Principles of Macroeconomics Chapter 12 Fiscal Policy Vocabulary 1 National debt the total amount the federal government still owes to the general public from past borrowing 2 Burden of the debt interest payments on the national debt as a percentage of GDP 3 Balanced budget multiplier the multiplier for a change in government purchases that is matched by an equal change in taxes 4 Debt ratio publicly held national debt as a percentage of GDP 5 Net tax multiplier the amount by which real GDP changes for each one dollar change in net taxes 6 Countercyclical fiscal policy a change in government purchases or net taxes designed to reverse or prevent a recession or a boom 7 Government outlays total disbursements by the government for purchases transfer payments and interest on the debt 8 Flow variable measures the difference between government spending and tax revenue over a given period usually a year 9 Stock variable measures the total amount that the federal government owes at a given point in time 10 Fiscal austerity opposite of fiscal stimulus Notes Introduction taxes Fiscal policies are changes in government purchases transfer payments and February 2009 Largest federal fiscal change since World War II o As a result the U S economy performed worse and the long slump continued September 2011 Plans for a second stimulus were announced o Half the size of first The Short Run Countercyclical Fiscal Policy Introduction In the long run fiscal policy has no demand side effects o If the government purchased more goods and services an equal amount of consumption and investment would be crowded out In the short run fiscal policy can have demand side effects on output and employment o An increase in government purchases can cause an increase in total spending and through the multiplier raise equilibrium GDP o An active fiscal policy could improve the performance of the economy over time By continually adjusting its own purchases or by changing net taxes the government might be able to keep the economy closer to its potential output thank it would otherwise be Could avoid recessions and booms Government attempts to smooth out the business cycle are called countercyclical fiscal policy a change in government purchases or net taxes designed to reverse or prevent a recession or a boom The Mechanics of Countercyclical Fiscal Policy If a decrease in investment spending or autonomous consumption spending shifts the aggregate expenditure line down and the economy starts heading toward a recession the government could shift the AE line back to its original position by increasing its own purchases or by decreasing net taxes with a change in tax or transfer policies A Change in Government Purchases o GDP Multiplier x G o To find the multiplier use 1 1 MPC o This equation tells us that if government purchases rise by a certain amount the aggregate expenditure line will shift upward just enough to bring the economy back to its potential output o Direct way of curing the recession A Change in Net Taxes o GDP Net tax Multiplier x T o Net tax multiplier the number a change in taxes is multiplied by in order to get the change in GDP o For any value of the MPC the multiplier for a change in net taxes will be smaller than the government purchases multiplier by a factor equal to the MPC o In the short run model the tax multiplier is the marginal propensity to consume times the expenditure multiplier and a negative in sign Net tax multiplier MPC x Expenditure Multiplier MPC 1 MPC Why is it negative A tax cut a negative change in taxes must be multiplied by a negative number to give us a positive change in GDP o A decrease in net taxes T increases disposable income but does not by itself cause a change in spending Combining Fiscal Changes Indirect way to cure a recession o Let s say the government decides to increase government purchases cut taxes and increase transfer payments The final impact on equilibrium GDP can be found by adding up the separate multiplier effects of each policy change Like a tax cut an increase in transfer payments amounts to a decrease in net taxes and works through the net tax multiplier The Balanced Budget Multiplier o Balanced Budget multiplier the multiplier for a change in government purchases that is matched by an equal change in taxes In the simple model of this chapter the balanced budget multiplier is always 1 0 no matter what the value of the MPC This means that when both G and T change in the same direction and by equal amounts equilibrium GDP will change in the same direction and by that same amount Expenditure multiplier Tax multiplier in absolute value Problems with Countercyclical Fiscal Policy Since 1970s economists have grown increasingly skeptical about the use of countercyclical fiscal policy Why Timing Problems o In most countries it usually takes many months for fiscal changes to be enacted Because of these delays regular use of countercyclical policy could very well be a destabilizing force o Decrease in taxes it runs smoothly House of Representatives Senate Chambers President if A tax cut may not take effect until long after it is needed stimulating the economy after it has recovered from a slump o Increase in government purchases To get the most value from a fiscal stimulus the government would ordinarily fund infrastructure projects fixing roads and bridges or building new schools Very few additional infrastructure projects will be shovel ready These projects require careful planning over time Irreversibility o After investment spending has returned to more normal levels the fiscal stimulation should be reversed as well so as not to overheat the economy o When it is time to take back an increase in government purchases or transfer payments or a decrease in taxes those who benefited and the politicians who represent them will oppose the reversal Taxes and Forward Looking Behavior o When changes in income are perceived as temporary the MPC is likely to be smaller Because of this countercyclical tax changes must be temporary tax changes The multiplier for a temporary tax change will be small The Reaction of the Federal Reserve o By the time any fiscal change would take place the Federal Reserve would have already taken the steps it thought necessary to adjust aggregate expenditure Any further changes in spending causes by fiscal policy would then be counteracted and effectively neutralized by the Federal Reserve The Long Run Deficits and the National Debt
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