INTRODUCTION This chapter confronts the following questions: Chapter 11 FISCAL POLICY LEVERS Can government spending and tax policies help ensure full employment? What policy actions will help fight inflation? What are the roles of government intervention? 2 TAXES AND SPENDING Up until 1915, the federal government collected few taxes and spent little. In 1902, it employed fewer than 350,000 people and spent $650 million. In 2000, it employs nearly 5 million people and spends more than $2 trillion. GOVERNMENT EXPENDITURE Government spending directly affects aggregate demand. Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus. 3 4 PURCHASES VS. TRANSFERS To understand how government spending affects aggregate demand, we must distinguish between government purchases and income transfers. Government spending on defense, highways, and health care is part of aggregate demand. Income transfers don t become part of AD until recipients decide to spend income. Income transfers are payments to individuals for which no current goods or services are exchanged, such as Social Security, welfare, unemployment benefits. FISCAL POLICY The federal government s tax and spending powers give it a great deal of influence over aggregate demand. The federal government can alter aggregate demand by: Purchasing more or fewer goods and services. Raising or lowering taxes. Changing the level of income transfer. 5 6
FISCAL POLICY FISCAL POLICY Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes. From a macro perspective, the federal budget is a tool that can change aggregate demand and macroeconomic outcomes. DETERMINANTS Internal market forces External shocks AS OUTCOMES Output Jobs Prices Growth Policy levers: Fiscal policy AD International balances 7 8 FISCAL STIMULUS THE POLICY GOAL Suppose the economy is experiencing a recessionary GDP gap of $400 billion. The recessionary GDP gap is the difference between full-employment GDP and equilibrium GDP. Price Level (ave erage price) P E Full-employment GDP AD 1 a GDP Equilibrium GDP gap b AS Q E = 5.6 6.0 = Q F Real GDP (trillions of dollars per year) 9 10 KEYNESIAN STRATEGY The Keynesian model of the adjustment process shows not only how the economy can get into trouble, but also how it might get out. From a Keynesian perspective, the way out of recession is to get someone to spend more on goods and services. The source of new spending could be a fiscal stimulus. KEYNESIAN STRATEGY A fiscal stimulus is tax cuts or spending hikes intended to increase (shift) aggregate demand. The general strategy is clear; however, the scope of desired intervention is not. Two strategic policy questions must be answered: By how much do we want to shift the AD curve to the right? How can we induce the desired shift? 11 12
THE NAIVE KEYNESIAN MODEL If GDP gap is $400 billion, why not just increase AD by that much? The naive Keynesian policy fails to achieve full employment. An increase in aggregate demand by the amount of the GDP gap will achieve full employment only if the aggregate supply curve is horizontal. PRICE LEVEL CHANGES When the AD curve shifts to the right, the economy moves up the AS curve, not horizontally to the right, changing both real output and prices. Shifting (increasing) aggregate demand by the amount of the GDP gap will achieve full employment only if the price level doesn t rise. 13 14 THE AD SHORTFALL THE AD SHORTFALL So long as the AS curve slopes upward, we must increase AD by more than the size of the recessionary GDP gap to achieve full employment. The AD shortfall is the amount of additional aggregate demand needed to achieve full employment after allowing for price level changes. The AD shortfall is the fiscal target. verage price) Price Level (av P E AD 1 AD 2 Recessionary GDP gap AD 3 a c d AS Q E = 5.6 Q F = 6.0 6.4 Real GDP (trillions of dollars per year) b AD shortfall e 15 16 MULTIPLIER EFFECTS Increased government spending is a form of fiscal stimulus. Every dollar of new government spending has a multiplied impact on aggregate demand. How much of a boost the economy gets depends on the value of the multiplier. The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles. 17 MULTIPLIER EFFECTS The total spending change equals the multiplier times the new spending injections. Total change in spending = multiplier X new spending injection Spending Multiplier = 1 (1- ) 18
MULTIPLIER EFFECTS MULTIPLIER EFFECTS The impact of fiscal stimulus on aggregate demand includes the new government spending plus all subsequent increases in consumer spending triggered by the additional government outlays: Increase in AD = multiplier X fiscal stimulus rage price) Price Level (aver P 1 Direct impact of rise in government spending + $200 billion b AD 1 Indirect impact via increased consumption + $600 billion a Current price level AD 2 AD 3 5.6 5.8 6.4 Q E Real GDP ($ trillions per year) 19 20 THE DESIRED STIMULUS The general formula for computing the desired stimulus is a simple rearrangement of the earlier formula: Desired fiscal stimulus = Spending Multiplier = Desired AD increase multiplier 1 (1- ) TAX CUTS By lowering taxes, the government increases the disposable income of the private sector. Disposable income is the after-tax income of consumers; personal income less personal taxes. Tax cuts directly increase the disposable income of consumers. The more important question is how does a tax cut affect spending. 21 22 TAXES AND CONSUMPTION The amount consumption increases depends on the marginal propensity to consume. Initial increase in consumption = X tax cut TAXES AND CONSUMPTION A tax cut contains less fiscal stimulus than an increase in government spending of the same size. The initial spending injection is less than the size of the tax cut. 23 24
