Chapter 29: Fiscal Policy

11© 2014 by McGraw-Hill Education Chapter 29 Fiscal Policy 2© 2014 by McGraw-Hill Education • What the difference is between contractionary and expansionary fiscal policy. • How fiscal policy can counteract short-run fluctuations. • What challenges are associated with fiscal policies. • How to calculate the fiscal multiplier. • How revenue and spending determine a government budget. • What the difference is between government deficit and debt. • What the costs and benefits of government debt are. What will you learn in this chapter? 3© 2014 by McGraw-Hill Education • Fiscal policy refers to government decisions about the level of taxation or government spending. • Fiscal policy affects the economy by influencing aggregate demand (AD). – Government spending. – Tax policies directly affect consumption, which impacts AD. Fiscal policy 24© 2014 by McGraw-Hill Education Fiscal policy can be either expansionary or contractionary. • Increased government spending and lower taxes have expansionary effects. • Decreased government spending and higher taxes have contractionary effects. Fiscal policy AD1 LRAS SRAS Y1 P1 Y1 P1 Y2 AD2 Y2 AD2 P2 Price level Output Price level AD1 LRAS SRAS Output P2 • Expansionary fiscal policy shifts the AD curve to the right. – Output increases. – Prices increase. • Contractionary fiscal policy shifts the AD curve to the left. – Output decreases. – Prices decrease. 5© 2014 by McGraw-Hill Education • Policy-makers try to use fiscal policy to smooth fluctuations in the economy. • The AD/AS model illustrates how fiscal policy can counteract the effects of economic shocks. – The model predicts that the economy can automatically correct itself. – Lawmakers often intervene because automatic correction can be a painful and slow process. Policy response to economic fluctuations 6© 2014 by McGraw-Hill Education 2 P1 Y1 AD2 P2 Y Initial market response to fall in AD Price level AD1 LRAS SRAS Output 2 2 P Y AD3 Y3 P3 2 Expansionary fiscal policy restores some AD Price level AD1 AD LRAS SRAS Output • The government can spend more or tax less. • Often called “Keynesian” economic policy. • The expansionary policy increases aggregate demand. • Output and price levels increase. Expansionary policy responses Expansionary policy can counteract decreases in AD. 37© 2014 by McGraw-Hill Education AD2 SRAS P1 Y1 P2 Y2 Price level AD1 LRAS Economy overheats from too much AD Output • The government can spend less or tax more. • The contractionary policy decreases aggregate demand. • Output and price levels decrease. 2 3 AD2 AD1 LRAS SRAS AD3 P Y2 Price level Contractionary fiscal policy lowers prices and output Output P Y3 Positive economic shocks may cause the economy to expand too rapidly. Contractionary policy can counteract increases in AD. Contractionary policy responses 8© 2014 by McGraw-Hill Education • Why should any government wait for the economy to correct itself when it can do the work much more quickly? • Fiscal policies are often educated guesses. • Time lags between when policies are chosen and when they are implemented often cause fiscal policy to be ineffective or even harmful: 1. Information lag: Understanding the current economy. 2. Formulation lag: Deciding on and passing legislation. 3. Implementation lag: Time to affect the economy. Time lags 9© 2014 by McGraw-Hill Education • Automatic stabilizers are taxes and government spending that affect fiscal policy without specific action from policy-makers. • Taxes work as automatic stabilizers because the income tax system is progressive. – As earnings rise, higher tax rates apply. This puts a check on overall spending. • Some types of government spending work as automatic stabilizers. – Unemployment insurance benefits and welfare programs have eligibility criteria based on income or unemployment status. Policy tools: discretionary and automatic 410© 2014 by McGraw-Hill Education • Policy-makers can also use discretionary fiscal policy, which refers to adjusting tax rates in response to economic conditions. – Information, formulation, and implementation lags can reduce the effectiveness of such policy. • Discretionary policy may be used when automatic stabilizers are unsuccessful in correcting the economy. Policy tools: discretionary and automatic 11© 2014 by McGraw-Hill Education • Politicians often cut taxes in response to recessions. • Tax cuts aren’t free because the government must find a way to make up for lost tax revenue. • Ricardian equivalence predicts that if there are tax cuts but no decrease in spending, people will not change their behavior. – People realize that the government will have to borrow money and at some point taxes will increase. Limits of fiscal policy: The money must come from somewhere 12© 2014 by McGraw-Hill Education • Changes in tax rates and government spending have different effects on the economy. • Economists use a multiplier that measures the effect of government spending or tax cuts on national income. • The multiplier effect is the increase in consumer spending that occurs when spending by one person causes others to spend more too. – This amplifies the impact of the initial government policy on the economy. The multiplier model 513© 2014 by McGraw-Hill Education • For example, consider what happens when someone hires a builder to construct a deck for $5,000. – This decision adds $5,000 to national GDP. • The builder may take his family on a $3,000 vacation that he couldn’t have afforded before he built your deck. – This decision adds $3,000 to national GDP. • The decision to build a deck adds $8,000 to GDP, more than the original amount of the deck. – This is the multiplier effect. The multiplier model 14© 2014 by McGraw-Hill Education • To determine how much more GDP increases, the multiplier uses the proportion of income people spend. • Consumption is based on the amount of income left after paying taxes. – People usually consume part of their income and save the rest. • The amount consumption increases when after-tax income increases by $1 is called the marginal propensity to consume (MPC). – The MPC is a number between 0 and 1. – It equals the fraction of an additional dollar that is spent when an individual receives an additional dollar of income. • For example, a MPC of 0.8 means that 80% of an additional dollar of