MacroEcomonics principles, application, and tools 7th edition by sullivan chapter 10

Fiscal Policy Fiscal Policy● fiscal policy Changes in government taxes and spending that affect the level of GDP... Fiscal Policy 10.1 THE ROLE OF FISCAL POLICYFiscal Policy and Aggregat

Fiscal Policy

Fiscal Policy

As President Obama’s administration began in January 2009, the

economy was in the midst of a very severe recession.

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How are tax rates and tax revenues related?

The Confucius Curve?

Did President Obama’s fiscal stimulus work as expected?

Evaluating the Obama Fiscal Stimulus

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A P P L Y I N G T H E C O N C E P T S

Fiscal Policy Fiscal Policy

● fiscal policy

Changes in government taxes and spending that affect the level of GDP.

Fiscal Policy 10.1 THE ROLE OF FISCAL POLICY

Fiscal Policy and Aggregate Demand

 FIGURE 10.1

Fiscal Policy in Action

Panel A shows that an increase in government spending shifts the aggregate demand curve from

AD0 to AD1, restoring the economy to full employment This is an example of expansionary policy.

Panel B shows that an increase in taxes shifts the aggregate demand curve to the left, from AD0 to

AD1, restoring the economy to full employment This is an example of contractionary policy.

Fiscal Policy 10.1 THE ROLE OF FISCAL POLICY (cont’d)

Fiscal Policy and Aggregate Demand

● expansionary policies

Government policy actions that lead

to increases in aggregate demand

● contractionary policies

Government policy actions that lead

to decreases in aggregate demand

Fiscal Policy 10.1 THE ROLE OF FISCAL POLICY (cont’d)

The Fiscal Multiplier

● stabilization policies

Policy actions taken to move the economy closer to full employment

or potential output

The Limits to Stabilization Policy

•As the government develops policies to stabilize the economy, it needs to take

the multiplier into account

•The total shift in aggregate demand will be larger than the initial shift As we will

see later in this chapter,

•U.S policymakers have taken the multiplier into account as they have developed policies for the economy

Fiscal Policy 10.1 THE ROLE OF FISCAL POLICY (cont’d)

The Limits to Stabilization Policy

What makes the problem of lags even worse is that economists are not very

accurate in forecasting what will happen in the economy

Fiscal Policy 10.1 THE ROLE OF FISCAL POLICY (cont’d)

The Limits to Stabilization Policy

LAGS

 FIGURE 10.2

Possible Pitfalls in Stabilization

Policy

Panel A shows an example of

successful stabilization policy

The solid line represents the behavior

of GDP in the absence of policies The

dashed line shows the behavior of GDP

when policies are in place Successfully

timed policies help smooth out

economic fluctuations.

Panel B shows the consequences of

ill-timed policies

Again, the solid line shows GDP in the

absence of policies and the dashed line

shows GDP with policies in place

Notice how ill-timed policies make

economic fluctuations greater

Fiscal Policy 10.2 THE FEDERAL BUDGET

Federal Spending

Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d)

Federal Spending

● discretionary spending

The spending programs that Congress authorizes on an annual basis

● entitlement and mandatory spending

Spending that Congress has authorized

by prior law, primarily providing support for individuals

Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d)

• Leave the existing programs in place and just raise taxes to pay for them.

• The government should save and invest now to increase GDP in the future to reduce the burden on future generations

• Reform the entitlement systems, placing more responsibility on individuals and families for their retirement and well-being

• Reform the health-care system to encourage more competition to reduce health-care expenditures

INCREASING LIFE EXPECTANCY AND AGING POPULATIONS

SPUR COSTS OF ENTITLEMENT PROGRAMS

APPLYING THE CONCEPTS #1: Why are the United States and many other countries facing dramatically increasing

costs for their government programs?

Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d)

Federal Revenues

Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d)

Federal Revenues

● supply-side economics

A school of thought that emphasizes the role that taxes play in the supply of output in the economy

● Laffer curve

A relationship between the tax rates and tax revenues that illustrates that high tax rates could lead to lower tax

revenues if economic activity is severely discouraged

SUPPLY-SIDE ECONOMICS AND THE LAFFER CURVE

Fiscal Policy

•While the idea that cutting tax rates might actually increase tax revenue is often attributed to economist Arthur Laffer, in fact, it is actually a much older idea than that.

