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  1. 1. Chapter 12: Fiscal PolicyMcGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
  2. 2. John Maynard Keynes and Fiscal Policy o John Maynard Keynes explained how a deficiency in demand could arise in a market economy. o He showed how and why the government should intervene to achieve macroeconomic goals. o He also advocated aggressive use of fiscal policy to alter market outcomes.12- LO-1
  3. 3. Fiscal Policy o Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes. o The premise of fiscal policy is that the aggregate demand for goods and services will not always be compatible with economic stability.12- LO-1
  4. 4. Components of Aggregate Demand o Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.12- LO-1
  5. 5. Components of Aggregate Demand o The four major components of aggregate demand are: – Consumption (C) – Investment (I) – Government spending (G) – Net exports (exports minus imports) (X- IM) AD = C + I + G + (X - IM)12- LO-1
  6. 6. Consumption (C) o Consumption refers to expenditures by consumers on final goods and services. o Consumption spending accounts for approximately two-thirds of total spending in the U.S. economy. o Consumers often change their spending behavior.12- LO-1
  7. 7. Investment (I) o Investment refers to expenditures on (production of) new plant and equipment in a given time period, plus changes in business inventories.12- LO-1
  8. 8. Government Spending (G) o Government spending includes expenditures on all goods and services provided by the public sector. o Income transfers are not included: oIncome transfers are payments to individuals for which no services are exchanged.12- LO-1
  9. 9. Net Exports (X-IM) o Net exports is the difference between export and import spending. o Currently Americans are buying more goods from abroad than foreigners are buying from us. o This means that U.S. net exports are negative.12- LO-1
  10. 10. Equilibrium o Aggregate demand is not a single number but instead a schedule of planned purchases. o Macro equilibrium is the combination of price level and real output that is compatible with both aggregate demand and aggregate supply.12- LO-1
  11. 11. The Desired Equilibrium o There is no guarantee that AD will always produce an equilibrium at full employment and price stability. o Sometimes there will be too little demand and sometimes there will be too much.12- LO-2
  12. 12. Inadequate Demand or Excessive Demand o AD could fall short of the full-employment equilibrium, leaving some potential output unsold at the equilibrium point. o AD could generate too much spending, causing the economy to produce at more than the full-employment equilibrium.12- LO-2
  13. 13. Fiscal Policy12- LO-2
  14. 14. The Nature of Fiscal Policy o C + I + G + (X - IM) seldom adds up to exactly the right amount of aggregate demand. o The use of government spending and taxes to adjust aggregate demand is the essence of fiscal policy.12- LO-2
  15. 15. Fiscal Stimulus o If AD falls short, there is a gap between what the economy can produce and what people want to buy. o The GDP gap is the difference between full-employment output and the amount of output demanded at current price levels.12- LO-4
  16. 16. Deficient Demand12- LO-4
  17. 17. More Government Spending o Increased government spending is a form of fiscal stimulus: oFiscal stimulus–tax cuts or spending hikes intended to increase (shift) aggregate demand.12- LO-4
  18. 18. Multiplier Effects o An increase in spending results in increased incomes. o All income is either spent or saved: oSaving–Income minus consumption or that part of disposable income not spent.12- LO-3
  19. 19. Multiplier Effects o Each dollar spent is re-spent several times. o As a result, every dollar has a multiplied impact on aggregate income.12- LO-3
  20. 20. Multiplier Effects o The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption:12- LO-3
  21. 21. Multiplier Effects o The marginal propensity to save (MPS) is the fraction of each additional (marginal) dollar of disposable income not spent on consumption:12- LO-3
  22. 22. Multiplier Effects o Spending and saving decisions are connected: MPS = 1 – MPC or MPC + MPS = 112- LO-3
  23. 23. Multiplier Effects and the Circular Flow o The fiscal stimulus to aggregate demand includes: oThe initial increase in government spending. oAll subsequent increases in consumer spending triggered by the government outlays. o Income gets spent and re-spent in the circular flow.12- LO-3
