Royal School of Administration

Chapter 11: Fiscal Policy in

the Short Run

Lectured by: HE (Dr.) MAM AMNOT

Group 9:

1. Chek Rasy 2. Chuop Theot Therith

3. Eath Sovanara 4. Hang Kakdareasey

5. Srun Sreyneang 6. Uon Ratha

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Learning Objectives:

1. Explain the goals and tools of fiscal policy

2. Distinguish between automatic stabilizers and discretionary fiscal policy and understand how the budget deficit is measured

3. Use the IS/MP model to understand how fiscal policy affects the economy in the short run

4. Use the IS/MP model to explain the challenge to using fiscal policy effectively

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Objective I:

Explain the goals

and tools of fiscal policy

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• What is Fiscal Policy?

Fiscal Policy refers to changes the federal government makes in taxes, purchases of goods and services, and transfer payments that are intended to achieve macroeconomic policy objective.

1. GOAL AND TOOLS OF FISCAL POLICY 1.1 Goal of Fiscal Policy (1)

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• Why government conduct Fiscal Policy?

Goals: The goal of fiscal policy is to reduce the severity

of macroeconomic fluctuation by increasing maximum:

1. employment 2. production 3. and purchasing power especially leaves

price stability

1.1 Goal of Fiscal Policy (2)

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1.1 Goal of Fiscal Policy (3)

• Who conduct this policy?

In US, the Fiscal Policy required an agreement between Congress and President.

Fed government makes many decisions about taxes and spending ,but not all of these decisions are fiscal policy actions because they are not intended to achieve macroeconomic goals.

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• How do the Fed government conduct this policy? Fiscal policy can affect the economy in the short-

run by causing changes in aggregate expenditure . A.E = C + I + G + NX Government used traditional and new tools of

fiscal policy that affect real GDP

1.2 Fiscal Policy Tools that affect Real GDP (1)

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Traditional tools (3):

(1) Government Purchase: goods and services

Government purchase goods and services increase in Government expenditure increase in aggregate expenditure increase in real GDP and employment.

(2) Taxes:

Change in taxes affects the consumption and investment component of aggregate expenditure.

1.2 Fiscal Policy Tools that affect Real GDP (2)

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(2) a. Consumption:

A decrease in the tax rate on personal income an increase in disposable income an increase in consumption an increase in AE an increase in real GDP and employment.

An increase in consumption taxes an increase in prices of consumption goods a decrease in consumption a decrease in aggregate expenditure a decrease in Real GDP and employment.

1.2 Fiscal Policy Tools that Affect Real GDP (3)

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(2) b. Investment

An increase in cooperate income taxes a decrease in the after-tax profitability of investment projects a decrease in aggregate expenditure a decrease in Real GDP an employment.

A decrease in corporate income taxes an increase the after-tax profitability of investment projects increase in aggregate expenditure a increase in Real GDP

1.2 Fiscal Policy Tools that Affect Real GDP (4)

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(3) Transfer Payment:

An increase in transfer payments an increase in disposable income an increase in consumption an increase in aggregate expenditure an increase in real GDP and employment.

1.2 Fiscal Policy Tools that Affect Real GDP (5)

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New tool:

• In October 2008, to deal with the financial recession, Congress passed the Troubled Asset Relief Program (TARP) to provided the Treasury and Fed with the $700 billion in funding to help market for mortgage-baked securities and other toxic asset in order to provide relief to financial that had trillion of dollars worth if these assets on their balance sheet.

• Is TARP a Fiscal Policy?

1.2 Fiscal Policy Tools that Affect Real GDP (6)

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• Expansionary fiscal policy is intended to increase real GDP and employment by increasing aggregate expenditure. It is used during the recession.

• Contractionary fiscal policy is intended to reduce increase in aggregate expenditure that seems likely to lead to inflation. It is used during inflation.

1.3 Type of Fiscal Policy

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Objective II:

Distinguish between automatic stabilizers and discretionary fiscal policy and understand how

the budget deficit is measured

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2. BUDGET DEFICIT DISCRETIONARY FISCAL POLICY AND AUTOMATIC STABILIZERS

Discretionary fiscal policy Automatic stabilizers

Government policy that involves deliberate change in taxes, transfer payments, or government purchase to achieve macroeconomic policy objectives.

Changes occur because the government decide to change current law to achieve macroeconomic policy objective.

Taxes, transfer payments, or government expenditures that automatically increase or decrease with business cycle.

Changes occur due to the effect of existing law.

Automatic stabilizers help to reduce the severity of business cycle by reducing the size of multiplier.

2.1 Discretionary Fiscal Policy and Automatic Stabilizers

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2.2 Budget Deficits/Surplus (1)

• Budget Deficits: The situation in which the government’s expenditure is greater than its tax revenue.

• Budget surplus: The situation in which the government’s expenditure is less than its tax revenue.

