CHAPTERS 10 and 13
Fiscal Policy

10a The Spending Multiplier

I. Introduction

A. Review : Fiscal Policy
1. Definition: discretionary fiscal policy
Deliberate changes in taxes (tax rates) and government spending by Congress to promote full-employment, price stability, and economic growth.

2. Fiscal Policy tools

a. government purchases (spending)
b. taxes
c. both

3. Expansionary Fiscal Policy

  • An increase in government expenditures for goods and services,
  • a decrease in taxes,
  • or some combination of the two

 

  • for the purpose of increasing aggregate demand and expanding real output
  • this will reduce UE

 

4. Contractionary Fiscal Policy

  • a decrease in government expenditures for goods and services,
  • an increase in net taxes,
  • or some combination of the two

 

  • for the purpose of decreasing aggregate demand and thus controlling inflation.

 

 

FISCAL POLICY

WE ALREADY KNOW:

If there is UE?
  • increase G
  • decrease T
  • both

If there is IN?

  • decrease G
  • increase T
  • both

 

NOW WE ARE GOING TO LEARN:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

B. HOW MUCH Should the Government Change G or T?

1. We know that: GDP = C + Ig + G + Xn
a. Assume:
1. equilibrium GDP = $400 billion
2. full employment GDP = $500 billion

b. What change in G is needed to achieve full employment?

c. graph

2. RESULT: Multiplier effect

II. The Multiplier Effect

A. Consumption (C) and Saving (S)
1. introduction
a. DI = C + S (ignoring taxes and imports)

b. the income consumption-relationship (yellow page)

c. the income-saving relationship (yellow page)

2. consumption and saving schedules

a. consumption schedule
1) A schedule showing the amounts households plan to spend for consumer goods at different levels of disposable income.

 

 

 

 

2) average propensity to consume (APC)

a) definition

Fraction (or percentage) of disposable income which households plan to spend for consumer goods and services; consumption divided by disposable income

b) formula
C

APC =
--------

income

b. saving schedule

1) A schedule which shows the amounts households plan to save (plan not to spend for consumer goods), at different levels of disposable income.

2) saving and dissaving

3) average propensity to save (APS)

a) definition
Fraction (or percentage) of disposable income which households save; saving divided by disposable income.

b) formula
S

APS =
--------

income

c) APC + APS = 1

 

c. marginal propensity to consume (MPC)

1) definition
  • The fraction of any change in disposable income spent for consumer goods;
  • Equal to the change in consumption divided by the change in disposable income.

2) formula
change in C

MPC =
-----------

change in income

d. marginal propensity to save (MPS)

1) definition
  • The fraction of any change in disposable income which households save;
  • Equal to the change in saving divided by the change in disposable income.

2) formula
change in S

MPS =
---------------

change in income

3) MPC +MPS = 1

 

3. MPC and MPS graphically

a. MPC = slope of consumption function

change in C

rise

MPC =
-----------
=
------
=
slope of C

change in income

run

 Using the graph above:
change in C

80

MPC =
-----------
=
------
=
0.8

change in income

100

b. MPS = slope of saving function
change in S

rise

MPS =

---------------
=
------

=

slope of S

change in income

run

Using the graph above:
change in S

40

MPS =

---------------
=
------

=

0.2

change in income

200

d. Are MPC and MPS really constant - Are the consumption function and saving function really straight lines?

 

NO - but it makes calculations easier.

 

If you cut taxes on lower income people and raise taxes on higher income people, what effect, if any, will it have on aggregate demand?

"Eliminate payroll taxes to improve economy"

Marketplace commentator Robert Reich thinks that reducing payroll taxes will get consumers to start spending again, which will help get the economy moving again.

Text / Link to audio:
http://marketplace.publicradio.org/display/web/2010/08/25/pm-reich-eliminate-payroll-taxes-to-improve-economy/

Audio:
http://marketplace.publicradio.org/www_publicradio/tools/media_player/popup.php?name=marketplace/pm/2010/08/25/marketplace_cast2_20100825_64&starttime=00:10:16.500&endtime=00:12:50.0

 

B Changing AD and The Multiplier Effect assuming No Inflation

1. Definition: Multiplier

The ratio of a change in the equilibrium GDP to the change in investment or in any other component of aggregate expenditures or aggregate demand;

The number by which a change in any component of aggregate expenditures or aggregate demand must be multiplied to find the resulting change in the equilibrium GDP.

