Chapter 13 Summary

Objective #5.

A change in government spending is an example of an autonomous change in aggregate spending. Holding the price level constant, this change in autonomous aggregate spending will change GDP by an amount equal to the multiplier times the change in autonomous aggregate spending. Recall that the multiplier in our simple model equals 1/(1 − MPC).

Objective #6.

A change in taxes or government transfers of a given size shifts the AD curve by less than an equal-sized change in government purchases. A decrease in taxes or increase in transfers will increase GDP by $MPC/(1 − MPC) times the change in taxes (measured in absolute value terms) or the change in transfers; an increase in taxes or a decrease in transfers will decrease GDP by $MPC/(1 − MPC) times the change in taxes or the change in transfers (measured in absolute value terms).

Objective #8.

Discretionary fiscal policy refers to fiscal policy that is the direct result of policy action by policymakers. It does not refer to automatic adjustment in the economy that occurs because of automatic stabilizers.

Objective #1.

Discretionary fiscal policy refers to the use of government spending or tax policy to manage aggregate demand (AD). Discretionary fiscal policy may be used to stimulate or contract AD.

Objective #2.

Government collects funds in the form of taxes and government borrowing and then uses these funds to make government purchases of goods and services and government transfers to individuals. Total government spending includes government expenditure on goods and services as well as government expenditure on transfer payments. • The three most expensive transfer programs in the United States are Social Security, Medicare, and Medicaid. • Social insurance refers to government programs aimed at protecting families against economic hardship.

Objective #7.

Holding everything else constant, when GDP increases, government tax revenue automatically increases. The effect of this automatic increase in government tax revenue when GDP rises is to reduce the size of the multiplier. • When the economy slows down and GDP falls, the automatic fall in government tax revenue acts like an automatic expansionary fiscal policy implemented in the face of the recession. • When the economy expands, the automatic increase in government tax revenue acts like an automatic contractionary fiscal policy implemented in the face of the expansion. • Government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands are referred to as automatic stabilizers since they act to automatically stabilize the economy. • Examples of automatic stabilizers include taxes, unemployment insurance benefits, Medicaid, and food stamps. Transfer programs as well as taxes can act as automatic stabilizers.

Objective #15.

Implicit liabilities are promises made by governments that represent debt not included in the government's debt statistics. In the United States, the largest implicit liabilities are Social Security, Medicare, and Medicaid. • Spending on Social Security is projected to rise dramatically over the next few decades due to demographic issues related to the retirement of the baby boomer generation. • Spending on Medicare and Medicaid is also projected to rise dramatically primarily because long-run health care spending increases faster than overall spending. • Both Social Security and Medicare are funded from dedicated taxes, a special tax levied on wages. At the time of this writing, there is a surplus of tax revenue from these dedicated taxes. For example, the surplus funds of Social Security are held in a Social Security Trust Fund. The funds in these trust funds are owed to the Social Security system and other trust funds by another part of the government; this debt is referred to as the United States government debt held by Social Security and other trust funds. The gross debt for the U.S. government thus consists of two parts: first, the public debt, and second, the United States government debt held by Social Security and other trust funds.

Objective #4.

Important lags exist in the use of fiscal or monetary policy. These lags include the time necessary for the government to realize the need for policy intervention, the time necessary for the government to develop policy, and the time necessary for the government to implement the policy and have the policy take effect. The existence of lags makes the use of fiscal policy and monetary policy to correct economic fluctuations more challenging than our simple analysis suggests.

Objective #13.

In the United States, government budget totals are kept for the fiscal year that starts on October 1 and runs through September 30. For example, fiscal 2008 began on October 1, 2007, and ended on September 30, 2008.

Objective #11.

Most economists do not endorse legislation requiring that the government maintain a balanced budget, since this type of rule would undermine the role of taxes and transfers as automatic stabilizers.

Tip #2.

