Fiscal Policy

John Maynard Keynes and Fiscal Policy

John Maynard Keynes explained how a deficiency in demand could arise in a market economy.

He showed how and why the government should intervene to achieve macroeconomic goals.

He advocated aggressive use of fiscal policy to alter market outcomes.

Fiscal Policy

Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes.

Components of Aggregate Demand

The premise of fiscal policy is that a given level of aggregate demand for goods and services will not always result in economic stability.

Aggregate Demand

Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

The four major components of aggregate demand:

Aggregate demand is not a single number but instead a schedule of planned purchases.

Components of Aggregate Demand

Consumption

Consumption refers to expenditures by consumers on final goods and services.

Consumption expenditures account for about two-thirds of total spending in U.S. economy.

Investment

Investment refers to expenditures in a given time period on:

The production of new plant and equipment (capital).

Changes in business inventories.

Investment expenditures accounts for 15% of U.S. spending.

Government Spending

Government spending includes expenditures on all goods and services provided by public sector.

Income transfers are not counted.

Government spending accounts for 17% of total spending.

Net Exports

Net exports is the difference between exports and imports.

In 2000 the U.S. bought more goods from abroad than foreigners bought from U.S.

Equilibrium

Aggregate demand is not a single number but instead a schedule of planned purchases.

Macro equilibrium is the combination of price level and real output that is compatible with both aggregate demand and aggregate supply.

There is no evident reason why AD will always produce an equilibrium at full employment and price stability.

Sometimes there will be too little demand and sometimes there will be too much.

Inadequate Demand

AD could generate less spending causing an inflationary equilibrium.

Excessive Demand

AD could generate too much spending causing the economy to produce at less than full employment.

The Desired Equilibrium

The Nature of Fiscal Policy

C + I + G + (X - M) seldom adds up to exactly the right amount of aggregate demand.

The use of government spending and taxes to adjust aggregate demand is the essence of fiscal policy.

Fiscal Policy

Fiscal Stimulus

If AD falls short, there is a gap between what the economy can produce and what people want to buy.

The GDP gap is the difference between full-employment output and the amount of output demanded at current price levels.

Deficient Demand

More Government Spending

Increased government spending is a form of fiscal-policy stimulus.

Fiscal stimulus — tax cuts or spending hikes intended to increase (shift) aggregate demand.

Multiplier Effects

An increase in spending results in increased incomes.

All income is either spent or saved.

Each dollar spent is re-spent several times.

The marginal propensity to consume (MPC) is the fraction of each additional dollar of disposable income spent on consumption.

The marginal propensity to save (MPS) is the fraction of each additional dollar of disposable income not spent on consumption

Spending and saving decisions are connected.

MPC and MPS

Multiplier Effects and the Circular Flow

The fiscal stimulus to aggregate demand includes:

The initial increase in government spending.

All subsequent increases in consumer spending triggered by the government outlays.

Multiplier Effects and the Circular Flow

Income gets spent and re-spent in the circular flow.

The Circular Flow

Spending Cycles

A demand stimulus initiated by increased government spending is a multiple of the initial expenditure.

The Multiplier Process at Work

Multiplier Formula

The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles.

Multiplier = 1/(1-MPC)

The multiplier process at work:

Every dollar of fiscal stimulus has multiplied impact on aggregate demand.

Multiplier Effects

Tax Cuts

Rather than increasing its own spending, government can cut taxes to increase consumption or investment spending.

Lowering taxes increases disposable income.

Disposable income is after-tax income of consumers.

Taxes and Consumption

If MPC is greater than zero, consumers spend some of a tax cut.

Initial increase in consumption =

MPC X tax cut

The cumulative increase in aggregate demand equals a multiple of the initial tax cut.

tax cut that increases disposable incomes stimulates consumer spending.

Taxes and Investment

Tax cuts can increase investment spending by increasing the expectations of after-tax profits.

Taxes were reduced in 1964 and in 1981 to stimulate spending.

President Bush promised even larger tax cuts in 2001.

Inflation Worries

Whenever the aggregate supply curve is upward sloping an increase in aggregate demand increases prices as well as output.

Clinton raised taxes partly because he feared inflationary pressures were building.

Fiscal Restraint

Fiscal restraint may be the proper policy when of inflation threatens.

Fiscal restraint — tax hikes or spending cuts intended to reduce aggregate demand.

Budget Cuts

Cutbacks in government spending directly reduce aggregate demand.

Multiplier Cycles

Government cutbacks have multiplied effect on aggregate demand.

Cumulative reduction in spending = multiplier X initial budget cut

Tax Hikes

Tax hikes reduce disposable income and thus reduce consumption.

Shift the aggregate demand curve to the left.

Tax increases have been used to “cool” the economy.

The Equity and Fiscal Responsibility Act of 1982 increased taxes to reduce inflationary pressures.

President Clinton restrained aggregate demand in 1993 with tax increase, but increased AD in 1997 with a five-year package of tax cuts.

Fiscal Guidelines

The fiscal strategy for attaining the goal of full employment is to shift the aggregate demand curve

Fiscal Restraint

Fiscal Policy Guidelines

Unbalanced Budgets

The use of the budget to manage aggregate demand implies that the budget will often be unbalanced.

Budget Deficit

The amount by which government expenditures exceed government revenues in a given time period.

The government borrows money to pay for deficit spending.

he federal government ran significant budget deficits between 1970 and 1997.

The deficit peaked at nearly $300 billion in 1992.

Now it’s over $300 again and heading up.

Budget Surplus

An excess of government revenues over government expenditures in a given time period.

1998, a combination of growing tax revenues and slower government spending created a budget surplus.

Unbalanced Budgets

Countercyclical Policy

In Keynes’ view, an unbalanced budget is perfectly appropriate if macro conditions call for a deficit or surplus.