Chapter 12

Countercyclical Fiscal Policy

*Problem*: Recession *Type of Policy*: Expansionary *Actions by Congress and President*: Increase government spending or cut taxes *Result*: Real GDP and the price level rise. *Problem*: Rising Inflation *Type of Policy: Contractionary *Actions by congress and President: Decrease government spending or raise taxes *Result: Real GDP and the price level fail

How do the multipliers work in north directions:

- Increases in gov't purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP - Decreases in gov't purchases and increases in taxes also have a multiplier effect on the equilibrium real GDP, but in this case, the effect is negative. - We look more closely at the gov't purchases multiplier and the tax multiplier in the appendix to this chapter

The two main reasons why getting the timing right can be more difficult with fiscal than monetary policy:

- The delays caused by the legislative process can be very long - Even after a change in the fiscal policy has been approved, it takes time to implement the policy.

Federal Gov't Expenditures '11-'12

-Canada Health Transfer 10% -Debt Charges 11% -Nonhealth transfers to other levels of gov't 11% -Defence and public safety 12% -Other Transfers 13% -Government operations 18% -Transfers to persons 25%

Federal Gov't Revenue 2012

-Personal Income tax 49% -GST 11% -Corporate Income tax 13% -Sales of goods and services $ crown corporations 11% -EI premiums 8% -Other taxes 8%

Contraditionary Fiscal Policy

-shifts aggregate demand curve to the left -involves decreasing government purchases or increasing taxes -Policymakers use contractionary fiscal policy to reduce increases in aggregate demand that seem likely to lead to inflation

*** APPLY THE MULTIPLIER EFFECT!

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A cut in tax rates affects equilibrium real GDP through two channels:

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

Expansionary and Contractionary fiscal policy ignores two important facts about the economy:

1). The economy experiences continuing inflation, with the price level rising every year. 2). The economy experiences long-run growth, with the LRAS curve shifting to the right every year. A dynamic aggregate demand and aggregate supply model takes these two facts into account, providing us with a more complete understanding of fiscal policy.

What are the 2 reasons that government spending has been declining for the past 50+ years

1). The federal gov't has been delegating the administration of certain responsibilities to provincial and territorial agencies (ex. the regulation of interprovincial and international highway traffic, and the management of forestry and natural resources). 2). The importance of health care in the budgets of other levels of gov't has grown.

Crowding out

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

The Multiplier Effect and Aggregate Demand

An initial 10 billion increase in gov't purchases shifts the aggregate demand curve to the right by 10 billion and the multiplier effect results in an even further shift

The Multiplier Effect and Aggregate Supply

An initial increase in government purchases combined with the multiplier effect shifts the AD curve to the right. Because the SRAS curve is upward sloping real GDP and the price level are both higher in the new equilibrium.

Crowding Out in the Short Run: An Expansionary Fiscal Policy Increases Interest Rates

As real GDP and income rise, the demand for money increases causing the equilibrium interest rate to rise.

Individual income tax

As we've seen, reducing the marginal tax rates on individual income will reduce the tax wedge faced by workers, thereby increasing the quantity of labour supplied.

Budget Deficit and Budger Surplus

Budget deficit: The situation in which the government's expenditures are greater than its tax revenue. Budget surplus The situation in which the government's expenditures are less than its tax revenue.

Fiscal Policy

Changes in federal taxes & purchases that are intended to achieve macroeconomic policy objectives.

Taxes on dividends and capital gains

Corporations distribute some of their profits in the form of payments known as dividends to shareholders, who may benefit from higher corporate profits by receiving capital gains, which are increases in the prices of assets. 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 the equilibrium real interest rate.

Deficits occur automatically during recessions for two reasons

During a recession, wages and profits fall, causing government tax revenues to fall. The government automatically increases its spending on transfer payments when the economy moves into recession.

The Effect of Crowding out in the short tun

Expansionary fiscal policy causes the AD curve to shift tot the right. Decrease in AD due to crowding out.

Government Purchases Multiplier: Tax Multiplier:

Gov't Purchases = (Change in equilibrium real GDP)/(Change in government purchases) Tax Multiplier = (Change in equilibrium real GDP) / (Change in Taxes) ** Tax multiplier is a negative number

Key idea of Fiscal Policy

Government can use fiscal policy to affect aggregate demand, thereby changing the price level and the level of real GDP.

Automatic Stabilizers

Government spending and taxes that automatically increase or decrease along with the business cycle.

Tax Simplification

In addition to the potential gains from cutting individual taxes, there are also gains from tax simplification. If the tax code were greatly simplified, the economic resources currently used by the tax preparation industry would be available to produce other goods and services. In addition to wasting resources, the complexity of the tax code may also distort the decisions made by households and firms. A simplified tax code would increase economic efficiency by reducing the number of decisions households and firms make solely to reduce their tax payments.

