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CHAPTER CHAPTER 11 Fiscal Policy © David Muir/Digital Vision/Getty Images. I n the early 1980s, under President Ronald Reagan, Fiscal policy is one of the major issues that touches the federal government reduced personal income everyone’s life. Fiscal policy is the use of government tax rates. The goal was to expand aggregate demand and spending and taxes to influence the nation’s output, boost national output and employment in order to end employment, and price level. Federal government spend- the recession of 1980–1981. In the 1990s, a key part of ing policies affect Social Security benefits, price supports President Bill Clinton’s economic program was to for dairy farmers, and employment in the defense indus- stimulate economic growth by boosting government try. Tax policies can change the amount of your paycheck spending on long-term investment. This investment and therefore influence whether you purchase a car or program included highways, bridges, fiber-optic commu- attend college. nications networks, and education. In 2001, the United Using fiscal policy to influence the performance of the States experienced a recession, and President George W. economy has been an important idea since the Bush proposed and signed into law a tax cut in order to Keynesian revolution of the 1930s. This chapter removes stimulate the economy. And in 2003, another tax cut bill the political veil and looks at fiscal policy from the view- was passed to create jobs and stimulate economic point of two opposing economic theories. First, you will growth. From May to July 2008, Americans received study Keynesian demand-side fiscal policies that “fine- about $170 billion in a tax-rebate stimulus package tune” aggregate demand so that the economy grows and intended to trigger a spending spree that would enable achieves full employment with a higher price level. Sec- the economy to avoid a recession. ond, you will study supply-side fiscal policy, which gained 282 prominence during the Reagan administration. Supplysiders view aggregate supply as far more important than aggregate demand. Their fiscal policy prescription is to increase aggregate supply so that the economy grows and achieves full employment with a lower price level. In this chapter, you will learn to solve these economic puzzles: • Does an increase in government spending or a tax cut of equal amount provide the greater stimulus to economic growth? • Can Congress fight a recession without taking any action? • How could one argue that the federal government can increase tax revenues by cutting taxes? Discretionary Fiscal Policy Here we begin where the previous chapter left off—that is, discussing the use of discretionary fiscal policy, as Keynes advocated, to influence the economy’s performance. Discretionary fiscal policy is the deliberate use of changes in government spending or taxes to alter aggregate demand and stabilize the economy. Exhibit 1 lists three basic types of discretionary fiscal policies and the corresponding ways in which the government can pursue each of these options. The first column of the table shows that the government can choose to increase aggregate demand by following an expansionary fiscal policy. The second column lists contractionary fiscal policy options the government can use to restrain aggregate demand. Increasing Government Spending to Combat a Recession Suppose the U.S. economy represented in Exhibit 2 has fallen into recession at equilibrium point E1, where aggregate demand curve AD1 intersects the aggregate supply curve, AS, in the near-full-employment range. (Note that for simplicity the aggregate demand and aggregate supply curves are drawn here as straight lines.) The price level measured by the CPI is 150, and a real GDP gap of $100 billion exists below the full-employment output of $6.1 trillion real GDP. As explained in the previous chapter (Exhibit 5), one approach the president and Congress can follow is provided by classical theory. The classical economists’ prescription is to wait because the economy will self correct to full employment in the long run by adjusting downward along AD1. But election time is approaching, so there is political pressure to do something about the recession now. Besides, recall Keynes’s famous statement, “In the long run, we are all dead.” Hence, policymakers follow Keynesian economics and decide to shift the aggregate demand curve rightward from AD1 to AD2 and thereby cure the recession. How can the federal government do this? In theory, any increase in consumption (C), investment (I), or net exports (X  M) can spur aggregate demand. But these spending boosts are not directly under the government’s control as is government spending (G). After all, there is always a long wish list of spending proposals for federal highways, health care, education, environmental programs, and so forth. Fiscal policy The use of government spending and taxes to influence the nation’s spending, employment, and price level. Discretionary fiscal policy The deliberate use of changes in government spending or taxes to alter aggregate demand and stabilize the economy. 