1. Chapter 11
FFiissccaall PPoolliiccyy

2. TThheeoorryy ooff FFiissccaall PPoolliiccyy
 What is fiscal policy?
 Government purchases, transfer payments, taxes,
and borrowing as they affect macroeconomic
variables such as real GDP, employment, the price
level, and economic growth.

3. FFiissccaall PPoolliiccyy TToooollss
 Two categories:
 Automatic stabilizers
 Automatic stabilizers are revenue and spending programs in
the federal budget that automatically adjust with the ups
and downs of the economy to stabilize disposable income
and, consequently, consumption and real GDP.
 Example: Federal income tax
 Discretionary fiscal policy
 Requires the deliberate manipulation of government
purchases, transfer payments, and taxes to promote
macroeconomic goals.

4. DDiissccrreettiioonnaarryy FFiissccaall PPoolliiccyy
 Increases in government spending or
decreases in taxes increases real GDP
 Decreases in government spending or
increases in taxes decreases real GDP

5. CChhaannggeess iinn GGoovveerrnnmmeenntt PPuurrcchhaasseess
Δ Real GDP demanded 1
MPC
G
-
= D ´
1
 Increase government purchases
– Stimulate the economy
– Upward shift of Aggregate
Expenditure line
– Increase in GDP

6. Effect of a $0.1 Trillion Increase in Government
Purchases on Aggregate Expenditure and Real
GDP Demanded
C + I + G + (X - M)
a
14.5
0 14.0 14.5 Real GDP
(trillions of dollars)
14.0
Aggregate expenditure (trillions of dollars)
45°
C + I + G’ + (X - M)
b
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.
0.1
Exhibit 1

7. CChhaannggeess iinn NNeett TTaaxxeess
 Decrease in net taxes
 Increases Disposable Income by ΔNet Taxes (NT)
 Increases Consumption by MPC ×ΔNT
 Upward shift of Aggregate Expenditure line
 Increase in GDP
-MPC
ΔNT MPC
MPC
-MPC
= ´ -
-
=
1
Δ Real GDP demanded
1
Simple tax multiplier

8. Effect of a $0.1 Trillion Decrease in Net Taxes on
Aggregate Expenditure and Real GDP Demanded
C + I + G + (X - M)
Aggregate expenditure (trillions of dollars)
14.4
0 14.0 14.4 Real GDP
(trillions of dollars)
a
14.0
45°
C’ + I + G + (X - M)
c
As a result of a
decrease in NT of $0.1
trillion, consumers, who
are assumed to have a
MPC of 0.8, spend $80
billion more and save
$20 billion at every
level of GDP. The
consumption function
shifts up by $80 billion,
as does the AE line.
0.08
An $80 billion increase of AE 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.
LO1 Exhibit 2

9. Discretionary FFiissccaall PPoolliiccyy ttoo CClloossee aa
CCoonnttrraaccttiioonnaarryy GGaapp
 When an economy is operating below its
potential output, the Keynesian model
suggests that the government should institute
expansionary fiscal policy, by:
increasing the government’s purchases
of goods & services, and/or,
cutting taxes.

11. Discretionary Fiscal Policy to Close a
Contractionary Gap
The aggregate demand curve AD
and the short-run aggregate supply
curve SRAS130 intersect at point e.
Output falls short of the economy’s
potential. The resulting
contractionary gap is $0.5 trillion.
This 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*.
LO2 Exhibit 3
Price
level
130
125
SRAS130
AD
e
Potential output
LRAS
AD*
e’
Real GDP
0 13.5 14.0 14.5
(trillions of dollars)
e*
e’’

12. Discretionary FFiissccaall PPoolliiccyy ttoo CClloossee aa
EExxppaannssiioonnaarryy GGaapp
 When inflation is a potential problem,
Keynesian analysis suggests a shift toward a
more contractionary fiscal policy by:
reducing government spending, and/or,
raising taxes.

