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Ma ch 11 fiscal policy (1)

This document discusses fiscal policy and its effects on the economy. It provides an overview of expansionary and contractionary fiscal policy tools and how governments can use changes in spending, taxes, and borrowing to stimulate or contract aggregate demand. The document also reviews the history of fiscal policy approaches, including the classical laissez-faire view, Keynesian policies developed during the Great Depression, and the use of automatic stabilizers to smooth economic fluctuations.

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PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University Fiscal Policy © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
• President Barack Obama claimed on February 17, 2010, that “it is largely thanks to the Recovery Act that a second depression is no longer a possibility.” The Japanese government cut taxes and increased spending to stimulate its troubled economy. • These are examples of fiscal policy, which focuses on the effects of taxing and public spending on aggregate economic activity. What is the proper role of fiscal policy in the economy? • Can fiscal policy reduce swings in the business cycle? • Why did fiscal policy fall on hard times for a quarter century, and what brought it back to life? • Does fiscal policy affect aggregate supply? • And how did the cash-for-clunkers program work out? © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2
Theory of Fiscal Policy • Fiscal policy • Government purchases, G • Transfer payments, TP • Taxes, T • Borrowing – As they affect macroeconomic variables • Real GDP, employment, the price level, and economic growth © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3
Fiscal Policy Tools • Automatic stabilizers – Structural features of government spending and taxation – Reduce fluctuations in disposable income and consumption over the business cycle – Adjust automatically • E.g.: Federal income tax • Discretionary fiscal policy – Deliberate manipulation of G, TP, and T to promote macroeconomic goals © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4
Expansionary Fiscal Policy • Expansionary fiscal policy – Increase G, decrease NT – To increase AD • Higher price level • Higher output – Used to close a recessionary gap • Price level < expected • Output < potential • Unemployment > natural rate © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5
Exhibit 1 Discretionary Fiscal Policy to Close a Recessionary Gap Price level 110 105 Potential output SRAS110 AD″ e″ LRAS AD* e′ Real GDP e* e 0 13.5 14.0 14.5 (trillions of dollars) The aggregate demand curve AD″ and the short-run aggregate supply curve, SRAS110, intersect at point e″. Output falls short of the economy’s potential. The resulting recessionary 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*. Recessionary gap © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 6 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Contractionary Fiscal Policy • Contractionary fiscal policy – Decrease G, increase NT – To decrease AD • Lower price level • Lower output – Used to close an expansionary gap • Price level > expected • Output > potential • Unemployment < natural rate © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7
Exhibit 2 Discretionary Fiscal Policy to Close an Expansionary Gap Price level 115 110 SRAS110 AD′ e′ Potential output LRAS AD* Real GDP (trillions of dollars) e″ e* 0 14.0 14.5 The aggregate demand curve AD′ and the short-run aggregate supply curve, SRAS110, intersect at point e′, resulting in an expansionary gap of $0.5 trillion. 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 the aggregate demand curve back to AD* and move the economy back to potential output at point e*. Expansionary gap © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 8 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Fiscal Policy • Expansionary and contractionary fiscal policies – Are difficult to achieve • Their proper execution assumes: • Potential output gauged accurately • Spending multiplier predicted accurately • AD shifts by just the right amount • Government entities - coordinate fiscal efforts • Shape of SRAS curve is known, unaffected by the policy © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9
The Multiplier and Time Horizon • Simple multiplier – Overstates ΔReal GDP • ΔReal GDP depends – Steepness of SRAS curve • Production costs increase • The steeper SRAS curve – Less impact of an AD shift on real GDP –More impact on price level – The smaller the spending multiplier © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10
Prior to the Great Depression • Classical economists – Group of 18th- and 19th-century economists – Economic downturns corrected themselves through natural market forces – Economy: self-correcting and needed no government intervention © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11
