Chapter 16 Fiscal Policy Fiscal policy involves changes in takes and government purchases to achieve policy goals Fiscal policy changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives Refer only to actions of the federal government Automatic stabilizers government spending and taxes that automatically increase or decrease along with the business cycle Economists measure government spending relative to the size of the economy by calculating government spending as percentage of GDP Government expenditures o Purchase o Interest on national debt o Grants to state and local government o Transfer payments Effects of fiscal policy on Real GDP and the price level Changes in government purchases and taxes o Lead to changes in aggregate demand Affect level of real GDP employment and price level o When economy is in recession increases in government purchase or decreases in taxes increase aggregate demand Expansionary and contractionary fiscal policy o Expansionary fiscal policy involves increasing government purchases or decreasing taxes o Disposable income is the income households have available to spend after they have paid their taxes o Goal of expansionary policy fiscal and monetary is to increase aggregate demand relative to what it would have been without the policy o Contractionary fiscal policy involves decreasing government purchases or increasing taxes Reduce increases in aggregate demand that seem likely to lead o Congress and president attempt to stabilize the economy using fiscal to inflation policy Affect price level and level of Real GDP Difficult to use fiscal policy to eliminate the effects of the business cycle and keep Real GDP Potential GDP A contractionary fiscal policy cause the price level to rise by less than it would have without the policy Fiscal policy in the dynamic aggregate demand and supply model Expansionary and contractionary fiscal policy ignore two facts about economy rising every year o The economy experiences continuing inflation with the price level o The economy experiences long run growth with the LRAS curve shifting to the right every year Government Purchases and Tax Multipliers Initial increase in government purchases is autonomous o A result of a decision by the government and not directly caused by changes in the level of real GDP o Something is induced if a change is caused by the initial increase in autonomous spending o Multiplier effect the series of induced increases in consumption spending that results from an initial increase in autonomous expenditures o Government purchases multiplier Change in equilibrium real GDP Change in government purchases o Tax multiplier Change in equilibrium real GDP Change in taxes Negative number because changes in taxes and changes in real GDP move in opposite directions Increase in taxes reduces disposable income consumption and real GDP Effect of changes in tax rates o The value of the tax rate affects the size of the multiplier effect Higher the tax rate the smaller the multiplier effect o Cut in taxes affect equilibrium real GDP Increase the disposable income of households which leads them to increase their consumption spending A cut in tax rates increases the size of the multiplier effect Effects of Aggregate supply o The actual change in real GDP resulting from an increase in government purchases or a cut I n taxes will be less than indicated by the simple multiplier effect with constant price level Multipliers work in both directions o Increases in government purchases and cuts in taxes have a positive o Decreases in government purchases and increases in taxes have a multiplier effect negative effect Limits of Using Fiscal Policy to Stabilize the Economy Takes time for policymakers to collect statistics and identify changes in the economy Control over monetary policy is concentrated in the hands of the FOMC Delays caused by the legislative process can be very long Even after a change in fiscal policy has been approved it takes time to implement the policy Government spending and private spending o The size of the multiplier effect may be limited if the increase in government purchases causes on of the nongovernment private components of aggregate expenditures to fall o Crowding out a decline in private expenditures as a result of an increase in government purchases Crowding out in short run o The greater the sensitivity of consumption investment and net exports to changes in interest rates the more crowding out will occur o Increase in government spending results in partial but not complete crowding out Crowding out in long run o Complete crowding out Private expenditures have fallen by the same amount that government purchases have increased o In the long run the economy returns to potential GDP o Any permanent increase in government purchases must come at the expense of private expenditures Fiscal policy and the stimulus package of 2009 o Consumers base their spending on their permanent income rather than on their current income A consumers permanent income reflects the consumer s expected future income o The actual movements in real GDP and employment are a mixture of the effects of the stimulus package Effects of other factors Fed Reserve s monetary policy other fiscal policy actions typical changes in real GDP and employment during a business cycle that occur independently of government policy Deficits surpluses and federal government debt Federal governments budget shows the relationship between its expenditures and its tax revenue Budget deficit the situation in which the government s expenditures are Budget surplus the situation in which the government s expenditures are greater than its tax revenue less than its tax revenue Discretionary fiscal policy can increase the federal budget deficit during recessions by increasing spending or cutting taxes to increase aggregate demand o Deficits occur automatically during recessions Wages and profits fall causing government tax revenues to fall Government increase its spending on transfer payments o Cyclically adjusted budget deficit or surplus the deficit or surplus in the federal government s budget if the economy were at potential GDP o Automatic budget surpluses and deficits can help to stabilize the economy Balance of the Federal Budget or cut spending worse To bring budget back into balance the government would have to raise taxes o These actions would reduce aggregate demand making recession To