2. GDP = initial spending x multiplier

change in real GDP
1
1

3. multiplier =

-----------------------------------
= -------------------
= ------------------

initial change in spending
MPS
1 - MPC

4. rationale -- how does the multiplier work?

a. THIS IS IMPORTANT!
(Be sure you understand figure 10.8: table and figure)

b. $20 billion bill in class example (KNOW THIS!)
Assume: MPC = .8, and I increases by $20 billion

c. the multiplier and the AS/AD graph: $20 billion bill in class example

FROM TEXTBOOK (13.1)

 

d. Does the multiplier work in reverse (if there is a decrease in AD)? See: artbuchwaldmultiplier.htm

 

5. multiplier and marginal propensities (slopes)

1

a. multiplier =

-------

MPS

1

b. multiplier =

------------

1 - MPC

c. a larger MPC (or smaller MPS) has a larger multiplier

6. The Complex Multiplier (or the ACTUAL multiplier)
[REVIEW MULTIPLIERS]
a. The Income = Expenditures Stream (income becomes spending or AD)

b. What ELSE can you do with your Disposable Income (DI) besides spend it?

  • you can save it
    • saving is a "leakage" from the income = expenditure stream
    • this creates the simple multiplier
  • you can also use it to pay taxes (another "leakage" from the income=expenditure stream )
  • you can also spend it on imports (another "leakage" from the income=expenditure stream )

 

  • so not all increases in income become additional spending or saving
  • How does this affect the size of the multiplier?

DI

C

AD

Leakages

Injections

S

I

T

G

M

X

c. If there are more leakages, the multiplier is smaller
1

actual multiplier =
-------------

leakages

d.

1

complex multiplier =
-------------

MPS + MPT + MPM

e. The Complex Multiplier is SMALLER than the Simple Multiplier because there are more leakages

(more is "torn" off before additional income is spent).

 

13a Fiscal Policy
 

III. Fiscal Policy

Deliberate changes in taxes (tax rates) and government spending by Congress to promote full-employment, price stability, and economic growth.

A. Fiscal Policy and Multipliers
REVIEW MULTIPLIERS
1. G and the multiplier
  • we'll use the SIMPLE multiplier
  • simple multiplier = 1/MPS

2. T and the multiplier

  • we'll use the lump-sum tax multiplier

a. lump-sum tax

A tax which is a constant amount (the tax revenue of government is the same) at all levels of GDP.

b. the lump-sum tax multiplier

1) is always one less than the simple multiplier, but negative ( = simple multiplier - 1)

2) lump-sum tax multiplier = -MPC / MPS

3. G AND T and the Multiplier

a. 's in G AND 's in T can be used in combination

b. "balanced budget" multiplier = 1

  • what happens to the governmet's budget if they use expansionary FP?
    • increase G
    • decrease T

     

  • What if the government changes both G and T by the same amount and in the same direction? Will GDP change?
    • increase G increase GDP, but HOW MUCH?
    • increase T decreases GDP, but HOW MUCH?

 

  • The 'balanced budget multiplier" always has a value of 1 since the tax multiplier is always one less than the government spending multiplier

 

V. Built-in Stability

A. When the economy enters a recession the government could:
  • use expasionary FP (discretionary FP)
  • do NOTHING (nondiscretionary FP)

B. What if the economy enters a recession and the government does NOTHING what happens?

  • If Taxes are directly related to GDP (income),
  • and Transfer Payments (welfare) are indirectly related to GDP,
  • what happens to AD after entering a recession?
    • taxes decrease
    • government spending on welfare increases

     

    • so AD increases even though the government did nothing

C. Built-in Stabilizer

A mechanism which increases government’s budget deficit (or reduces its surplus) during a recession and increases government’s budget surplus (or reduces its deficit) during inflation without any action by policy makers;

the tax system is one such mechanism.

