Fiscal Policy•Keynesian view•Discretionary versus non-discretionary fiscal policy•The automatic stabilizers•Fiscal policy to close a contractionary gap.•The tax multiplier•Fiscal policy to close an expansionary gap.•Problems with fiscal policy

Fiscal PolicyThe use of the taxing and spending powers of government to regulate aggregate expenditure, and thereby to stabilize the economy

The economy needs to be stabilized. The economy

can be stabilized. The economy should be stabilized. This is the

Keynesian view

Employment Act of 1946

This legislation established a

responsibility for the federal government to promote “maximum

employment, production, and

purchasing power.”

Discreti onary versusnon-discreti onary spending

Discretionary fiscal policy is the deliberate manipulation of government purchases, taxation, and transfer payments to pursue macroeconomic goals such as full employment and price stability.

The Bush tax stimulus package of 2008 is an example of

discretionary fiscal policy

Automati c stabilizersNon-discretionary or “built-in” features of government spending and taxation that reduce fluctuations in disposable income, and thus consumption, over the business cycle.

•Tax rates for various types of income are set by elected officials. Tax collections depend on the employment levels/incomes, profits, capital gains, retails sales, . . .•Elected officials establish eligibility requirements and support levels for needs-tested transfer payments—e.g., TANF, food stamps, and unemployment compensation. Actual government outlays for needs-tested transfer payments depend on (1) the number of persons eligible; and (2) the number of those eligible that actually file claims.

As the economy enters a recession, federal revenues tend to decline while at the same time transfer payments rise. Thus recession

brings about an automatic decline of net taxes (NT)

DINTY

Remember that: DI = Y - NT

DINTY

Keynesian RxIf a lack of aggregate expenditure is

the problem, why not use the spending and taxing powers of the federal government to stimulate

aggregate expenditure

Using expansionary fi scal pol icyto c lose a contracti onary gap

MXGIbNTa

AEAEAE’

Real GDP (Y)Y YF

YF is full-employment (potential) GDP.

Contractionary gap

•Increase in G•Decrease in NT

Effect of a $0.1 trillion increase in G on AE and real GDP demanded

C+I+G+(X-M)

a

14.0 14.50 Real GDP(trillions of dollars)

14.0

14.5

Aggr

egat

e ex

pend

iture

(tril

lions

of d

olla

rs)

45°

C+I+G’+(X-M)

bAs a result of a$0.1 trillion increase in government purchases, the aggregate expenditure line shifts up by $0.1 trillion, increasing the real GDP demanded by $0.5 trillion. This model assumes price level remains unchanged.

0.1

bGY

1

1

10

Effect of a $0.1 trillion decrease in net taxes on aggregate expenditure and real GDP demanded

C+I+G+(X-M)

a

14.0 14.50 Real GDP(trillions of dollars)

14.0

14.5

Aggr

egat

e ex

pend

iture

(tril

lions

of d

olla

rs)

45°

C’+I+G+(X-M)

b

As a result of a decrease in NT of $0.1 trillion, consumers, who are assumed to have a MPC of 0.8, spend $80 billion more and save $20 billion at every level of GDP. The consumption function shifts up by $80 billion, as does the AE line.

0.08

An $80 billion increase of AE line eventually increases real GDP demanded by $0.4 trillion. Keep in mind that the price level is assumed to remain constant during all this.

Simple tax multi plier

bNTbY

1

1)(

Note: We assume imports are autonomous. Thus the multiplier is given by:

b11

[1]

We can rewrite [1] as:

b

bNTY

1

Tax multiplier

12

Discretionary fiscal policy: close a contractionary gapPr

ice

leve

l

125

130

AD

SRAS130

e

Potential outputLRAS

The aggregate demand curve AD and the short-run aggregate supply curve SRAS130 intersect at point e. Output falls short of the economy’s potential. The resulting contractionary gap is $0.5 trillion.

Real GDP (trillions of dollars)

0 14.0 14.513.5

AD*e’

e*

This gap could be closed by discretionary fiscal policy that increases aggregate demand by just the right amount. An increase in government purchases, a decrease in net taxes, or some combination could shift aggregate demand out to AD*, moving the economy out to its potential output at e*.

e’’

13

Discretionary fiscal policy: close expansionary gap

Pric

e le

vel

135

130AD’

SRAS130

e’

Potential outputLRAS

The aggregate demand curve AD’ and the short-run aggregate supply curve SRAS130 intersect at point e’ resulting in an expansionary gap of $0.5 trillion.

Real GDP (trillions of dollars)

0 14.0 14.5

AD*

e*

Discretionary fiscal policy aimed at reducing aggregate demand by just the right amount could close this gap without inflation. An increase in net taxes, a decrease in government purchases, or some combination could shift aggregate demand back to AD* and move the economy back to its potential output at e*.

e’’

Problems with (discreti onary) fi scal policy

1. Policy lags2. Permanent income