283 284 PA RT 4 MACROECONOMIC THEORY AND POLICY EXHIBIT 1 Discretionary Fiscal Policies Expansionary Fiscal Policy Contractionary Fiscal Policy Increase government spending Decrease taxes Increase government spending and taxes equally Decrease government spending Increase taxes Decrease government spending and taxes equally Rather than crossing their fingers and waiting for things to happen in the long run, suppose that members of Congress gladly increase government spending to boost employment now. But just how much new government spending is required? Note that the economy is operating $100 billion below its full-employment output, but the horizontal distance between AD1 and AD2 is $200 billion. This gap between AD1 and AD2 is indicated by the dotted line between points E1 and X. This means that the aggregate demand curve must be shifted to the right by $200 billion. But it is not necessary to increase government spending by this amount. The following formula can be used to compute the amount of additional government spending required to shift the aggregate demand curve rightward and establish a new full-employment real GDP equilibrium: Initial change in government spending (ΔG)  spending multiplier ¼ change in aggregate demand (total spending) Spending multiplier (SM) The ratio of the change in real GDP to an initial change in any component of aggregate expenditures, including consumption, investment, government spending, and net exports. As a formula, spending multiplier equals 1/(1  MPC) or 1/MPS. The spending multiplier (SM) in the formula amplifies the amount of new government spending. The spending multiplier is the change in aggregate demand (total spending) resulting from an initial change in any component of aggregate demand, including consumption, investment, government spending, and net exports. Assume the MPC is 0.75, and therefore the value for the spending multiplier in our example is 4. The next section explains the algebra behind the spending multiplier so our example can be solved: ΔG  4 ¼ $200 billion ΔG ¼ $50 billion Note that the Greek letter Δ (delta) means “a change in.” Thus, it takes $50 billion worth of new government spending to shift the aggregate demand curve to the right by $200 billion. As described in the previous chapter (Exhibit 6), bottlenecks occur throughout the upward-sloping range of the AS curve. This means prices rise as production increases in response to greater aggregate demand. Returning to Exhibit 2, you can see that $50 billion worth of new government spending shifts aggregate demand from AD1 to AD2. As a result, firms increase output upward along the aggregate supply curve, AS, and total spending moves upward CHAPTER 11 EXHIBIT 2 FISCAL POLICY Using Government Spending to Combat a Recession The economy in this exhibit is in recession at equilibrium point E1 on the intermediate range of the aggregate supply curve, AS. The price level is 150, with an output level of $6 trillion real GDP. To reach the full-employment output of $6.1 trillion in real GDP, the aggregate demand curve must be shifted to the right by $200 billion real GDP, measured by the horizontal distance between point E1 on curve AD1 and point X on curve AD2. The necessary increase in aggregate demand from AD1 to AD2 can be accomplished by increased government spending. Given a spending multiplier of 4, a $50 billion increase in government spending brings about the required $200 billion rightward shift in the aggregate demand curve, and equilibrium in the economy changes from E1 to E2. Note that the equilibrium real GDP changes by $100 billion and not by the full amount by which the aggregate demand curve shifts horizontally. AS E2 155 Price level (CPI) E1 X 150 AD2 AD1 Full employment 0 6 6.1 6.2 Real GDP (trillions of dollars per year) CAUSATION CHAIN Increase in government spending Increase in the aggregate demand curve Increase in the price level and the real GDP along aggregate demand curve AD2. This adjustment mechanism moves the economy to a new equilibrium at E2, with full employment, a higher price level of 155, and a real GDP of $6.1 trillion per year. At point E2 the economy experiences demand-pull inflation. And here is the important point: Although the aggregate 285 286 PA RT 4 MACROECONOMIC THEORY AND POLICY EXHIBIT 3 The Spending Multiplier Effect Round 1 2 3 4 . . . All other rounds Component of Total Spending New Consumption Spending Government spending Consumption Consumption Consumption . . . Consumption Total spending $ 50 38 29 22 . . . 