D. Tax Progressivity

  • A tax system wherein the average tax rate (tax revenue/GDP) rises with GDP.
  • The more progressive the tax system, the greater the economy's built-in stability.

IV. Evaluating Fiscal Policy: Cyclically-Adjusted Budget (also called the Full-Employment or Standardized Budget)

What happens to the government budget deficit if it uses expansionary FP?

What happens to the government budget deficit if the economy enters a recession and the government does NOTHING?

So, if the government budget deficit increases when the economy enters a recession, does this indicate that the government is doing some SOMETHING (expansionary FP) or NOTHING?

Since deficits increase during recessions whether the government does SOMETHING or NOTHING we cannot use larger deficits as an indicator that the government is doing something.

Therefore, economists have created a the concept of a "full employment budget"

An increase in the cyclically adjusted (standardized or full-employment) budget deficit is an indicator of discretionary expansionary FP

- actual budget

A listing of amounts spent by the Federal government (to purchase goods and services and for transfer payments) and the amounts of tax revenue collected by it in any (fiscal) year.

- cyclical deficit

A Federal budget deficit which is caused by a recession and the consequent decline in tax revenues.

GRAPH

- cyclically-adjusted (full-employment or standardized) budget

A comparison of the government expenditures and tax collections which WOULD occur if the economy operated at full employment throughout the year.

GRAPH

- structural deficit

The extent to which the Federal government’s expenditures exceed its tax revenues when the economy is at full employment (or the extent to which its current expenditures exceed the projected tax revenues which would accrue if the economy were at full employment); also known as a full-employment budget deficit.

 

V. Problems, Criticisms, and Complications

A. Problems of Timing
1. RECOGNITION LAG is the elapsed time between the beginning of recession or inflation and awareness of this occurrence.

2. ADMINISTRATIVE LAG is the difficulty in changing policy once the problem has been recognized.

3. OPERATIONAL LAG is the time elapsed between change in policy and its impact on the economy.

B. Political Considerations:
Government has other goals besides economic stability, and these may conflict with stabilization policy.

1. A political business cycle may destabilize the economy:
Election years have been characterized by more expansionary policies regardless of economic conditions. Some call this a political business cycle:

The alleged tendency of Congress to destabilize the economy by reducing taxes and increasing government expenditures before elections and to raise taxes and lower expenditures after elections.

2. State and local finance policies may offset federal stabilization policies.

They are often procyclical, because balanced-budget requirements cause states and local governments to raise taxes in a recession or cut spending making the recession possibly worse.

In an inflationary period, they may increase spending or cut taxes as their budgets head for surplus.

3. The crowding-out effect may be caused by fiscal policy.

a. REVIEW MULTIPLIERS

b. DEFINITION: Crowding Out Effect

A rise in interest rates and a resulting decrease in planned investment caused by the Federal government’s increased borrowing in the money market.

c. "Crowding-out" may occur with government deficit spending.

It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy.

d. Some economists argue that little crowding out will occur during a recession.

e. Economists agree that government deficits should not occur at FE.,

f. it is also argued that monetary authorities could counteract the crowding-out by increasing the money supply to accommodate the expansionary fiscal policy.

 

VII. Supply-Side Fiscal Policy and the Multiplier

A. What is "Supply-Side FP" ?
1. The contention that tax reductions will shift the aggregate supply curve to the right.
(see the graph below).

2. There are three main reasons for this:

a. Saving and investment - lower taxes will increase disposable incomes, thereby increasing household savings, lowering interest rates, and increase investment in new technology

b. Work incentives – lower tax rates will increase after tax wages from work, thereby increasing work incentives and productivity, therefore, shift supply to the right.,

c. Risk Taking – lower tax rates prod risk taking individuals and businesses to risk their energy and financial capital on new production methods and new products and, therefore, shift supply to the right.