Prior to the Great Depression • Laissez-faire – Free markets – Balanced budget – Natural market forces • Flexible: – Prices, wages, interest rates • Move the economy to potential GDP – No need for government intervention © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12
Great Depression and World War II • Keynesian theory and policy – Developed in response to the problem of high unemployment during the Great Depression – Prices and wages: ‘Sticky’ downward – Natural forces would not necessarily close the recessionary gap – Government: increase AD © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13
Great Depression and World War II • World War II – Increase production – No cyclical unemployment • Employment Act of 1946 – Law that assigned to the federal government – The responsibility for promoting full employment and price stability © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14
Automatic Stabilizers • Smooth out fluctuations in disposable income – Stimulate AD during recessions –Dampen AD during expansions • Automatic stabilizers – Federal income tax –Unemployment insurance – Welfare payments © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15
Automatic Stabilizers • Federal income tax system is progressive – The fraction of income paid in taxes increases as a taxpayer’s income increases – Relieves some of the inflationary pressure • During an economic expansion – Cushions declines in disposable income, in consumption, and in aggregate demand • During a recession © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16
Automatic Stabilizers • Unemployment insurance –Adds to the unemployment insurance fund • During economic expansions – More workers contribute –Subtracts from the unemployment insurance fund during contractions – Unemployment increases • Welfare payments – Automatically increase during hard times • As more people become eligible © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17
From the Golden Age to Stagflation • 1960s, Golden Age of fiscal policy – Increase or decrease AD • To smooth economic fluctuations – Federal budget deficit to stimulate an economy experiencing a recessionary gap – Tax cut to stimulate business investment, consumption, and employment © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18
From the Golden Age to Stagflation • 1970s: Stagflation – Higher inflation – Higher unemployment – From decreased AS • Crop failures • Higher OPEC-driven oil prices • Adverse supply shocks © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19
Limits on Fiscal Policy’s Effectiveness • Concerns regarding the effectiveness of discretionary fiscal policy – Stagflation – The difficulty of estimating the natural rate of unemployment – The time lags involved in implementing fiscal policy – The distinction between current income and permanent income – The possible feedback effects of fiscal policy on aggregate supply © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20
Fiscal Policy and Natural UR • Underestimate the natural rate of unemployment – Expansionary fiscal policy • Increase AD; Short run: – Increase output – Decrease unemployment • Expansionary gap; Long run: – Decrease SRAS – Inflation – Decrease output © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21
Exhibit 3 When Discretionary Fiscal Policy Overshoots Potential Output Price level 120 110 SRAS120 SRAS110 AD Potential output LRAS c a 0 14.0 14.2 AD′ b Real GDP (trillions of dollars) If public officials underestimate the natural rate of unemployment, they may attempt to stimulate aggregate demand even if the economy is already producing its potential output, as at point a. This expansionary policy yields a short-run equilibrium at point b, where the price level and output are higher and unemployment is lower, so the policy appears to succeed. But the resulting expansionary gap will, in the long run, reduce the short-run aggregate supply curve from SRAS110 to SRAS120, eventually reducing output to its potential level of $14.0 trillion while increasing the price level to 120. Thus, attempts to increase production beyond potential GDP lead only to inflation in the long run. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 22 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Fiscal Policy and Natural UR • Political business cycles – Economic fluctuations that occur when discretionary policy is manipulated for political gain • Public officials – Use fiscal policy to boost their reelection chances © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23
Lags in Fiscal Policy • Fiscal policy – Lag: the time to approve and implement fiscal legislation – Less effective – Too late –More harm than good © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24
Fiscal Policy and Permanent Income • Permanent income – Income that individuals expect to receive on average over the long term • Temporary tax rate change – Not effective –Small change in personal income –Small change in consumption – Less saving © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25