TAXES AND CONSUMPTION THE TAX CUT MULTIPLIER An AD shortfall can be closed with a tax cut. Tax Cut First round of spending: More consumption = X tax cut More saving = MPS X tax cut Desired fiscal stimulus Desired tax cut = Second round of spending: More income More consumption More saving More income More saving Third round of spending: More consumption Cumulative change in saving: = tax cut 25 26 TAXES AND INVESTMENT A tax cut may also be an effective mechanism for increasing investment spending. Tax cuts have been used numerous times to stimulate the economy. INCREASED TRANSFERS Increasing transfer payments such as social security, welfare, unemployment benefits, and veterans benefits can stimulate the economy. The initial fiscal stimulus of increased transfer payments is: Initial fiscal stimulus (injection) = X increase in transfer payments 27 28 FISCAL RESTRAINT There are times when the economy is expanding too fast and fiscal restraint is more appropriate. Fiscal restraint is using tax hikes or spending cuts intended to reduce (shift) aggregate demand. The AD excess is the amount by which aggregate demand must be reduced to achieve price stability after allowing for price-level changes. 29 THE FISCAL TARGET The first task is to determine how much AD needs to fall: Desired AD reduction Desired fiscal restraint = Multiplier Excess AD = Multiplier The AD excess exceeds the GDP gap. 30
EXCESS AGGREGATE DEMAND BUDGET CUTS Price Level (a average price) P E P F f Inflationary GDP gap E 2 Excess AD E 1 AS AD 2 AD 1 Budget cuts reduce government spending and induces cutbacks in consumer spending. The budget cuts have a multiplied effect on AD equal to: Cumulative reduction in spending = multiplier X initial budget cut Q 2 = 5.8 Q F = 6.0 Q 1 = 6.2 Real Output (trillions of dollars per year) 31 The budget cuts should be equal to the size of the desired fiscal restraint. 32 TAX HIKES Tax hikes can be used to shift the AD curve to the left. The direct effect of tax increases is a reduction in disposable income. TAX HIKES Taxes must be increased more than a dollar to get a dollar of fiscal restraint. Desired fiscal restraint Desired increase in taxes = 33 34 REDUCED TRANSFERS A third option for fiscal restraint is to reduce transfer payments. A cut in transfer payments works like a tax hike, reducing the disposable income of transfer recipients. The desired reduction in transfers is the same as a desired tax increase. Reduced transfers are seldom used since recipients include the aged, poor, unemployed and disabled. 35 A PRIMER: SIMPLE RULES The essence of fiscal policy is the deliberate shifting of the aggregate demand curve. The steps required to formulate fiscal policy are: Specify the amount of the desired AD shift. Select the policy tools needed to induce the desired shift. 36
FISCAL STIMULUS FISCAL RESTRAINT Policy Option AD shortfall Desired fiscal stimulus the multiplier Increase government purchases Cut taxes Increased transfers Amount desired fiscal stimulus desired fiscal stimulus desired fiscal stimulus Policy Option excess AD Desired fiscal restraint the multiplier Reduce government purchases Increase taxes Reduce transfers Amount desired fiscal restraint desired fiscal restraint desired fiscal restraint 37 38 A WARNING: CROWDING OUT Fiscal policy guidelines are a useful tool but neglect a critical dimension of fiscal policy. How is the government going to finance its expenditures? Some of the intended fiscal stimulus may be offset by the crowding out of private investment expenditure. Crowding out is a reduction in private-sector borrowing (and spending) caused by increased government borrowing. 39 TIME LAGS Fiscal policy is somewhat hampered because it takes time to recognize that a problem exists and then formulate policy to address the problem. In addition, the very nature of the macro problems could change if the economy is hit with other internal or external shocks. 40 PORK-BARREL POLITICS Once a tax or spending plan arrives at the U.S. Capitol, politics take over. If taxes are cut, they want their constituents to get the biggest tax savings. No member of Congress wants spending cuts in their own districts. No-one in Congress wants a tax hike or spending cut before the election. THE CONCERN FOR CONTENT Guidelines for fiscal policy do not say anything about how the government spends its money or whom it taxes. It does matter whether federal expenditures are devoted to military hardware, urban transit systems, or tennis courts. 41 42
THE SECOND CRISIS Our economic goals include not only full employment and price stability, but also a desirable mix of output, equitable distribution of income, and adequate economic growth. The relative emphasis on, and sometimes exclusive concern for, stabilization objectives to the neglect of related GDP content has been designated by Joan Robinson as the second crisis of economic theory Fiscal policy can be directed toward private expenditure (C + I) or public expenditure (G). 43 End of Chapter 11 FISCAL POLICY LEVERS