61 $200 Note: All amounts are rounded to the nearest billion dollars per year. demand curve has increased by $200 billion, the equilibrium real GDP has increased by only $100 billion, from $6 to $6.1 trillion. Conclusion In the intermediate segment of the aggregate supply curve, the equilibrium real GDP changes by less than the change in government spending times the spending multiplier. Spending Multiplier Arithmetic Revisited1 Marginal propensity to consume (MPC) The change in consumption spending resulting from a given change in income. Now let’s pause to tackle the task of explaining in more detail the spending multiplier of 4 used in the above example. The spending multiplier begins with a concept called the marginal propensity to consume (MPC). The marginal propensity to consume is the change in consumption spending resulting from a given change in income. Algebraically, MPC ¼ change in consumption spending change in income Exhibit 3 illustrates numerically the cumulative increase in aggregate demand resulting from a $50 billion increase in government spending. In the initial round, the government spends this amount for bridges, national defense, and so forth. Households receive this amount of income. In the second round, these households spend $38 billion (0.75  $50 billion) on houses, cars, groceries, and other products. In the third round, the incomes of realtors, autoworkers, grocers, and others are boosted by $38 billion, and they spend $29 billion (0.75  $38 billion). Each round 1. This section duplicates material presented earlier in the chapters titled “The Keynesian Model” and “The Keynesian Model in Action.” The reason for repeating this material is that an instructor may choose to skip the Keynesian model presented in these two chapters. CHAPTER 11 287 FISCAL POLICY of spending creates income for consumption re-spending in a downward spiral throughout the economy in smaller and smaller amounts until the total level of aggregate demand rises by an extra $200 billion. Conclusion Any initial change in spending by the government, households, or firms creates a chain reaction of further spending, which causes a greater cumulative change in aggregate demand. You might recognize from algebra that the spending multiplier effect is a process based on an infinite geometric series. The formula for the sum of such a series of numbers is the initial number times 1/(1  r), where r is the ratio that relates the numbers. Using this formula, the sum (total spending) is calculated as $50 billion (ΔG)  [1/(1  0.75)] ¼ $200 billion. By simply defining r in the infinite series formula as MPC, the spending multiplier for aggregate demand is expressed as Spending multiplier ¼ 1 1  MPC Aplying this formula to our example: Spending multiplier ¼ 1 1 ¼ ¼4 1  0:75 0:25 If households spend a portion of each extra dollar of income, then the remaining portion of each dollar is saved. The marginal propensity to save (MPS) is the change in saving resulting from a given change in income. Therefore: The change in saving resulting from a given change in income. MPC þ MPS ¼ 1 rewritten as MPS ¼ 1  MPC Hence, the above spending multiplier formula can be rewritten as Spending multiplier ¼ Marginal propensity to save (MPS) 1 MPS Since MPS and MPC are related, the size of the multiplier depends on the size of the MPC. What will the result be if people spend 80 percent or 33 percent of each dollar of income instead of 50 percent? If the MPC increases (decreases), consumers spend a larger (smaller) share of each additional dollar of output/income in each round, and the size of the multiplier increases (decreases). Exhibit 4 lists the multiplier for different values of MPC and MPS. Economists use real-world macroeconomic data to estimate a more complex multiplier than the simple multiplier formula developed in this chapter. Their estimates of the long run real-world MPC range from 0.80 to 0.90. An MPC of 0.50 is used in the above examples for simplicity. 