Chapter 16: Fiscal Policy

Tax Multiplier

(Change in equilibrium real GDP)/(Change in taxes) This number should be NEGATIVE

Government Purchases Multiplier

(Changes in equilibrium Real GDP)/(Changes in government purchases) This number should be POSITIVE

Relationship between tax and LRAS: Corporate Income Tax

*Encourage investment spending* by increasing the return corporations receive from new investment in equipment, factories, and office buildings. Can increase the pace of technological chagne

Influences of cuts in taxes on equilibrium real GDP

1. A cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending 2. A cut in tax rates increases the size of the multiplier effect

Sources of Revenue for the Federal Government Expenditure came from

1. Income taxes 2. Social insurance taxes 3. Corporate taxes 4. Other taxes/revenues

In 2012 the Federal Government Expenditure was spent on

1. Transfer Payments 2. Defense spending 3. Grants to state/local governments 4. Interest Rate payments 5. Other expenditures

Multiplier

1/1-MPC

Limits: Crowding out

An increase in government expenditure may lead to a decrease in private expenditures (as G increases, I/C decrease)

Fiscal Policy Actions that impact supply side

Attempt to increase aggregate supply by changing taxes to increase the incentives to work, save, invest, and start a business

Multiplier Effect on AD curve

Causes AD curve to shift right AD1 --> AD2 : Initial increase in government purchases AD2 --> AD3 : Multiplier effect results in a further shift

Fiscal Policy

Changed in federal taxes/government purchases that are intended to achieve macroeconomics goals

Why is the Tax Multiplier negative?

Changes in taxes and changes in real GDP move in opposite directions An increase in taxes reduces disposable income, consumption, and real GDP, and a decrease in taxes raises disposable income, consumption and real GDP

Crowding out in the long run

Complete crowding out: private expenditures have fallen by the same amount that government purchases have increased Decrease in C (more inventive to save), I (cost of borrowing increased), and NX offsets the increase in government purchases

Dividends

Corporations distribute some of their profits to shareholders in the form of payments

What does Fiscal Policy Exclude?

Does not include state or local government changes, taxes/spendings that are not intended to achieve macroeconomic goals

Multiplier: Effects of Aggregate Supply

Due to the upwards slope of the SRAS, when the AD curve shifts to the right, the price level will rise. As a result of this, equilibrium real GDP will not increase by the full amount that the multiplier effect indicates.

Multiplier: The effect works in both ways

EXP: Increased government purchases/decreased tax= positive multiplier effect on real GDP CONT: Decreased government purchases/increased tax= negative multiplier effect on real GDP

A cut in taxes (individual income tax and business income tax)

Has an INDIRECT effect on aggregate demand. Cutting the individual income tax will increase household disposable income and consumption spending. Cutting taxes on business income tax can increase aggregate demand by increasing business investment.

Federal Expenditures

Includes all government purchases + all other federal government spending

Capital Gaisn

Increase in the price of an asset (EX: stock)

Crowding out in the short run

Increased government expenditure will lead to an increase in the interest rate ---> Government Exp. Increase = Income/profit increase= money demanded increase ---> Money demanded increase = interest rate increase Higher interest rate will result in a decline in each component of private expenditures

Government expenditure trends

Increases during Cold War (1950s-1990s), decreases when the Cold War ended (1990s-2001), Increases during War on Terrorism (2001-2010)

Relationship between tax and LRAS: Individual Income Tax

Increases the quantity of labor supplied, *raises the return to entrepreneurship*, increases the return to saving

Contractionary Fiscal Policy

Involves decreasing government purchases or increasing taxes. Used to reduce increases in aggregate demand that seem likely to lead to inflation. As a result Real GDP and Price Level fall.

Expansionary Fiscal Policy

Involves increasing government purchases or decreasing taxes. Used to bring aggregate demand back to potential GDP and get out of recession. As a result Real GDP and Price Level rise.

Relationship between tax and LRAS: Taxes on dividends/capital gains

Lowering the tax rates on dividends and capital gains *INCREASES the supply of loanable funds* from households to firms, increasing saving and investment and lowering equilibrium interest rate

Government prucahses

Spending that the government receives a good/service in return EX: When the federal government purchases an aircraft carrier or services of an FBI agent

Spending before the great depression

State/local spending > Federal Spending

Limits: Timing Issues

Takes more time to pass changes in fiscal policy because it needs the Presidents and congress approval. After it has gotten approval it takes long for it to implement the policy (EX: construction)

Cyclically adjusted budget deficit or surplus

The deficit or surplus in the federal government's budget if the economy were at potential GDP

Tax Wedge

The difference between the pretax and the posttax return to an economic activity EX: Wage of $20 and tax of 25% $20-$15= $5 tax wedge

Discretionary Fiscal Policy

The government takes action to change spending or taxes. EX: Tax cuts Congress passed in 2008, 2009, 2010

Smaller the tax wedge for any economic activity

The more of that economic activity will occur EX: working, saving, investing or starting a bueinss

Multipier Effect

The series of induced increases (caused by initial autonomous spending increase) in consumption spending that results from an initial increase in autonomous expenditure (initial increase in government purchase)

The Limits of Fiscal Policy

Timing issues, crowding out

Budget Surplus

When expenditure < tax revenue

Budget Deficit

When expenditure > tax revenue

Increase in government purcahses

Will INCREASE aggregate demand DIRECTLY because government purchases are a component of aggregate demand

Multiplier: Effects of Tax Rate

The value of tax rate affects the size of the multiplier effect The higher the tax rate, the smaller the multiplier effect. If the tax rate is higher, then the smaller the amount of any increase in income that households have available to spend, which reduces the size of the multiplier effect.

Automatic Budget Surpluses and Deficits

Transfer payments can help stabilize an economy. When the economy moves into a recession, wages and profits fall, which reduces the taxes that households and firms owe the government. This keeps spending higher than it would have been.

Automatic Stabilizer

Types of government spending and taxes that automatically increases and decreases along with the business cycle; happens without government action EX: When economy is expanding and employment is increasing, government spending on unemployment insurance will decrease

Large budget deficits usually occur during...

Wars/recession when defense spending/expansionary fiscal policy increases