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CHAPTER
SLIDES
BY
SOLINA LINDAHL
13(28)
Fiscal Policy
FOOD FOR THOUGHT….
SOME GOOD BLOGS AND OTHER SITES TO GET THE JUICES FLOWING:
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What you will
learn in this chapter
? What fiscal policy is and why it is an important tool in
managing economic fluctuations
? Which policies constitute an expansionary fiscal policy
and which constitute a contractionary fiscal policy
? Why fiscal policy has a multiplier effect and how this
effect is influenced by automatic stabilizers
? Why governments calculate the cyclically adjusted
budget balance
? Why a large public debt may be a cause for concern
? Why implicit liabilities of the government are also a
cause for concern
To
Video
To First
Active Learning
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LEARN BY DOING: APPLICATION VIDEO
They’re back! Keynes vs. Hayek: the fight of the century, round
2. Is fiscal policy stabilizing or destabilizing? Has the Great
Recession proved either man right? Click here or below. (10:10
minutes)
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BACK TO
FISCAL POLICY: THE BASICS
Government spending and tax revenue for some
high-income countries in 2013
Source: OECD.
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FISCAL POLICY: THE BASICS
The government funds many programs through
tax revenues.
Some important terms:
Government transfers: payments by the
government to households for which no good or
service is provided in return.
Social insurance programs: government programs
(transfer payments) intended to protect families
against economic hardship.
Social Security
Medicare
Medicaid
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SOURCES OF TAX REVENUE IN THE
U.S., 2013
Source: Bureau of Economic Analysis
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GOVERNMENT SPENDING IN THE U.S.,
2013
Government
transfers:
Social
Security,
Medicare
and
Medicaid are
the biggest
programs.
Government
purchases:
National
defense and
education are
the biggest
categories.
Source: Bureau of Economic Analysis
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LEARN BY DOING: PRACTICE QUESTION
Government programs that are designed to
protect individuals or families from
economic hardship are described as:
a) fiscal policy.
b) discretionary fiscal policy.
c) monetary policy.
d) social insurance.
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THE GOVERNMENT BUDGET AND TOTAL
SPENDING
GDP = C + I + G + X – IM
The government directly controls G and
indirectly affects C and I.
How?
Household incomes are affected by taxes
and transfers, and business investment is
affected by taxes and regulations.
So the government can shift the AD
curve.
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FISCAL POLICY
Fiscal policy: the use of taxes, government
transfers, or government purchases of
goods and services to shift the aggregate
demand curve.
I tried a
tax cut.
C
O
George, I’m
gonna go in
a different
direction.
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EXPANSIONARY AND
CONTRACTIONARY FISCAL POLICY
Expansionary fiscal policy: fiscal policy that
increases aggregate demand:
• an increase in government purchases of
goods and services
• a cut in taxes
• an increase in government transfers
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Expansionary fiscal
policy:
extra fuel for the
economy
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EXPANSIONARY FISCAL POLICY
CAN CLOSE A RECESSIONARY GAP
Aggregate
price level
LRAS
P2
SRAS1
E2
P1
E1
AD2
AD1
Y1
YP
Recessionary gap
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Real GDP
Potential
output
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Instead of waiting for
the long-run
correction
mechanism, policy
makers could choose
to stimulate AD and
move the economy
back toward long-run
equilibrium.
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EXPANSIONARY AND
CONTRACTIONARY FISCAL POLICY
Contractionary fiscal policy: fiscal policy
that decreases aggregate demand:
• a reduction in government purchases of goods
and services
• an increase in taxes
• a reduction in government transfers
Contractionary fiscal
policy:
brakes for the economy
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CONTRACTIONARY FISCAL POLICY
CAN CLOSE AN INFLATIONARY GAP
Aggregate
price level
LRAS
SRAS1
P1
Instead of waiting for
the long-run
correction
mechanism, policy
makers could choose
to contract AD and
move the economy
back toward long-run
equilibrium.
E1
P2
E2
AD1
AD2
YP
Potential
output
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Inflationary
G H T
2 0gap
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Real GDP
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LEARN BY DOING: PRACTICE QUESTION
Do you think the government is right to
begin massive spending programs during
deep recessions?
a) Yes
b) No
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LEARN BY DOING: PRACTICE QUESTION
Suppose a country wishes to produce at its potential
output level. Holding everything else constant, identify
which of the following policy initiatives might help it
reach this goal and how these policy initiatives would
help.
a) The government initiates policies that encourage
private investment spending.
b) The government increases the amount of money it
borrows in the loanable funds market to increase
its level of government spending in the economy.
c) The government increases taxes on consumers
and corporations.
d) The government authorizes new spending
programs.
