Fiscal Policy

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Taxes and Spending. In 1902, the federal government employed fewer than 350,000 people and spent about $650 million.Today, the federal government employs over 4 million and spends over $ 2 trillion.. Government Revenue. Government expansion started with the 16th Amendment to the U.S. Constitution (

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Fiscal Policy

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1. Fiscal Policy Chapter 11

2. Taxes and Spending In 1902, the federal government employed fewer than 350,000 people and spent about $650 million. Today, the federal government employs over 4 million and spends over $ 2 trillion.

3. Government Revenue Government expansion started with the 16th Amendment to the U.S. Constitution (1913) which extended the taxing power to incomes. Today, the federal government collects over $2 trillion a year in tax revenues.

4. Government Expenditure Government spending directly affects aggregate demand. Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

5. Purchases vs. Transfers Government purchases are part of aggregate demand, income transfers are not. Income transfers are payments to individuals for which no current goods or services are exchanged.

6. Fiscal Policy The federal government can alter aggregate demand by:

7. Fiscal Policy From a macro perspective, the federal budget is a tool that can change aggregate demand and macroeconomic outcomes.

8. Fiscal Policy

9. Fiscal Stimulus Suppose the economy is experiencing a recessionary GDP gap of $400 billion. The recessionary GDP gap is the difference between full-employment GDP and equilibrium GDP.

10. The Policy Goal

11. Keynesian Strategy From a Keynesian perspective, the way out of recession is to get someone to spend more on goods and services. A fiscal stimulus is tax cuts or spending hikes intended to increase (shift) aggregate demand.

12. Keynesian Strategy Two strategic policy questions must be answered:

13. The Fiscal Target If GDP gap is $400 billion, why not just increase AD by that much?

14. The Naive Keynesian Model An increase in AD by $400 billion will achieve full employment in the naive Keynesian policy. An increase in aggregate demand by the amount of the GDP gap will achieve full employment only if the aggregate supply curve is horizontal.

15. Price Level Changes When the AD curve shifts to the right, the economy moves up the AS curve, not horizontally to the right. Both real output and prices change.

16. Price Level Changes Shifting (increasing) aggregate demand by the amount of the GDP gap will achieve full employment only if the price level doesnít rise.

17. The AD Shortfall So long as the AS curve slopes upward, AD must increase by more than the size of the recessionary GDP gap to achieve full employment.

18. The AD Shortfall The AD shortfall is the amount of additional aggregate demand needed to achieve full employment after allowing for price level changes. The AD shortfall is the fiscal target.

19. The AD Shortfall

20. More Government Spending Increased government spending is a form of fiscal stimulus.

21. Multiplier Effects Every dollar of new government spending has a multiplied impact on aggregate demand.

22. Multiplier Effects How much of a boost the economy gets depends on the value of the multiplier.

23. Multiplier Effects The total spending change equals the multiplier times the new spending injections.

24. Multiplier Effects The impact of fiscal stimulus on aggregate demand includes the new government spending plus all subsequent increases in consumer spending triggered by the additional government outlays:

25. Multiplier Effects

26. The Desired Stimulus The general formula for computing the desired stimulus is a simple rearrangement of the earlier formula:

27. Tax Cuts By lowering taxes, the government increases the disposable income of the private sector. Disposable income is the after-tax income of consumers; personal income less personal taxes.

28. Taxes and Consumption Tax cuts directly increase the disposable income of consumers. The amount consumption increases depends on the marginal propensity to consume.

29. Taxes and Consumption A dollar of tax cut is less stimulative than a dollar increase in government purchases.

30. Taxes and Consumption An AD shortfall can be closed with a tax cut.

31. The Tax Cut Multiplier

32. Taxes and Investment A tax cut may also be an effective mechanism for increasing investment spending. Tax cuts have been used numerous times to stimulate the economy.

33. Increased Transfers Increasing transfer payments stimulates the economy. The initial fiscal stimulus of increased transfer payments is:

34. Fiscal Restraint There are times when the economy is expanding too fast and fiscal restraint is more appropriate. Fiscal restraint is using tax hikes or spending cuts intended to reduce (shift) aggregate demand.

35. The Fiscal Target The AD excess is the amount by which aggregate demand must be reduced to achieve price stability after allowing for price-level changes. The AD excess exceeds the GDP gap.

36. The Fiscal Target The first task is to determine how much AD needs to fall:

37. Excess Aggregate Demand

38. Budget Cuts Budget cuts reduce government spending and induces cutbacks in consumer spending.

39. Tax Hikes Tax hikes can be used to shift the AD curve to the left. The direct effect of tax increases is a reduction in disposable income.

40. Tax Hikes Taxes must be increased more than a dollar to get a dollar of fiscal restraint.

41. Reduced Transfers A cut in transfer payments works like a tax hike, reducing the disposable income of transfer recipients. The desired reduction in transfers is the same as a desired tax increase.

42. Fiscal Guidelines The essence of fiscal policy is the deliberate shifting of the aggregate demand curve.

43. A Primer: Simple Rules The steps required to formulate fiscal policy are: Specify the amount of the desired AD shift. Select the policy tools needed to induce the desired shift.

44. Fiscal Stimulus

45. Fiscal Restraint

46. A Warning: Crowding Out Some of the intended fiscal stimulus may be offset by the crowding out of private investment expenditure. Crowding out is a reduction in private-sector borrowing (and spending) caused by increased government borrowing.

47. Time Lags It takes time to recognize that a problem exists and then formulate policy to address the problem. The very nature of the macro problems could change if the economy is hit with other internal or external shocks.

48. Pork-Barrel Politics Members of Congress want their constituents to get the biggest tax savings. They donít want spending cuts in their own districts. They donít want a tax hike or spending cut before the election.

49. Fiscal Policy End of Chapter 11

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