chapter 25 fiscal policy and the business cycle introduction to economics (combined version) 5th...

Chapter 25

Fiscal Policy and the

Business Cycle

Introduction to Economics (Combined Version) 5th Edition

Using Fiscal Stimulus to Fight Recession In this figure, a negative

output gap has developed at E1.

To reach the natural level of real output at E2 , without waiting for a downward shift of the AS, the AD curve could be shifted to the right, from AD1 to AD2.

That could be done either by increasing real government purchases or reducing net taxes.


Problems of Timing Lags in fiscal policy include

delays of several months before it is known that an output gap has developed,

delays while Congress passes needed legislation, and

delays after policy decision is made before AD curve shifts.

Because of lags, action must be taken based on forecasts, which are not fully accurate.

Fiscal stimulus that is applied too late may take effect only after recovery has already begun, in which case it will cause overshooting at the next cyclical peak.


Some kinds of spending, like military procurement, involve long lead times

How Large a Stimulus The amount of stimulus needed to

close the output gap depends on the size of the multiplier effect.

The effective fiscal multiplier means the amount by which real GDP increases in response to $1 of fiscal stimulus.

For the United States, the effective fiscal multiplier is probably less than 2 and possibly less than 1.

Example: With an effective fiscal multiplier of 2, a fiscal stimulus of $250 billion would be needed to close the $500 billion output gap shown in this figure.


Economists are still debating whether the economic stimulus act of 2008 (ARRA) was too large or too small.

Mathematics of the MultiplierReview of Appendix to Chapter 5 The Keynesian expenditure multiplier is equal to 1/(1-mpc)

where mpc is the marginal propensity to consume. The Keynesian expenditure multiplier measures the horizontal

shift in the AD curve as a result of $1 of added government purchases.

The Keynesian net tax multiplier is equal to mpc/(1-mpc). Note: The Keynesian expenditure multiplier is greater than the

“effective multiplier” reported in many statistical studies of fiscal stimulus. The “effective multiplier” measures the amount by which the output gap is reduced by a $1 stimulus, not the amount of shift in the AD curve.


The Crowding Out Effect Fiscal stimulus increases the

deficit and causes interest rates to rise.

Higher interest rates reduce planned investment and purchases of durable goods bought on credit.

The reduction in planned investment and consumption partly offsets the effect of the fiscal stimulus.

The tendency of an increased government deficit to reduce planned investment and purchases of consumer durables is called the crowding-out effect.

Monetary policy and the crowding-out effect

• The crowding out effect is minimized if the central bank uses expansionary monetary policy to hold interest rates constant when fiscal stimulus is applied

• Such coordinated use of expansionary monetary policy and fiscal stimulus is called accommodating monetary policy


Reversibility Countercyclical fiscal policy

requires that fiscal stimulus be applied at the start of a contraction.

The fiscal stimulus should be reversed at the start of the following expansion to avoid overshooting.

Politically motivated time-inconsistency may make it hard to reverse fiscal stimulus as an election approaches.


Apply fiscal stimulus here

Reverse fiscal stimulus here

Fiscal Priorities Fiscal stimulus is most effective if

the money can be spent immediately. Following are examples of fast-acting fiscal stimulus: Subsidies to “shovel ready”

forms of spending like road repairs

Cash payments of tax rebates to consumers

The fastest-acting forms of fiscal stimulus may not be the country’s highest spending priorities.

Projects like health-care reform or infrastructure projects may have long lags because of needed planning, design, and permitting.


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Every political group has its own set of spending priorities

Automatic vs. Discretionary Fiscal Policy Discretionary fiscal stimulus

means changes in laws to increase government purchases, increase transfer payments, or cut taxes.

Automatic fiscal stimulus means changes in purchases, transfers, or taxes that occur because of changes in GDP and the price level.

Example: More is spent on unemployment benefits when the economy enters a recession.


Discretionary stimulus requires the signing of new laws

Automatic Stabilizers Because automatic fiscal

policy like unemployment benefits tends to increase the deficit when the economy enters recession, they tend to moderate the business cycle.

The same can be said of taxes that increase as the economy enters an expansion.

Together, such taxes and expenditures are known as automatic stabilizers.


Automatic stabilizers

apply stimulus here . . .

. . . and they reverse the

stimulus here

A Cyclical Deficit In 2010, when the economy was in recession, the actual U.S. budget deficit was 8.4

percent of GDP. If real output had been at its natural level with the same tax and spending laws, the

structural budget deficit would have been just 6.3 percent of GDP. The difference between the two indicated a cyclical deficit of 2.1 percent of GDP.


A Cyclical Surplus• In 2000, when the economy was at the peak of an expansion, the actual U.S. budget

surplus was 2.5 percent of GDP.• If real output had been at its natural level with the same tax and spending laws, the

structural budget surplus would have been just 0.9 percent of GDP.• The difference between the two (1.6 percent) indicated a cyclical surplus.


The Budget Process The U.S. government operates on a fiscal

year from October 1 to September 30. Example: Fiscal year 2014 starts October 1, 2013.

In the winter before the fiscal year, the President submits a budget message to Congress.

Congress passes a nonbinding budget resolution in the spring.

It should pass 12 appropriations bills to authorize spending by the end of September.

If it does not, the government has to operate on the basis of a continuing resolution.


Spending Not Subject to the Annual Budget Cycle

Entitlements: federal benefit programs such as social security and Medicare that are not subject to the annual budget process

Interest expenditures: interest payments on the national debt are another category of expenditure that is not subject to annual review

Discretionary spending includes all items subject to the annual appropriations process.


Tax Expenditures Tax expenditure is a

tax deduction or other tax preference intended to encourage behavior that serves some purpose of public policy.

This table lists the twelve largest tax expenditures for 2012. Total tax expenditures that year were about $1.2 trillion, about one-third of the amount of ordinary cash expenditures.


More Slideshows


More classroom-ready slideshows on fiscal policy:

•The Truth about Taxes: What are our Choices? These slides were originally prepared for a presentation to a local chapter of the League of Women Voters. They focus on the issue of changes in tax rates vs. broader tax reform that broadens the tax base.• The Case against the Mortgage Interest Deduction is a case study in tax expenditure.

If you have trouble with the links on this slide, check the index of slideshows on Ed Dolan’s Econ Blog, (dolanecon.blogspot.com)

http://www.slideshare.net/dolaneconslide/the-truth-about-taxes-what-are-our-choices

http://www.slideshare.net/dolaneconslide/the-case-against-the-mortgage-interest-deduction

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