income is spent and 20% is saved. Deriving the multiplier 15© 2014 by McGraw-Hill Education Consider the following situations where there is an increase in income that leads to an increase in consumption expenditures. • Calculate the marginal propensity to consume (MPC). Active Learning: Deriving the MPC Situation Increase in Income ($) Increase in Consumption Expenditures ($) Marginal Propensity to Consume (MPC) A 1,000 900 B 500 400 C 300 100 616© 2014 by McGraw-Hill Education • The government-spending multiplier is the amount that GDP increases when government spending increases by $1. Government−spending multiplier = 1 1 − MPC • A smaller MPC results in a smaller government- spending multiplier. • A larger MPC results in a larger government- spending multiplier. Multiplier effect of government spending 17© 2014 by McGraw-Hill Education Consider a situation where the marginal propensity to consume is 0.6. • Calculate the government-spending multiplier. • Use this to determine how much GDP will increase if the government spends $10 million on federal highway repairs. Active Learning: Government-multiplier effect 18© 2014 by McGraw-Hill Education • The taxation multiplier is the amount that GDP decreases by when taxes increase by $1. Taxation multiplier = −MPC1 − MPC • The multiplier effect of tax cuts is smaller than the effect of government spending. • Tax cuts boost GDP indirectly through an effect on consumption. Multiplier effect of government transfers and taxes 719© 2014 by McGraw-Hill Education Consider a situation where the marginal propensity to consume is 0.6. • Calculate the taxation multiplier. • Use this to determine how much GDP will increase if there are $10 million in tax cuts. Active Learning: Taxation multiplier effect 20© 2014 by McGraw-Hill Education The impact of tax cuts and government spending varies by the MPC. The government spending and taxation multipliers Marginal propensity to Consume (MPC) Government- spending multiplier 1/(1 – MPC) A $500 million stimulus would increase GDP by: Taxation multiplier MPC/(1 – MPC) A $500 million tax cut would increase GDP by: 0.2 1.25 $625 million –0.25 $125 million 0.4 1.67 $835 million –0.67 $335 million 0.6 2.50 $1.25 billion –1.50 $750 million 0.8 5.00 $2.50 billion –4.00 $ 2 billion • Note that for the same MPC, the government spending multiplier is higher than the taxation multiplier. • The difference is greater as the MPC increases. 21© 2014 by McGraw-Hill Education • The government may want to influence the economy by changing the amount it spends or taxes. • In practice, this may require the government going into debt. • Governments’ budgets contain tax revenues as their source of income and government purchases and transfer payments as expenditures. – Transfer payments are payments from the government to individuals for programs that don’t involve a purchase of goods or services. The government budget 822© 2014 by McGraw-Hill Education • The government may budget expenditures greater than income by issuing debt. – The budget deficit is the amount of money a government spends beyond its revenue. – The budget surplus is the amount of revenue a government brings in beyond what it spends. The government budget Billions of 2010 dollars Percent of GDP 0 4 8 12 16 20 24 28 32 0 200 400 600 800 1,000 1,200 1,400 1,600 1940 1950 1960 1970 1980 1990 2000 2010 Billions of constant 2010 dollars Percent of GDP Since the 1940s, the U.S. has consistently maintained a budget deficit. U.S. government deficit since 1940 23© 2014 by McGraw-Hill Education • Public debt is the total amount of money that a government owes at a point in time. – Public debt is the cumulative sum of deficits and surpluses. The public debt Total debt in billions of 2010 dollars Percent of GDP 0 25 50 75 100 125 0 3,000 6,000 9,000 12,000 15,000 1940 1950 1960 1970 1980 1990 2000 2010 Billions of 2010 U.S. dollars Percent of GDP U.S. government debt since 1940 U.S. government debt has risen rapidly in the last decade, with larger budget deficits. 24© 2014 by McGraw-Hill Education Almost every country in the world has some debt. The public debt 31.9 60.7 61.3 67.4 109 147.8 183.5 Country (rank) Public debt as a percent of GDP 0 50 100 150 200 Korea (24) Ireland (12) United States (11) France (10) Italy (3) Greece (2) Japan (1) Debt in various OECD countries, 2010 There is a wide discrepancy in the amount of debt owed among countries. 925© 2014 by McGraw-Hill Education Is government debt good or bad? Benefits of government debt • It allows the government to be flexible when something unexpected happens. • Government debt can pay for investments that lead to economic growth and prosperity. Costs of government debt • The direct cost associated with government debt is the interest on borrowing. • There are indirect costs associated with government debt distorting credit markets. • The government must consider who bears the burden of the debt. • People today benefit when the government borrows, but future generations will have to repay the loans. Most economists believe that some debt is necessary to have a smoothly functioning government. What are the costs and benefits? 26© 2014 by McGraw-Hill Education • The level of taxation and government spending is called fiscal policy. – Expansionary fiscal policy can be used during a recession to increase AD. – Contractionary fiscal policy can be used during a boom to decrease AD. • The government might want to change fiscal policies to counteract economic fluctuations. Summary 27© 2014 by McGraw-Hill Education • The two main challenges the government faces when implementing fiscal policy are time lags and Ricardian equivalence. • The government-spending multiplier measures how much output increases when government spending increases. • The taxation multiplier measures how much output increases when taxation falls. • The government-spending multiplier is larger than the taxation multiplier. Summary 10 28© 2014 by McGraw-Hill Education • The government budget includes all of the revenue it collects in taxes and the money it spends on government programs. – There is a deficit when the government spends more than it collects. – There is a surplus when the government collects more than it spends. • The public debt is the total amount of money that the government has borrowed over time. Summary