Ln13 miller950022 17_ln13

Copyright ©2014 Pearson Education, Inc. All rights reserved. 13-2
Introduction
In response to the economic downturn of 2008-2009,
Congress passed the American Recovery and
Reinvestment Act (ARRA) as an attempt to stimulate
total planned expenditures through additional
government spending.
Although large portions of the federal funds authorized
by ARRA were allocated to states, states spent no more
than 5 percent of the total ARRA funds they received.
This chapter will help you explore the questions of what
the government hoped to accomplish through ARRA and
why states spent only a small fraction of their funds.

Learning Objectives
• Use traditional Keynesian analysis to evaluate the
effects of discretionary fiscal policy
• Discuss ways in which indirect crowding out and
direct expenditure offsets can reduce the
effectiveness of fiscal policy actions
• Explain why the Ricardian equivalence theorem
calls into question the usefulness of tax changes

Learning Objectives (cont'd)
• List and define fiscal policy time lags and
explain why they complicate efforts to
engage in fiscal “fine tuning”
• Describe how certain aspects of fiscal policy
function as automatic stabilizers for the
country

Chapter Outline
• Discretionary Fiscal Policy
• Possible Offsets to Fiscal Policy
• Discretionary Fiscal Policy in Practice:
Coping with Time Lags
• Automatic Stabilizers
• What Do We Really Know About Fiscal
Policy?

Did You Know That ...
• The U.S. government’s American Recovery and
Reinvestment Act of 2009 entailed a greater overall
expenditure of funds than the eight-year-long Iraqi
conflict?
• In this chapter, you will learn about how variations
in government spending and taxation affect both
real GDP and the price level.

Discretionary Fiscal Policy
• Fiscal Policy
– The discretionary changing of government
expenditures or taxes in order to achieve
national economic goals, such as:
• High employment (low unemployment)
• Price stability
• Economic growth

Discretionary Fiscal Policy (cont'd)
• An increase in government spending will
stimulate economic activity
• Changes in government spending:
– Military spending
– Education spending
– Budgets for government agencies

Figure 13-1 Expansionary and Contractionary Fiscal
Policy: Changes in Government Spending, Panel (a)

Figure 13-1 Expansionary and Contractionary Fiscal
Policy: Changes in Government Spending, Panel (b)

• Questions
– Would the increase in government spending
equal the size of the gap?
– What impact would expansionary fiscal policy
have on the price level?

Policy Example: Net Real GDP Effect of “Cash-for-
Clunkers” Spending: Zero
• In 2009, the U.S. government offered $3,500 to
$4,500 to people who surrendered used cars and
bought new vehicles.
• This program aimed to remove high-pollution
vehicles from the roads and to increase private
expenditures on new cars and trucks.
• Economic research suggests that the Cash-for-
Clunkers program shifted the timing of vehicle
purchases, but that it did not increase the total
expenditures on cars and trucks. Consequently, it
was not a very effective fiscal stimulus.

• Change in taxes
– A rise in taxes causes a reduction in aggregate
demand because it can reduce consumption
spending, investment expenditures, and net
exports

Figure 13-2 Contractionary and Expansionary Fiscal
Policy: Changes in Taxes, Panel (a)

Figure 13-2 Contractionary and Expansionary Fiscal
Policy: Changes in Taxes, Panel (b)

• Question
– What would be the long-run impact of a tax cut
on real GDP if the economy is at full-
employment equilibrium?

Possible Offsets to Fiscal Policy
• Fiscal policy does not operate in a vacuum
and important questions must be answered
– How are expenditures financed and by whom?
– If taxes are increased what does government do
with the taxes?
– What will happen if individuals worry about
increases in future taxes?