Fiscal Policy During the 1980s • Fiscal policy affects aggregate supply – Unintentionally – Higher unemployment benefits funded with higher taxes on earning • Unemployed: increase C • Employed: decrease C • No change in: AD, real GDP • Redistribution of income © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26
Fiscal Policy During the 1980s • Fiscal policy affects aggregate supply – Higher unemployment benefits funded with higher taxes on earning • Reduce the opportunity cost of not working – Decrease in labor supply • Reduce the opportunity cost of leisure – Decrease labor supply • Decrease aggregate supply • Decrease economy’s potential GDP © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27
Fiscal Policy During the 1980s • 1981, President Ronald Reagan and Congress – 23% reduction in average income tax rates to increase aggregate supply – Government spending grew faster than tax revenue • Higher budget deficits, which stimulated aggregate demand – Longest peacetime expansion to that point in the nation’s history © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28
1990 to 2007 • 1980s-mid1990s: large budget deficits –Reduced the use of discretionary fiscal policy • As a tool for economic stabilization • 1993 recovery under way – Increase tax on high-income households • 1994: more discipline of federal spending © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29
1990 to 2007 • 1994-1998, Strong economic recovery – Growing consumer spending – Business optimism –Market globalization – Strong stock market • 1993 – 1998 – Tax revenues: +8.3% per year – Federal outlays: +3.2% per year © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30
1990 to 2007 • 1998: Federal surplus $70 billion • 2000: Federal surplus $236 billion • Early 2001- Recession: 10-year tax cut • September 11, 2001: Terrorist attack • 2003-2007 Recovery –Employment: + 8 million – Federal deficit (2004) $413 billion – Federal deficit (2007) $161 billion © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31
Fiscal Policy and the Great Recession • December 2007 – recession – Declining home prices – Rising foreclosure rates • Borrowers failed to pay their mortgages • Early 2008, $168 billion plan to stimulate the softening economy – Borrowed money: added to federal deficit – $117 billion one-time tax rebate – Disappointing results © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 32
Fiscal Policy and the Great Recession • 2008, Recession - gathered steam – Job losses • 31,000 a month – first quarter of 2008 • 191,000 a month in the second quarter – Third quarter • Monthly job losses: 334,000 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33
Fiscal Policy and the Great Recession • September 2008, Lehman Brothers – Nation’s fourth-largest investment bank • Assets of over $600 billion • 25,000 employees – Largest bankruptcy in U.S. history • Financial crisis – Froze credit markets around the world © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34
Fiscal Policy and the Great Recession • October 2008, TARP – $700 billion Troubled Asset Relief Program – To unfreeze financial flows by investing in financial institutions – Helped calm credit markets © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 35
Fiscal Policy and the Great Recession • Forth quarter of 2008 – Real GDP fell 8.9% (at an annualized rate) – Job losses - averaged 662,000 a month –Unemployment rate: 7.4% © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 36
Fiscal Policy and the Great Recession • American Recovery & Reinvestment Act – Estimated cost of $831 billion • Largest stimulus measure in U.S history –Enacted in February 2009 • Projected to last two years – All deficit spending • Unemployed labor and idle capital would be put to work © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 37
Fiscal Policy and the Great Recession • American Recovery & Reinvestment Act – If the spending multiplier >1 – A dollar of government spending produces more than a dollar of new output and income – 37% for tax benefits • One time reduction for individuals – 28% for entitlements (such as Medicaid) – 35% for grants, contracts, and loans • Some “shovel ready” infrastructure projects - slow to get underway © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 38
Fiscal Policy and the Great Recession • Between the second quarter of 2008 and the second quarter of 2010 –Changes in real GDP • Largest drop, 8.9%: the fourth quarter of 2008 –Changes in government purchases • Drop of 1.7 %, first quarter of 2009 (the Stimulus Bill) • Grew the most, 5.9%, the next quarter © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 39
Exhibit 4 Percent Change in Real GDP and Government Purchases by Quarter (Annualized Rate) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 40 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Fiscal Policy and the Great Recession • Employment – Fell by 8 million , December 2007 – December 2009 • 6.1% decline –Added back 4 millions job, next three years –Unemployment rate: above 8% in 2012 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 41