To answer
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LEARN BY DOING: PRACTICE QUESTION
(answers to previous question)
Any policy initiative that shifts AD to the right will help the
country move toward its potential output level. Items (a) and
(d) will both shift AD to the right: government policies that
stimulate private investment spending lead to higher levels of
aggregate spending and a rightward shift in AD; and new
spending by government will also lead to higher levels of
aggregate spending and a rightward shift in AD. Item (b) will
cause the AD to shift to the right unless the increase in
government borrowing crowds out private investment to the
point where private investment decreases by an amount equal
to the increase in government spending. In that case item (b)
would result in no shift in the AD curve. Item (c) will reduce
disposable income and lead to lower levels of aggregate
spending: AD may shift to the left if the decrease in spending is
greater than the increase in government spending, or AD may
shift to the right if the increase in government spending is
greater than the decrease in spending
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CAN EXPANSIONARY FISCAL POLICY
ACTUALLY WORK?
There are critics who argue:
“Government
spending always
crowds out private
spending.”
“Government
borrowing always
crowds out private
investment spending.”
“Government
budget deficits
reduce private
spending.”
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CAN EXPANSIONARY FISCAL POLICY
ACTUALLY WORK?
Claim 1: “Government spending always
crowds out private spending.”
The statement is wrong because it assumes a zerosum game in which the aggregate income earned
in the economy is always a fixed sum—which isn’t
true. It also assumes that resources in the economy
are always fully employed—and the only way to
increase government spending is at firms’
expense.
You’re squeezed only
if the hot tub is full.
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CAN EXPANSIONARY FISCAL POLICY
ACTUALLY WORK?
Claim 2: “Government borrowing always
crowds out private investment spending.”
This is true only part of the time: It depends
upon whether the economy is depressed.
If it is, a fiscal expansion will lead to higher
incomes, which lead to increased savings.
The Recovery Act of 2009 was a case in point:
despite high levels of government borrowing,
U.S. interest rates stayed near historic lows.
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CAN EXPANSIONARY FISCAL POLICY
ACTUALLY WORK?
Claim 3: “Government budget deficits
reduce private spending.”
This is known as “Ricardian equivalence” (after
the nineteenth-century economist David
Ricardo).
It assumes that consumers, seeing the higher
debt levels, will cut their spending today to save
for inevitable increases in future tax rates
necessary to pay down the debt.
Does this give too much credit to consumers’
foresight and budgeting discipline? Probably.
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A CAUTIONARY NOTE: LAGS IN FISCAL
POLICY
In the case of fiscal policy, there is an
important reason for caution: There are
significant lags in its use.
It takes time to:
1. realize the recessionary or inflationary gap
by collecting and analyzing economic
data.
2. develop a plan.
3. implement the action plan (spending the
money).
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LEARN BY DOING: PRACTICE QUESTION
Contractionary fiscal policy:
a) is most helpful for restoring an economy to the
potential output level of production when there is
a recessionary gap.
b) shifts the AD curve to the right, restoring the
equilibrium level of output to the potential output
level for the economy.
c) often causes inflation or an increase in the
aggregate price level.
d) if effective, shifts AD to the left, resulting in a
reduction in the aggregate output and the
aggregate price level for a given short-run
aggregate supply curve (SRAS).
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LEARN BY DOING: PRACTICE QUESTION
Which of the following statements is true? Holding
everything else constant:
a) an economy can eliminate an inflationary gap
by increasing government spending.
b) expansionary fiscal policy refers to an increase
in taxes.
c) when potential output is greater than actual
aggregate output, the economy faces an
recessionary gap.
d) when SRAS intersects AD to the right of the longrun aggregate supply (LRAS) curve, the
economy faces a recessionary gap.
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ECONOMICS
IN ACTION
WHAT WAS IN THE RECOVERY ACT?
The American Recovery and Reinvestment Act of
2009 (billions of dollars)
One effect of the recession was a sharp drop in revenues at
the state and local levels, which in turn forced these lower
levels of government to cut spending. Federal aid was sent
to mitigate these
cuts.
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THE MULTIPLIER
Recall: The multiplier idea was introduced
by Keynes.
The multiplier magnifies new spending into
greater levels of income and output because
each round of spending becomes income for
someone else.
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FISCAL POLICY AND THE MULTIPLIER
Multiplier effects of an increase in
government purchases of goods and
services:
Recall that (if we assume a simple case with no
taxes or international trade),
the multiplier is 1/(1 – MPC)
Example: if MPC = 0.5, the multiplier would be 1/(1 – 0.5)= 2.
So $50 billion of new government spending would create
($50 billion) × 2 = $100 billion increase in real GDP.
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FISCAL POLICY AND THE MULTIPLIER
Multiplier effects of changes in government
transfers and taxes
Will a $50 billion tax cut (or increase in transfers) have
the same effect as a $50 billion increase in government
purchases?
No. Example: if the MPS=0.5, a change in tax or
transfers is smaller than an equivalent change in
government purchases from the outset.
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FISCAL POLICY AND THE MULTIPLIER
The size of the shift of the aggregate
demand curve depends on the type of
fiscal policy.
Changes in government purchases have a
more powerful effect on the economy than
equal-sized changes in taxes or transfers.
