Fiscal Policy

Fiscal policy: The use of government

taxes and spending to alter
macroeconomic outcomes
The federal budget is a tool that can
shift aggregate demand and thereby
alter macroeconomic outcomes
11-1

Objectives of Fiscal policy

Reducing unemployment.
Controlling Inflation.
High and stable economic growth.
The avoidance of balance of
payments deficits and excessive
exchange rate fluctuations.
11-2

Instruments of Fiscal policy:

Government Expenditure
Government purchases are part of
aggregate demand, income transfers
are not
Income transfers: Payments to
individuals for which no current
goods or services are exchanged
11-3

Instruments of Fiscal policy:

Taxes and Spending
Today, the federal government
Employs over 4 million people and
spends more than $3.5 trillion a year
Collects nearly $3 trillion a year in
taxes, with nearly half that from
individual income taxes
Spends all of its tax revenuesand
more, borrowing additional funds
11-4

How Fiscal Policy affects 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 transfers

11-5

Fiscal Policy
DETERMINANTS
Internal
market
forces

OUTCOMES
AS

Output
Jobs
Prices

External
shocks

Growth
Policy tools:
Fiscal
policy

AD

International
balances

11-6

Fiscal Stimulus
Suppose the economy is experiencing a
recessionary GDP gap of $400 billion
From a Keynesian perspective, the
solution is to get someone to spend
more on goods and services

11-7

Equilibrium with Unemployment

11-8

Equilibrium with unemployment,

full employment and inflation

11-9

Equilibrium with inflation

11-10

Keynesian Strategy
(In case of unemployment)
Fiscal stimulus: Tax cuts or spending
hikes intended to increase (shift)
aggregate demand
Two strategic policy questions:
By how much do we want to shift the
AD curve to the right?
How can we induce the desired shift?
11-11

More Government Spending

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
11-12

Tax Cuts
By lowering taxes, the government
increases disposable income, which
stimulates the consumption component of
AD.
The amount consumption increases
depends on the marginal propensity to
consume. Initial increase
in consumption

MPC tax cut

11-13

Multiplier Effects
Cumulative change
initial change
multiplier
in spending
in consumption

A dollar of tax cut contains less

stimulus than a same size increase in
government purchases
desired fiscal stimulus
Desired tax cut
MPC
11-14

Increased Transfers
Increasing transfer payments
stimulates the economy
Initial fiscal
increase in
MPC
stimulus (injection)
transfer payments

11-15

Fiscal Restraint
At times the economy is expanding too fast
and fiscal restraint is more appropriate
Inflationary GDP gap: The amount by
which equilibrium GDP exceeds fullemployment
Fiscal restraint: Tax hikes or spending cuts
intended to reduce (shift) aggregate demand

11-16

A Warning: Crowding Out

Some of the intended fiscal stimulus
may be offset by the crowding out of
private expenditure.
Crowding out: A reduction in privatesector borrowing (and spending)
caused by increased government
borrowing.
11-17