Fiscal Policy and the Great Recession • Federal deficit – $161 billion in 2007 – $459 billion in 2008 – $1.4 trillion in 2009 • When 41 cents of each dollar spent by the federal government was borrowed – $1.3 trillion in 2010 – $1.3 trillion in 2011 – $1.3 trillion in 2012 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 42
Cash for Clunkers • June 24, 2009, CARS act –Consumer Assistance to Recycle and Save Act – “Cash-for-clunkers” program –Appropriated $1 billion to pay from $3,500 to $4,500 to each car buyer who traded a “clunker” • Older car with gas mileage < 18 miles per gallon • Drivable, registered and insured © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 43 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cash for Clunkers • CARS act –Congress put $2 billion more into the pot • Limited the program to a month – 2,000 people needed to process paperwork • Trouble reimbursing dealers – some dealers had to drop out of the program – 680,000 new vehicles were sold during the month of the program © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 44 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cash for Clunkers • Evidence – Overwhelming majority of those car sales • Would have occurred anyway during the last half of 2009 – Net effect of the program: only 125,000 additional vehicle sales • Government cost of $24,000 per additional sale © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 45 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cash for Clunkers • Did the economy get a boost? – The $3 billion spent on the program • Money the government didn’t have • Increased the federal deficit – Taxes must be raised or other government spending must be cut –Some of the stimulus benefited other economies • Japanese manufacturers: 41% of sales • The Big Three: 39% of sales © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 46 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cash for Clunkers • Did the economy get a boost? – Automakers already received the $83 billion in bailout funds • $34 billion would not likely ever be repaid – The clunker money - down payment on a new car • Additional monthly payments • Fewer purchases of housing, furniture, clothes, vacation trips, and other items © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 47 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cash for Clunkers • Did the economy get a boost? –Mandate: destruction of each trade-in vehicle • Removed up to 680,000 drivable cars from the used-car market • Raising the prices of the used cars – That low-income households tend to buy • Reduced the supply of salvageable used parts – Bought mostly by low-income drivers © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 48 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Appendix Demand-Side Effects of G and NT • At any given price level, other things constant – An increase in government purchases or in transfer payments • Increases real GDP demanded – An increase in net taxes • Decreases real GDP demanded © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 49 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Appendix Demand-Side Effects of G and NT • Increase in government purchases – Stimulate the economy –Upward shift of AE line – Increase in GDP 1 MPC G     1 Δ Real GDP demanded © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 50 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 5 Effect of a $0.1 Trillion Increase in Government Purchases on Aggregate Expenditure and Real GDP Demanded C+I+G′+(X-M) C+I+G+(X-M) a 14.5 14.0 45° b 0.1 0 14.0 14.5 Real GDP (trillions of dollars) Aggregate expenditure (trillions of dollars) As 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 51 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Appendix Demand-Side Effects of G and NT • Decrease in net taxes – Increases DI by ΔNT – Increases C by MPC×ΔNT – Upward shift of AE line – Increase in GDP MPC MPC -MPC -MPC 1 ΔNT      1 Simple tax multiplier Δ Real GDP demanded © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 52 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 6 Effect of a $0.1 Trillion Decrease in Net Taxes on Aggregate Expenditure and Real GDP Demanded C′+I+G+(X-M) C+I+G+(X-M) a Aggregate expenditure (trillions of dollars) 14.5 14.0 45° b 0 14.0 14.5 Real GDP 0.08 (trillions of dollars) As a result of a decrease in net taxes of $0.1 trillion, or $100 billion, consumers, who are assumed to have a marginal propensity to consume of 0.8, spend $80 billion more and save $20 billion more at every level of real GDP. The consumption function shifts up by $80 billion, or $0.08 trillion, as does the aggregate expenditure line. An $80 billion increase of the aggregate expenditure 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 53 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Ma ch 11 fiscal policy (1)

  • 1.
    PowerPoint Slides preparedby: Andreea CHIRITESCU Eastern Illinois University Fiscal Policy © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 2.