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FISCAL POLICY AND THE MULTIPLIER
A few notes:
It’s actually more complicated, because
(unlike most real tax policy) we use simple
lump-sum taxes: taxes that don’t depend
on the taxpayer’s income.
If it’s not a lump-sum tax, the tax revenue
will depend on the level of real GDP (and
reduce the size of the multiplier).
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TYPES OF FISCAL POLICY
Automatic stabilizers: government
spending and taxation rules that
cause fiscal policy to be
automatically expansionary when
the economy contracts and
automatically contractionary when
the economy expands
(unemployment insurance).
In contrast, discretionary fiscal
policy arises from deliberate actions
by policy makers rather than rules
(the Obama stimulus).
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LEARN BY DOING: PRACTICE QUESTION
Holding everything else constant, the multiplier
effect for taxes or transfers:
a) is the same as the multiplier effect for changes
in autonomous aggregate spending.
b) is smaller than the multiplier effect for changes
in autonomous aggregate spending.
c) is larger than the multiplier effect for changes in
autonomous aggregate spending.
d) may be smaller than, larger than, or equal to
the multiplier effect for changes in autonomous
aggregate spending.
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ECONOMICS
IN ACTION
Austerity and the Multiplier
New evidence from Europe suggests that the “multiplier effect” is
real…
Several nations experimented with “austerity” (sharp cuts in spending
plus tax increases) because of debt concerns… but many did not.
The Fiscal Multiplier,
2009-2013
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THE BUDGET BALANCE
How do surpluses and deficits fit into the analysis
of fiscal policy?
Are deficits ever a good thing and surpluses a
bad thing?
(And what’s the difference between deficit and
debt?)
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Click
here
for real-time
debt
clock
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THE BUDGET BALANCE MEASURES
FISCAL POLICY
SGovernment = T – G – TR
Government saving (Surplus) = tax revenues (T) –
government purchases (G) and transfers (TR).
A budget surplus is a positive budget balance,
and a budget deficit is a negative budget
balance.
Other things equal, discretionary expansionary fiscal
policies reduce the budget balance for that year.
Other things equal, discretionary contractionary fiscal
policies increase the budget balance for that year.
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THE BUDGET BALANCE AND THE
BUSINESS CYCLE
Some of the fluctuations in the budget balance
are due to the effects of the business cycle.
(Shaded areas are recessions.)
Sources: Bureau of Economic Analysis; National Bureau of Economic Research.
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THE BUDGET BALANCE AND THE
BUSINESS CYCLE
The budget deficit as a percentage of GDP moves
closely with the unemployment rate.
Sources: Bureau of Economic Analysis; Bureau of Labor Statistics
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THE BUSINESS CYCLE AND THE
CYCLICALLY ADJUSTED BUDGET
BALANCE
To separate the effects of the business cycle from
the effects of discretionary fiscal policy,
governments estimate the cyclically adjusted
budget balance: an estimate of the budget
balance if the economy were at potential output.
Years of large
budget deficits also
tend to be years
when the economy
has a large
recessionary gap.
Sources: Congressional
Budget Office; Bureau
of Economic
Analysis.
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WORLD WAR I WAR BOND
The U.S. deficit
rises (and so
does the debt)
during war
times.
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LEARN BY DOING: PRACTICE QUESTION
Holding everything else constant, the
government’s deficit:
a) tends to increase during a recession.
b) tends to increase during an expansion.
c) will increase if the government pursues
expansionary fiscal policy.
d) Answers (a) and (c) are both correct.
e) Answers (b) and (c) are both correct.
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PHILOSOPHIES ON BALANCING THE
BUDGET
There are various philosophies about requiring a
balanced budget:
…and lose the ability
to help during a
recession.
Balance the budget
over the business
cycle on average…
Require an
annually
balanced
budget…
…and trust the
politicians to keep
the long-run
budget healthy?
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ECONOMICS
IN ACTION
EUROPE’S SEARCH FOR A FISCAL RULE
1999: some European nations adopted a common
currency, the euro.
Each government was required to keep its budget deficit
below 3% of the country’s GDP or face penalties.
This pact limited a country’s ability to use fiscal
policy.
Then, after the 2008 financial crisis, Greece, Ireland,
Portugal, Spain, and Italy lost the confidence of their
investors, who worried they couldn’t pay their debt.
Was it too much debt? No, only Greece had a
deficit above 3% of GDP; Ireland and Spain ran
surpluses.
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BUDGET POLICY IN THE UNITED
STATES
The United States has its own version of the
original, flawed European stability pact.
The constitutions of 49 of the 50 states require a
balanced budget every year.
When recession struck in 2008, most states
were forced to slash spending and raise taxes
in the face of a recession, exactly the wrong
thing from a macroeconomic point of view.
Europe has since changed to a rule that
requires a mostly balanced structural budget.
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LONG-RUN IMPLICATIONS OF FISCAL
POLICY
Persistent budge …
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