(cont'd)
• Crowding-out effect
– The tendency of expansionary fiscal policy to
cause a decrease in planned investment or
planned consumption in the private sector
– This decrease normally results from the rise of
interest rates

Figure 13-3 The Crowding-Out Effect,
Step by Step

Figure 13-4 The Crowding-Out Effect

(cont'd)
• Ricardian Equivalence Theorem
– The proposition that an increase in the
government budget deficit has no effect on
aggregate demand
– Reason: people anticipate that a larger deficit
today will mean higher taxes in the future and
adjust their spending accordingly

(cont'd)
• Permanent income hypothesis
– The theory of consumption known as the
permanent income hypothesis asserts that an
individual’s current consumption depends on
anticipated lifetime income.
– Therefore, a temporary tax cut will have a
restrained effect on aggregate consumption.

(cont'd)
• Direct Expenditure Offsets
– Actions on the part of the private sector in
spending income that offset government fiscal
policy actions
– Any increase in government spending in an area
that competes with the private sector will have
some direct expenditure offset

What If . . . The federal government seeks to boost real
GDP by funding health care spending that people had
already planned to do on their own?
• In recent years, the U.S. government has
shifted a larger share of discretionary
expenditures toward construction of more
public hospitals and clinics.
• Although some private health care
companies had originally planned to expand
their facilities, the federally-funded projects
caused the plans for private facilities to be
cancelled.
• The result was a direct fiscal offset.

(cont'd)
• The supply-side effects of changes in taxes
– Expansionary fiscal policy could involve reducing
marginal tax rates
• Advocates argue this increases productivity since
individuals will work harder and longer, save more, and
invest more
• The increased productivity will lead to more economic
growth

(cont'd)
• Supply-side effects of changes in taxes
– Lower tax rates lead to an increase in
productivity because individuals will work harder
and longer, save more, and invest more
– Increased productivity will in turn lead to more
economic growth, thus higher real GDP
– Results: Lower marginal tax rates will not
necessarily reduce tax revenues due to a larger
tax base

Figure 13-5 Laffer Curve

Discretionary Fiscal Policy in Practice:
Coping with Time Lags
• Question
– Is the conduct of fiscal policy as precise as it
appears?
• Answer
– The difficulty is that the conduct of fiscal policy
involves a variety of lags.

Discretionary Fiscal Policy in Practice: Coping
with Time Lags (cont'd)
• Time lags
– Recognition Time Lag
• The time required to gather information about the
current state of the economy

• Time lags
– Action Time Lag
• The time required between recognizing an economic
problem and putting policy into effect
– Particularly long for fiscal policy which requires
congressional approval

• Time lags
– Effect Time Lag
• The time it takes for a fiscal policy to affect the
economy

• Fiscal policy time lags are:
– Long – a policy designed to correct a recession
may not produce results until the economy is
experiencing inflation
– Variable in length – they can be from 1-3 years,
and the timing of the desired effect cannot be
predicted
• Because fiscal policy time lags tend to be
variable, policymakers have a difficult time
fine-tuning the economy

Automatic Stabilizers
• Automatic or Built-In Stabilizers
– Changes in government spending and taxation
that occur automatically without deliberate
action of Congress
• The tax system
• Unemployment compensation
• Welfare spending

Automatic Stabilizers (cont’d)
• The Tax System
– Incomes and profits fall when business activity
slows down, and the government’s tax revenues
drop as well
– Some economists consider this an automatic tax
cut, which therefore stimulates aggregate
demand

• Unemployment Compensation and Income
Transfer Payments
– Unemployment compensation reduces changes in
people’s disposable income. Their disposable
income remains positive, although at a lower
level
– In a recession, more people are eligible for
income transfer payments and do not experience
as dramatic a drop in disposable income

• Stabilizing Impact
– The key impact of these systems is the ability to
mitigate changes in disposable income,
consumption, and the equilibrium level of GDP
– If disposable income is prevented from falling as
much as it otherwise would in a recession, the
downturn will be moderated

Policy Example: Do Fiscal Policy Effects
Vary As Real GDP Rises or Falls?
• In looking at the impact of discretionary fiscal
policy, economic researchers have found that each
additional dollar of non-defense spending boosts
real GDP by about $1.10.
• The impact of an increase in defense spending is
greater.
• During a recession, each added dollar of defense
spending boosts real GDP by more than $3.50.
• During an expansion, each additional dollar of
defense expenditure results in a $1.20 increase in
real GDP.

