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CHAPTER 11 -- Part 1: FISCAL POLICY
You should know LO1 after reading this chapter.
The Keynesian theory of macro instability is examined in this chapter.
It can be used to alter macroeconomic outcomes.
The government's tax and spending activities are excessive.
The federal government spent little until 1915.
In 1901, the federal government employed 350,000 people and spent $650 million.
The federal government employs over 4 million people and spends $3 trillion a year.
Taxes on imports, whiskey, and tobacco were the main source of government revenue before that.
The federal government had a revenue base once it had the power to tax incomes.
Social Security payroll taxes are the second-largest revenue source.
The federal government depended on customs, whiskey, and tobacco taxes in the 19th century.
Both federal government expenditures and tax revenues were small.
Things are different today.
Uncle Sam borrows money to pay for federal spending.
The implications of the budget deficits that help finance federal spending are examined in Chapter 12.
Government spending on defense, highways, and health care involves the purchase of goods and services in product markets.
The government doesn't buy anything when it mails out Social Security checks.
Income from taxpayers is transferred to retired workers.
Income transfer or interest payment on the national debt is the rest of federal spending.
Purchasing less goods and services.
Either raising or lowering taxes.
Income transfers are changed.
This tool is put into the macroeconomic outcomes.
Fiscal policy can be used to pursue our economic goals, but we begin our study by looking at its potential to ensure full employment.
We look at the impact on inflation.
Fiscal policy can change the mix of output and income.
Fiscal policy is the use of government tax and spending powers to change outcomes.
Shifts of the aggregate demand curve are what fiscal policy works on.
The basic premise of fiscal policy is that the market's short-run macro equilibrium may not be compatible with real output.
The Keynesian model of the adjustment process helps us understand how an econ omy can get into such trouble but also how it might get out.
He emphasized the amount by which equilibrium how new injections of spending into the circular flow add up to much larger changes in GDP.
Employment GDP is the way out of the recession.
Someone should be spending more on goods and services.
Increased government purchases or tax cuts that induce increased consumption are some of the things that could increase spending.
The size of the desired AD shift is obvious at first glance.
Keynes believed that policy might work.
Full employment is the intent of the expansionary fiscal policy.
The naive Keynesian model expects this.
No one was concerned that prices would go up.
Prices may not go up every time demand goes up.
The AS curve may be horizontal over some ranges of output.
The AS curve is expected to slope upward eventually.
Dollar-for-dollar doesn't translate into increased real GDP in those circumstances.
The consequences of the aggregate supply curve are shown in Figure 11.3.
If we increased aggregate demand by $400 billion, it would equal the GDP gap.
As demand picks up, we expect cost pressures to increase, pushing the price level up the AS curve.
The real output is higher.
The Keynesian policy fails to achieve full employment.
We don't abandon fiscal policy even though the naive Keynesian approach doesn't work.
We must increase aggregate demand by more than the GDP gap in order to achieve full employment if the AS curve slopes upward.
Figure 11.3 shows the new policy target.
The aggregate demand curve must change.
In order to achieve full employment, aggregate demand must increase by the amount of the AD shortfall.
For the time being, we focus on the policy options for increasing aggregate demand by the desired amount.
Increasing government spending is the simplest way to shift demand.
The AD curve would be shifted rightward, moving us closer to full employment.
The government doesn't need to make up the entire shortfall in demand.
Market participants get additional income when the government buys more goods and services.
The recipients of this income will spend it.
Each dollar is spent and respent many times.
In Chapter 10, we encountered the multiplier adjustment process.
The multi +$200 billion plier process is set to start.
A lot of punch is added to fiscal policy by the multiplier.
Each dollar of new government expenditure would increase aggregate demand by $4 and the multiplier would have a value of 4.
The effects will increase consumption spending by $600 billion.
The second equation is the same as the first but in a different way.
The "fiscalStimulus" is the new spending injection that sets the process in motion.
Government spending has a powerful policy lever.
The risk of error is increased by the multiplier.
In his first year, President George W. Bush faced this dilemma.
He wanted a tax cut spread out over several years.
Critics worried that too much fiscalStimulus might accelerate inflation.
A compromise of over $1 trillion was struck in 2001.
The attacks put a damper on consumer and investor spending.
President Bush asked Congress to approve more government spending and tax cuts to keep the economy growing.
It would be easier to make policy decisions if we could anticipate events.
We could easily calculate the required increase in the rate of government spending if we knew the exact dimensions of aggregate demand.
We assumed the policy goal was to increase aggregate demand by the amount of the AD shortfall.
We don't know the exact size of the shortfall in aggregate demand.
When taxes and imports enter the picture, the mul in South Korea is harder to calculate.
The calculations helped the South Korean government decide how much fiscal stimulation was needed to keep the economy out of recession.
Increased government purchases aren't the only way to close the GDP gap.
