Post on 14-Dec-2015
Congress The President
BUDGET
Taxes Spending
FiscalPolicy
Fiscal Policy
• A tool of macroeconomic policy that seeks to influence the level of economic activity through control of government expenditure and taxation.
• There are two types of fiscal policy:– Automatic Stabilizers– Discretionary Policies
Fiscal Policy: Automatic Stabilizers
• Automatic stabilizers– Built in, non-discretionary elements in fiscal
policy that serve to reduce the impact of economic events automatically. For example,
• A fall in output and national income reduces government tax liabilities and increases unemployment and welfare payments.
– Lower tax receipts and higher transfer payments increase the government’s budget deficit and restore some of the lost income.
Fiscal Policy: Discretionary Policy
• Discretionary Fiscal Policy– Expansionary Fiscal Policy
• Decreases in taxes and/or increases in spending that tend to increase economic activity.
– Contractionary Fiscal Policy• Increases in taxes and/or decreases in spending that
tend to dampen economic activity.
• Fiscal policy may work on the demand side of the economy or the supply side.
Government Spending Rises
TaxesDecrease
Fiscal Policy: Demand Side Transmission Mechanism
InvestmentSpending isCrowded Out
ExportSpending isCrowded OutAggregate
Spending Increases
Price Level Rises
SpendingDecreases
Interest Rates Rise
DeficitIncreases
Imports RiseExports Fall
Expansionary Fiscal Policy
Government Spending Rises
TaxesDecrease
Fiscal Policy: Demand Side Transmission Mechanism
Export SpendingIs Crowded Out
InvestmentSpending isCrowded Out
Aggregate Spending Increases
Price Level Rises
SpendingDecreases
Interest Rates Rise
DeficitIncreases
Imports RiseExports Fall
Expansionary Fiscal Policy
Demand Side Logic: The Multiplier
• Expansionary fiscal policy causes aggregate demand to rise such that demand exceeds supply.– Government spending affects aggregate demand
directly.– Changing tax rates affects aggregate demand
primarily through changes in consumption spending.
Demand Side Logic: The Multiplier
• Inventories fall unexpectedly, prompting firms to produce more output.
• As output increases, income rises, causing consumption to rise.
• Once again, demand exceeds supply, causing inventories to fall…….etc.
The Multiplier: Summary
/\ Gov’t Spend /\ Inventories /\ Income /\ Consumption
$100 $100 $100 $90 $90 $90 $81
$81 $81 $72.90 $72.90 $72.90 $65.61 $65.61 $65.61 $59.05
$100 $1000 $1000 $900
The Multiplier: An Example
1) Government spending rises by $100.
2) Aggregate demand rises by $100 and now exceeds current aggregate supply by $100.
3) Inventories fall by $100.
4) Firms produce just enough to replace the inventories.
The Multiplier: An Example
5) Production and national income rise by $100.
6) Consumption now rises, but not by $100.– Consumption rises by less than $100 because some
part of the increase in income is saved.
7) Let consumption rise by $90.
8) Repeat from step 2.
Government Spending Rises
TaxesDecrease
Fiscal Policy: Demand Side Transmission Mechanism
InvestmentSpending isCrowded Out
ExportSpending isCrowded OutAggregate
Spending Increases
Price Level Rises
SpendingDecreases
Interest Rates Rise
DeficitIncreases
Imports RiseExports Fall
Expansionary Fiscal Policy
Demand Side Logic: Interest Rates
• As the economy expands, demand for credit increases.
• If the Federal Reserve does not fully accommodate the rise in credit demand, interest rates rise.– Rising interest rates tend to dampen investment
spending.
Demand Side Logic: Interest Rates
• If as interest rates rise, assets in the USA become more attractive than assets in the rest of the world, the dollar rises.– An increase in the value of the dollar tends to
cause exports to fall.
Demand Side Logic: Price Level
• As the economy expands, firms compete with each other for resources.– There is a tendency at some point for factor
payments to rise.
• If monetary policy is accommodative, the price level rises.
• At full employment of resources, further expansion of spending results in pure inflation.
Expansionary Demand Side Fiscal Policy
AD1
SRAS
Y
P
Y1 Y2* Y3
P1
AD2
P2
Expansionary fiscal policyshifts the AD curve from AD1 to AD2.
If prices do not rise, the fiscal stimulus causes Y to rise to Y3.
But as Y rises money demand rises,causing interest rates to rise andinvestment and net exportsto rise by smaller amounts. As Y rises, competition for resources causes other prices to rise.
Equilibrium Y occurs at Y2 and P2.
National income rises from Y1
to Y2*. Prices rise from P1 to P2.
0
LRAS
Contractionary Demand Side Fiscal Policy
AD1
SRAS
Y
P
Y1 Y2* Y3
P1
AD2
P2
Contractionary fiscal policyshifts the AD curve from AD2 to AD1.If prices do not fall, the fiscal contraction causes Y to fall to Y1.
But as Y falls, money demand falls,causing interest rates to fall andinvestment and net exportsto fall by smaller amounts. As Y falls, less competition for resources causes other prices to fall.
Equilibrium Y occurs at Y2 and P1.
National income falls from Y1
to Y2. Prices fall from P2 to P1.
0
LRAS
Demand Side Fiscal Policy and Deficits
• Summary:– Tax cuts and increased government spending lead
to government budget deficits.– But, as output rises, so do tax revenues so
ultimately the revenues lost because of the rate decrease are recovered as the tax base expands.
• Conclusion: The deficit may increase or decrease.
Fiscal Policy: Supply Side
• Expansionary fiscal policy– The federal government decreases taxes.
• People work more: People save more: Firms invest more.
• Aggregate supply increases, unemployment falls, inflation falls.
Fiscal Policy: Supply Side
• Contractionary fiscal policy– The federal government increases taxes.
• People work less: People save less: Firms invest less.
• Aggregate supply decreases, unemployment rises, inflation rises.
Fiscal Policy: Supply Side Fiscal Policy: Supply Side Transmission MechanismTransmission Mechanism
ProductivityRises
After-tax ROR Rises
Investment Rises
Interest RatesFall
After-tax WageHigher
Increase in Labor Supply
Lower BusinessTax Rates
Lower PersonalTax Rates
Savings Rise
Aggregate SupplyRises
Unemployment Falls
Inflation Falls
Tax Cuts: Labor Supply
• The decrease in marginal income tax rates encourages people to work more.– People are willing to work more because they now
keep more of their wages.• More specifically, they get to keep more of the last
dollar earned.
– Therefore, the increased labor supply increases output without putting upward pressure on wages.
Tax Cuts: Saving and Investment
• Business tax cuts increase business profits.– Higher profits encourage investment in new
capital.
• Individual tax cuts stimulate household savings.– Increased savings contribute to lower interest rates
and increased investment in new capital.
• New capital increases productivity, thus, lowering costs and inflationary pressures.
Expansionary Supply Side Fiscal Policy
AD1
SRAS1
Y
P
Y1 Y2*
P1
P2
Expansionary fiscal policyshifts the AS curve from AS1 to AS2.
As productivity rises and costs fall, output increases while prices fall.
Equilibrium Y occurs at Y2 and P2.
National income rises from Y1
to Y2. Prices fall from P1 to P2.
0
SRAS2
LRAS
Supply Side Fiscal Policy and Deficits
• Summary:– Tax cuts lead to increased economic activity.– As output rises, so do tax revenues so ultimately
the revenues lost because of the rate decrease are recovered as the tax base expands.
• Conclusion: The deficit may decrease if government spending does not rise.