chapter 12copyright ©2010 by south-western, a division of cengage learning. all rights reserved...
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Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
ECON
Designed byAmy McGuire, B-books, Ltd.
McEachern 2010-2011
12CHAPTERFiscal Policy
Macro
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Fiscal Policy Tools
LO1
Automatic stabilizers– Revenue and spending programs– Adjust automatically• E.g.: Federal income tax
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Fiscal Policy Tools
LO1
Discretionary fiscal policy– Deliberate manipulation of G, TP, and T– Increase in G or TP• Increases real GDP demanded– Increase in net taxes• Decreases real GDP demanded
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Changes in Government Purchases
LO1
Increase government purchases– Stimulate the economy– Upward shift of AE line– Increase in GDP
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
LO1
Effect of a $0.1 Trillion Increase in Government Purchases on Aggregate Expenditure and Real GDP
Demanded
C + I + G + (X - M)
a
14.0 14.50 Real GDP(trillions of dollars)
14.0
14.5
Agg
rega
te e
xpen
ditu
re (
trill
ions
of
dolla
rs)
45°
C + I + G’ + (X - M)
b
As a result of a $0.1 trillion increase in government purchases, the aggregate expenditure line shifts up by $0.1 trillion, increasing the real GDP demanded by $0.5 trillion. This model assumes price level remains unchanged.
0.1
Exhibit 1
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Changes in Net Taxes
LO1
Decrease in net taxes– Increases DI by ∆NT– Increases C by MPC ×∆NT– Upward shift of AE line– Increase in GDP
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
14.0 14.40 Real GDP(trillions of dollars)
Effect of a $0.1 Trillion Decrease in Net Taxes on Aggregate Expenditure and Real GDP Demanded
C + I + G + (X - M)
a14.0
14.4
Agg
rega
te e
xpen
ditu
re (
trill
ions
of
dolla
rs)
45°
C’ + I + G + (X - M)
c
As a result of a decrease in NT of $0.1 trillion, consumers, who are assumed to have a MPC of 0.8, spend $80 billion more and save $20 billion at every level of GDP. The consumption function shifts up by $80 billion, as does the AE line.
0.08
An $80 billion increase of AE line eventually increases real GDP demanded by $0.4 trillion. Keep in mind that the price level is assumed to remain constant during all this.
LO1 Exhibit 2
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
LO2
Discretionary Fiscal Policy
Expansionary fiscal policy
Contractionary gap
Price level < expected
Output < potential
Unemployment > natural rate
Increase G, decrease NT
Increase AD
Higher price level
Higher output
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
LO2
Expansionary Fiscal Policy
To close a contractionary gap
Output < potential
Unemployment > natural rate
Expansionary fiscal policy
Increase G
Decrease NT
Increase AD
Increase output
Increase price level
Close the contractionary gap
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Discretionary Fiscal Policy to Close a Contractionary Gap
The aggregate demand curve AD and the short-run aggregate supply curve SRAS130 intersect at point e. Output falls short of the economy’s potential. The resulting contractionary gap is $0.5 trillion. This gap could be closed by discretionary fiscal policy that increases aggregate demand by just the right amount. An increase in government purchases, a decrease in net taxes, or some combination could shift aggregate demand out to AD*, moving the economy out to its
potential output at e*.
LO2 Exhibit 3P
rice
leve
l
125
130
AD
SRAS130
e
Potential outputLRAS
Real GDP
(trillions of dollars)0 14.0 14.513.5
AD*e’
e*
e’’
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
LO2
Contractionary Fiscal Policy
To close an expansionary gap
Output > potential
Unemployment < natural rate
Contractionary fiscal policy
Decrease G
Increase NT
Decrease AD
Decrease output
Decrease price level
Close the expansionary gap
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Discretionary Fiscal Policy to Close an Expansionary Gap
The aggregate demand curve AD’ and the short-run aggregate supply curve SRAS130 intersect at point e’ resulting in an expansionary gap of $0.5 trillion.