Two multipliers are presented and used in this chapter: the multiplier for a change in government spending and the multiplier for a change in taxes. The multiplier for a change in government spending equals 1/(1 − MPC), while the multiplier for a change in taxes equals [−MPC/(1 − MPC)]. For example if the MPC equals 0.8, then the multiplier for a change in government spending is equal to 5, while the multiplier for a change in taxes is equal to −4. A $1 increase in government spending will increase aggregate output by $5, holding everything else constant, while a $1 increase in taxes will decrease aggregate output by $4, holding everything else constant. Make sure you work some problems using these multipliers and that you understand why they do not have equivalent values. Also, spend time thinking about why the multiplier for government spending is positive while the multiplier for a change in taxes is negative. An increase in government spending represents an increase in the level of spending in the economy and will stimulate aggregate production, while an increase in taxes reduces the level of spending in the economy and will therefore contract aggregate production.

Objective #12.

When governments spend more than their tax revenue, they usually borrow the extra funds needed. Governments that run persistent deficits find that they have a rising government debt. • A government deficit is the difference between the amount of money a government spends and the amount of money the government receives in taxes over a given period of time. • A government debt is the sum of money a government owes at a particular point in time. • The public debt refers to the government debt held by individuals and institutions outside the government at a particular point in time. • When the government runs persistent budget deficits, it competes with firms that plan to borrow funds for investment spending. The government borrowing may crowd out private investment spending and lead to a reduction in the economy's long-run growth rate. • When the government runs persistent budget deficits, this leads to financial pressure on future budgets due to the increasing size of the interest payments on the accumulated debt. Holding everything else constant, a government that owes large amounts in interest must raise more revenue from taxes or spend less. • Governments that print money to pay their bills find that this leads to inflation. • The long-run effects of persistent budget deficits suggest that governments should run a budget that is approximately balanced over time.

Tip #5.

You will want to understand what the cyclically adjusted budget balance is and how it relates to the budget balance and to potential GDP. The cyclically adjusted budget balance is an estimate of what the budget balance would be if real GDP were exactly equal to potential GDP. This measure takes into account the extra tax revenue the government would receive and the smaller level of transfer payments the government would make if the recessionary gap were eliminated or the tax revenue the government would lose and the extra transfer payments the government would make if the inflationary gap were eliminated. The cyclically adjusted budget balance fluctuates less than the actual budget deficit, because years with a large budget deficit are typically associated with large recessionary gaps.

cyclically adjusted budget balance

an estimate of what the budget balance would be if real GDP were exactly equal to potential output.

expansionary fiscal policy

fiscal policy that increases aggregate demand by increasing government purchases, decreasing taxes, or increasing transfers.

discretionary fiscal policy

fiscal policy that is the direct result of deliberate actions by policymakers rather than rules.

contractionary fiscal policy

fiscal policy that reduces aggregate demand by decreasing government purchases, increasing taxes, or decreasing transfers.

debt-GDP ratio

government debt as a percentage of GDP, frequently used as a measure of a government's ability to pay its debts.

public debt

government debt held by individuals and institutions outside the government.

social insurance

government programs—like Social Security, Medicare, unemployment insurance, and food stamps—intended to protect families against economic hardship.

automatic stabilizers

government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands without requiring any deliberate actions by policymakers. Taxes that depend on disposable income are the most important example of automatic stabilizers.

implicit liabilities

spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics. In the United States, the largest implicit liabilities arise from Social Security and Medicare, which promise transfer payments to current and future retirees (Social Security) and to the elderly (Medicare).

lump-sum taxes

taxes that don't depend on the taxpayer's income.

fiscal year

the time period used for much of government accounting, running from October 1 to September 30. Fiscal years are labeled by the calendar year in which they end.

Objective #9.

Recall that the budget balance equals tax revenue minus government spending on both goods and services as well as government transfers. We can write the budget balance, SGovernment, symbolically as SGovernment = T − G − TR. • A positive budget balance indicates a budget surplus, while a negative budget balance indicates a budget deficit. • Holding everything else constant, discretionary expansionary fiscal policy reduces the budget balance, while discretionary contractionary policy increases the budget balance. • Equal-sized changes in government spending or taxes impact the budget balance equally, but have very different impacts on AD due to the multiplier effect of a change in government spending being greater than the multiplier effect of an equal sized change in government taxes or transfers. • Changes in the budget balance often are the result of economic fluctuations.