288 PA RT 4 MACROECONOMIC THEORY AND POLICY EXHIBIT 4 (1) Marginal Propensity to Consume (MPC) 0.90 0.80 0.75 0.67 0.50 0.33 Relationship between MPC, MPS, and the Spending Multiplier (2) Marginal Propensity to Save (MPS) 0.10 0.20 0.25 0.33 0.50 0.67 (3) Spending Multiplier 10 5 4 3 2 1.5 CHECKPOINT What Is the MPC for Uncle Sam’s Stimulus Package? Assume there is concern that the economy is heading into a recession, and a stimulus package of $170 billion is passed by the federal government. The administration predicts that this measure will provide a $850 billion boost to GDP this year because consumers will spend their extra cash on plasma televisions and other items. For this amount of stimulus, what is the established value of MPC used in this forecast? Cutting Taxes to Combat a Recession Another expansionary fiscal policy intended to increase aggregate demand and restore full employment calls for the government to cut taxes. Let’s return to point E1 in Exhibit 2. As before, the problem is to shift the aggregate demand curve to the right by $200 billion. But this time, instead of a $50 billion increase in government spending, assume Congress votes for a $50 billion tax cut. How does this cut in taxes affect aggregate demand? First, disposable personal income (take-home pay) increases by $50 billion—the amount of the tax reduction. Second, once again assuming the MPC is 0.75, the increase in disposable personal income induces new consumption spending of $38 billion (0.75  $50 billion). Thus, a cut in taxes triggers a multiplier process similar to, but smaller than, the spending multiplier. Exhibit 5 demonstrates that a tax reduction adds less to aggregate demand than does an equal increase in government spending. Column 1 reproduces the effect of increasing government spending by $50 billion, and column 2 gives for comparison the effect of lowering taxes by $50 billion. Note that the only difference between increasing government spending and cutting taxes by the same amount is the impact in the initial round. The reason is that a tax cut injects zero new spending into the economy because the government has purchased no new goods and services. CHAPTER 11 EXHIBIT 5 289 FISCAL POLICY Comparison of the Spending and Tax Multipliers Increase in aggregate demand from Round 1 2 3 4 . . . All other rounds Note: Component of Total Spending (1) $50 billion Increase in Government Spending (þΔG) (2) $50 billion Cut in Taxes (Δ T) Government spending Consumption Consumption Consumption . . . $ 50 $ 0 38 29 22 . . . 38 29 22 . . . Consumption Total spending 61 $200 61 $150 All amounts are rounded to the nearest billion dollars per year. The effect of a tax reduction in round 2 is that people spend a portion of the $50 billion boost in after-tax income from the tax cut introduced in round 1. Subsequent rounds in the tax multiplier chain generate a cumulative increase in consumption expenditures that totals $150 billion. Comparing the total changes in aggregate demand in columns 1 and 2 of Exhibit 4 leads to the following: Conclusion A tax cut has a smaller multiplier effect on aggregate demand than an equal increase in government spending. The tax multiplier can be computed by using a formula and the information from column 2 of Exhibit 5. The tax multiplier is the change in aggregate demand (total spending) resulting from an initial change in taxes. Mathematically, the tax multiplier is given by this formula: Tax multiplier ¼ 1  spending multiplier Returning to Exhibit 2, the tax multiplier formula can be used to see how large a tax cut is needed to shift the aggregate demand curve rightward by $200 billion and restore full employment. Applying the formula given above and a spending multiplier of 4 yields a tax multiplier of 3. Note that the sign of the tax multiplier is always negative. Thus, a $66.6 billion tax cut is needed to shift the aggregate Tax multiplier The change in aggregate demand (total spending) resulting from an initial change in taxes. As a formula, tax multiplier equals 1  spending multiplier. 