•Yu Juo, one of the twelve wise men who succeeded Confucius in ancient China, was asked what should be done in the case of a famine if the

government had insufficient funds He replied that the tax rate should be cut to 10 percent Skeptical government bureaucrats did not have enough funds at a 20 percent rate, so how could they cut it to 10 percent?

•Yu Juo replied, “Cutting taxes and limiting your expenses allow people to raise their standard of living Afterwards, you will no longer need to worry about famine and shortage.”

•Revenue estimators in Washington, D.C, do not share entirely in Yu Juo’s wisdom, but they do recognize that cutting tax rates will stimulate economic activity.

THE CONFUCIUS CURVE?

APPLYING THE CONCEPTS #2: How are tax rates and tax

revenues related?

Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d)

The Federal Deficit and Fiscal Policy

● budget deficit

The amount by which government spending exceeds revenues in a given year

● budget surplus

The amount by which government revenues exceed government expenditures in a given year

Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d)

Automatic Stabilizers

● automatic stabilizers

The increased federal budget deficit works through three channels:

1 Increased transfer payments such as unemployment insurance, food stamps,

and other welfare payments increase the income of some households, partly offsetting the fall in household income

2 Other households whose incomes are falling pay less in taxes, which partly

offsets the decline in their household income Because incomes do not fall as much as they would have in the absence of the deficit, consumption spending does not decline as much

3 Because the corporation tax depends on corporate profits and profits fall in a

recession, taxes on businesses also fall Lower corporate taxes help to prevent businesses from cutting spending as much as they would otherwise during a recession

Fiscal Policy 10.2 THE FEDERAL BUDGET (cont’d)

Are Deficits Bad?

No – Automatic Stabilizers Yes – Crowding Out

P R I N C I P L E O F O P P O R T U N I T Y C O S T

The opportunity cost of something is what you sacrifice to get it.

Fiscal Policy 10.3 FISCAL POLICY IN U.S HISTORY

The Depression Era

The Kennedy Administration

During the 1930s, politicians did not believe in modern fiscal policy, largely because they feared the consequences of government budget deficits According to Brown,

fiscal policy was expansionary only during two years of the Great Depression, 1931 and 1936

Although modern fiscal policy was not deliberately used during the 1930s, the growth

in military spending at the onset of World War II in 1941 increased total demand in the economy and helped pull the economy out of its long decade of poor performance But

to see fiscal policy in action, we need to turn to the 1960s It was not until the

presidency of John F Kennedy during the early 1960s that modern fiscal policy came

to be accepted

Fiscal Policy 10.3 FISCAL POLICY IN U.S HISTORY (cont’d)

The Vietnam War Era

● permanent income

An estimate of a household’s long-run average level of income

The Reagan Administration

The tax cuts enacted during 1981 at the beginning of the first term of President Ronald Reagan were significant However, they were not proposed to increase aggregate

demand Instead, the tax cuts were justified on the basis of improving economic

incentives and increasing the supply of output

Fiscal Policy FISCAL POLICY IN U.S HISTORY (cont’d)

In late 1990’s, tax increases, limited government spending, and economic growth which increased revenues resulted in the U.S experienced a surplus Tax cuts and stimulus packages designed to stimulate the economy after the recessions of 2001 and 2008 resulted in U.S deficits again.

Fiscal Policy

EVALUATING THE OBAMA FISCAL STIMULUS

APPLYING THE CONCEPTS #3: Did President Obama’s fiscal

stimulus work as expected?

•The Council of Economic Advisors was required to determine the effectiveness of the stimulus package and make regular reports to Congress

•They determined that employment and growth were higher in the second and third quarter of 2009 than would have been expected, but could not be sure the stimulus package was the cause

•Using conventional models and comparisons with other countries, the council

determined that the package avoided the loss about one million jobs

•However, unemployment was still almost 10 percent and high unemployment will

linger for years

•Even if there was a positive effect, the lingering effect of the recession would still be painful

K E Y T E R M S