Chapter 16 Fiscal Policy PDF

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Thorough lecture and textbook notes for the chapter. taught by Doyle, but book is by Coppick. ...

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Chapter 16 – Fiscal Policy What is Fiscal Policy?  The use of government spending and taxes to influence the economy  Makes use of told of the federal government/budget  Tax and spending changes are legislated by congress and the president  We will discuss o How the government case use fiscal policy to stimulate the economy? o How fiscal policy might be used to slow down rapid growth o How do these strategies affect government budgets, deficits, and debt? o The multiplier process – the way in which the effects of fiscal policy ripple through the economy Expansionary Fiscal Policy  Occurs when the government increases spending or decreases taxes to stimulate the economy toward expansion  Fiscal policy makes use of either government spending (G) to affect the component of aggregate demand  Or they increase consumption by decreasing taxes.  Suppose that the aggregate demand falls in the country. It would shift to a new equilibrium point, in the long run all prices adjust so the AD would adjust back to full employment, however, the price would be lower than originally o The goal of expansionary fiscal policy is to shift AD back to the original AD so that the economy returns to full employment without waiting for long run adjustments  Fiscal Policy During the Great Recession o Government enacted 2 significant fiscal policy initiatives to ease the pain of the recession when it began  Feb 2008 George W Bush signed the Economic Stimulus act  Tax rebate for American s  A typical 4-person family received around $1800 back (as a check in the mail)  This costed the about 168 billion dollars  They were hoping the citizens would send not save this money to help stimulate the economy  In fact, it made the conditions worsen  Real GDP plummeted and unemployment rose  Obama came in and signed the American Recovery and Reinvestment Act of 2009 one month after being in office  This focused on government spending  This act entailed $787 billion dollars o Both of these acts may seem different (the first tax centered the second government spending centered) but they both aimed to increase AD

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o Fiscal policy tends to focus on aggregate demand  At the end of this chapter we will consider an alternative which uses govt spending and taxes to affect aggregate supply Fiscal Policy and Budget Deficits o So how does the government pay for all the spending or deal with the shortfall in tax revenue?  Borrowing! o Assume outlays equal tax revenue, then the economy slips into recession and the govt increases spending by $100 billion.  The government must pay for this $100 billion through borrowing  It must sell $100 billion worth of treasury bonds  The fed govt is in deficit of $100 billion  But really the deficit will rise by more than the 100 because tax revenue will fall (even if the tax rate stays the same because unemployment increases and income falls) o Bottom line is clear, expansionary fiscal policy leads to increases in budget deficits and debt  The prescription may seem weird,  For example, if you lost your job, would it make sense for you to go on a spending binge? Probably not  However expansionary fiscal policy sometimes works in the macro perspective because spending by one person is income for another person (creates a snowball effect)

Contractionary Fiscal Policy  Occurs when the government decreases spending or increases taxes to slow economic expansion  Used to reduce AD, 2 reasons the govt might want to do this o As we discussed earlier, expansionary fiscal policy can create deficits and debts, so in an economic expansionary time an increase in taxes or a decrease in spending might help pay off those deficits and debts o Second, the govt might want to reduce AD if it believes that the economy is expanding beyond its long run capabilities  Y* if the full employment sustainable for the long run, the govt does not want the economy overheating from too much spending and creating inflation  On a graph imagine the short run equilibrium being at a place where unemployment is below the natural level and full employment is above the natural level  Contractionary fiscal policy moves the AD back to the original long term equilibrium to avoid the price level rising to a higher level point C with the normal long run adjustments

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o Contractionary and expansionary fiscal policy serve to counteract the ups and downs of the business cycles Countercyclical Fiscal Policy o An economy that grows at a consistent rate is preferable to an economy that grows in an erratic fashion o Because of this politician generally employ fiscal policy to counteract the business cycle  This is known as countercyclical fiscal policy o Uses expansionary policy during economic downturns and contractionary during economic expansions  Intended to reduce the fluctuations caused by the business cycles

Multipliers  Initial effects of fiscal policy can snowball into further effects  Recall first that when one person spends it becomes another person’s income o This is for both private spending and government spending (if the govt spends money for new roads that becomes income for suppliers of road supplies, etc)  Now learn the second concept that increases in income lead to an increase in consumption o MPC – marginal propensity to consumer  Portion of additional income that is spent on consumption  FORMULA: MPC = change in consumption/change in income o Here’s how MPC works, suppose $100 billion is spent on govt employees for salary increases, then those employees spend 75 cents for every dollar they earned, their MOC is .75  That means that they spend 75 Billion of 100 Billion that was gifted, this means $175 billon of spending has occurred  Not supposed the people who they spend it on also have an MPC of .75 that means that about 56.2 billion of spending is generated from them  This makes a total of 231 billion from the original 100 billion  This all occurred through “multiplying”  To determine the total impact on spending from any initial government expenditures we need to use the spending multiplier formula o This tells us the total impact on spending from an initial change of a given amount o The greater the MPC, the greater the, multiplier o Formula: 1/ (1 - MPC) o If the MPC is .75 from the 100 billion example, then the multiplier is 4 meaning that, in the end the total spending is 4 times the initial change in govt spending (400 billion)  The spending multiplier implies that the tools of fiscal policy are very powerful

