Chapter 16

Budget Surpluses

- A budget surplus occurs when the government's expenditures are less than its tax revenue.

Crowding out in the Long Run

- In the long run, the increase in government purchases will have no effect on real GDP; the reduction in consumption, investment, and net exports will exactly offset the increase in government purchases. - The long run effect is simply to increase the size of the government sector within the economy.

one-time tax rebates

- increase consumption spending by less than a permanent tax cut because they increase current income

government purchases is included in _______________

government expenditures

government purchases multiplier

(change in equilibrium real GDP)/ (Change in government purchases)

tax multiplier

(change in equilibrium real GDP)/ (Change in taxes) - the tax multiplier will be a negative number: an increase in taxes will decrease equilibrium real GDP, and vice versa. - we expect the tax multiplier to be smaller than the government purchases multiplier.

Budget Deficits

- A budget deficit occurs when the government's expenditures are greater than its tax revenue. - Occur during wartime and during recessions. As tax receipts fall, and automatic stabilizers like increases in transfer payments take effect.

Crowding out in the short run - money market

- A temporary increase in government purchases will cause the demand for money, and hence the interest rate, to rise. With the higher interest rate, consumption, investment, and net exports all fall.

Aggregate Demand and the Multiplier Effect

- if the government increases its spending on goods and services, then aggregate demand increases immediately. This is the autonomous increase in aggregate demand. - but then people receive this increased spending as increased income and increase their consumption spending accordingly. This is the induced increase in aggregate demand. - the series of induced increases in consumption spending that results from the initial increase in autonomous expenditures is known as the multiplier effect. - An increase in government purchases and a cut in taxes have a positive multiplier effect. - A decrease in government purchases and an increase in taxes have a negative multiplier effect - the higher the tax rate, the smaller the multiplier effect.

decreases in tax rates

- increasing the disposable income of households, leading them to increase their consumption spending. - increasing the size of the multiplier effect, since more of any increase in income becomes disposable income.

contractionary fiscal policy in the AD-AS model

- involves decreasing government purchases or increasing taxes. This is like the reverse of expansionary fiscal policy.

permanent income

- reflects consumers expected future income

current income

- reflects current disposable income

Crowding out in the short run- AD-AS Model

- A temporary increase in government purchases will cause the demand for money, and hence the interest rate, to rise. With the higher interest rate, consumption, and net exports all fall. - So the initial increase in spending is partially offset by the crowding out.

dynamic AS and AD model

- Congress and the president can use fiscal policy to affect real GDP and the price level

the posttax wage

- When an individual decides how much to work, he bases the decision on how much an hour of work will increase his ability to consume goods and services

discretionary fiscal policy

- the intentional actions the government takes to change spending or taxes.

Tax Simplification

- A simplified tax code would increase economic efficiency by reducing the number of decisions households and firms make solely to reduce their tax payments.

Cyclically adjusted budget deficit or surplus

- Cyclically adjusted budget deficit or surplus: the deficit or surplus in the federal governments budget if the economy were at potential GDP. This is the amount that spending needs to be cut, or taxes raised, in order to bring the federal budget into balance in the long run. The rest is due to autonomic stabilizers.

The Effect of the Stimulus on the Federal Budget

- In 2009, Congress passed the "stimulus package", a combination of increased government spending (about 2/3) and also decreased taxes (about 1/3) - The effect of the stimulus package on federal expenditures and revenue was not immediate, but mostly occurred over the following two years. - They expected real GDP and employment to rise, but GDP increased and employment fell.

Contractionary Fiscal Policy in the Dynamic AD-AS Model

- the federal government projects that aggregate demand will rise so much that employment is beyond the full-employment level causing high inflation. It enacts a contractionary fiscal policy to decrease aggregate demand, again ideally to the full employment level.

where does the federal government get money from?

- the majority of federal revenues come from taxes on individual employment: individual income taxes and "payroll taxes" earmarked to fund Social Security and Medicare. - taxes on corporate profits constitute about 1/7th of federal receipts. - the remainder of federal revenue comes from excise taxes, tariffs on imports, and other fees from firms and individuals.

liquidity constrained

- the spending of this type of consumer is more likely to depend on their current income

the pretax wage

- when a firm decides how many people to employ, it considers how much it has to pay in total for each worker

increase in aggregate demand

- will not only result in real GDP rising; it will also result in a price level increase, because the short-run aggregate supply curve is upward-sloping.

