1. Chapter 12:
Fiscal Policy
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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.
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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.
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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.
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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)
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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13. Fiscal Policy
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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.
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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.
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16. Deficient Demand
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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.
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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.
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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.
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20. Multiplier Effects
o The marginal propensity to consume
(MPC) is the fraction of each additional
(marginal) dollar of disposable income
spent on consumption:
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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:
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22. Multiplier Effects
o Spending and saving decisions are
connected:
MPS = 1 – MPC
or
MPC + MPS = 1
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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.
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24. Spending Cycles
o The demand stimulus initiated by
increased government spending is a
multiple of the initial expenditure.
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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)
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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.
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27. Multiplier Effects
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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.
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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 cut
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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 consumption
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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.
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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.
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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.
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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.
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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.
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36. Multiplier Cycles
o Government cutbacks have a multiplied
effect on aggregate demand:
Cumulative reduction in spending =
multiplier x initial budget cut
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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.
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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.
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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.
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40. Unbalanced Budgets
o The use of the budget to manage
aggregate demand implies that the
budget will often be unbalanced.
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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 revenues
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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.
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43. Budget Surplus
o Budget surplus–an excess of government
revenues over government expenditures in
a given time period:
Budget surplus = Government spending <
Tax revenues
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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.
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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.
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46. Fiscal Policy
End of Chapter 12
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