290 PA RT 4 MACROECONOMIC THEORY AND POLICY demand curve rightward by $200 billion and restore full-employment equilibrium at point E2. Mathematically, Change in taxes ðΔTÞ  tax multiplier ¼ change in aggregate demand ΔT  3 ¼ $200 billon ΔT ¼ $66.6 billon A word of warning concerning the above analysis: In reality, the assumption that the MPC remains unchanged in response to a tax cut may be invalid. In 1964, Congress enacted President Kennedy’s tax-cut proposal. The tax multiplier worked, and consumer spending lifted the economy out of a recession. On the other hand, in 1975, President Gerald Ford persuaded Congress to reduce income taxes to help increase aggregate demand during a recession. This time, however, the size of the tax multiplier fell because consumers reduced their MPC. This occurred because people saved much of the tax cut, rather than spending it. As a result, the anticipated boost to aggregate demand did not materialize. Early in 2001, the United States experienced a recession that ended the longest economic expansion in U.S. history. In response, President Bush and Congress agreed to send out about $40 billion in tax rebates and phase in new lower marginal rates in coming years. In 2003, the personal income tax rate reductions scheduled for later years by the 2001 tax cut law were accelerated. Again, the key to the amount of real GDP growth depends on the size of the MPC, and in turn the tax multiplier. What proportion of the tax cut is spent for consumption? The answer means the difference between a deeper or milder recession, as well as the speed of recovery. Using Fiscal Policy to Combat Inflation So far, Keynesian expansionary fiscal policy, born of the Great Depression, has been presented as the cure for an economic downturn. Contractionary fiscal policy, on the other hand, can serve in the fight against inflation. Exhibit 6 shows an economy operating at point E1 on the classical range of the aggregate supply curve, AS. Hence, this economy is producing the full-employment output of $6.1 trillion real GDP, and the price level is 160. In this situation, any increase in aggregate demand only causes inflation, while real GDP remains unchanged. Suppose Congress and the president decide to use fiscal policy to reduce the CPI from 160 to 155 because they fear the wrath of voters suffering from the consequences of inflation. Although a fall in consumption, investment, or net exports might do the job, Congress and the president may be unwilling to wait, and they prefer taking direct action by cutting government spending. Given a marginal propensity to consume of 0.75, the spending multiplier is 4. As shown by the horizontal distance between point E1 on AD1 and point E0 on AD2 in Exhibit 6, aggregate demand must be decreased by $100 billion in order to shift the aggregate demand curve from AD1 to AD2 and establish equilibrium at E2, with a price level of 155. Mathematically, ΔG  4 ¼ $100 billion ΔG ¼ $25 billion Using the above formula, a $25 billion cut in real government spending would cause a $100 billion decrease in the aggregate demand curve from AD1 to AD2. The result is a temporary excess aggregate supply of $100 billion, measured by the distance CHAPTER 11 EXHIBIT 6 FISCAL POLICY Using Fiscal Policy to Combat Inflation The economy in this exhibit is in equilibrium at point E1 on the classical range of the aggregate supply curve, AS. The price level is 160, and the economy is operating at the full-employment output of $6.1 trillion real GDP. To reduce the price level to 155, the aggregate demand curve must be shifted to the left by $100 billion, measured by the horizontal distance between point E1 on curve AD1 and point E0 on curve AD2. One way this can be done is by decreasing government spending. With MPC equal to 0.75, and therefore a spending multiplier of 4, a $25 billion decrease in government spending results in the needed $100 billion leftward shift in the aggregate demand curve. As a result, the economy reaches equilibrium at point E2, and the price level falls from 160 to 155, while real output remains unchanged at full capacity. An identical decrease in the aggregate demand curve can be obtained by a hike in taxes. A $33.3 billion tax increase works through a multiplier of 3 and provides the needed $100 billion decrease in the aggregate demand curve from AD1 to AD2. AS Price level (CPI) E1 160 E′ E2 155 AD2 Full employment 0 6 AD1 6.1 Real GDP (trillions of dollars per year) CAUSATION CHAIN Decrease in government spending or increase in taxes Decrease in the aggregate demand curve Decrease in the price level from E0 to E1. As explained in Exhibit 5 of the previous chapter, the economy follows classical theory and moves downward along AD2 to a new equilibrium at E2. Consequently, inflation cools with no change in the full-employment real GDP. Another approach to the inflation problem would be for Congress and the president to raise taxes. Although tax increases are often considered political suicide, let’s suppose Congress calculates just the correct amount of a tax hike required to reduce aggregate demand by $100 billion. Assuming a spending multiplier of 4, the tax multiplier is 3. Therefore, a $33.3 billion tax hike provides the necessary $100 billion 291