An Applications Approach to Contemporary Economics By Robert J. Carbaugh 4th Edition

Copyright ©2006 by Thomson South-Western. All rights reserved.

An Applications Approach to Contemporary EconomicsBy Robert J. Carbaugh4th Edition

Chapter 13:

Fiscal Policy and the Federal Budget

Carbaugh, Chap. 13 2

Fiscal Policy Fiscal policy is the use of government

expenditures and taxes to promote particular economic goals such as full employment, stable prices and economic growth.

Discretionary (tuy nghi) fiscal policy is the deliberate use of changes in government expenditures and taxation.

Automatic stabilizers consist of changes in government spending and tax revenues that occur automatically as the economy fluctuates.


Discretionary Fiscal Policy Expansionary fiscal policy: Increase

government spending or cut taxes Increases real output, employment and income Is used to combat a recession

Contractionary fiscal policy: Decrease government spending or increase taxes. Decreases real output, employment and income Is used to fight inflation


Fiscal Policy and Aggregate Demand 1. Combating a recession: When the

economy is in a recession, real output falls below its potential (full employment) output, the government can use expansionary fiscal policy to increase aggregate demand: Increase government spending Decrease taxes Use combination of the two


Fiscal Policy and Aggregate Demand Combating a recession: Example: MPC = 0.75 What happens to aggregate demand and thus

output if government: 1. Increases its spending by $25 billion 2. Cuts personal income tax by $25 billion 3. how much should the G cut in tax to increase total

income by $100bn 4. how much should the G increase in tax to decrease

total income by $100bn


Disposable income Disposable income = Income –taxesTaxes increase, then Disposable income

(DI) decreasesTaxes decrease, then Disposable income

(DI) increase


Expansionary fiscal policyFiscal Policy

AD0

Pri

ce l

eve

l (p

ric

e in

dex

)

AD1

A

AS0

B

Increase in output

Full employment output

0

100

700 800 900

Real output ($ bill.)


Fiscal Policy and Aggregate Demand 2.Combating inflation: When the economy

has high inflation (e.g.. demand-pull inflation causes the real output higher than the economy’s potential or full-employment output), the government can use contractionary fiscal policy to reduce aggregate demand: Decrease government spending Increase taxes Use combination of the two


Contractionary fiscal policyFiscal Policy

AD0

Pri

ce l

eve

l (p

ric

e in

dex

)

AD1A

AS0

B

900 1,100

Fall in price level

Decrease in real output Full

employment0

110

120



Automatic Stabilizers Automatic stabilizers consist of changes in

government spending and tax revenues that occur automatically as the economy fluctuates.

The automatic stabilizers prevent aggregate demand from decreasing as much in a recession or increasing as much in an expansion, so as to stabilize the economy.

Automatic stabilizers: tax system, government transfer payments.


Problems of Fiscal Policy Timing lags Irreversibility Crowding-out effect Foreign-trade effect


Timing Lags (do tre ve thoi gian) Recognition lag: A lag between the time when a

recession or inflation begins and the time when it is aware of. It takes time for government to realize that there is a recession or inflation.

Administrative lag: A lag between the time when the need for fiscal action is recognized and the time when the action is taken.

Operational lag: A lag between the time when fiscal action is taken and the time when it has effect on real output, employment or the price level


Irreversibility It is difficult to reverse changes in

government spending or taxes Many expenditure programs and tax

changes become permanent Inflexibilities hinder the operation of fiscal

policy


Crowding-Out Effect (Tac dong chen lan) When the economy is in a recession, government

enacts expansionary fiscal policy by increasing government spending.

To finance government budget deficit, the government borrows funds in the money market.

The increase in the demand for money raises the interest rate.

Higher interest rate lower investment. Some investment will be crowded out(hat ra).

The crowded-out effect may weaken the stimulus of the expansionary fiscal policy.


Crowding-out effect

Fiscal Policy

Government spendingexceeds taxes, resulting

in a budget deficit.

The government entersthe loanable funds market

and issues more securities.

As the demand for loanablefunds rises, interest

rates increase.

