An Applications Approach to Contemporary Economics By Robert J. Carbaugh 4th Edition
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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
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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.
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Carbaugh, Chap. 13 3
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
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Carbaugh, Chap. 13 4
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
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Carbaugh, Chap. 13 5
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 $100bn
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Carbaugh, Chap. 13 6
Disposable income Disposable income = Income –taxesTaxes increase, then Disposable income
(DI) decreasesTaxes decrease, then Disposable income
(DI) increase
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Carbaugh, Chap. 13 7
Expansionary fiscal policyFiscal Policy
AD0
Pri
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eve
l (p
ric
e in
dex
)
AD1
A
AS0
B
Increase in output
Full employment output
0
100
700 800 900
Real output ($ bill.)
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Carbaugh, Chap. 13 8
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
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Carbaugh, Chap. 13 9
Contractionary fiscal policyFiscal Policy
AD0
Pri
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l (p
ric
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AD1A
AS0
B
900 1,100
Fall in price level
Decrease in real output Full
employment0
110
120
Real output ($ bill.)
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Carbaugh, Chap. 13 10
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.
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Carbaugh, Chap. 13 11
Problems of Fiscal Policy Timing lags Irreversibility Crowding-out effect Foreign-trade effect
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Carbaugh, Chap. 13 12
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
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Carbaugh, Chap. 13 13
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
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Carbaugh, Chap. 13 14
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.
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Carbaugh, Chap. 13 15
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.
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Carbaugh, Chap. 13 16
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
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Carbaugh, Chap. 13 17
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.
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Carbaugh, Chap. 13 18
Supply-side fiscal policyFiscal Policy
The goal of supply-sidetax cuts
AS0
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ric
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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
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l (p
ric
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dex
)AD0
A
B
AS1
AD1
0
100
110
Real output (billion dollars)
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Carbaugh, Chap. 13 19
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.
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Carbaugh, Chap. 13 20
The Laffer CurveFiscal Policy
Tax
re
ven
ue
($ b
illi
on
s)
A
48 85
B
1000
200
300
Tax rate (%)
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Carbaugh, Chap. 13 21
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
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Carbaugh, Chap. 13 22
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
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Carbaugh, Chap. 13 23
Deficits and surpluses of U.S. government
Fiscal Policy
Source: From Economic Report of the President,2005
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Carbaugh, Chap. 13 24
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
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Carbaugh, Chap. 13 25
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).
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Carbaugh, Chap. 13 26
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%)
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Carbaugh, Chap. 13 27
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, ….
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Carbaugh, Chap. 13 28
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.
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Carbaugh, Chap. 13 29
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
Real output ($ bill.)
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Carbaugh, Chap. 13 30
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.
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Carbaugh, Chap. 13 31
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).
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Carbaugh, Chap. 13 32
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
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Carbaugh, Chap. 13 33
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.
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Carbaugh, Chap. 13 34
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.
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Carbaugh, Chap. 13 35
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.
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Carbaugh, Chap. 13 36
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.
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Carbaugh, Chap. 13 37
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.
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Carbaugh, Chap. 13 38
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.