Fiscal policy

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• 1. If an economy operates in the short run
• at point a, restrictive fiscal policy
  will
• increase AD and move the economy toward point c.
• decrease AD and move the economy toward point b.
• increase SRAS and move the economy toward point
  b.
• decrease SRAS and move the economy toward point
  c.
• 2. When the economy is operating at point a,
  reliance
• on the self-correcting
  mechanism will
• result in higher resource prices and a shift to
  the left in the SRAS curve.
• result in lower resource prices and a shift to
  the right in the SRAS curve.
• lead to lower interest rates and a shift to the
  right in the AD curve.
• lead to higher interest rates and a shift to the
  left in the AD curve.
• e. do both a and d.
• 3. Which of the following will a Keynesian most
  likely favor if the economy is operating at point
  a?
• a. a tax cut
• b. an increase in government expenditures
• c. restrictive fiscal policy

2
4. If the output of the economy is Y1,
which of the following would a Keynesian
economist be most likely to favor? a. a
reduction in government expenditures b. an
increase in government expenditures c. an
increase in taxes d. continuation of the current
tax and expenditure policies 5. If
the output of the economy is Y1, which of the
following would a new classical economist be most
likely to favor? a. a reduction in government
expenditures b. a reduction in taxes c. an
increase in taxes d. continuation of the current
tax and expenditure policies
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6. When government expenditures exceed revenue
from all sources, a. a budget deficit is
present. b. the supply of money will
increase. c. the governments outstanding debt
will decline. d. all of the above are true.
7. According to the Keynesian view, which of the
following would most likely decrease aggregate
demand? a. a decrease in tax rates b. a
decrease in government expenditures c. an
increase in transfer payments d. an increase in
the budget deficit
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Budgets
1. Deficits
Expenditures gt Revenue
2. Surpluses

• Expenditures lt Revenues

3. As a tool of Fiscal Policy
Discretionary changes in taxes and/or spending
affect the Budget
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Keynesian View of Fiscal Policy
Expansionary
-move out to full employment
Restrictive
-move back toward full employment
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Expansionary
SRAS1
PriceLevel
LRAS
P2
P1
e1
P3
AD1
Goods Services(real GDP)
YF
Y1

• Equilibrium below full employment. Two options

1. Wait for SRAS1 to shift out to SRAS2
2. Shift AD1 out to AD2
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Restrictive
PriceLevel
LRAS
SRAS1
P3
P1
e1
P2
AD1
Goods Services(real GDP)
YF
Y1

• Equilibrium above full employment at Y1.

1. Will lead to the long-run equilibrium E3 at a
higher price level as SRAS shifts to SRAS2. or
2. Reduce demand to AD2 and lead to equilibrium
E2.
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Crowding Out
1. Finance Deficit by Borrowing
government competes with businesses for funds
2. interest rates go up
businesses can afford less investments
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3. international consequenses
demand for
appreciates
fewer exports
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(No Transcript)
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Opposing View
1. Deficits shift taxes
people save for future taxes
2. interest rates don't go up
makes fiscal policy impotent
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New Classical View
PriceLevel
SRAS1
G
H
G
P1
AD1
Goods Services(real GDP)
Y1

• Government deficit would shift AD1 to AD2.
• Household saving keeps demand unchanged at AD1.

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New Classical View
Loanable FundsMarket
Real interestrate
S1
e1
r1
D1
Quantity of loanable funds
Q1
Q2
1. Government borrows from the loanable funds
market, increasing the demand (to D2).
2. People save for expected higher future taxes
(raising the supply of loanable funds to S2.)
3. Loans increase, but interest rate doesnt.
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Problems with Fiscal Policy
1. Timing
recognize
enact program
put into effect
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1. Business slump
LRAS
PriceLevel
SRAS1
P0
E0
P1
AD0
Goods Services(real GDP)
Y0
Y1
1. Equilibrium at E0
2. AD decreases to AD1 and output falls to Y1
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1. Business slump
LRAS
PriceLevel
SRAS1
P0
E0
P1
e1
AD0
AD1
Goods Services(real GDP)
Y0
Y1
3. While policy is being enacted, private
investment has begun to recover.
4. AD has begun shifting back to AD0 on its
own, the effects of fiscal policy over-shift AD
to AD2.
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1. Business slump
LRAS
PriceLevel
SRAS1
P3
P2
P0
E0
P1
e1
AD2
AD0
AD1
Goods Services(real GDP)
Y0
Y1
Y2

• The price level in the economy rises (from P1 to
  P2) as the economy is now overheating.

