Chapter 12 The Short Run Countercyclical Fiscal Policy The Short Run Countercyclical Fiscal Policy In the short run fiscal policy can have demand side effects on output and employment Countercyclical fiscal policy government attempts to smooth out the business cycle by adjusting its own purchases or by changing net taxes The Mechanics of Countercyclical Fiscal Policy A Change in Government Purchases GDP Multiplier x G A Change in Net Taxes By cutting taxes or increasing transfers the govt can increase the spending of those directly affected such as the households who get the tax cut or receive the transfers If disposable income increases by 1000 spending would increase by MPC x 1000 this is the initial rise in spending caused by the tax cut o MPC 0 6 the final rise in GDP from a 1000 billion tax cut must be 60 of the rise in GDP that we get from a 1000 billion rise in govt purchases Net tax multiplier the number a change in taxes is multiplied by in order to get the change in GDP Difference between the expenditure multiplier and the tax multiplier o While the govt purchases multiplier is positive the tax multiplier is negative In the short run model the tax multiplier is the MPC x the expenditure multiplier and negative in sign o Net tax multiplier MPC x Expenditure Multiplier MPC 1 MPC GDP Net tax multiplier x T Combining Fiscal Changes When fiscal policy changes on multiple fronts the final impact on equilibrium GDP can be found by adding up the separate multiplier effects of each policy change The Balanced Budget Multiplier budget deficit Government purchases and net taxes increase by equal amounts no rise in o The expenditure multiplier that applies to govt purchases is larger than the tax multiplier o GDP rises when taxes and govt purchases are increased by equal Balanced budget multiplier the final multiplier effect of equal changes in G amounts and T o Always has the value of 1 0 no matter the value of the MPC o When both G and T change in the same direction and by equal amounts equilibrium GDP will change in that same direction and by that same amount Problems with Countercyclical Fiscal Policy Timing Problems It usually takes many months or longer for fiscal changes to be enacted o A decision to decrease taxes in the US has to go through the House then the Senate then the president usually does not go smoothly o Increasing govt purchases takes time too very few additional infrastructure projects will be shovel ready when the stimulus is needed Because of the long delays regular use of countercyclical policy could be a destabilizing force in the economy Irreversibility Reversing a fiscal stimulus is difficult When it is time to take back an increase in govt purchases or transfer payments or a decrease in taxes those who benefited will oppose the reversal Taxes and Forward Looking Behavior Temporary tax changes designed to last only until the economy comes back to potential output Most of the increase in disposable income will be saved multiplier for a temporary tax change will be small The Reaction of the Federal Reserve The Federal Reserve can generally act more rapidly and flexibly than can Congress o By the time any fiscal change would take place the Federal Reserve would have already taken the steps it thought necessary to adjust AE The Long Run Deficits and the National Debt Budget deficits can have some immediate consequences raising interest rates and crowding out consumption and investment spending o Another consequence increase in the government s debt National debt the amount that the federal government owes at any given point in time o Equal to the total of all past years deficits minus whatever the government has paid back the national debt over time Numbers in Perspective o Decisions about govt spending and taxes also determine the change in Prices rose during 50 year period so real government outlays and the real national debt rose considerably less than these nominal figures suggest The government s spending and its total debt should always be viewed in relation to the economy s total income As a country s total income grows it will want more of the things that government can provide becomes richer o Therefore we expect government spending to rise as a nation o As income grows a country can handle higher interest payments on its debt Budget related figures such as government purchases tax revenues or govt debt should be considered relative to a nation s total income as percentages of GDP Outlays Revenue and the Deficit In addition to purchasing goods and services the govt also disburses funds for transfer payments and to pay interest on its debt NOT part of govt purchases when we measure GDP Transfer and interest payments represent funds flowing out of the govt Government outlays the total outflow of funds for government purchases transfer payments and interest on the national debt Budget surplus Tax revenue Outlays Budget deficit Outlays Tax revenue Deficits over Time The Deficit and the National Debt Recessions are associated with budget deficits Economic fluctuations affect both transfer payments and tax revenues o Automatic changes occur without any change in govt policy Recessions cause transfer payments to rise cause a drop in tax revenue because household income and corporate profits decrease during recessions In a recession because transfers rise and tax revenue falls the federal budget deficit automatically increases or the surplus decreases In an expansion because transfers decrease and tax revenue rises the budget deficit automatically decreases or the surplus increases The federal deficit and surplus are flow variables they measure the difference between govt spending and tax revenue over a given period The national debt is a stock variable it measures the total amount that the federal govt owes at a given point in time Each year the government runs a deficit it must borrow funds equal to the deficit adding to the national debt o The govt borrows these funds by issuing federal govt bonds If the govt runs a surplus it uses the surplus to pay back some of the national debt Budget deficits which add to the public s holdings of federal government bonds add to the national debt Surpluses which decrease the public s bond holdings subtract from the national debt Debt ratio the nominal federal debt held by the public as a percentage of nominal GDP The National Debt Myths and Realities National debt clocks show debt in dollars rather than as a
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