South Korea's finance minister said the state projects and increased financial support to exporters.
The government is considering a tax cut, Mr. Jin said.
He spoke after the president met with the economy.
There are plans to boost the economy with permission of DOW JONES & COMPANY, INC.
South Korea's government increased spending on roads, bridges, and telecom networks due to fear of a decline in demand.
The government hoped that a fiscalStimulus would offset a decline in export sales.
Mayland of Clear View Economics in Cleveland said that Ken took off in the July-September period because of a tax cut for consumers.
The post was excerpted with permission.
The personal income tax cut that took effect July 1 was partially responsible for the increase in spending according to some analysts.
Consumers use most of the increased income to buy more products.
Any "Big Spender" would help from the public sector or the private sector.
Consumer and investor decisions can change.
Fiscal policy can encourage changes.
Goods and services are bought and taxes are levied by Congress.
More after-tax income is put into the hands of consumers.
Congress wanted to shift the consumption component of demand.
A tax cut increases disposable income.
There is a marginal propensity to consume.
The tax-cut dollar will be divided between saving and spending.
Consumers will spend $0.75 out of every tax-cut if the MPC is 0.75.
The aggregate demand curve is shifted to the right by a tax cut.
The initial consumption spree is caused by a tax cut.
Producers and workers will use the additional income from the new consumer spending to increase their own consumption.
The path already depicted in Figure 11.4 will be propelled along by this.
The impact on aggregate demand of a fiscal policy is increased by the multiplier.
There is an important difference here.
Aggregate demand increased by $800 billion when we increased government spending by $200 billion.
Aggregate demand increases by only $600 billion when taxes are cut.
Consumer saving explains the lesser stimulative power of tax cuts.
Part of a tax cut is spent.
People save the rest.
The successive rounds of the multiplier process are shown in Figure 11.5.
The tax cut is used to increase both consumption and saving.
Only part of the tax cut used for consumption enters the circular flow as a spending injection.
Every dollar of government purchases goes into the circular flow.
We can close the shortfall with a tax cut.
It means that the tax cut must be larger than theStimulus.
More consumption of spending increases the amount of money saved.
Assumptions were made to calculate Source: Decision Economics, Inc.
Permission was granted for this to be reproduced.
The Bush tax cuts boosted consumption, increased real GDP growth, and reduced unemployment.
We're using a consumption shift instead of increased government spending.
In Figure 11.3, we assumed that the desiredStimulus is $200 billion and the Monetary Policy Committee is 0.75.
Consumers increase their rate of spending and save the rest of the money.
The added spending enters the circular flow and begins the process of increasing demand.
This comparison of government purchases and tax cuts shows how tax cuts might affect spending.
This doesn't mean that tax cuts are bad, just that they need to be bigger than the spending they are meant to cut.
The Foundation at www.heritage.org/ 2001 tax cut boosted both consumer spending and real GDP growth according to the News.
Tax cuts and increased government spending have different effects on government budgets.
The result is described in Table 11.1.
Investment decisions are guided by expectations of future profit.
If there is a cut in corporate taxes, it will encourage more investment.
There is a multiplier effect when additional investment spending enters the circular flow.
If the government decided to spend $50 billion per year on a new fleet of space shuttles and to raise income taxes by the same amount, this would be a curious result.
$50 billion has been injected by the increase in the rate of government spending.
The higher taxes don't increase the amount of leakage.
This initial increase in aggregate spending will start a process of multipliers.
The balanced budget is equal to 1.
A $50 billion increase in annual government expenditure combined with an equivalent increase in taxes increases aggregate demand by $50 billion per year.
In 1963, President John F. Kennedy announced his intention to reduce taxes in order to boost the economy.
Ronald Reagan initiated the second-largest tax cut in history.
In 1981 the Congressional Congress cut personal taxes by $250 billion and business taxes by $70 billion.
At the end of the 1980s, President George H. Bush proposed to cut the capital gains tax in order to encourage investment.
The idea of tax incentives for investment was embraced by President Clinton.
He favored a tax credit for new investments in plant and equipment to increase the level of investment.
The tax-cut stops were pulled out by President Bush.
After taking office in 2001, he convinced Congress to pass a tax cut for consumers.
Business tax cuts were done in 2002 and 2003 by him.
AD was shifted to the right by the cumulative impact of the tax cuts.
Increasing transfer payments is a third fiscal policy option that stimulates the economy.
Social Security recipients, welfare recipients, unemployment insurance beneficiaries, and veterans will have more disposable income to spend.
Aggregate demand will be boosted by the increase in consumption.
Increased transfer payments don't increase injections dollar-for-dollar.
Consumers will save some of their additional transfer payments, but only part of the additional income will be injected into the spending stream.
The aggregate demand curve is shifted further to the right by the initial stimulation.
The objective of fiscal policy is not always to increase demand.
