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# 07 fiscal policy

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### 07 fiscal policy

1. 1. Chapter 21 Fiscal Policy• Key Concepts• Summary• Practice Quiz• Internet Exercises ©2000 South-Western College Publishing 1
2. 2. In this chapter, you will learn to solve these economic puzzles:Why Can Ronald Reagan aIs andid Congress fight think increase in governmentspending orgovernment couldthe federal a tax cut of equal recession without by increase tax revenues amount the greater stimulus taking any action? cutting taxes? to economic growth? 2
3. 3. What is a Discretionary Fiscal Policy?The deliberate use of changes in government spending or taxes to alter aggregate demand and stabilize the economy 3
4. 4. What are examples ofExpansionary Fiscal Policy? • Increase government spending • Decrease taxes • increase government spending and taxes equally 4
5. 5. What are examples ofContractionary Fiscal Policy? • Decrease government spending • Increase taxes • Decrease government spending and taxes equally 5
6. 6. Government Spending to Combat a Recession Price Level AS E2155155 E1 X150 AD1 AD2 Full Employment Real GDP 0 \$6 \$6.1 \$6.2 6
7. 7. Increase in the price level and the real GDP Increase in the aggregate demand curveIncrease ingovernment spending 7
8. 8. With an MPC of 0.75, what is theSpending Multiplier?1/1-MPC = 1/1-0.75 = 1/25/100 = 1 /  = 4 8
9. 9. How much will real GDP increase by with anincrease in government spending of \$50 bil? 4 x \$50 bil = \$200 bil 9
10. 10. What is the Tax Multiplier?The change in aggregate demand (total spending) resulting from an initial change in taxes 10
11. 11. What happens when government cuts taxes by \$50 bil?The multiplier process is less because initial spending increases only by \$38 bil instead of \$50 bil 11
12. 12. What is the formula for the Tax Multiplier? 1 – spending multiplier 12
13. 13. How much does real GDPincrease by with a cut in taxes of \$50 bil? 3 x \$50 bil = \$150 bil 13
14. 14. Can we assume that theMPC will remain fixed?No, it can change from one time period to another 14
15. 15. Can Fiscal Policy be used to combat Inflation?Yes, this would happen when the economy is operating in the Classical or Intermediate range of the aggregate supply curve 15
16. 16. What will happen to AD with a cut in G spending of 25 bil?-\$25 bil x 4 = -\$100 bil 16
17. 17. Using Fiscal Policy to Price Level Combat Inflation AS160 E1 E´155 E2 AD1 Full AD2 Employment 0 \$6 \$6.1 Real GDP 17
18. 18. Decrease in the price level Decrease in the aggregate demand curveDecrease ingovernment spending 18
19. 19. What will happento AD with a cut in Taxes of 33.3 bil?\$33.3 x -3 = -\$100 bil 19
20. 20. What is the BalancedBudget Multiplier?An equal change in government spending and taxes, which changes aggregate demand by the amount of the change in government spending 20
21. 21. What is anAutomatic Stabilizer?Federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction 21
22. 22. What are examples of Automatic Stabilizers? • Transfer payments• Unemployment compensation • Welfare 22
23. 23. What is a Budget Surplus?A budget in which government revenues exceed government expenditures in a given time period 23
24. 24. What is a Budget Deficit? A budget in which government expenditures exceed government revenues in a given time period 24
25. 25. \$2,500 Automatic Stabilizers T\$1,000 G Spending and Taxes surplus Budget Budget deficit \$750 \$500 \$250 G Real GDP \$4 \$6 \$8 25
26. 26. Budget offsets inflation Tax collections fall and government transfer payments riseIncrease in real GDP 26
27. 27. Budget offsets recession Tax collections fall and government transfer payments riseDecrease in real GDP 27
28. 28. What is Supply-Side Fiscal Policy?A fiscal policy that emphasizes government policies that increase aggregate supply 28
29. 29. What is the purpose of Supply-Side Fiscal Policies?To achieve long-run growth in real output, full employment, and a lower price level 29
30. 30. Demand-Side Fiscal Policy Price Level AS250 E2200 Full E1 Employment150 AD2100 AD1 Real GDP 0 2 4 6 8 10 12 30
31. 31. Increase in the aggregate demand curve Increase in governmentspending; decrease in net taxes 31
32. 32. Supply-Side Fiscal Policy Price Level AS1250 AS2200 E1150 Full E2 Employment100 AD Real GDP 0 2 4 6 8 10 12 32
33. 33. Increase in the aggregate supply curveDecrease in resourceprices; technologicaladvances; subsidies; decrease in regulations 33
34. 34. Supply-Side Policies Affect Labor Markets tax-cut Before After tax-cut labor supply labor supply E1 Wage rateW1W2 E2 Labor Q of Labor Demand 0 L1 L2 34
35. 35. Will an increase in Taxes lead to higherGovernment Revenues? That depends on where the economy is on the Laffer Curve 35
36. 36. What is the Laffer Curve?Puts forth the idea that increasing taxes from zero will increase tax revenues up to a certain point 36
37. 37. What happens beyond a certain point?Tax revenues begin to decline as the economic pie begins to shrink 37
38. 38. Why does the Economic Pie begin to shrink? Workers have less incentive to work and investors have less of an incentive to invest 38
