Fiscal Policy, Deficits, and Debt

30

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Fiscal Policy

Recall;• AD = C + I + G + X - M• Changes in AD will have significant

effects on the economy.• Economic problems such as inflation and

unemployment• Changes in AD components leads to

changes in AD

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Fiscal Policy• Recall that the government sector purchase

goods and services (G) and collect taxes (T)

• The government can use: G and T to affect AD

• Fiscal policy: deliberate changes in G and/or T to achieve full employment, price stability, and economic growth.

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Fiscal Policy

How to use fiscal policy?• Performed by the government via its tools: G

and/or T

• Note that G has a direct effect on AD while T has indirect effect (through C and S)

• Two different fiscal policies: Expansionary Fiscal Policy and Contractionary Fiscal Policy

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Expansionary Fiscal Policy

• Used to face a recession• When: GDP (or Y) < AE• Need to increase the level of AE• Increase level of G, and / or Reduce

level of T• Both will increase the level of Y

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Expansionary Fiscal Policy

Real GDP (billions)

Pric

e le

vel

AD2

AD1

increase inaggregate demand

AS

$510

P1

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Expansionary Fiscal PolicyExample;• Assume we have a sharp decline in I from I0 to I1. (show the

graph? )

• Result: what will happen to AD(show the graph?)

• This may cause a problem .……….• What is the solution? Use …………..fiscal policy.• What are the tools of such fiscal Policy to use?

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Expansionary Fiscal Policy

• Assume that GDP0=$505,

• When I falls, GDP1=$485• This is accompanied by an increase

unemployment.• How much we need ∆G, ∆ T, or both?

Recall that MPC=75%, and Gm=4, Tm=3• ∆G: ∆Y = ∆G . M

20 = ∆G . 4 ∆G = $5• ∆T: ∆Y = - ∆T . M

20 = - ∆T . 3 ∆T = - $6.67

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Expansionary Fiscal PolicyTherefore; ∆C = MPC.T=(0.75)(6.67) = +5∆S = MPS.T=(0.25)(6.67) = +1.67

• What if we used both?∆Y= ∆ G mg + ∆T mt

20 = ∆G(4)+ ∆T(3)20 = 1.25(4)+ 5(3)20 = 2(4)+ 4(3)20 = 2.75(4)+ 3(3)

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Contractionary Fiscal Policy

• Used to face a demand-pull inflation• When: GDP (or Y) > AE• Need to reduce the level of AE• Reduce level of G, or/ and Increase

level of T• Both will reduce the level of Y

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Contractionary Fiscal Policy

Real GDP (billions)

Pric

e le

vel

AD2

AD1

decrease inaggregate demand

AS

$522

P2a

bP1

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Contractionary Fiscal PolicyExample;• Assume we have a increase in I from I0 to I1. (show the graph? )

• Result: what will happen to AD(show the graph?)

• This may cause a problem .……….• What is the solution? Use …………..fiscal policy.• What are the tools of such fiscal Policy to use?

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Contractionary Fiscal Policy

• Assume that GDP0=$505,

• When I falls, GDP1=$515• This is accompanied by an increase prices.• How much we need ∆G, ∆ T, or both?

Recall that MPC=75%, and Gm=4, Tm=3• ∆G: ∆Y = ∆G . M

-10 = ∆G . 4 ∆G = $2.5• ∆T: ∆Y = - ∆T . M

-10 = - ∆T . 3 ∆T = - $3.34

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Contractionary Fiscal PolicyTherefore;

∆C = MPC.T=(0.75)(3.34) = -2.505∆S = MPS.T=(0.25)(6.67) = -0.835

• What if we used both?∆Y= ∆ G mg + ∆T mt

10 = ∆G(4)+ ∆T(3)10 = 1 (4)+ 2(3)10 = 1.75(4)+ 1(3)10 = 0.25(4)+ 3(3)

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Policy Options: G or T?• To expand the size of government (if they are concerned about unmet social needs or

infrastructure)

• If recession, then increase government spending• If inflation, then increase taxes

• To reduce the size of government(when they think government is too large and inefficient)

• If recession, then decrease taxes• If inflation, then decrease government spending

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Other ConsiderationsThe crowding‑out effect The crowding‑out effect may be caused by fiscal policy.“Crowding‑out” may occur with government deficit spending. It may increase the interest rate and reduce private spending (Private Investment Spending) which weakens or cancels the stimulus of fiscal policy.

Standardized Budget (Full-Employment Budget)Public Budget = Total Revenue – Government SpendingTotal Revenue is coming usually from Tax RevenueTotal Revenue >Government Spending…Budget SurplusTotal Revenue < Government Spending….Budget DeficitIf the budget was initially balanced, expansionary fiscal policy creates a budget deficit..How??

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