Expansionary Fiscal Policy in the Dynamic AD-AS Model

- the federal government projects that aggregate demand will not rise by enough to maintain full employment. It enacts as an expansionary fiscal policy to increase aggregate demand, hopefully to the full employment level. - the price level is higher than it would have been without expansionary fiscal policy.

Can we use fiscal policy to stabilize the economy?

- Timing fiscal policy is harder due to - Legislative delay: congress needs to agree on the actions - Implementation delay: large spending projects may take months or even years to begin, even once approved. - Government might crowd out private spending

Federal Government Debt

- When the federal government runs a budget deficit, it finances its activities by selling Treasury securities. The total value of those securities outstanding is known as the federal government debt, or the national debt. - The national debt increased dramatically during the first two worlds wars and the two worst recessions. - In the long run, a debt that increases in size relative to GDP can pose a problem. This problem is reduced if the government debt was incurred to finance infrastructure, education, or research and development; these serve as a long term investment for the economy.

How large are Supply-side effects?

- While decreasing tax rates would likely result in more economic activity, the magnitude of the effect is debatable - Workers may not be able to change their work hours very much - Savings and investment may not be affected much by tax rates - The majority of the effect of tax rate cuts may come through aggregate demand.

crowding out

- a decline in private expenditures as a result of an increase in government purchases.

Individual income tax

- affects labor supply decisions and the returns to entrepreneurship - cutting the individual income tax reduces the tax wedge and increases the quantity of labor supplied.

Corporate income tax

- affects the incentives of firms to engage in investment - cutting the corporate income tax can increase the return to investment and innovation and can increase the pace of technological change

Tax on dividends and capital gains

- affects the supply of loanable funds from households to firms, and hence the real interest rate, and also affects the way firms disburse profits. - lowering taxes on capital gains and dividends paid to stockholders increases the supply of loanable funds and increases savings and investment. It also lowers the equilibrium real interest rate.

how much government spending is federal?

- before the Great Depression, most government spending was at the state or local level; now the federal government's share is two-thirds to three-quarters.

fiscal policy

- changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth.

how does a budget deficit act as an automatic stabilizer and reduce the severity of a recession?

- consumers spend more than they would in the absence of social insurance programs, like unemployment. - during recessions, tax obligations fall due to falling wages and profits. - transfer payments to households increase.

what does the federal government spend money on?

- defense spending, salaries of FBI agents, operating national parks, and funding scientific research - around half of federal expenditures are spend on transfer payments, like Social Security, Medicare, and unemployment insurance. - the rest is spend of grants to state and local governments to support their activities, like crime prevention and education; and on paying interest on the federal debt.

federal expenditures as a percent of GDP

- federal expenditures is almost 25% of GDP - a smaller proportion is now spent on government purchases of goods and services (mostly on military spending)

what are the gains from simplifying the tax code?

- greater clarity of the decisions made by households and firms. - resources from the tax preparation industry freed up for other endeavors - increased efficiency of households and firms.

when would the government enact contractionary fiscal policy?

- if the government believes real GDP will be above potential GDP, it can enact contractionary fiscal policy in an attempt to restore long run equilibrium, decreasing inflation.

when would the government enact expansionary fiscal policy?

- if the government believes real GDP will be below potential GDP, it can enact expansionary fiscal policy in an attempt to restore long-run equilibrium, decreasing unemployment.

expansionary fiscal policy in the AD-AS model

- involves increasing government purchases or decreasing taxes. - Increasing government purchases directly increases aggregate demand. - Decreasing taxes indirectly affects aggregate demand by increasing disposable income, and hence consumption spending.

automatic stabilizers

- some forms of government spending and taxes automatically increase of decrease along with the business cycle

tax wedge

- the difference between pretax and posttax return to an economic activity. - A large tax wedge distorts the incentives of individuals and firms to take part in economic activities, generally resulting in lower levels of economic activity, lower real GDP.