14. Discretionary Fiscal Policy to Close an Expansionary Gap
The aggregate demand curve AD’
and the short-run aggregate supply
curve SRAS130 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 aggregate demand back
to AD* and move the economy back
to its potential output at e*.
LO2 Exhibit 4
Price
level
135
130
SRAS130
AD’
e’
Potential output
LRAS
AD*
Real GDP
e’’
e*
0 14.0 14.5
(trillions of dollars)

15. CCoonnttrraaccttiioonnaarryy aanndd EExxppaannssiioonnaarryy
FFiissccaall PPoolliiccyy
 Difficult to achieve
 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

16. TThhee MMuullttiipplliieerr aanndd tthhee TTiimmee HHoorriizzoonn
 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

17. TThhee EEvvoolluuttiioonn ooff FFiissccaall PPoolliiccyy
1. Prior to the Great Depression
 Classical economists
– Laissez-faire; Free markets
– Balanced budget
– Natural market forces
• Flexible:
• Prices
• Wages
• Interest rates
• NO government intervention needed

18. AAuuttoommaattiicc SSttaabbiilliizzeerrss
• Automatic Stabilizers:
Without any new legislative action, they tend to
increase the budget deficit (or reduce the surplus)
during a recession and increase the surplus (or reduce
the deficit) during an economic boom.
• The major advantage of automatic stabilizers is that
they institute counter-cyclical fiscal policy without the
delays associated with legislative action.

19. AAuuttoommaattiicc SSttaabbiilliizzeerrss
• Examples of automatic stabilizers
– Unemployment compensation
– Corporate profit tax
– A progressive income tax

20. TThhee EEvvoolluuttiioonn ooff FFiissccaall PPoolliiccyy
2. The Great Depression and World War II
– Keynesian theory and policy
• Prices and wages: ‘Sticky’ downward
• Increase AD
– WWII
• Increase production
• No cyclical unemployment
– Employment Act of 1946, Government:
• Full employment
• Economic stability

21. TThhee EEvvoolluuttiioonn ooff FFiissccaall PPoolliiccyy
3. From the Golden Age to Stagflation
– 1960s: demand-management policy
• Increase or decrease AD
– 1970s: Stagflation
• Higher inflation
• Higher unemployment
• From decreased AD
• Crop failures
• Higher OPEC-driven oil prices
• Adverse supply shocks

22. FFiissccaall PPoolliiccyy aanndd tthhee NNaattuurraall RRaattee ooff
UUnneemmppllooyymmeenntt
 Underestimate natural rate of unemployment
– Expansionary fiscal policy
• Increase AD; Short run:
• Increase output
• Decrease unemployment
• Expansionary gap; Long run:
• Decrease SRAS
• Inflation
• Decrease output

23. When Discretionary Fiscal Policy Overshoots
Potential Output
If public officials underestimate the
natural rate of unemployment, they
may attempt to stimulate AD even if
the economy is already producing at
its potential output, a.
This expansionary policy yields a
short-run equilibrium at 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 SRAS,
eventually reducing output to its
potential level of $14.0 trillion while
increasing the price level to 140.
Thus, attempts to increase production
beyond its potential GDP lead only to
inflation in the long-run
LO3 Exhibit 5
Price
level
140
130
SRAS140
c
SRAS130
AD
Potential output
LRAS
AD’
Real GDP
0 14.0 14.2
b
(trillions of dollars)
a

24. LLaaggss iinn FFiissccaall PPoolliiccyy
 Fiscal policy
– Time
• Approve
• Implement
– Less effective
– Too late
– More harm than good

25. FFiissccaall PPoolliiccyy aanndd PPeerrmmaanneenntt IInnccoommee
 Permanent income
– On average, over long term
 Temporary tax rate change
– Not effective
– Small change in personal income
– Small change in consumption
– Less saving

26. The Feedback EEffffeeccttss ooff FFiissccaall PPoolliiccyy
oonn AASS
 Fiscal policy
– Affects Aggregate Supply – unintentional
– Higher unemployment benefits
• Unemployed; increase C
• Paid: higher taxes on earnings
• Employed: decrease C
• Same MPC for employed and unemployed
• No change in: AD, real GDP
• Redistribution of income
• Decrease labor supply
• Decrease AS

27. TThhee EEvvoolluuttiioonn ooff FFiissccaall PPoolliiccyy
4. Since 1990: from deficits to surpluses
 1980s – mid-1990s: large deficits
 1993 recovery under way
– Increase tax on high-income households
 1994: Decreased federal spending
 1993 – 1998
– Tax revenues: +8.3% per year
– Federal outlays: +3.2% per year

28. TThhee EEvvoolluuttiioonn ooff FFiissccaall PPoolliiccyy
4. Since 1990: from deficits to surpluses back to deficits
– 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) $400 billion
– Federal deficit (2007) under $200 billion
– Recession beginning December 2007
– Federal deficit increased to $450 billion in 2008; now
forecast between $1 trillion and $2 trillion