The Economic Effect of a Tax Reform

Increase in LRAS without changes, Additional increase in LRAD because tax changes, all moves to RIGHT

Should the Federal Budget Always be balanced?

Many ecumenists believe that it is a good idea for the federal government to have a balanced budget when the economy is at potential GDP. But few economists believe that the federal government should attempt to balance its budget every year because it might have to take actions that would destabilize the economy. Some economists argue that the federal government should normally run a deficit, even at potential GDP

How Large Are Supply-Side Effects?

Most economists would agree that there are supply-side effects to reducing taxes: decreasing marginal income tax rates will increase the quantity of labour supplied, cutting the corporate income tax will increase investment spending, and so on. The magnitude of the effects is the subject of considerable debate, however. Economists who are skeptical of their magnitude believe that tax cuts have their greatest effect on aggregate demand rather than on aggregate supply. Ultimately, the debate over the size of the supply-side effects of tax policy may subside over time as more studies are conducted on the effects of differences in tax rates on labour supply and on saving and investment decisions.

What does the expansionary fiscal policy do to aggregate demand curve

Shift to the right. Involves increasing government purchases or decreasing taxes - Cutting the individual income tax will increase household disposable income, the income households have available to spend after they have paid their taxes, and consumption spending.

Tax Wedge

The difference between the pretax and posttax return to an economic activity. The tax wedge applies to the marginal tax rate, which is the fraction of each additional dollar of income that must be paid in taxes. When workers, savers, investors, or entrepreneurs change their behaviour as a result of a tax change, economists say that there has been a behavioural response to the tax change. We next look briefly at the effects on aggregate supply of cutting some common taxes.

The Federal Government Debt, 1967-2012

The federal government debt increases whenever the federal government runs a budget deficit. The large deficits of the 1980s and 1990s increased the debt significantly. The debt actually began to fall in the 2000s as the federal government brought budget deficits down and began to run budget surpluses. This trend continued until 2009, when Canada's Economic Action Plan was launched.

The Federal Budget Deficit, 1967-2012

The federal government has run a budget deficit for most of the past 50 years. The federal budget balance tends to be more in deficit when the economy is in recession, and the deficit tends to be smaller when the economy is doing well. You should note that the federal government changed its accounting standards in fiscal year 1983-1984, which makes comparisons between years before 1983 to later years suspect.

Is Government Debt a Problem?

The federal government is not in danger of defaulting on its debt because it can raise the funds it needs through taxes or spending cuts to make the interest payments on the debt, which are currently about 11 percent of total federal expenditures. If an increasing debt drives up interest rates, crowding out of investment spending may occur, which means a lower capital stock in the long run and a reduced capacity of the economy to produce goods and services. This effect is somewhat offset if some of the government debt was incurred to finance improvements in infrastructure, such as bridges, highways, and ports; to finance education; or to finance research and development.

Corporate income tax

The federal government taxes the profits earned by corporations under the corporate income tax. Cutting the marginal corporate income tax rate would encourage investment spending by increasing the return corporations receive from new investment goods, potentially increasing the pace of technological change if innovations are embodied in these goods.

Federal Government Expidentures

The federal government's share of government spending has been falling for the past 50-plus years. Like other levels of government, the federal government has been spending an increasing amount on health care over the past 20 years.

More.. Crowding Out in the Long Run

The long-run effect of a permanent increase in government spending is complete crowding out, where the decline in investment, consumption, and net exports exactly offsets the increase in government purchases, and aggregate demand remains unchanged. In the long run, the economy returns to potential GDP. An expansionary fiscal policy doesn't have to cause complete crowding out in the short run. If the economy is below potential GDP, it is possible for both government purchases and private expenditures to increase. But in the long run, and permanent increase in government purchases must come at the expense of private expenditures.

Multiplier effect

The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures.

Does Government Spending Reduce Private Spending?

The size of the multiplier effect may be limited if the increase in government purchases causes one of the nongovernment, or private, components of aggregate expenditures—consumption, investment, or net exports—to fall.

What does this table (countercyclical fiscal policy) do:

The table isolates the effect of fiscal policy by holding constant monetary policy and all other factors affecting the variables involved. In other words, we are again invoking the ceteris paribus condition. A contractionary fiscal policy causes the price level to rise by less than it would have without the policy.

Federal Government debt

The total value of bonds outstanding, which is equal to the sum of past budget deficits.

Contractionary fiscal policy

involves decreasing government purchases or increasing taxes

Expansionary fiscal policy

involves gov't purchases or decreasing taxes