Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved...

Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved

ECON

Designed byAmy McGuire, B-books, Ltd.

McEachern 2010-2011

12CHAPTERFiscal Policy

Macro


Fiscal Policy Tools

LO1

Automatic stabilizers– Revenue and spending programs– Adjust automatically• E.g.: Federal income tax


Fiscal Policy Tools

LO1

Discretionary fiscal policy– Deliberate manipulation of G, TP, and T– Increase in G or TP• Increases real GDP demanded– Increase in net taxes• Decreases real GDP demanded


Changes in Government Purchases

LO1

Increase government purchases– Stimulate the economy– Upward shift of AE line– Increase in GDP


LO1

Effect of a $0.1 Trillion Increase in Government Purchases on Aggregate Expenditure and Real GDP

Demanded

C + I + G + (X - M)

a

14.0 14.50 Real GDP(trillions of dollars)

14.0

14.5

Agg

rega

te e

xpen

ditu

re (

trill

ions

of

dolla

rs)

45°

C + I + G’ + (X - M)

b

As a result of a $0.1 trillion increase in government purchases, the aggregate expenditure line shifts up by $0.1 trillion, increasing the real GDP demanded by $0.5 trillion. This model assumes price level remains unchanged.

0.1

Exhibit 1


Changes in Net Taxes

LO1

Decrease in net taxes– Increases DI by ∆NT– Increases C by MPC ×∆NT– Upward shift of AE line– Increase in GDP


14.0 14.40 Real GDP(trillions of dollars)

Effect of a $0.1 Trillion Decrease in Net Taxes on Aggregate Expenditure and Real GDP Demanded

C + I + G + (X - M)

a14.0

14.4

Agg

rega

te e

xpen

ditu

re (

trill

ions

of

dolla

rs)

45°

C’ + I + G + (X - M)

c

As a result of a decrease in NT of $0.1 trillion, consumers, who are assumed to have a MPC of 0.8, spend $80 billion more and save $20 billion at every level of GDP. The consumption function shifts up by $80 billion, as does the AE line.

0.08

An $80 billion increase of AE line eventually increases real GDP demanded by $0.4 trillion. Keep in mind that the price level is assumed to remain constant during all this.

LO1 Exhibit 2


LO2

Discretionary Fiscal Policy

Expansionary fiscal policy

Contractionary gap

Price level < expected

Output < potential

Unemployment > natural rate

Increase G, decrease NT

Increase AD

Higher price level

Higher output


LO2

Expansionary Fiscal Policy

To close a contractionary gap

Output < potential

Unemployment > natural rate

Expansionary fiscal policy

Increase G

Decrease NT

Increase AD

Increase output

Increase price level

Close the contractionary gap


Discretionary Fiscal Policy to Close a Contractionary Gap

The aggregate demand curve AD and the short-run aggregate supply curve SRAS130 intersect at point e. Output falls short of the economy’s potential. The resulting contractionary gap is $0.5 trillion. This gap could be closed by discretionary fiscal policy that increases aggregate demand by just the right amount. An increase in government purchases, a decrease in net taxes, or some combination could shift aggregate demand out to AD*, moving the economy out to its

potential output at e*.

LO2 Exhibit 3P

rice

leve

l

125

130

AD

SRAS130

e

Potential outputLRAS

Real GDP

(trillions of dollars)0 14.0 14.513.5

AD*e’

e*

e’’


LO2

Contractionary Fiscal Policy

To close an expansionary gap

Output > potential

Unemployment < natural rate

Contractionary fiscal policy

Decrease G

Increase NT

Decrease AD

Decrease output

Decrease price level

Close the expansionary gap


Discretionary Fiscal Policy to Close an Expansionary Gap

The aggregate demand curve AD’ and the short-run aggregate supply curve SRAS130 intersect at point e’ resulting in an expansionary gap of $0.5 trillion.

Discretionary fiscal policy aimed at reducing aggregate demand by just the right amount could close this gap without inflation. An increase in net taxes, a decrease in government purchases, or some combination could shift aggregate demand back to AD* and move the economy back to its potential output at e*.

LO2 Exhibit 4P

rice

leve

l

135

130AD’

SRAS130

e’


Real GDP

(trillions of dollars)0 14.0 14.5

AD*

e*

e’’


LO2

Contractionary & Expansionary Fiscal Policy

Difficult to achieve

Potential output gauged accurately

Spending multiplier predicted accurately

AD shifts by just the right amount

Government entities – coordinate fiscal efforts

Shape of SRAS curve is known, unaffected by the policy


LO2

The Multiplier and the Time Horizon

Simple multiplier

Overstates ∆Real GDP

∆Real GDP depends

Steepness of SRAS curve

Production costs increase

The steeper SRAS curve

Less impact of an AD shift on real GDP

More impact on price level

The smaller the spending multiplier


Evolution of Fiscal Policy

LO3

1. Prior to the Great Depression Classical economists– Laissez-faire; Free markets– Balanced budget– Natural market forces• Flexible:• Prices • Wages• Interest rates

– No need for government intervention



LO3

2. The Great Depression and World War II– Keynesian theory and policy• Prices and wages: ‘Sticky’ downward• Increase AD– WWII• Increase production• No cyclical unemployment– Employment Act of 1946, Government:• Full employment• Economic stability


Automatic Stabilizers

LO3

Smooth out fluctuations DI– Stimulate AD (recessions)– Dampen AD (expansions) Federal income tax– Progressive income tax Unemployment insurance Welfare payments



LO3

3. From the Golden Age to Stagflation– 1960s: demand-management policy• Increase or decrease AD– 1970s: Stagflation• Higher inflation• Higher unemployment• From decreased AD• Crop failures• Higher OPEC-driven oil prices• Adverse supply shocks


Fiscal Policy and Natural UR

LO3

Underestimate natural rate of unemployment

– Expansionary fiscal policy• Increase AD; Short run:• Increase output• Decrease unemployment

• Expansionary gap; Long run:• Decrease SRAS• Inflation• Decrease output


When Discretionary Fiscal Policy Overshoots Potential Output

If public officials underestimate the natural rate of unemployment, they may attempt to stimulate AD even if the economy is already producing at its potential output, a.This expansionary policy yields a short-run equilibrium at b, where the price level and output are higher and unemployment is lower, so the policy appears to succeed.But the resulting expansionary gap will, in the long-run, reduce the SRAS, eventually reducing output to its potential level of $14.0 trillion while increasing the price level to 140.Thus, attempts to increase production beyond its potential GDP lead only to inflation in the long-run

LO3 Exhibit 5P

rice

leve

l

130

140

AD

SRAS130


Real GDP

(trillions of dollars)0 14.0 14.2

AD’

b

a

SRAS140

c


Lags in Fiscal Policy

LO3

Fiscal policy– Time• Approve • Implement– Less effective– Too late– More harm than good



LO3

4. Since 1990: from deficits to surpluses 1980s – mid-1990s: large deficits 1993 recovery under way– Increase tax on high-income households 1994: Decreased federal spending 1993 – 1998– Tax revenues: +8.3% per year– Federal outlays: +3.2% per year



LO3

4. Since 1990: from deficits to surpluses back to deficits– 1998: Federal surplus $70 billion– 2000: Federal surplus $236 billion– Early 2001 – Recession: 10-year tax cut– September 11, 2001: Terrorist attack– 2003 – 2007 Recovery– Employment: +8 million– Federal deficit (2004) $400 billion– Federal deficit (2007) under $200 billion– Recession beginning December 2007– Federal deficit increased to $450 billion in 2008; now

forecast between $1 trillion and $2 trillion

Chapter 12Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved...

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