  24. 24. Spending Cycles o The demand stimulus initiated by increased government spending is a multiple of the initial expenditure.12- LO-3
  25. 25. Multiplier Formula o The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles: Multiplier = 1/(1-MPC)12- LO-3
  26. 26. Multiplier Formula o The multiplier process at work: Initial change Total change = Multiplier x in government in spending spending o Every dollar of fiscal stimulus has a multiplied impact on aggregate demand.12- LO-3
  27. 27. Multiplier Effects12- LO-3
  28. 28. Tax Cuts o Rather than increasing its own spending, government can cut taxes to increase consumption or investment spending. o A tax cut directly increases disposable income: oDisposable income is the after-tax income of consumers.12- LO-4
  29. 29. Taxes and Consumption o As long as the MPC is greater than zero, a tax cut will stimulate more consumer spending: Initial increase in consumption = MPC x tax cut12- LO-3
  30. 30. Taxes and Consumption o The cumulative increase in aggregate demand equals a multiple of the tax induced change in consumption. Cumulative change in spending = multiplier x initial change in consumption12- LO-3
  31. 31. Taxes and Consumption o A tax cut that increases disposable incomes stimulates consumer spending. o The cumulative increase in aggregate demand is a multiple of the initial tax cut.12- LO-3
  32. 32. Taxes and Investment o Tax cuts can increase investment spending by increasing the expectations of after-tax profits. o Taxes were reduced in 1964 and in 1981 to stimulate spending. o President Bush pushed even larger tax cuts in 2001, 2002, and 2003.12- LO-3
  33. 33. Inflation Worries o Whenever the aggregate supply curve is upward-sloping, an increase in aggregate demand increases prices as well as output. o President Clinton raised taxes partly because he feared inflationary pressures were building.12- LO-4
  34. 34. Fiscal Restraint o Fiscal restraint may be the proper policy when inflation threatens: o Fiscal restraint: tax hikes or spending cuts intended to reduce (shift) aggregate demand.12- LO-4
  35. 35. Budget Cuts o Cutbacks in government spending directly reduce aggregate demand. o As with spending increases, the impact of spending cuts is magnified by the multiplier.12- LO-3
  36. 36. Multiplier Cycles o Government cutbacks have a multiplied effect on aggregate demand: Cumulative reduction in spending = multiplier x initial budget cut12- LO-3
  37. 37. Tax Hikes o Tax increases reduce disposable income and thus reduce consumption. o This shifts the aggregate demand curve to the left. o Tax increases have been used to “cool down” the economy.12- LO-4
  38. 38. Tax Hikes o The Equity and Fiscal Responsibility Act of 1982 increased taxes to reduce inflationary pressures. o President Clinton restrained aggregate demand in 1993 with a tax increase, but increased aggregate demand in 1997 with a five-year package of tax cuts.12- LO-4
  39. 39. Fiscal Guidelines o The policy goal is to match aggregate demand with the full-employment potential of the economy. o The fiscal strategy for attaining that goal is to shift the aggregate demand curve.12- LO-4
  40. 40. Unbalanced Budgets o The use of the budget to manage aggregate demand implies that the budget will often be unbalanced.12- LO-5
  41. 41. Budget Deficit o Budget deficit–the amount by which government expenditures exceed government revenues in a given time period: Budget deficit = Government spending > Tax revenues12- LO-5
  42. 42. Budget Deficit o The government borrows money to pay for deficit spending. o The federal government ran significant budget deficits between 1970 and 1997.12- LO-5
  43. 43. Budget Surplus o Budget surplus–an excess of government revenues over government expenditures in a given time period: Budget surplus = Government spending < Tax revenues12- LO-5
  44. 44. Budget Surplus o By 1998, a combination of growing tax revenues and slower government spending created a budget surplus. o Starting in 2003, however, the budget returned to a deficit due to tax cuts, increased defense spending, and the Iraq War.12- LO-5
  45. 45. Countercyclical Policy o In Keynes’ view, an unbalanced budget is perfectly appropriate if macro conditions call for a deficit or a surplus. o A balanced budget is appropriate only if the resulting aggregate demand is consistent with full-employment equilibrium.12- LO-5
  46. 46. Fiscal Policy End of Chapter 1212-46