• Unless the expansionary fiscal policy is
  reversed, wages and other resource prices will
  eventually increase, shifting SRAS back to SRAS2
  (driving the price level up to P3).

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2. Business is booming
LRAS
PriceLevel
SRAS1
P2
P0
E0
AD0
Goods Services(real GDP)
Y0
Y2
1. Demand shifts AD out to AD2, and prices
upward to P2.
2. Restrictive Fiscal Policy is considered
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2. Business is booming
LRAS
PriceLevel
SRAS1
P2
e2
P0
E0
P1
AD2
AD0
AD1
Goods Services(real GDP)
Y0
Y1
Y2
2. The price level falls (from P2 to P1) as the
economy is thrown into a recession.
3. With the timing lag, fiscal policy does not
work instantaneously.
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2. Business is booming
LRAS
PriceLevel
SRAS1
P2
e2
P0
E0
AD2
AD0
Goods Services(real GDP)
Y0
Y2
4. Investment returns to its normal rate
(shifting AD2 back to AD0).
5. The effects of fiscal policy over-shift AD to
AD1.
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Problems with Fiscal Policy
2. Automatic stabilizers
increase deficit
increase surplus
-Unemployment compensation
-Corporate Profit Tax
-Progressive Income Tax

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In summary
1. policy timing is crucial
2. Automatic stabilizers reduce fluctuations
3. Fiscal policy is actually less potent than
believed
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Supply-Side Economics
reducing taxes adds incentive to work, invest and
save
makes working more fun!
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Supply-Side Effects
LRAS1
PriceLevel
SRAS1
E1
P0
AD1
Goods Services(real GDP)
YF2
YF1
1. Lower marginal tax rates shifts AD1 out to
AD2, and SRAS LRAS shift to the right.
2. If the tax cuts are financed by budget
deficits, AD may expand by more than supply,
bringing an increase in the price level.
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Top One-Half Percent Taxes
Share of personal income taxes paid by top ½
of earners
Obama
30
28
26
24
22
20
18
16
14
1960
1995
1990
1980
1975
1970
1965
1985
2000
2005

• Their share of taxes paid has increased as the
  top tax rates have declined.
• This indicates that the supply side effects are
  strong for these taxpayers.

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Soaking the Rich?

• Since 1986 the top tax rate has been less than
  40 .
• The top one-half percent of earners have paid
  more than 25 of the personal income tax every
  year since 1997.
• Well above the 14 to 19 from the 1960s and
  1970s.

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US Fiscal Policy 1960-2006
1. Generally small deficits except during
recessions. 2. Budget deficits generally
increased during recessions and shrank during
expansions, (automatic stabilizers, not
discretionary policy) 3. Reductions in income
tax rates and sharp increases in defense
expenditures led to large deficits during the
1980s. 4. The deficits replaced by surpluses in
the 1990s.
5. Real economic growth was strong and the
inflation rate low during 80s and 90s
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US Fiscal Policy 1960-2006
6. The combination of -the 2001 recession
-the economys sluggish recovery -the Bush
Administrations tax cut, and -increases in
defense spending quickly moved the budget from
surplus to deficit at the beginning of the new
century.
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1940-1971 Data
30
1972-2006 Data
2003
-375 2004
-400 2005
-300 2006
-247.7
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Deficits to Surpluses
1. strong expansion
2. Less defense spending
3. Baby Boomers
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Federal Expenditures and Revenues
Federal Government Expenditures and Revenues (as
a share of GDP)
24
22
20
18
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
33
Growth of Real Federal Government and Defense
Expenditures

• During the 1980s, rapid growth of defense
  spending pushed federal spending upward and
  contributed substantially to the large deficits
  of the decade.
• During the 1990s, defense cuts retarded the
  growth of federal spending and thereby helped
  shift the budget to surplus.

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Fiscal Policy Economic Performance

• In the 1960s, most economists believed fiscal
  policy was highly potent and could be used to
  smooth out the business cycle.
• Confidence in the ability of policy makers to
  implement countercyclical fiscal policy has
  waned.
• Most now believe that fiscal policy exerts only a
  modest impact on aggregate demand, much like the
  crowding-out and new classical models imply.
• Since 1980, real growth has been strong during
  periods of both expanding (1980s and 2002-2006)
  and contracting (1990s) deficits.