Eco 6351 Economics for Managers Chapter 12. Fiscal Policy

1. Eco 6351Economics for ManagersChapter 12. Fiscal Policy Prof. Vera Adamchik

2. Undesired equilibrium • There is no guarantee that AD will always produce an equilibrium at full employment and price stability. • Sometimes there will be too little demand and sometimes there will be too much. • Equilibrium output is not necessarily the same as the full employment level of output. • Hence, the aggregate demand for goods and services will notalways be compatible with economic stability.

3. PRICE LEVEL (average price) REAL OUTPUT (quantity per year) Inadequate Demand LRAS SRAS Too much AD: Inflation c P2 P* a b AD2 Too little AD: Unemployment AD* AD1 Q2 Q1 QFE

4. Components of AD • The four major components of aggregate demand are: • consumption expenditure (C) • investment (I) • government expenditure (G) • net exports (NX = exports minus imports = X-M) • These four components of AD sum to real GDP (see Chapter 2)

5. Determinants of AD = C+I+G+NX • Change in consumer spending (C): • Consumer wealth • Consumer expectations • Consumer indebtedness • Taxes

6. Determinants of AD = C+I+G+NX • Change in investment spending (I): • Real interest rates • Expected returns • Expected future business conditions • Technology • Degree of excess capacity • Business taxes

7. Determinants of AD = C+I+G+NX • Change in government spending (G) • Change in net export spending (NX) • National income abroad • Exchange rates

8. Fiscal Policy The government’s attempt to influence the economy by setting and changing taxes, its purchases of goods and services (that is, government spending), and transfer payments to achieve macroeconomic objectives such as full employment, sustained long-term economics growth, and low inflation.

9. In the following discussion we assume a horizontal (Keynesian) segment of the SRAS curve.

10. Increasing Demand in the Horizontal Range P SRAS AD1 Price Level P1 AD2 Q Q1 Q2 Real Domestic Output, GDP

11. Decreasing Demand in the Horizontal Range SRAS AD2 Price Level P1 AD1 Q2 Q1 Real Domestic Output, GDP

12. Fiscal Policy Tools: Government Spending

13. PRICE LEVEL (average price) Equilibrium output 5.6 6.0 REAL GDP ($ trillions per year) Q1 QFE A numerical example LRAS SRAS b a P1 Current price level GDP gap AD1 Full employment

14. AD =GDP= C+I+G+(X-M) 5.6 tril. = 3 tril.+1 tril. + 0.9 tril. + 0.7 tril. We would like to increase real GDP to 6 tril. In order to increase AD, the government may increase its spending. The question is: By how much?

15. Disposable Income • Disposable income is the income earned from the supply of productive services - wages, interest, rent, and profit - PLUS transfer payments from the government MINUS taxes

16. Marginal Propensity to Consume • The extent to which a change in disposable income changes consumption expenditure depends on the marginal propensity to consume • The marginal propensity to consume (MPC)is the fraction of a change in disposable income that is consumed

17. Marginal Propensity to Consume • The marginal propensity to consumeis calculated as the change in consumption expenditure divided by the change in disposable income:

18. Marginal Propensity to Save • The extent to which a change in disposable income changes saving depends on the marginal propensity to save • The marginal propensity to save (MPS)is the fraction of a change in disposable income that is saved

19. Marginal Propensities to Save • The marginal propensity to saveis calculated as the change in saving divided by the change in disposable income:

20. Marginal Propensities to Consume and Save • The marginal propensity to consume plus the marginal propensity to save sum to 1: MPC + MPS = 1

21. IN GOD WE IN GOD WE IN GOD WE IN GOD WE TRUST TRUST TRUST TRUST MPC and MPS MPC = .75 MPS = .25

22. Multiplier Effects • Each dollar spent is re-spent several times. • As a result, every dollar has a multiplied impact on aggregate expenditure.

23. The Multiplier Process at Work

24. The Multiplier • The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles.

25. The Government Expenditure Multiplier The G Multiplier = 1/(1-MPC) If MPC = 0.75, The G Multiplier = 1/(1-0.75) = 4.

26. The Ultimate Effect The ultimate change in AD after an infinite number of spending cycles = The G multiplier * The initial change in government spending = 4 * 100 bil. = 400 bil. (that is, 0.4 tril.) The new eqm GDP = the old eqm GDP + the ultimate change in AD = 5.6 tril. + 0.4 tril. = 6.0 tril.

27. PRICE LEVEL (average price) REAL GDP ($ trillions per year) Multiplier Effects LRAS Direct impact of rise in government spending + $100 billion Indirect impact via increased consumption + $300 billion SRAS b a P1 Current price level AD2 AD3 AD1 5.6 5.7 6.0 Q1 QF

28. Fiscal Policy Tools: Taxes

29. A numerical example (cont.) • Rather than increasing its own spending, government can cut taxes to increase consumption or investment spending.

30. The Lump-Sum Tax Multiplier The T Multiplier = -MPC/(1-MPC) If MPC = 0.75, The T Multiplier = -0.75/(1-0.75) = -3.

31. The new eqm GDP = the old eqm GDP + the ultimate change in AD; • 5.6 tril. + the ultimate change in AD = 6.0 tril.; • Theultimate change in AD= 6.0 - 5.6 = 0.4 tril. (that is, 400 bil.).

32. The ultimate change in AD = The T multiplier * The initial change in taxes; • +400 bil. = -3 * the initial change in T; • The init. change in T = 400/(-3) = -133.3 bil.; • That is, the government should decrease taxes by 133.3 bil.

33. Multiplier and Price Level

34. Increasing Demand in the Horizontal Range P SRAS AD1 Price Level P1 AD2 Q Q1 Q2 Real Domestic Output, GDP

35. Inflation Worries • Whenever the aggregate supply curve is upward sloping an increase in aggregate demand increases prices as well as output. • Whenever the aggregate supply curve is vertical an increase in aggregate demand increases prices but has no impact on output.

36. Increasing Demand in the Intermediate Range P SRAS Price Level P4 P3 AD3 AD4 Q Q3 Q4 Real Domestic Output, GDP

37. Increasing Demand in the Vertical Range P SRAS P6 Price Level P5 AD6 AD5 Q Qconstant Real Domestic Output, GDP

38. Inflation and the Multiplier SRAS Full Multiplier Effect Reduced Multiplier Effect Due to Inflation Price Level P2 AD3 P1 AD2 AD1 GDP1 GDP2 GDP3 Real Domestic Output, GDP

39. Fiscal Guidelines • The fiscal strategy for attaining the goal of full employment is to shift the aggregate demand curve

40. Fiscal Guidelines • Problem: insufficient demand • Solution: increase AD • Methods: • increase government spending, • cut taxes, • increase transfer payments. • Problem: excess demand • Solution: decrease AD • Methods: • decrease government spending, • raise taxes, • decrease transfer payments.

41. Government Budget

42. Government Budget • Governments: • collect taxes, T • spend G on goods and services • Budget deficit: if G > T • Budget surplus: if G < T

43. Unbalanced Budgets • The use of fiscal policy to manage aggregate demand implies that the budget will often be unbalanced.

44. Budget Deficit • Budget deficit: if G > T • The government borrows money to pay for deficit spending.

45. Budget Deficit • The federal government ran significant budget deficits between 1970 and 1997. • The deficit peaked at nearly $300 billion in 1992.

46. Budget Surplus • Budget surplus: if G < T • By 1998, a combination of growing tax revenues and slower government spending created a budget surplus.

47. Unbalanced Budgets • In Keynes’ view, an unbalanced budget is perfectly appropriate if macro conditions call for a deficit or surplus.