39. 39. The Laffer Curve BRmax Federal Tax Revenue C R A Federal Tax Rate D 0 Tmax T 100% 39
40. 40. Key Concepts 40
41. 41. Key Concepts• What is a Discretionary Fiscal Policy?• What are examples of Expansionary Fiscal Policy• What are examples of Contractionary Fiscal Poli• With an MPC of 0.75, what is the Multiplier?• How much will real GDP increase by with an incr 41
42. 42. Key Concepts cont.• What is the Tax Multiplier?• What is the formula for the Tax Multiplier?• Can Fiscal Policy be used to combat Inflation?• What will happen to AD with a cut in G spend• What is the Balanced Budget Multiplier? 42
43. 43. Key Concepts cont.• What is an Automatic Stabilizer?• What is a Budget Surplus?• What is a Budget Deficit?• What is Supply Side Fiscal Policy?• What is the Laffer Curve? 43
44. 44. Summary 44
45. 45. Fiscal policy is the use ofgovernment spending, taxes, andtransfer payments for the purpose ofstabilizing the economy. 45
46. 46. Discretionary fiscal policy followsthe Keynesian argument that thefederal government should manipulateaggregate demand in order to influencethe output, employment, and pricelevels in the economy. Discretionaryfiscal policy requires either newlegislation to change governmentspending or taxes in order to stabilizethe economy. 46
47. 47. Expansionary fiscal policy is adeliberate increase in governmentspending, a deliberate decrease intaxes, or some combination of thesetwo options. 47
48. 48. Contractionary fiscal policy is adeliberate decrease in governmentspending, a deliberate increase intaxes, or some combination of thesetwo options. Using eitherexpansionary or contractionary fiscalpolicy, the government can shift theaggregate demand curve in order tocombat recession, cool inflation, orachieve other macroeconomic goals. 48
49. 49. Discretionary Fiscal Policies Expansionary Contractionary• Increase government • Decrease governmentspending spending• Decrease taxes • Increase taxes• Increase government • Decrease governmentspending and taxes spending and taxesequally equally 49
50. 50. The tax multiplier is themultiplier by which an initialchange in taxes changes aggregatedemand (total spending) after aninfinite number of spending cycles.Expressed as a formula, the taxmultiplier = 1 - spending multiplier. 50
51. 51. A balanced budget multiplier innot neutral. A dollar of governmentspending increases real GDP morethan a dollar cut in taxes. Thus, eventhough the government does not spendmore than it collects in taxes, it is stillstimulating the economy. 51
52. 52. Combating recession and inflationcan be accomplished by changinggovernment spending or taxes. Thetotal change in aggregate demandfrom a change in governmentspending is equal to the change ingovernment spending times thespending multiplier. The total changein aggregate demand from a change intaxes is equal to the change in taxestimes the tax multiplier. 52
53. 53. Increase in the price level and the real GDP Increase in the aggregate demand curveIncrease ingovernment spending 53
54. 54. Decrease in the price level Decrease in the aggregate demand curveDecrease ingovernment spending 54
55. 55. A budget surplus occurs whengovernment revenues exceed governmentexpenditures. A budget deficit occurswhen government expenditures exceedgovernment revenues. 55
56. 56. Automatic stabilizers are changesin taxes and government spending thatoccur automatically in response tochanges in the level of real GDP. Thebusiness cycle therefore createsbraking power: A budget surplus slowsdown an expanding economy. Abudget deficit reverses a downturn inthe economy. 56
57. 57. \$2,500 Automatic Stabilizers T\$1,000 G Spending and Taxes surplus Budget Budget deficit \$750 \$500 \$250 G Real GDP \$4 \$6 \$8 57
58. 58. According to supply-side fiscalpolicy, lower taxes encourage work,saving, and investment, which shiftthe aggregate supply curve rightward.As a result, output and employmentincrease without inflation. 58
59. 59. The Laffer curve represents therelationship between the income taxrate and the amount of income taxrevenue collected by the government. 59
60. 60. Chapter 21 Quiz ©2000 South-Western College Publishing 60
61. 61. 1. Contractionary fiscal policy is deliberate government action to influence aggregate demand and the level of real GDP through a. expanding and contracting the money supply. b. encouraging business to expand or contract investment. c. regulating net exports. d. decreasing government spending or increasing taxes. D. The money supply is under control of the Federal Reserve and not Congress. 61
62. 62. 2. The spending multiplier is defined as a. 1 / (1 - marginal propensity to consume). b. 1 / (marginal propensity to consume). c. 1 / (1 - marginal propensity to save). d. 1 / (marginal propensity to consume + marginal propensity to save. A. The spending multiplier is also defined as 1/MPS. 62
63. 63. 3. If the marginal propensity to consume (MPC) is 0.60, the value of the spending multiplier is a. 0.4. b. 0.6. c. 1.5. d. 2.5. D. Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.60) = 1 / 40/100 = 5 / 2 = 2.5 63