Tip #3.

Review the distinction between fiscal policy that is discretionary versus fiscal policy that reflects the impact of automatic stabilizers.

Objective #16. [From Appendix]

Taxing income at a tax rate t allows us to model a macroeconomy where taxes increase as the level of aggregate output increases. The inclusion of this tax rate alters the multiplier for a change in autonomous spending from 1/(1 − MPC) to 1/[1− MPC(1 − t)]. This new multiplier will have a smaller value than the original multiplier for a given MPC.

Objective #3.

The basic equation of national income accounting, GDP = C + I + G + X −IM, reminds us that government purchases of goods and services (G) has a direct impact on total spending in the economy. The government also affects D through changes in taxes and transfers, and it may affect I through government policy. • Increases in taxes, holding everything else constant, reduce disposable income and consumer spending. Decreases in taxes, holding everything else constant, increase disposable income and consumer spending. • Increases in government transfer payments, holding everything else constant, increase disposable income and consumer spending. Decreases in government transfer payments, holding everything else constant, decrease disposable income and consumer spending. • Government can impact the incentives to engage in investment spending through changes in tax policy. • The government can use changes in taxes or government spending to shift the AD curve. Holding everything else constant, AD shifts to the right with increases in government spending, decreases in taxes, or increases in government transfers; AD shifts to the left with decreases in government spending, increases in taxes, or decreases in government transfers. • When the country faces a recessionary gap, aggregate output is less than potential output: use of expansionary fiscal policy will shift AD to the right to help eliminate the gap between actual and potential GDP. • When an economy faces an inflationary gap, aggregate output is greater than potential output: use of contractionary fiscal policy will shift AD to the left to help eliminate the gap between actual and potential GDP.

Objective #10.

The cyclically adjusted budget balance estimates the size of the budget balance if real GDP was exactly equal to potential output. It effectively eliminates the impact of recessionary or inflationary gaps on tax revenue and government transfers.

Objective #14.

The debt-GDP ratio is a measure used to assess the ability of governments to pay their debt. The debt-GDP ratio measures government debt as a percentage of GDP. This measure recognizes that the size of the economy as a whole, as measured by GDP, provides information about the amount of potential taxes a government can collect. When GDP grows at a faster rate than the rate of growth of the government's debt, then the burden of paying the debt is falling relative to the government's ability to collect tax revenue. • The debt-GDP ratio can fall even when debt is rising provided that GDP grows faster than debt. • The debt-GDP ratio will rise when debt is rising if GDP grows more slowly than debt.

Tip #4.

The use of the multiplier thus far in our models presumes a horizontal SRAS. If the SRAS is upward sloping, then the impact on aggregate output will be smaller than that predicted by the multiplier. Essentially this tip should remind you that a horizontal SRAS implies a fixed price level, while an upward-sloping SRAS implies that the aggregate price level is not fixed. A shift in AD due to a change in autonomous spending or taxes will cause a larger change in aggregate output (and a change equal to the amount predicted by the multiplier effect) if the aggregate price level is constant than if the aggregate price level is allowed to change. Let's look at a diagram of this represented in Figure 13.1.AD1 is our initial AD curve; SRAS1 is the short-run aggregate supply curve if the aggregate price level is held constant, and SRAS2 is the short-run aggregate supply curve if the aggregate price level is allowed to vary in the short run. Initially the economy is at point E1, producing Y1 at an aggregate price level P1. When autonomous aggregate spending increases, this shifts AD1 to AD2, and the horizontal distance Y1 to Y3 measures the multiplier effect on aggregate output (moving from the initial equilibrium E1 to the new equilibrium E3). However, given SRAS2 a rightward shift in AD from AD1 to AD2 increases output from Y1 to Y2 while simultaneously increasing the aggregate price level from P1 to P2 (moving from the initial equilibrium E1 to the new equilibrium E2).

Tip #1.

This chapter contains some new vocabulary. You need to be familiar with these concepts, including the government deficit, government debt, implicit liabilities, and the debt-GDP ratio. As in the other chapters it is essential that you learn and understand any new terms that are introduced. Many of the terms in this chapter represent complicated concepts or relationships.