o The government can not only change its spending and taxing but also multiples of this spending then ripple through the economy over several periods What are the Shortcomings of Fiscal Policy? 1. Time Lags a. Recognition lag i. In the real world it is difficult to determine whether the economy is turning up or down ii. GDP is released quarter and the final estimate is not known until 3 months after the period in question iii. Unemployment rates lag even farther behind iv. Growth is not constant, one bad quarter does not signal a recession v. All of these make it very hard to determine and recognize when expansion and contraction starts b. Implementation lag i. It takes time to implement fiscal policy ii. One or more governing body must approve tax and spending legislation iii. For US it must go through both houses of congress and the president c. Impact lag i. It takes time for the complete effects if fiscal or monetary policy to materialize ii. Multiplier makes fiscal powerful but it takes time to ripple through the economy d. *If these lags take too long they can actually magnify the business cycle, for example if expansionary fiscal policy hit when we are already in expansionary they might lead to excessive aggregate demand and inflation i. automatic stabilizers 1. government programs that automatically implement countercyclical fiscal policy in response to economic conditions 2. this is one possibility for alleviating the lag problem (some examples of automatic stabilizers include) a. progressive income tax – it guarantees that when individual income falls the tax bills will fall and the opposite for when income rises b. taxes on corporate profits – same idea with progressive taxes c. unemployment compensation – increases govt spending automatically when the number of un employed people rises and decreases govt spending when fewer people are unemployed d. welfare programs – same idea as unemployment 2. Crowding Out a. This shortcoming addresses the actual impact of government spending and the multiplier effect

b. The critique is that government spending might be a substitute for private spending i. Private spending falls in response to an increase in government spending c. Say the government starts a program where is buys a new laptop for every college student in America i. If the government is buying, then the students won’t buy for themselves ii. People Might spend on other items but they might save as well iii. When private spending falls because there is too much govt spending it is called crowding out iv. This causes aggregate demand to NOT increase and the fiscal policy becomes ineffective d. Essentially every dollar of government spending crowds out a dollar of private spending 3. Saving Shifts a. The new classical critique of fiscal policy says that an increase in govt spending and decreases in taxes are largely offset by increase in savings because people realize that spending today HAS to be paid off later so taxes must rise sooner or later i. But if savings increase then consumption falls which mitigates the effects of the govt spending What is Supply Side Fiscal Policy?  It is lost possible to implement fiscal policy with the intent of affecting the supply side of the economy The Supply Side Perspective  Involves the use of government sending and taxes to affect the production (supply side0 of the economy  When LRAS shift it means a new level of full employment output o The government can implement fiscal policy and use the tax code t encourage technological advancement o Businesses have received tax credits for expenses related to research and development (firms that spend on research and development of new technology pay lower taxes than firms that don’t) o This provides incentive that encourages innovation and ultimately generates a greater supply of output  The goal of fiscal policy is to shift LRAS  There are many fiscal policy initiatives that focus on supply side  R&D tax credits – reduced taxes are available for firms that spend resources to develop new technology  focus on education - subsidies or tax breaks for education expenses create incentives to invest in education

Lower corporate profit tax rates – lower taxes increase the incentive for corporations to undertake activities that generate more profit  Lower marginal income tax rates – create incentive for people to work harder and produce more since they get to keep a large share of their income *All of these share two characteristics – the increase the incentives for productive activities and they each take time to affect AS (that’s why they are emphasized as long run solutions to growth problems) 

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Marginal Income Tax Rates  tax rates and tax revenue o some politicians advocate for tax rate cuts and say that a tac rate cut can lead to an increase in tax revenue, but how?  They argue that a tax cut stimulates work effort, employment, and income  Tax revenue rises because more people are employed and income levels are higher  The Laffer Curve o Total income tax revenue depends on the level of income and the tax rate o FROMULA: income tax rate = tax rate x income o Laffer curve is an illustration of the relationship between tax rates and tax revenue o There are 2 regions of the Laffer curve  Region 1 - increasing tax rates leads to increasing tax revenues  BUT at some point tax rates become too high so they provide significant disincentives for earning income  Region 2 – decrease in tax rate leads to more tax revenue example a 90% tax rate is a he disincentive o At some rate the tax revenue is maximized...