Discretionary fiscal policy aimed at reducing aggregate demand by just the right amount could close this gap without inflation. An increase in net taxes, a decrease in government purchases, or some combination could shift aggregate demand back to AD* and move the economy back to its potential output at e*.
LO2 Exhibit 4P
rice
leve
l
135
130AD’
SRAS130
e’
Potential outputLRAS
Real GDP
(trillions of dollars)0 14.0 14.5
AD*
e*
e’’
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
LO2
Contractionary & Expansionary Fiscal Policy
Difficult to achieve
Potential output gauged accurately
Spending multiplier predicted accurately
AD shifts by just the right amount
Government entities – coordinate fiscal efforts
Shape of SRAS curve is known, unaffected by the policy
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
LO2
The Multiplier and the Time Horizon
Simple multiplier
Overstates ∆Real GDP
∆Real GDP depends
Steepness of SRAS curve
Production costs increase
The steeper SRAS curve
Less impact of an AD shift on real GDP
More impact on price level
The smaller the spending multiplier
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Evolution of Fiscal Policy
LO3
1. Prior to the Great Depression Classical economists– Laissez-faire; Free markets– Balanced budget– Natural market forces• Flexible:• Prices • Wages• Interest rates
– No need for government intervention
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Evolution of Fiscal Policy
LO3
2. The Great Depression and World War II– Keynesian theory and policy• Prices and wages: ‘Sticky’ downward• Increase AD– WWII• Increase production• No cyclical unemployment– Employment Act of 1946, Government:• Full employment• Economic stability
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Automatic Stabilizers
LO3
Smooth out fluctuations DI– Stimulate AD (recessions)– Dampen AD (expansions) Federal income tax– Progressive income tax Unemployment insurance Welfare payments
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Evolution of Fiscal Policy
LO3
3. From the Golden Age to Stagflation– 1960s: demand-management policy• Increase or decrease AD– 1970s: Stagflation• Higher inflation• Higher unemployment• From decreased AD• Crop failures• Higher OPEC-driven oil prices• Adverse supply shocks
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Fiscal Policy and Natural UR
LO3
Underestimate natural rate of unemployment
– Expansionary fiscal policy• Increase AD; Short run:• Increase output• Decrease unemployment
• Expansionary gap; Long run:• Decrease SRAS• Inflation• Decrease output
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
When Discretionary Fiscal Policy Overshoots Potential Output
If public officials underestimate the natural rate of unemployment, they may attempt to stimulate AD even if the economy is already producing at its potential output, a.This expansionary policy yields a short-run equilibrium at b, where the price level and output are higher and unemployment is lower, so the policy appears to succeed.But the resulting expansionary gap will, in the long-run, reduce the SRAS, eventually reducing output to its potential level of $14.0 trillion while increasing the price level to 140.Thus, attempts to increase production beyond its potential GDP lead only to inflation in the long-run
LO3 Exhibit 5P
rice
leve
l
130
140
AD
SRAS130
Potential outputLRAS
Real GDP
(trillions of dollars)0 14.0 14.2
AD’
b
a
SRAS140
c
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Lags in Fiscal Policy
LO3
Fiscal policy– Time• Approve • Implement– Less effective– Too late– More harm than good
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Evolution of Fiscal Policy
LO3
4. Since 1990: from deficits to surpluses 1980s – mid-1990s: large deficits 1993 recovery under way– Increase tax on high-income households 1994: Decreased federal spending 1993 – 1998– Tax revenues: +8.3% per year– Federal outlays: +3.2% per year
Chapter 12 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved
Evolution of Fiscal Policy
LO3
4. Since 1990: from deficits to surpluses back to deficits– 1998: Federal surplus $70 billion– 2000: Federal surplus $236 billion– Early 2001 – Recession: 10-year tax cut– September 11, 2001: Terrorist attack– 2003 – 2007 Recovery– Employment: +8 million– Federal deficit (2004) $400 billion– Federal deficit (2007) under $200 billion– Recession beginning December 2007– Federal deficit increased to $450 billion in 2008; now
forecast between $1 trillion and $2 trillion