64. 64. 4. Assume the economy is in recession and real GDP is below full employment. The marginal propensity to consume (MPC) is 0.80, and the government increases spending by \$500 billion. As a result, aggregate demand will rise by a. zero. b. \$2,500 billion. c. more than \$2,500 billion. d. less than \$2,500 billion. B. Change in aggregate demand (∆Y) = initial change in government spending (∆G) x spending multiplier. Spending multiplier = 1 / 1 - MPC) = 1 / (1 - 0.80) = 1 / 20/100 = 5 ∆Y = \$500 billion x 5 ∆Y = \$2,500 billion 64
65. 65. 5. Mathematically, the value of the tax multiplier in terms of the marginal propensity to consume (MPC) is given by the formula a. MPC − 1. b. (MPC − 1) MPC. c. 1 / MPC. d. 1 − [1 / 1 − MPC)].D. The tax multiplier is also stated as Tax multiplier = 1 - spending multiplier. 65
66. 66. 6. Assume the marginal propensity to consume (MPC) is 0.75 and the government increases taxes by \$250 billion. The aggregate demand curve will shift to the a. left by \$1,000 billion. b. right by \$1,000 billion. c. left by \$750 billion. d. right by \$750 billion.C. The tax multiplier is -3 (1 - spending multiplier) and -3 times \$250 equals a \$750 billion decrease. The movement is left because consumers have less money to spend. 66
67. 67. 7. If no fiscal policy changes are made, suppose the current aggregate demand curve will increase horizontally by \$1,000 billion and cause inflation. If the marginal propensity to consume (MPC) is 0.80, federal policymakers could follow Keynesian economics and restrain inflation by a. decreasing government spending by \$200 billion. b. decreasing taxes by \$100. c. decreasing taxes by \$1,000 billion. d. decreasing government spending by \$1000 billion. A. Change in government spending (∆G) x spending multiplier = change in aggregate demand, rewritten: ∆G = change in aggregate demand / spending multiplier Spending multiplier = 1 / (1-MPC) = 1 / (1-0.80) = 1 / 20/100 = 5 ∆G = -\$1,000/5, ∆G = -\$200 billion. 67
68. 68. 8. If no fiscal policy changes are implemented, suppose the future aggregate demand curve will exceed the current aggregate demand curve by \$500 billion at any level of prices. Assuming the marginal propensity to consume is 0.80, this increase in aggregate demand could be prevented by a. increasing government spending by \$500 billion. b. increasing government spending by \$140 billion. c. decreasing taxes by \$40 billion. d. increasing taxes by \$125 billion.D. Change in taxes (∆T) x tax multiplier = change in aggregate demand, rewritten:Tax multiplier = 1 - spending multiplierSpending multiplier = 1 / (1-MPC) = 1 / (1-0.80) = 1 / 20/100 = 5Tax multiplier = 1 - 5 = -4, ∆T x -4 = -\$500 billionT = \$125 billion 68
69. 69. 9. Suppose inflation is a threat because the current aggregate demand curve will increase by \$600 billion at any price level. If the marginal propensity to consume (MPC) is 0.75, federal policy-makers could follow Keynesian economics and restrain inflation by a. decreasing taxes by \$600 billion. b. decreasing transfer payments by \$200 billion. c. increasing taxes by \$200 billion. d. increasing government spending by \$150 billion. C. 3 x \$200 billion = \$600 billion. 69
70. 70. 10. If no fiscal policy changes are implemented, suppose the future aggregate demand curve will shift and exceed the current aggregate demand curve by \$900 billion at any level of prices. Assuming the marginal propensity to consume is 0.90, this increase in aggregate demand could be prevented by a. increasing government spending by \$500 billion. b. increasing government spending by \$140 billion. c. decreasing taxes by \$40 billion. d. increasing taxes by \$100 billion.D. Change in taxes (T) x tax multiplier = change in aggregate demand, rewritten: Tax multiplier = 1 - spending multiplier Spending multiplier = 1 / (1-MPC) = 1/(1-0.90) = 1/10/100 = 10 70
71. 71. 11. Which of the following is not an automatic stabilizer? a. Defense spending. b. Unemployment compensation benefits. c. Personal income taxes. d. Welfare payments.A. Defense spending does not automatically change levels as real GDP changes. 71
72. 72. 12. Supply-side economics is most closely associated with a. Karl Marx. b. John Maynard Keynes. c. Milton Friedman. d. Ronald Reagan.D. The most familiar supply-side economic policy of the Reagan administration was the tax cuts implemented in 1981. 72
73. 73. 13. Which of the following statements is true? a. A reduction in tax rates along the downward- sloping portion of the Laffer curve would increase tax revenues. b. According to supply-side fiscal policy, lower tax rates would shift the aggregate demand curve to the right, expanding the economy and creating some inflation. c. The presence of automatic stabilizers tends to destabilize the economy. d. To combat inflation, Keynesians recommend lower taxes and greater government spending. A. 73
74. 74. The Laffer Curve BRmax Federal Tax Revenue C R A Federal Tax Rate D 0 Tmax T 100% 74
75. 75. Internet ExercisesClick on the picture of the book, choose updates by chapter for the latest internet exercises 75
76. 76. END 76