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2.2 Budget Deficits/Surplus (2)

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2.2 Budget Deficits/Surplus (3)

• Budget deficit/surplus happen automatically.

Economic expansion => (income, output, employment)↑ ⇒ T ↑ &TR ↓ => Budget deficit ↓ or Budget surplus ↑

• Any particular year, Budget deficit/surplus result from:

– Discretionary fiscal policy (cyclically adjusted budget deficit or surplus)

– The response of automatic stabilizer

Budget deficit= Cyclically adjusted budget deficit +

Effect of automatic stabilizers

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2.2 Budget Deficits/Surplus (4)

• Cyclically adjusted budget deficit or surplus:

– Measure what the deficit/surplus in the federal government would be if real GDP equaled potential GDP.

– Would exist if worker were fully employed.

• If Cyclically adjusted budget deficit Expansionary fiscal policy

• If Cyclically adjusted budget surplus Contractionary fiscal policy

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2.2 Budget Deficits/Surplus (5)

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2.2 Budget Deficits/Surplus (6)

• The deficit and the debt: Budget deficit Government sells bond/ securities gross federal debt held by the public.

– If debt becomes very large, the government may have to raise taxes to higher level or cut back on other types of spending.

– In long run, if an increasing debt raises interest rates, it leads to lower investment that reduce capital stock and production of goods and services.

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Objective III:

Use the IS/MP model to understand how fiscal policy affects the economy

in the short run

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3.1 Fiscal Policy and IS Curve

• Fiscal policy affects aggregate expenditure,

which causes the IS curve to shift as the

following figures.

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3. THE SHORT-RUN EFFECTS OF FISCAL POLICY

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3.2. Using Discretionary Fiscal Policy to fight a recession

• Many governments used discretionary fiscal

policy to try to reduce the severity of the 2007-

2009 economic downturn. For example,

President Obama signed the $814billion

American Recovery and Reinvestment Act into

law on February 17,2009. The act aims to

increase transfer payments and spending on

goods and services, to cut tax to households

and firms and aid to state and local

governments.

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Now we can use IS-MP model to analyze these effect

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• Automatic stabilizers is an immediate fiscal

policy response to a decline in aggregate

expenditure. This automatic fiscal response

reduces the adverse consequences of the initial

shock, so any given decrease in aggregate

expenditure has a smaller effect on real GDP

and employment.

• As the following figure shows the automatic

stabilizers at work in response to an increase in

uncertainty that leads to reduced investment

spending.

3.3 Automatic Stabilizers

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• How does it both relate? Why is it important?

• Recall, Multiplier? How does it affect to Y?

• Formula, 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = ∆𝑌

∆𝐼=

1

1− 1−𝑡 𝑀𝑃𝐶

Ex1: Tax Rate = 0 => ∆𝑌

∆𝐼=

1

1− 1−0 0.9= 10

Analysis, if ∆𝐼 = ±1 unit ⇒ ∆𝑦 = ±10 𝑢𝑛𝑖𝑡𝑠.

Ex2: Tax Rate = 20% => ∆𝑌

∆𝐼=

1

1− 1−0.2 0.9= 3.6

Analysis, if ∆𝐼 = ±1 unit ⇒ ∆𝑦 = ±3.6 𝑢𝑛𝑖𝑡𝑠 𝑜𝑛𝑙𝑦.

3.4 Personal Income Tax Rates and the Multiplier (1)

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As results:

• Multiplier effect: The process by which an initial

change in autonomous expenditure leads to a

larger change in equilibrium GDP.

• Gov’t can determine the size of multiplier by

reducing or increasing the tax rate. Tax rate and

Multiplier have negative relation due to its relation

in formula, 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = ∆𝑌

∆𝐼=

1

1− 1−𝑡 𝑀𝑃𝐶 .

3.4 Personal Income Tax Rates and the Multiplier (2)

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• How Tax Rates effects on 𝑌𝑃?

• The Tax Rates, here, will be discussed on:

(1) Individual Income Tax (IIT)

(2) Corporate Income Tax (CIT)

(3) Taxes on Dividends (TD) & Capital Gain (TCG)

• 𝑌𝑃 is determined by:

𝑄𝐿

𝑄𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑜𝑜𝑑

𝑇ℎ𝑒 𝑜𝑣𝑒𝑟𝑎𝑙 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦

3.5 The Effects of Changes in Tax Rates on Potential GDP

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(1) Individual Income Tax (IIT):

𝐼𝐼𝑇 ↓ => 𝑄𝐿 (𝑠𝑢𝑝𝑝𝑙𝑦) ↑ => 𝑌𝑃 ↑

Tax on sole proprietorships’ profit ↓ => 𝑌𝑃 ↑

Entrepreneurship ↑

Opening new business ↑

Employment ↑

Tax on Return from saving of household↓

=> household saving ↑ => loanable fund ↑

=> Investment ↑ => 𝑌𝑃 ↑

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(2) Corporate Income Tax (CIT)

𝐶𝐼𝑇 ↓ => Investment spednig ↑ => Capital Good & Technology ↑ => 𝑌𝑃 ↑

(3) Tax on dividends and capital gain (TD & TCG)

TD & TCG ↓ => Capital Stock ↑ => 𝑌𝑃 ↑

As result:

Decreasing in Tax Rates (IIT, CIT, TD & TCG)

cause increasing in capital, labor and the

overall level of efficiency (Also known as

supply-side effect of fiscal policy) and 𝑌𝑃 ↑ will

be automatically increased.