The federal government can use both sides of the budget for restraining aggregate demand.
The budget tools are used in reverse.
We want to reduce government spending, increase taxes, or decrease transfer payments.
The first thing we have to do is figure out how much we want aggregate demand to fall.
The AS and AD 1 curves intersect.
AD needs to shift by more than the GDP gap.
The inflationary GDP gap is larger than AD excess.
Our fiscal policy target is the excess aggre employment equilibrium after gate demand.
We must allow for price-level changes to restore price stability.
This is accomplished by the AD 2 curve.
We have less output and less inflation.
The AD curve needs to be shifted to the left to account for the AD excess.
Taking into account multiplier effects, we calculate how much government spending or taxes must be changed to achieve the desired shift.
Budget cuts are the first option to consider.
The answer is simple, we first calculate the desired fiscal restraint.
We reduced government expenditure by that amount.
Some of the restraint will be dissipated in pricelevel reductions if aggregate demand is reduced by that amount.
The desired reduction in aggregate demand will be achieved by budget cuts of less than $400 billion.
The multiplier is 4 if we assume a marginal propensity to consume of 0.75.
A military cutback would cause a lot of employees to be out of work.
Thousands of workers would get smaller paychecks.
The workers would have to cut back on their own spending.
Aggregate demand would be hit first by a cut in government spending and then by cutbacks in consumer spending.
The impact of this process is highlighted in the News.
The power of the multiplier process is revealed by the marginal propensity to consume again.
When the government reduces their income by $100 billion, the consumption of aerospace workers will decrease by $75 billion.
The story should sound familiar from this point.
Consumer spending will be reduced by $300 billion as a result of the $100 billion government cutback.
$400 billion is the total drop in spending.
Excess aggregate demand would be eliminated by this cumulative reduction in spending.
In 1992, the first decline in three years and the largest in almost Morgan Guaranty in New York, federal purchases of goods and services dropped 3.3 percent.
LucindaHarper chases fell more than 6.0 percent during the year.
The economy is feeling the pinch.
Aggregate demand is decreased by reductions in governmental spending on goods and services.
Aggregate demand is further reduced by the effects of multipliers.
The AD curve can be shifted by tax increases.
Less aggregate demand is achieved by reduced consumption.
As consumers tighten their belts, the multiplier process leads to a larger shift of aggregate demand.
Changes in taxes must always be larger than the changes in injections.
The marginal propensity to consume determines how much larger it is.
Consumers would reduce their consumption by $100 billion if taxes were increased by this amount.
A cumulative reduction in spending of $400 billion is achieved by the F I S C A L P O L I C Y T O L S multiplier.
Aggregate demand would shift from AD 1 to AD 3.
Tax increases have been used to cool the economy.
Vietnam War expenditures helped to drive up prices in 1968, as the economy was rapidly approaching full employment.
Congress imposed a 10 percent surtax on income, which took $10 billion away from consumers.
Spending was reduced in 1969 due to resultant effects.
There was great concern in 1982 that the 1981 tax cuts were excessive.
Congress withdrew some of its earlier tax cuts in order to reduce inflationary pressure.
For the years 1983 to 1985 the Tax Equity and Fiscal Responsibility Act increased taxes by $90 billion.
This shifted aggregate demand to the left.
Reducing transfer payments is one of the options for fiscal restraint.
Consumers spend less with less income.
The size of the transfer cut can be used to calculate the desired tax increase.
Transfer cuts don't have the same fiscal impact as a tax hike.
The aged, the poor, the unemployed, and the disabled are all affected by a cut in transfer payments.
The lever can be used to reduce the rate of increase in transfer benefits.
deliberate shifting of the aggregate demand curve is the essence of fiscal policy.
The policy tools needed to induce the desired shift can be selected.
There are a variety of tools for managing aggregate demand in the fiscal policy toolbox.
If the economy is in a slump, the government can increase purchases of government goods and services.
Reducing government purchases, raising taxes, and cutting transfer payments can help the government reduce inflationary pressures when the economy is overheated.
Table 11 summarizes the policy options.
The guidelines are easy to understand, as this list of options might first appear.
One needs to know the size of the AD shortfall and the marginal prosperity to consume to use them.
The fiscal policy guidelines are useful.
The government might want to increase federal purchases by $50 billion.
If the government raised taxes for this purpose, the fiscalStimulus would be mostly offset by declines in consumption and investment.
In Chapter 12 we look at the budget deficits that help finance fiscal policy.
There may be a blip in the unemployment or inflation rate.
We may want to make sure that the GDP gap is not a recession.
It will take time to get Congress to pass a policy strategy.
We will have to wait for the many steps in the multiplier process to unfold once it's implemented.
The fiscal policy rescue may not arrive for a while.
If the economy is hit with other shocks, the nature of our macro problems could change.
Politics take over when a tax or spending plan arrives at the Capitol.
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