Firms and householdspurchase less machinery,

equipment, autos, and homes.Thus government spending

crowds out privatesector spending.


Foreign Trade Effect Suppose an expansionary fiscal policy is

implemented to increase output The expansionary fiscal policy can cause interest

rate to rise Higher interest rate attracts more international

funds Domestic currency appreciates that causes a fall

in net export and thus output, so partially offset the expansionary fiscal policy


Fiscal Policy and Aggregate Supply Supply-side effects of changes in taxes: Changes in tax rate will affect the incentive of

people to work, save and invest. Supply-side policy:

A decrease in marginal tax rates will cause people to work, save and invest more. Aggregate supply curve shifts to the right resulting in a higher output and a lower price level.

A decrease in marginal tax rates may also cause people to spend and thus increase aggregate demand. Output increases but the price level may increase as well.


Supply-side fiscal policyFiscal Policy

The goal of supply-sidetax cuts

AS0

Pri

ce l

eve

l (p

ric

e in

dex

)

AD0

A

B

AS1

Increase in real output

Fall in prices

0

90

100

900800

Real output (billion dollars)

A more dismal view ofsupply-side tax cuts

AS0

Pri

ce l

eve

l (p

ric

e in

dex

)AD0

A

B

AS1

AD1

0

100

110

Real output (billion dollars)


Fiscal Policy and Aggregate Supply Do cuts in tax rate cause tax revenues rise

or fall? Tax revenue = Tax rate x Taxable income The Laffer curve shows the relationship

between the income tax rate and the total tax revenue.

As the tax rate rises from 0 percent, total revenue rises, reaches the maximum and start to fall.


The Laffer CurveFiscal Policy

Tax

re

ven

ue

($ b

illi

on

s)

A

48 85

B

1000

200

300

Tax rate (%)


Government budget The main mechanism of fiscal policy is the federal

budget. Change in federal taxes or spendings are the

tools for shifting ADC or ASC. The use of federal budget to stabilize the

economy suggests that federal budget will often be unbalanced. Budget deficit Budget surplus Balanced budget


Government Budget

Government budget = Tax revenue – Government spending

If tax revenue = Government spending: Balanced government budget

If tax revenue > Government spending: Government budget surplus

If tax revenue < Government spending: Government budget deficit


Deficits and surpluses of U.S. government

Fiscal Policy

Source: From Economic Report of the President,2005


Federal debt held by the public

Federal Deficit

Source: Economic Report of the President, 2005

1940 $43.0 44.0%1945 236.0 106.01955 227.0 57.01965 261.0 38.01975 3954.0 25.01985 1,500.0 36.01995 3,603.0 49.02000 3,410.0 35.02004 4,721.0 37.0

Federal Federal debt asYear debt (bill.) a % of GDP


Federal deficit and federal debts Federal deficit is the difference between federal

spending and revenue in a given year. federal debts represent the cumulative amount of

outstanding borrowing from the public over the nation’s history

Main measure of federal debts is the debt held by the public.

The amount of borrower itself does not make a good indicator of the debt burden; it should be viewed in relation to the nation’ income (GDP).


Sales and ownership of federal debts Federal government borrows by issuing

securities, most thru Treasury Department. The securities are marketable. These include: Treasury bills, notes and bonds

with variety of maturities (1-30 months).\ Who lend government?

US treasury and other federal ageencies (42%) Private domestic investors ( 25%) Foreign investors ( 24%) Federal reserve banks ( 9%)


federal debts: Good or bad? Necessary if

Borrowing during recessions help the economy by maintaining income

Wartime borrowing: improve national defense Federal borrowing for investment spending:

building roads, bridges, training workers….

Bad if not for purposes mentioned because cost may outweigh benefits: reduction of funds for investment, interest rates, ….


Should there be a balanced-budget amendment? Advantages:

Disadvantages This would make recessions more freequent and

severe. Balabced budget requirement make recessions more

painful and longer By eliminating the automatic stabilizer that protect people in a

downturn By instead requiring measures to cut spending or increase

taxes during slowdown when the economy is already suffering from the lack of demand.