    • President BarackObama claimed on February 17, 2010, that “it is largely thanks to the Recovery Act that a second depression is no longer a possibility.” The Japanese government cut taxes and increased spending to stimulate its troubled economy. • These are examples of fiscal policy, which focuses on the effects of taxing and public spending on aggregate economic activity. What is the proper role of fiscal policy in the economy? • Can fiscal policy reduce swings in the business cycle? • Why did fiscal policy fall on hard times for a quarter century, and what brought it back to life? • Does fiscal policy affect aggregate supply? • And how did the cash-for-clunkers program work out? © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2
  • 3.
    Theory of FiscalPolicy • Fiscal policy • Government purchases, G • Transfer payments, TP • Taxes, T • Borrowing – As they affect macroeconomic variables • Real GDP, employment, the price level, and economic growth © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3
  • 4.
    Fiscal Policy Tools • Automatic stabilizers – Structural features of government spending and taxation – Reduce fluctuations in disposable income and consumption over the business cycle – Adjust automatically • E.g.: Federal income tax • Discretionary fiscal policy – Deliberate manipulation of G, TP, and T to promote macroeconomic goals © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4
  • 5.
    Expansionary Fiscal Policy • Expansionary fiscal policy – Increase G, decrease NT – To increase AD • Higher price level • Higher output – Used to close a recessionary gap • Price level < expected • Output < potential • Unemployment > natural rate © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5
  • 6.
    Exhibit 1 DiscretionaryFiscal Policy to Close a Recessionary Gap Price level 110 105 Potential output SRAS110 AD″ e″ LRAS AD* e′ Real GDP e* e 0 13.5 14.0 14.5 (trillions of dollars) The aggregate demand curve AD″ and the short-run aggregate supply curve, SRAS110, intersect at point e″. Output falls short of the economy’s potential. The resulting recessionary 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*. Recessionary gap © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 6 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 7.
    Contractionary Fiscal Policy • Contractionary fiscal policy – Decrease G, increase NT – To decrease AD • Lower price level • Lower output – Used to close an expansionary gap • Price level > expected • Output > potential • Unemployment < natural rate © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7
  • 8.
    Exhibit 2 DiscretionaryFiscal Policy to Close an Expansionary Gap Price level 115 110 SRAS110 AD′ e′ Potential output LRAS AD* Real GDP (trillions of dollars) e″ e* 0 14.0 14.5 The aggregate demand curve AD′ and the short-run aggregate supply curve, SRAS110, intersect at point e′, resulting in an expansionary gap of $0.5 trillion. 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 the aggregate demand curve back to AD* and move the economy back to potential output at point e*. Expansionary gap © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 8 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 9.
    Fiscal Policy •Expansionary and contractionary fiscal policies – Are difficult to achieve • Their proper execution assumes: • Potential output gauged accurately • Spending multiplier predicted accurately • AD shifts by just the right amount • Government entities - coordinate fiscal efforts • Shape of SRAS curve is known, unaffected by the policy © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9
  • 10.
    The Multiplier andTime Horizon • Simple multiplier – Overstates ΔReal GDP • ΔReal GDP depends – Steepness of SRAS curve • Production costs increase • The steeper SRAS curve – Less impact of an AD shift on real GDP –More impact on price level – The smaller the spending multiplier © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10
  • 11.
    Prior to theGreat Depression • Classical economists – Group of 18th- and 19th-century economists – Economic downturns corrected themselves through natural market forces – Economy: self-correcting and needed no government intervention © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11
  • 12.
    Prior to theGreat Depression • Laissez-faire – Free markets – Balanced budget – Natural market forces • Flexible: – Prices, wages, interest rates • Move the economy to potential GDP – No need for government intervention © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12
  • 13.
    Great Depression andWorld War II • Keynesian theory and policy – Developed in response to the problem of high unemployment during the Great Depression – Prices and wages: ‘Sticky’ downward – Natural forces would not necessarily close the recessionary gap – Government: increase AD © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13
  • 14.
    Great Depression andWorld War II • World War II – Increase production – No cyclical unemployment • Employment Act of 1946 – Law that assigned to the federal government – The responsibility for promoting full employment and price stability © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14
  • 15.