B. Effect on the multiplier - REVIEW MULTIPLIERS

Larger multiplier: instead of going from Q1 to Q2 (simple multiplier) the economy goes to Q3

C. Supply side economists sometimes argue that if lower taxes raise GDP, tax revenues may actually rise.

Laffer Curve

 

D. Many economists are skeptical of supply-side theories.

1. Effect of lower taxes on a supply is not supported by evidence.

2. Tax impact on supply takes extended time, but demand impact is more immediate.

 

 

13b Other Fiscal Policy Issues and Government Debt
 

VIII. Other FP Issues

A. Policy in the Great Depression (see videos)

B. New Keynesian and New Classical FP (see videos)

B. Government Budget Deficits and Trade (see videos)

IX. The U.S. Public Debt

A. Introduction
1. OPTIONAL
CNN Deficit and Dept Quiz (2011):
http://money.cnn.com/quizzes/2010/news/fiscal-debt/index.html

2. Debt vs. Deficit

a. The national or public debt is the TOTAL accumulation of the Federal government's total deficits and surpluses that have occurred through time.

b. The federal government's budget DEFICITS and SURPLUSES are ANNUAL differences between the revenue collected and government spending.

3. Size of the debt: TOTAL DEBT

a. $7.96 trillion in 2005.

b. $ 11.9 trillion in 2009

c. $16.4 trillion in 2012

 

B. Ownership of the public debt

1. Debt Held by the Public – all federal debt held by individuals, corporations, state or local governments, foreign governments and other entities outside of the United States government.

2012: 60% of total debt

  • 33% foreign owned (China owns about a quarter, Japan a fifth)
  • 10% owned by banks,etc.
  • 6% owned by US individuals
  • 11% Other including state and local governments

2. Intragovernmental Holdings – government securities held by government trust funds, such as the Social Security trust fund and the Medicare trust fund, and the Federal Reserve.

2012: 40%

  • 29% US government agencies
  • 11% Federal Reserve

 

2009

 

3. International comparison

https://www.cia.gov/library/publications/the-world-factbook/rankorder/2186rank.html

 

C. Debt and GDP 

1. Debt: TOTAL vs. % GDP

 

 

 

2. PUBLIC DEBT as a % of GDP

 

D. False Concerns of a Large Public Debt

1. Bankruptcy
a. refinancing

b. taxation

2. Burdening Future Generations

E. Substative Issues of a Large Public Debt (see below)

1. Income Distribution

2. Incentives

3. Foreign-Owned Public Debt

4. Crowding out of Private Investment

 G. The Future

The nonpartisan CBO in September of 2013 released a study warning that the next few years of declining deficits will be followed by a surge of red ink to cover the mounting costs of Social Security, Medicare and Medicaid.

The federal government’s net interest payments would grow to 5 percent of GDP, compared with an average of 2 percent over the past 40 years, mainly because federal debt would be much larger and interest rates will rise.

Federal spending for Social Security, Medicare and Medicaid would increase to a total of 14 percent of GDP by 2038, or twice the 7 percent average of the past 40 years.

http://www.thefiscaltimes.com/Articles/2013/09/17/CBO-Interest-Rates-Will-Spike-Debt-100-GDP

Substantive Issues

Interest charges are the main burden imposed by the debt. Interest on the debt was $360 billion in 2012, or 2.3% of GDP

Repayment of the debt affects income distribution. If working taxpayers will be paying interest to the mainly wealthier groups who hold the bonds, this probably increases income inequality.

Since interest must be paid out of government revenues, a large debt and high interest can increase tax burden and may decrease incentives to work, save, and invest for taxpayers.

A higher proportion of the debt is owed to foreigners than in the past, and this can increase the burden since payments leave the country. But Americans also own foreign bonds and this offsets the concern. Foreigners held about 25 percent of the public debt in 2005., 33% in 2012

Some economists believe that public borrowing crowds out private investment, but the extent of this effect is not clear

There are some positive aspects of borrowing even with crowding out.
1. If borrowing is for public investment that causes the economy to grow more in the future, the burden on future generations will be less than if the government had not borrowed for this purpose.

2. Public investment makes private investment more attractive. For example, new federal buildings generate private business; good highways help private shipping, etc.

   

 

 

 

 

 

 

 

 

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