Figure 13-6 Automatic Stabilizers

What Do We Really Know About
Fiscal Policy?
• Fiscal policy during normal times
– Congress ends up doing too little too late to help
in a minor recession
– Fiscal policy that generates repeated tax
changes (as has happened) creates uncertainty

Fiscal Policy? (cont'd)
• Fiscal policy during abnormal times
– Fiscal policy can be effective
• The Great Depression—fiscal policy may be able to
stimulate aggregate demand
• Wartime—during World War II real GDP increased
dramatically

Fiscal Policy? (cont'd)
• The “soothing” effect of Keynesian fiscal
policy
– Should we encounter a severe downturn, fiscal
policy is available
• Knowing this may reassure consumers and investors
– Stable expectations encourage a smoothing of
investment spending

You Are There: Why a Federal Stimulus Project
Took Time to Provide Stimulus
• A portion of ARRA funds were devoted to paying for
insulation of private homes.
• After an initial attempt to get the insulation project
underway, the Detroit agency facilitating this
process realized that it hadn’t complied with all of
the federal requirements for hiring firms to do the
work.
• Thus, any stimulus to the Detroit economy was
delayed while the agency had to start the hiring
process all over again.

Issues & Applications: How Federal “Stimulus”
Was Swallowed Up by States
• Figure 13-7 on the next slide displays:
– The cumulative quantity of grants of
discretionary funds transmitted from the federal
government to state governments since late
2008
– The net stock of borrowing by state
governments

Figure 13-7 Federal Funds Transmittals to U.S. State
Governments and Net Borrowings of State
Governments Since 2008

Issues & Applications: How Federal “Stimulus”
Was Swallowed Up by States (cont’d)
• The patterns in the graph suggest that the
funds transferred to states were largely
used to pay off debts that been incurred in
earlier years.
• Only about 5 percent of the grants to states
were used to finance new projects.
• Consequently, there was a 95 percent direct
fiscal offset.

Summary Discussion of Learning
Objectives
• The effects of discretionary fiscal policy
using traditional Keynesian analysis
– Increases in government spending and
decreases in taxes increase aggregate demand
– Decreases in government spending and
increases in taxes decrease aggregate demand

Objectives (cont'd)
• How indirect crowding out and direct
expenditure offsets can reduce the
effectiveness of fiscal policy actions
– Deficits increase interest rates
– Some government spending replaces private
spending
• If the Ricardian equivalence theorem is
valid, a tax cut has no effect on total
planned expenditures and aggregate
demand

Objectives (cont'd)
• Fiscal policy time lags and the effectiveness
of fiscal “fine tuning”
– The time lags for fiscal policy are the recognition
time lag, action time lag, and the effect time lag
– The time lags are long and variable
• Automatic stabilizers are changes in tax
payments, unemployment compensation,
and welfare payments that automatically
change with the level of economic activity

Appendix D: Fiscal Policy: A Keynesian
Perspective
• The traditional Keynesian approach to fiscal policy
differs in three ways from that presented in
Chapter 13:
– It emphasizes the underpinnings of the components of
aggregate demand
– It assumes that government expenditures are not
substitutes for private expenditures and that current taxes
are the only taxes taken into account by consumers and
firms
– It focuses on the short run and so assumes that as a first
approximation, the price level is constant

Figure D-1 The Impact of Higher Government
Spending on Aggregate Demand

Figure D-2 The Impact of Higher Taxes on
Aggregate Demand

Appendix D: The Balanced-Budget
Multiplier
• Balanced-budget increase in real spending
– The government increases spending by $1 and
pays for it by raising current taxes by $1
• Balanced-budget multiplier is equal to 1

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