    Automatic Stabilizers •Smooth out fluctuations in disposable income – Stimulate AD during recessions –Dampen AD during expansions • Automatic stabilizers – Federal income tax –Unemployment insurance – Welfare payments © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15
  • 16.
    Automatic Stabilizers •Federal income tax system is progressive – The fraction of income paid in taxes increases as a taxpayer’s income increases – Relieves some of the inflationary pressure • During an economic expansion – Cushions declines in disposable income, in consumption, and in aggregate demand • During a recession © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16
  • 17.
    Automatic Stabilizers •Unemployment insurance –Adds to the unemployment insurance fund • During economic expansions – More workers contribute –Subtracts from the unemployment insurance fund during contractions – Unemployment increases • Welfare payments – Automatically increase during hard times • As more people become eligible © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17
  • 18.
    From the GoldenAge to Stagflation • 1960s, Golden Age of fiscal policy – Increase or decrease AD • To smooth economic fluctuations – Federal budget deficit to stimulate an economy experiencing a recessionary gap – Tax cut to stimulate business investment, consumption, and employment © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18
  • 19.
    From the GoldenAge to Stagflation • 1970s: Stagflation – Higher inflation – Higher unemployment – From decreased AS • Crop failures • Higher OPEC-driven oil prices • Adverse supply shocks © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19
  • 20.
    Limits on FiscalPolicy’s Effectiveness • Concerns regarding the effectiveness of discretionary fiscal policy – Stagflation – The difficulty of estimating the natural rate of unemployment – The time lags involved in implementing fiscal policy – The distinction between current income and permanent income – The possible feedback effects of fiscal policy on aggregate supply © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20
  • 21.
    Fiscal Policy andNatural UR • Underestimate the natural rate of unemployment – Expansionary fiscal policy • Increase AD; Short run: – Increase output – Decrease unemployment • Expansionary gap; Long run: – Decrease SRAS – Inflation – Decrease output © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21
  • 22.
    Exhibit 3 WhenDiscretionary Fiscal Policy Overshoots Potential Output Price level 120 110 SRAS120 SRAS110 AD Potential output LRAS c a 0 14.0 14.2 AD′ b Real GDP (trillions of dollars) If public officials underestimate the natural rate of unemployment, they may attempt to stimulate aggregate demand even if the economy is already producing its potential output, as at point a. This expansionary policy yields a short-run equilibrium at point b, where the price level and output are higher and unemployment is lower, so the policy appears to succeed. But the resulting expansionary gap will, in the long run, reduce the short-run aggregate supply curve from SRAS110 to SRAS120, eventually reducing output to its potential level of $14.0 trillion while increasing the price level to 120. Thus, attempts to increase production beyond potential GDP lead only to inflation in the long run. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 22 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 23.
    Fiscal Policy andNatural UR • Political business cycles – Economic fluctuations that occur when discretionary policy is manipulated for political gain • Public officials – Use fiscal policy to boost their reelection chances © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23
  • 24.
    Lags in FiscalPolicy • Fiscal policy – Lag: the time to approve and implement fiscal legislation – Less effective – Too late –More harm than good © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24
  • 25.
    Fiscal Policy andPermanent Income • Permanent income – Income that individuals expect to receive on average over the long term • Temporary tax rate change – Not effective –Small change in personal income –Small change in consumption – Less saving © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25
  • 26.
    Fiscal Policy Duringthe 1980s • Fiscal policy affects aggregate supply – Unintentionally – Higher unemployment benefits funded with higher taxes on earning • Unemployed: increase C • Employed: decrease C • No change in: AD, real GDP • Redistribution of income © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26
  • 27.
    Fiscal Policy Duringthe 1980s • Fiscal policy affects aggregate supply – Higher unemployment benefits funded with higher taxes on earning • Reduce the opportunity cost of not working – Decrease in labor supply • Reduce the opportunity cost of leisure – Decrease labor supply • Decrease aggregate supply • Decrease economy’s potential GDP © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27
  • 28.