Expansionary fiscal policy and the multiplier

Fiscal Policy

AD0

Pri

ce l

eve

l (p

ric

e in

dex

)

AD1

A

AS0

B

Indirect effect of increased consumption

spending

C

AD2

Direct effect of an increase in government

spending

85

90

95

100

105

110

115

120

125

130

650 700 750 800 850 900 950



Expansionary fiscal policy and the multiplier Notice that the particular increase in

Aggregate Demand take place within the horizontal region of ASC, where the price level is constant.

→ Thus the real output will increase by the full amonut of the multiplier. But unemployment falls because firms will employ workers who were laid off during the recession.


Question 3 A tax reduction for households tends to increase

consumption spending and also aggregate demand. Given an upward-sloping aggregate supply curve, the increase in aggregate demand results in an increase in output and also an increase in the price level.

However, a tax reduction may also improve incentives to work, save, and invest, which would cause the aggregate supply curve to increase.

An increase in aggregate supply results in an increase in output but a decrease in the price level.

If aggregate demand increases by a greater (smaller) amount than aggregate supply, the economy’s price level will increase (decrease).


Question 4 . Discretionary fiscal policy is the deliberate use of

changes in government expenditures and taxation to affect aggregate demand and influence the economy’s performance in the short run.

The main advantage of using fiscal policy is that it has the potential to stabilize the economy’s output and price level. Recessions and inflation can be combated.

The main disadvantage is that fiscal policy may not work very well in practice. Among the problems facing fiscal policy are timing lags, irreversibility, inflationary bias, the crowding-out effect, and the foreign-trade effect


Question 5 Discretionary fiscal policy is based on the multiplier

principle. If, for example, the government purchases its Air Force

aircraft from Boeing, its profits and employment increase. As Boeing workers realize larger paychecks and the firm’s owners realize higher dividends, they respond by purchasing products such as automobiles from Ford Motor Company. Therefore, Ford realizes higher profits and hires additional workers, and consumer spending again increases. Each round of added spending increases aggregate demand. When all of these effects are combined, the total impact on the quantity of goods and services demanded will be larger than the initial stimulus from increased government expenditures, according to the multiplier effect.


Question 7 A balanced budget amendment could make

recessions more severe. Suppose the economy enters a period of increasing unemployment and declining incomes that results in decreasing tax revenues.

To balance its budget, the government must either increase taxes or decrease spending. Both of these policies cause aggregate demand to decrease, which would tend to shove the economy even deeper into the recession.


Question 8 According to Keynesian economists, a tax cut increases

the take-home pay of households, which results in an increase in consumption spending and an increase in aggregate demand.

According to supply-side economists, a tax cut increases the returns to working, saving, and investment and thus causes the aggregate supply curve to increase. In addition to these economic effects, supply-siders also believe that the government needs to look at tax revenues.

If the tax rate were zero, for instance, the economy’s output could be very high, but tax revenues would be zero and the government would not have funding for the provision of public goods and services.


Question 9 When there is a crowding-out effect, private

spending (consumption spending or investment) decreases as a result of increased government expenditures and subsequent budget deficits. Because of crowding out, expansionary fiscal policy is less effective in combating recession than it could be.

Crowding out would most likely take place when spending is robust and money is tight.


Question 10 . To combat a recession, government would

enact an expansionary fiscal policy by increasing expenditures or decreasing taxes.

To combat inflation, government would enact a contractionary fiscal policy by decreasing expenditures or increasing taxes.


Question 11 Given an upward-sloping aggregate supply curve, a tax

cut that increases aggregate supply would cause national output to increase and the price level to decline.

However, critics of supply-side economics maintain that the impact of a tax cut on incentives to work, save, and invest may not be as large as supply-side advocates maintain.

Moreover, supply-side advocates may underestimate the effects of tax cuts on aggregate demand. Lastly, the tax cut may result in falling tax revenues, depending on where the economy is on the Laffer Curve.

An Applications Approach to Contemporary Economics By Robert J. Carbaugh 4th Edition

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