B
LRAS
PL
SRAS1
MPC=.8
PL1
AD1
Y1
650B
Yfe
900B
RGDP
1.
Solve
∆ in tax = 62.5B
LRAS
PL
SRAS1
MPC=.8

62.5B
PL1
AD2
AD1
Y1
650B
Yfe
900B
RGDP
AD will shift
by the initial
change in tax
and eventually
reach the full
employment
level of output
due to the
multiplier
•Fix the problem using the components of Aggregate Demand
•Remember that:
•AD=C+I+G+Xn
•C = a + b Yd
Where
C= consumption
a= autonomous spending
b= Marginal Propensity to Consume
Yd= Disposable Income
•Equilibrium is found where AD=Yd
Find the equilibrium level of production when:
AD = 50 + .8 Yd + 75 + 22 + 5
C
I
G
Xn
AD = (50 + .8 Yd) + 75 + 22 + 5
C
I
G
Xn
AD = (50 + .8 Yd) + 75 + 22 + 5
Yd = .8 Yd + 152
.2Yd = 152
Yd = 760
-Now draw a AD/AS graph with a full employment level of production that
equals1100
-What is the problem?
-What is the size of the initial gap?
-Fix the problem using a spending change.
-Now fix the problem using a tax change.
-Finally, fix 20% of the problem using a spending change and 80% using a tax
change
Answers to policy questions are in bold:
--Problem= recession
--The gap is the difference between the equilibrium level of GDP and
the full-employment level of GDP: 1100-760=340
GDP Gap= 340
--(∆ spend) (5) = 340
Increase spending by 68
--(∆ tax) (4) = 340
Decrease tax by 85
--Combination
Take 20% of 340 to find how much of the gap needs to be changed
using the spending increase: .2 x 340 = 68
(∆ spend) (5) = 68
20% spending increase = 13.6
Take 80% of 340 to find how much of the gap needs to be changed
using a tax decrease: .8 x 340 = 272
(∆ tax) (4) = 272
80% tax cut = 68