    Fiscal Policy Duringthe 1980s • 1981, President Ronald Reagan and Congress – 23% reduction in average income tax rates to increase aggregate supply – Government spending grew faster than tax revenue • Higher budget deficits, which stimulated aggregate demand – Longest peacetime expansion to that point in the nation’s history © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28
  • 29.
    1990 to 2007 • 1980s-mid1990s: large budget deficits –Reduced the use of discretionary fiscal policy • As a tool for economic stabilization • 1993 recovery under way – Increase tax on high-income households • 1994: more discipline of federal spending © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29
  • 30.
    1990 to 2007 • 1994-1998, Strong economic recovery – Growing consumer spending – Business optimism –Market globalization – Strong stock market • 1993 – 1998 – Tax revenues: +8.3% per year – Federal outlays: +3.2% per year © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30
  • 31.
    1990 to 2007 • 1998: Federal surplus $70 billion • 2000: Federal surplus $236 billion • Early 2001- Recession: 10-year tax cut • September 11, 2001: Terrorist attack • 2003-2007 Recovery –Employment: + 8 million – Federal deficit (2004) $413 billion – Federal deficit (2007) $161 billion © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31
  • 32.
    Fiscal Policy andthe Great Recession • December 2007 – recession – Declining home prices – Rising foreclosure rates • Borrowers failed to pay their mortgages • Early 2008, $168 billion plan to stimulate the softening economy – Borrowed money: added to federal deficit – $117 billion one-time tax rebate – Disappointing results © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 32
  • 33.
    Fiscal Policy andthe Great Recession • 2008, Recession - gathered steam – Job losses • 31,000 a month – first quarter of 2008 • 191,000 a month in the second quarter – Third quarter • Monthly job losses: 334,000 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33
  • 34.
    Fiscal Policy andthe Great Recession • September 2008, Lehman Brothers – Nation’s fourth-largest investment bank • Assets of over $600 billion • 25,000 employees – Largest bankruptcy in U.S. history • Financial crisis – Froze credit markets around the world © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34
  • 35.
    Fiscal Policy andthe Great Recession • October 2008, TARP – $700 billion Troubled Asset Relief Program – To unfreeze financial flows by investing in financial institutions – Helped calm credit markets © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 35
  • 36.
    Fiscal Policy andthe Great Recession • Forth quarter of 2008 – Real GDP fell 8.9% (at an annualized rate) – Job losses - averaged 662,000 a month –Unemployment rate: 7.4% © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 36
  • 37.
    Fiscal Policy andthe Great Recession • American Recovery & Reinvestment Act – Estimated cost of $831 billion • Largest stimulus measure in U.S history –Enacted in February 2009 • Projected to last two years – All deficit spending • Unemployed labor and idle capital would be put to work © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 37
  • 38.
    Fiscal Policy andthe Great Recession • American Recovery & Reinvestment Act – If the spending multiplier >1 – A dollar of government spending produces more than a dollar of new output and income – 37% for tax benefits • One time reduction for individuals – 28% for entitlements (such as Medicaid) – 35% for grants, contracts, and loans • Some “shovel ready” infrastructure projects - slow to get underway © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 38
  • 39.
    Fiscal Policy andthe Great Recession • Between the second quarter of 2008 and the second quarter of 2010 –Changes in real GDP • Largest drop, 8.9%: the fourth quarter of 2008 –Changes in government purchases • Drop of 1.7 %, first quarter of 2009 (the Stimulus Bill) • Grew the most, 5.9%, the next quarter © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 39
  • 40.
    Exhibit 4 PercentChange in Real GDP and Government Purchases by Quarter (Annualized Rate) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 40 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 41.
    Fiscal Policy andthe Great Recession • Employment – Fell by 8 million , December 2007 – December 2009 • 6.1% decline –Added back 4 millions job, next three years –Unemployment rate: above 8% in 2012 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 41
  • 42.
