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Fiscal Policy

Fiscal Policy. How much spending does it take?. Introduction. http://www.youtube.com/watch?v=1qhJPqyJRo8&feature=plcp&context=C49f6c9cVDvjVQa1PpcFMdkWSNt1EsUKtB5fYByDq14YICcdVaANI%3D. What is FISCAL Policy?. Fiscal Policy Spending – where does it all go?.

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Fiscal Policy

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  1. Fiscal Policy How much spending does it take?

  2. Introduction • http://www.youtube.com/watch?v=1qhJPqyJRo8&feature=plcp&context=C49f6c9cVDvjVQa1PpcFMdkWSNt1EsUKtB5fYByDq14YICcdVaANI%3D What is FISCAL Policy?

  3. Fiscal Policy Spending – where does it all go? http://www.nytimes.com/interactive/2012/02/13/us/politics/2013-budget-proposal-graphic.html

  4. HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND • Fiscal policy – taxing, spending, and borrowing • influences saving, investment, and growth in the long run. • In the short run, fiscal policy primarily affects the aggregate demand. • What are challenges to fiscal policy implementation?

  5. Changes in Government Purchases • There are two macroeconomic effects from the change in government purchases: • The multiplier effect • The crowding-out effect http://www.youtube.com/watch?v=H3nyc8XHrQc

  6. The Multiplier Effect • Government purchases are said to have a multiplier effect on aggregate demand. • Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.

  7. 2. . . . but the multiplier effect can amplify the shift in aggregate demand. $20 billion AD3 AD2 Aggregate demand, AD1 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion . . . Figure 4 The Multiplier Effect Price Level Quantity of 0 Output

  8. A Formula for the Spending Multiplier • The formula for the multiplier is: • Multiplier = 1/(1 –MPC) • An important number in this formula is the marginal propensity to consume (MPC). • It is the fraction of extra income that a household consumes rather than saves.

  9. A Formula for the Spending Multiplier • If the MPC = 3/4, then the multiplier will be: Multiplier = 1/(1 – 3/4) = 4 • In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

  10. The Crowding-Out Effect • Fiscal policy may not affect the economy as strongly as predicted by the multiplier. • An increase in government purchases causes the interest rate to rise. • What are the consequences of a higer interest rate?

  11. The Crowding-Out Effect • This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. • The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

  12. 4. . . . which in turn partly offsets the initial increase in 2. . . . the increase in $20 billion aggregate demand. spending increases money demand . . . r2 3. . . . which AD2 increases r the AD3 equilibrium M D2 interest rate . . . 1. When an increase in government purchases increases aggregate demand . . . Figure 5 The Crowding-Out Effect (a) The Money Market (b) The Shift in Aggregate Demand Price Interest Money Level Rate supply Aggregate demand, AD1 Money demand, MD Quantity Quantity 0 Quantity fixed 0 of Money of Output by the Fed http://www.youtube.com/watch?v=RGlt0nEQdRI&feature=plcp&context=C48ec1e6VDvjVQa1PpcFMdkWSNt1EsUByRZ_JiwOoaMf6ZO6WVkJM%3D

  13. Changes in Taxes • When the government cuts personal income taxes, it increases households’ take-home pay. • Households save some of this additional income. • Households also spend some of it on consumer goods. • Increased household spending shifts the aggregate-demand curve to the right.

  14. Changes in Taxes • The size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding-out effects. • It is also determined by the households’ perceptions about the permanency of the tax change.

  15. What are the Types of Taxes? • Proportional Taxes • A tax with a constant % paid regardless of income • Flat tax • Progressive Taxes • A tax where the % paid in taxes increases as income increases • U.S. Personal Income Tax • Regressive Taxes • The lower your income the higher % you pay in taxes • Sales Tax

  16. Proportional, regressive, or progressive?

  17. USING POLICY TO STABILIZE THE ECONOMY • Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946, which states that: • “it is the continuing policy and responsibility of the federal government to…promote full employment and production.”

  18. The Case for Active Stabilization Policy • The Employment Act has two implications: • The government should avoid being the cause of economic fluctuations. • The government should respond to changes in the private economy in order to stabilize aggregate demand. • What economic school of thought does this follow? Who would be against active stablization?

  19. The Case against Active Stabilization Policy • Some economists argue that monetary and fiscal policy destabilizes the economy. • Monetary and fiscal policy affect the economy with a substantial lag – rational expectations!!! • They suggest the economy should be left to deal with the short-run fluctuations on its own.

  20. Automatic Stabilizers • Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. • Automatic stabilizers include the tax system and some forms of government spending.

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