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Changes in Tax Rates makes:

(1) Multiplier effect => Y changes

(2) Supply-side effect => YP changes

(with negative relation)

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Objective IV: Use the IS-MP model to

explain the challenges to using fiscal policy effectively

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4. THE LIMITATIONS OF FISCAL POLICY

4.1 Policy Lags to the effectiveness of fiscal policy (1)

• Recognition lags exists because it takes time for an event such as stock market crash or a housing market crash to show up in the data on consumption, investment, output and employment.

• Implementation lags exists because it takes time for policymakers to decide how to respond to events such as demand shocks and supply shocks.

• Impact lags exists because it takes tome for a change in policy to have an effect on output, employment, and inflation.

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4.1 Policy Lags to the effectiveness of fiscal policy (2)

• The responds lag is different for automatic stabilizers than for discretionary fiscal policy because automatic stabilizers respond immediately, without the need for political coordination.

• Because of lags, government make changes to discretionary fiscal policy. Fiscal policymakers are also limited by the quality of economic forecasts and by model uncertainty

• Fiscal policy faces challenges such as change in household wealth, and the much on the magnitude of the multipliers for changing in government purchase and taxes.

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4.2 Economic Forecasts Government make changes to discretionary fiscal policy based on their forecasts of how the economy will be performing in the future.

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4.3 The Uncertainty of Economic Models Fiscal policy faces have centered on the magnitude of the multipliers for changes in government purchase and taxes. The uncertainty of multipliers make it difficult for economists to provide policy makers with clear advice on whether policy should increase in government spending or more tax cuts.

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4.4 The Uncertainty of Economic Models

• Crowding out is a reduction in private investment caused by government budget deficits, may occur and offset some of the effects of fiscal policy.

• Households and firms are forward-looking in the sense that they care about the future when they make decisions about how much to consume and invest. Household may reduce their consumption now to save to pay higher taxes, and firms may reduce investment in anticipation of lower future profits.

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4.5 Fiscal Multipliers Effects (1)

The fiscal multiplier effect occurs when an initial injection into the economy causes a bigger final increase in national income.

The value of the Multiplier depends upon: – If people spend a high % of any extra income, then

there will be a big multiplier effect. – However if any extra money is withdrawn from the

circular flow the multiplier effect will be very small. • Monetarists argue the fiscal multiplier will be limited by

the crowding out effect. E.g. if the government increase Aggregate Demand through higher spending or tax cuts then this increases consumer spending. However, the rise in borrowing (and higher bond yields) leads to a decline in private sector investment. Therefore, there is no overall increase in AD.

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4.5 Fiscal Multipliers Effects (2)

Multiplier Effect of a Tax Cut

• A tax cut has no effect on government spending, but, it should effect Consumer spending (C) and I (investment). For example, imagine the government cut VAT from 17.5% to 15%. This has two effects:

1. Firstly, if consumers maintain the same spending habits, they will have more disposable income left over to buy more goods.

2. Secondly, they may be encouraged to buy goods (especially expensive electrical goods) etc., because they are cheaper.

• Therefore, in theory, a tax cut should boost consumer spending and this leads to an overall rise in AD.

• This means firms will get an increase in orders and sell more goods. This increase in output, will encourage some firms to hire more workers to meet higher demand. Therefore, these workers will now have higher incomes and they will spend more. This is why there is a multiplier effect. Extra spending benefits others in the economy.

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CONCLUDING REMARK

• In the short run fiscal policy effect aggregate expenditure, which then cause changes in real GDP and employment.

• A decrease in personal taxes increase disposal income so consumption spending increase, which will increase aggregate expenditure, and so real GDP and employment.

• The challenges to fiscal policy happened to the extend of Policy lags, economic forecasts, and the size of multiplier in government spending or tax cutting.

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SUMMARY

Fiscal Policy

What? Who? Why? How?

Tool: -G - T -TR

-New Tool

Budget Deficit/ Surplus

-Automatic Stabilizer

-Discretionary fiscal policy

Short-run effect of

Fiscal policy (IS-MP model)

Limitation

Business cycle

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Thank You for Your Attention!