    Fiscal Policy andthe Great Recession • Federal deficit – $161 billion in 2007 – $459 billion in 2008 – $1.4 trillion in 2009 • When 41 cents of each dollar spent by the federal government was borrowed – $1.3 trillion in 2010 – $1.3 trillion in 2011 – $1.3 trillion in 2012 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 42
  • 43.
    Cash for Clunkers • June 24, 2009, CARS act –Consumer Assistance to Recycle and Save Act – “Cash-for-clunkers” program –Appropriated $1 billion to pay from $3,500 to $4,500 to each car buyer who traded a “clunker” • Older car with gas mileage < 18 miles per gallon • Drivable, registered and insured © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 43 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 44.
    Cash for Clunkers • CARS act –Congress put $2 billion more into the pot • Limited the program to a month – 2,000 people needed to process paperwork • Trouble reimbursing dealers – some dealers had to drop out of the program – 680,000 new vehicles were sold during the month of the program © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 44 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 45.
    Cash for Clunkers • Evidence – Overwhelming majority of those car sales • Would have occurred anyway during the last half of 2009 – Net effect of the program: only 125,000 additional vehicle sales • Government cost of $24,000 per additional sale © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 45 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 46.
    Cash for Clunkers • Did the economy get a boost? – The $3 billion spent on the program • Money the government didn’t have • Increased the federal deficit – Taxes must be raised or other government spending must be cut –Some of the stimulus benefited other economies • Japanese manufacturers: 41% of sales • The Big Three: 39% of sales © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 46 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 47.
    Cash for Clunkers • Did the economy get a boost? – Automakers already received the $83 billion in bailout funds • $34 billion would not likely ever be repaid – The clunker money - down payment on a new car • Additional monthly payments • Fewer purchases of housing, furniture, clothes, vacation trips, and other items © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 47 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 48.
    Cash for Clunkers • Did the economy get a boost? –Mandate: destruction of each trade-in vehicle • Removed up to 680,000 drivable cars from the used-car market • Raising the prices of the used cars – That low-income households tend to buy • Reduced the supply of salvageable used parts – Bought mostly by low-income drivers © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 48 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 49.
    Appendix Demand-Side Effectsof G and NT • At any given price level, other things constant – An increase in government purchases or in transfer payments • Increases real GDP demanded – An increase in net taxes • Decreases real GDP demanded © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 49 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 50.
    Appendix Demand-Side Effectsof G and NT • Increase in government purchases – Stimulate the economy –Upward shift of AE line – Increase in GDP 1 MPC G     1 Δ Real GDP demanded © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 50 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 51.
    Exhibit 5 Effectof a $0.1 Trillion Increase in Government Purchases on Aggregate Expenditure and Real GDP Demanded C+I+G′+(X-M) C+I+G+(X-M) a 14.5 14.0 45° b 0.1 0 14.0 14.5 Real GDP (trillions of dollars) Aggregate expenditure (trillions of dollars) As 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 51 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 52.
    Appendix Demand-Side Effectsof G and NT • Decrease in net taxes – Increases DI by ΔNT – Increases C by MPC×ΔNT – Upward shift of AE line – Increase in GDP MPC MPC -MPC -MPC 1 ΔNT      1 Simple tax multiplier Δ Real GDP demanded © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 52 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  • 53.
    Exhibit 6 Effectof a $0.1 Trillion Decrease in Net Taxes on Aggregate Expenditure and Real GDP Demanded C′+I+G+(X-M) C+I+G+(X-M) a Aggregate expenditure (trillions of dollars) 14.5 14.0 45° b 0 14.0 14.5 Real GDP 0.08 (trillions of dollars) As a result of a decrease in net taxes of $0.1 trillion, or $100 billion, consumers, who are assumed to have a marginal propensity to consume of 0.8, spend $80 billion more and save $20 billion more at every level of real GDP. The consumption function shifts up by $80 billion, or $0.08 trillion, as does the aggregate expenditure line. An $80 billion increase of the aggregate expenditure 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 53 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.