Chapter 21 Fiscal Policy

1. Chapter 21Fiscal Policy • Key Concepts • Summary • Practice Quiz • Internet Exercises ©2000 South-Western College Publishing

2. In this chapter, you will learn to solve these economic puzzles: Is an increase in government spending or a tax cut of equal amount the greater stimulus to economic growth? Why did Ronald Reagan think the federal government could increase tax revenues by cutting taxes? Can Congress fight a recession without taking any action?

3. What is a Discretionary Fiscal Policy? The deliberate use of changes in government spending or taxes to alter aggregate demand and stabilize the economy

4. What are examples of Expansionary Fiscal Policy? • Increase government spending • Decrease taxes • increase government spending and taxes equally

5. What are examples of Contractionary Fiscal Policy? • Decrease government spending • Increase taxes • Decrease government spending and taxes equally

6. Government Spending to Combat a Recession AS E2 155 155 Price Level E1 X 150 AD2 AD1 Full Employment Real GDP 0 $6 $6.1 $6.2

7. Increase in the price level and the real GDP Increase in the aggregate demand curve Increase in government spending

8. With an MPC of 0.75, what is the Spending Multiplier? 1/1-MPC = 1/1-0.75 = 1/25/100 = 1 /  = 4

9. How much will real GDP increase by with an increase in government spending of $50 bil? 4 x $50 bil = $200 bil

10. What is theTax Multiplier? The change in aggregate demand (total spending) resulting from an initial change in taxes

11. What happens when government cuts taxes by $50 bil? The multiplier process is less because initial spending increases only by $38 bil instead of $50 bil

12. What is the formula for the Tax Multiplier? 1 – spending multiplier

13. How much does real GDP increase by with a cut in taxes of $50 bil? 3 x $50 bil = $150 bil

14. Can we assume that the MPC will remain fixed? No, it can change from one time period to another

15. Can Fiscal Policy be used to combat Inflation? Yes, this would happen when the economy is operating in the Classical or Intermediate range of the aggregate supply curve

16. What will happen to AD with a cut in G spending of 25 bil? -$25 bil x 4 = -$100 bil

17. Using Fiscal Policy to Combat Inflation AS Price Level E1 160 E´ 155 AD1 E2 Full Employment AD2 0 $6 $6.1 Real GDP

18. Decrease in the price level Decrease in the aggregate demand curve Decrease in government spending

19. What will happen to AD with a cut in Taxes of 33.3 bil? $33.3 x -3 = -$100 bil

20. What is the Balanced Budget Multiplier? An equal change in government spending and taxes, which changes aggregate demand by the amount of the change in government spending

21. What is anAutomatic Stabilizer? Federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction

22. What are examples of Automatic Stabilizers? • Transfer payments • Unemployment compensation • Welfare

23. What is aBudget Surplus? A budget in which government revenues exceed government expenditures in a given time period

24. What is a Budget Deficit? A budget in which government expenditures exceed government revenues in a given time period

25. Automatic Stabilizers $2,500 T $1,000 Budget deficit Budget surplus $750 G Spending and Taxes $500 G $250 Real GDP $4 $6 $8

26. Budget offsets inflation Tax collections fall and government transfer payments rise Increase in real GDP

27. Budget offsets recession Tax collections fall and government transfer payments rise Decrease in real GDP

28. What is Supply-Side Fiscal Policy? A fiscal policy that emphasizes government policies that increase aggregate supply

29. What is the purpose of Supply-Side Fiscal Policies? To achieve long-run growth in real output, full employment, and a lower price level

30. Demand-Side Fiscal Policy AS 250 Price Level E2 200 Full Employment E1 150 AD2 100 AD1 Real GDP 6 0 2 4 8 10 12

31. Increase in the aggregate demand curve Increase in government spending; decrease in net taxes

32. Supply-Side Fiscal Policy AS1 250 Price Level AS2 200 E1 150 Full Employment E2 100 AD Real GDP 6 0 2 4 8 10 12

33. Increase in the aggregate supply curve Decrease in resource prices; technological advances; subsidies; decrease in regulations

34. Supply-Side Policies Affect Labor Markets Before tax-cut labor supply After tax-cut labor supply E1 W1 Wage rate E2 W2 Labor Demand Q of Labor 0 L1 L2

35. Will an increase in Taxes lead to higher Government Revenues? That depends on where the economy is on the Laffer Curve

36. What is theLaffer Curve? Puts forth the idea that increasing taxes from zero will increase tax revenues up to a certain point

37. What happens beyond a certain point? Tax revenues begin to decline as the economic pie begins to shrink

38. Why does the Economic Pie begin to shrink? Workers have less incentive to work and investors have less of an incentive to invest

39. The Laffer Curve B Rmax C Federal Tax Revenue R D A Federal Tax Rate 0 Tmax T 100%

40. Key Concepts

41. Key Concepts • What is a Discretionary Fiscal Policy? • What are examples of Expansionary Fiscal Policy? • What are examples of Contractionary Fiscal Policy? • With an MPC of 0.75, what is the Multiplier? • How much will real GDP increase by with an increase in government spending of $50 bil?

42. Key Concepts cont. • What is the Tax Multiplier? • What is the formula for the Tax Multiplier? • Can Fiscal Policy be used to combat Inflation? • What will happen to AD with a cut in G spending of 25 bil? • What is the Balanced Budget Multiplier?

43. Key Concepts cont. • What is an Automatic Stabilizer? • What is a Budget Surplus? • What is a Budget Deficit? • What is Supply Side Fiscal Policy? • What is the Laffer Curve?

44. Summary

45. Fiscal policy is the use of government spending, taxes, and transfer payments for the purpose of stabilizing the economy.

46. Discretionary fiscal policy follows the Keynesian argument that the federal government should manipulate aggregate demand in order to influence the output, employment, and price levels in the economy. Discretionary fiscal policy requires either new legislation to change government spending or taxes in order to stabilize the economy.

47. Expansionary fiscal policy is a deliberate increase in government spending, a deliberate decrease in taxes, or some combination of these two options.

48. Contractionary fiscal policy is a deliberate decrease in government spending, a deliberate increase in taxes, or some combination of these two options. Using either expansionary or contractionary fiscal policy, the government can shift the aggregate demand curve in order to combat recession, cool inflation, or achieve other macroeconomic goals.

49. Discretionary Fiscal Policies Expansionary Contractionary • Increase government spending • Decrease taxes • Increase government spending and taxes equally • Decrease government spending • Increase taxes • Decrease government spending and taxes equally

50. The tax multiplier is the multiplier by which an initial change in taxes changes aggregate demand (total spending) after an infinite number of spending cycles. Expressed as a formula, the tax multiplier = 1 - spending multiplier.