Chapter 12 Fiscal Policy

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I. Theory of Fiscal Policy

Fiscal policy uses government purchases, transfer payments, taxes, and borrowing to affect macroeconomic variables such as employment, the price level, and the level of GDP.

Tools of fiscal policy:

1. Automatic Stabilizers – Structural features of government spending and taxation that smooth fluctuations in disposable income, and hence consumption, over the business cycle.

- Federal Income Tax

2. Discretionary Fiscal Policy – The deliberate manipulation of government purchases, taxation, and transfers in order to promote macroeconomic goals such as full employment, price stability, and economic growth.

- Changes in Government Purchases

II. Discretionary Fiscal Policy

A. Changes in Government Purchases

Example:

D Real GDP = DG * (1/1-MPC)

B. Changes in Net Taxes

Decrease in net taxes à increases disposable income à consumption increases à increases real GDP demanded.

Increase in net taxes à decreases disposable income à consumption decreases à decreases real GDP demanded.

Example:

Simple tax multiplier- The ratio of a change in equilibrium real GDP demanded to the initial change in autonomous net taxes that brought it about; the numerical value of the simple tax multiplier is -MPC/1-MPC.

D Real GDP = DNT * (-MPC/1-MPC)

Notes:

1. Increase in government spending, increases equilibrium real GDP demanded. (simple government purchase multiplier >0)

2. Increase in net taxes, decreases equilibrium real GDP demanded. (simple tax multiplier <0)

III. Including Aggregate Supply (Discretionary Policy Continued)

Often natural market forces will take a long time to close a contractionary gap.

A. Discretionary Fiscal Policy in Response to a Contractionary Gap

Suppose that in short-run equilibrium, we have a contractionary gap. Unemployment is above the natural rate. If the market adjusts naturally, the nominal price of resources will drop in the long run; short-run aggregate supply would shift out to achieve equilibrium at potential output.

Often, however, wages and prices are slow to adjust. Government may introduce fiscal policy to move the economy more quickly back to potential output. They might change net taxes or government spending or both.

Example:

B. Discretionary Fiscal Policy in Response to an Expansionary Gap

If short-run equilibrium price level exceeds the level on which long-term contracts were based, output exceeds potential GDP. In the long run, we expect the short-run aggregate supply curve to shift back, returning the economy to potential output and increasing the price level.

Use of discretionary fiscal policy can avoid inflation.

Example:

Precisely calculated fiscal policies are hard to achieve because the government must know:

1. The spending multiplier

2. Whether aggregate demand can be shifted the correct amount

3. What the potential output level is

4. How to coordinate fiscal efforts among government agencies

5. The shape of aggregate supply curve in the short run

C. The Multiplier and the Time Horizon

The steeper the short-run aggregate supply curve, the less impact a given shift in the aggregate demand curve has on output and the more impact it has on the price level, so the smaller the spending multiplier.

If the economy is already producing its potential output, the spending multiplier is zero in the long run.

IV. Problems with Discretionary Fiscal Policy

A. Fiscal Policy and the Natural Rate of Unemployment

To use discretionary fiscal policy, public officials must correctly estimate the natural rate.

Example:

B. Lags in Fiscal Policy

The time required to approve and implement fiscal policy may make it less effective as a tool for stabilization. Imposed at the wrong time, measures may cause more harm than good.

C. Discretionary Policy and Permanent Income

Permanent Income – Income individuals expect to receive on average over the long term.

People base their consumption decisions not just on current income but also on permanent income.

If people view tax changes as only temporary, they will not have their desired effect.

Example: Temporary tax surcharge increase in 1967

To the extent that consumers base spending decisions on their permanent income, attempts to fine-tune the economy with tax-rate adjustments thought to be temporary will be less effective.

D. Feedback Effects of Fiscal Policy on Aggregate Supply

Fiscal policy may affect aggregate supply, often unintentionally.

Changes in transfer payments/taxes not only affect AD, but could cause changes in the labor supply.

Both automatic stabilizers, unemployment insurance and the progressive income tax, and discretionary fiscal policy, such as changes in tax rates, may affect individual incentives to work, spend, save, and invest, although these effects are usually unintended.

V. The Evolution of Fiscal Policy

Prior to the Great Depression, public policy was based on the views of classical economists. The object of fiscal policy was only to balance the budget.

Classical economists – A group of 18^th- and 19^th- century economists who believed that recessions were short-run phenomena that corrected themselves through natural market forces; thus they believed the economy was self-correcting.

- They believed that most economic crises were caused by sources other than market forces (wars, poor growing seasons, and changes in tastes.)

- They felt that active fiscal policy would do more harm than good.

- Recessions/inflation temporary and would be fixed by market forces.

A. Great Depression and WWII

3 things happened to increase the use of discretionary fiscal policy

1. 1936 Keynes' The General Theory

Keynesian theory and policy were developed to address the problem of unemployment arising from the Great Depression.

- He argued that prices, wages were not flexible enough to ensure full employment of resources.

- Business expectations might at times be so grim, that even high low rates wouldn’t get firms investing.

2. WWII increased production and eliminated cyclical unemployment during the war years, pulling the economy out of the depression.

3. Employment Act of 1946 gave the federal government the responsibility for promoting full employment and price stability.

B. Golden Age to Stagflation

1960s were the golden age of fiscal policy

Demand-management policies were not suited to deal with stagflation.

C. U.S. Budget Deficits of the 1980s and 1990s

1981 President Reagan and Congress agreed on a 23% reduction in average income tax rates and a major buildup in defense, with no offsetting reduction in domestic programs. (Tax cut phased in over 3 years.)

Tax reduction represented a supply-side idea that lower taxes would increase work incentives and increase labor supply and other resources, thus increasing potential GDP.

Supply-side theory predicted that real GDP would increase so much that tax revenue might actually increase.

Did the supply-side experiment work?

D. Balancing the Federal Budget

1993 Taxes increased substantially on high-income households

1994 Congress introduced more discipline on federal spending as part of plan to balance budget by 2002.

At the same time, the economy experienced a vigorous recovery fueled by increased consumer spending and business optimism.

1998 Budget Balanced

Toward the end of the 90s, the economy has been performing so well that there has been no need to consider using discretionary fiscal policy.

VI. Automatic Stabilizers

Automatic stabilizers smooth fluctuations in disposable income over the business cycle, thereby boosting aggregate demand during periods of recession and dampening aggregate demand during periods of expansion.

Example

Federal Income Tax system is progressive (fraction of income paid in taxes increases as income increases).

Expansion à growing fraction of income goes to taxes à slowing the growth in DI and C.

This relieves the inflationary pressure associated with expansions.

Example

Unemployment Insurance

Recession à unemployment increases à payments are made from the insurance fund to those who are unemployed à This increases their disposable income and decreases the impact of the recession.

Because of Automatic Stabilizers

1. GDP fluctuates less than it otherwise would

2. Disposable Income varies proportionately less than does real GDP

The stronger automatic stabilizers are, the less the need for discretionary fiscal policy.