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Fiscal Policy

CHAPTER

12

© 2003 South-Western/Thomson Learning

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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 categoriesAutomatic stabilizersDiscretionary fiscal policy

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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

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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.

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Exhibit 1: Increase in Government Purchases

Ag

gre

ga

te e

xp

en

dit

ure

(t

rill

ion

s o

f d

olla

rs)

10.0

0

45º

Real GDP (trillions of dollars)

C + I + G + (X – M)

a

10.5 b

C + I + G' + (X – M)

10.5

0.1

10.0

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Government Purchases Multiplier

The simple multiplier for a change in government purchases, other things constant, equals

MPC1

1

Thus, we can say that for a given price level, and assuming that consumption varies with income

)1

1(

MPCGrealGDP

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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 increasesAn increase in net taxes, other things constant, reduces disposable income at each level of real GDP consumption decreases

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Exhibit 2: Decrease in Autonomous Net Taxes

10.0

0

45º

Real GDP (trillions of dollars)

10.0

C + I + G + (X – M)

a

Ag

gre

gat

e ex

pen

dit

ure

(t

rill

ion

s o

f d

olla

rs)

10.4 c

C' + I + G + (X – M)

0.08

10.4

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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

Therefore, the change in real GDP can be determined as

)1

(MPC

MPCNTrealGDP

MPC

MPC

1

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Exhibit 3: Contractionary Gap

Pri

ce

lev

el

130

Potential output

0 Real GDP (trillions of dollars)

SRAS130

Contractionary gap

e*

10.0

e125

AD

9.5

e"

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Exhibit 3: Contractionary Gap

Pri

ce

lev

el

130

Potential output

0Real GDP

(trillions of dollars)

SRAS130

Contractionary gap

e*

10.0

e125

AD

9.5

AD*

e'

10.5

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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 outputIn the long run, firms and resource owners will adjust to the unexpectedly high price levelThe 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

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Exhibit 4: Expansionary Gap

0

Potential output

10.0 Real GDP (trillions of dollars)

Pri

ce le

vel

SRAS130

AD'

10.5

135 e'

*

Expansionary gap

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Exhibit 4: Expansionary Gap

0

Potential output

10.0 Real GDP (trillions of dollars)

Pri

ce le

vel

SRAS130

AD'

10.5

135 e'

*

Expansionary gap

*130

AD

e

e''

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Problems with Fiscal PolicyPrecise expansionary and contractionary fiscal policies are difficult to achieve, for their proper execution assumes that

The relevant spending multiplier can be predicted accuratelyAggregate demand can be shifted by just the right amountThe potential level of output is accurately gaugedVarious government entities can somehow coordinate their fiscal effortsThe shape of the short-run aggregate supply curve is known and remains constant

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Natural Rate of UnemploymentThe 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

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Exhibit 5: When Discretionary

(trillions of dollars)

Potential output

LRAS

10.00

Real GDP

130

AD

a

AD'

b

10.2

SRAS130

SRAS140

c140

Fiscal Policy Overshoots

Pri

ce l

evel

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Lags in Fiscal PolicyThe 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

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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

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Feedback EffectsFiscal policy may unintentionally affect aggregate supplyFor 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

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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

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Feedback Effects

Conversely, workers who find their after-tax 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