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2
Fiscal Policy
Fiscal policy refers to government purchases, transfer payments, taxes, and borrowing as they affect macroeconomic variables such as real GDP, employment, the price level, and economic growth
Two categoriesAutomatic stabilizersDiscretionary fiscal policy
3
Automatic Stabilizers
Refer to revenue and spending items in the federal budget that automatically change with the ups and downs of the economy so as to stabilize disposable income and, hence, consumption and real GDP
4
Discretionary Fiscal Policy
Requires ongoing congressional decisions involving the deliberate manipulation of government purchases, taxation, and transfers to promote macroeconomic goals such as full employment, price stability, and economic growth.
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Exhibit 1: Increase in Government Purchases
Ag
gre
ga
te e
xp
en
dit
ure
(t
rill
ion
s o
f d
olla
rs)
10.0
0
45º
Real GDP (trillions of dollars)
C + I + G + (X – M)
a
10.5 b
C + I + G' + (X – M)
10.5
0.1
10.0
6
Government Purchases Multiplier
The simple multiplier for a change in government purchases, other things constant, equals
MPC1
1
Thus, we can say that for a given price level, and assuming that consumption varies with income
)1
1(
MPCGrealGDP
7
Change in Net Taxes
A change in net taxes also affects real GDP demanded, but the effect is less direct
A decrease in net taxes, other things constant, increases disposable income at each level of real GDP consumption increasesAn increase in net taxes, other things constant, reduces disposable income at each level of real GDP consumption decreases
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Exhibit 2: Decrease in Autonomous Net Taxes
10.0
0
45º
Real GDP (trillions of dollars)
10.0
C + I + G + (X – M)
a
Ag
gre
gat
e ex
pen
dit
ure
(t
rill
ion
s o
f d
olla
rs)
10.4 c
C' + I + G + (X – M)
0.08
10.4
9
Simple Tax Multiplier
The effect of a change in net taxes on real GDP demanded equals the resulting shift in the consumption function times the simple spending multiplier
Therefore, the change in real GDP can be determined as
)1
(MPC
MPCNTrealGDP
MPC
MPC
1
10
Exhibit 3: Contractionary Gap
Pri
ce
lev
el
130
Potential output
0 Real GDP (trillions of dollars)
SRAS130
Contractionary gap
e*
10.0
e125
AD
9.5
e"
11
Exhibit 3: Contractionary Gap
Pri
ce
lev
el
130
Potential output
0Real GDP
(trillions of dollars)
SRAS130
Contractionary gap
e*
10.0
e125
AD
9.5
AD*
e'
10.5
12
Fiscal Policy: Contractionary Gap
What if policy makers overshoot the mark and stimulate aggregate demand more than needed to achieve potential GDP?
In the short run, real GDP will exceed potential outputIn the long run, firms and resource owners will adjust to the unexpectedly high price levelThe short-run supply curve will shift back until it intersects the aggregate demand curve at potential output, increasing the price still further but reducing real GDP to potential output
13
Exhibit 4: Expansionary Gap
0
Potential output
10.0 Real GDP (trillions of dollars)
Pri
ce le
vel
SRAS130
AD'
10.5
135 e'
*
Expansionary gap
14
Exhibit 4: Expansionary Gap
0
Potential output
10.0 Real GDP (trillions of dollars)
Pri
ce le
vel
SRAS130
AD'
10.5
135 e'
*
Expansionary gap
*130
AD
e
e''
15
Problems with Fiscal PolicyPrecise expansionary and contractionary fiscal policies are difficult to achieve, for their proper execution assumes that
The relevant spending multiplier can be predicted accuratelyAggregate demand can be shifted by just the right amountThe potential level of output is accurately gaugedVarious government entities can somehow coordinate their fiscal effortsThe shape of the short-run aggregate supply curve is known and remains constant
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Natural Rate of UnemploymentThe unemployment rate that occurs when the economy is producing its potential GDP is called the natural rate of unemployment
Before adopting discretionary policies, public officials must correctly estimate this natural rate
This problem is presented in Exhibit 5
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Exhibit 5: When Discretionary
(trillions of dollars)
Potential output
LRAS
10.00
Real GDP
130
AD
a
AD'
b
10.2
SRAS130
SRAS140
c140
Fiscal Policy Overshoots
Pri
ce l
evel
18
Lags in Fiscal PolicyThe time required approving and implementing fiscal legislation may hamper its effectiveness and weaken discretionary fiscal policy and may in fact do more harm than good
Since a recession is not usually identified as such until at least six months after it begins, and since the eight recessions since 1949 lasted an average of 11 months, this leaves a narrow window in which to execute discretionary fiscal policy
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Permanent Income
Permanent income is the income a person expects to receive on average over the long run
Thus, changes in taxes that are regarded as temporary will not stimulate consumption and may render fiscal policy ineffective
20
Feedback EffectsFiscal policy may unintentionally affect aggregate supplyFor example, suppose the government increases unemployment benefits and finances these transfer payments with higher taxes on current workers. If the marginal propensity to consume is the same for both groups, the reduction in spending by those whose taxes increase should just offset the increase in spending by transfer recipients
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Feedback Effects
But what of possible effects of these changes on the labor supply?
The unemployed, who benefit from increased transfers, now have less incentive to find work
22
Feedback Effects
Conversely, workers who find their after-tax wage reduced by the higher tax rates may be less willing to work
The supply of labor could decrease as a result of offsetting changes in taxes and transfers with the result that aggregate supply would decline economy’s potential GDP would decline