macroeconomics ch 11

8/10/2019 Macroeconomics Ch 11

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Macroeconomics

Dr. Karim Kobeissi

Arts, Sciences and Technology University in

Lebanon


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Chapter 11: Fiscal Policy


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Introduction

The governments tax and spending activitiesinfluence economic outcome (GDP).

Keynesian theory emphasizes the markets

lack of self adjustment, particularly in

recessions. If the market doesnt self adjust,

then the government may have to intervene.

Specifically, the government may have to use

its tax and spending power (fiscal policy) tostabilize the macro economy.


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Fiscal Policy Refers to changes in government

expenditures and/or taxes to achieve

particular economic goals, such as low

unemployment rate, price stability, and

economic growth.

Government expenditures is the sum of

government purchases and transferpayments.


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Fiscal Policy Definitions

Expansionary fiscal policyrefers to increases ingovernment expenditures

and/or decreases in taxesto achieve macroeconomicgoals.

Contractionary fiscalpolicy attempts to

decrease governmentexpenditures and/orincreases in taxes toachieve macroeconomicgoals.


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A Key Assumption

In our discussion of fiscal policy, we assume that

any change in government spending is due to a

change in government purchases and not to a

change in transfer payments.


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Demand-Side Fiscal Policy

A change in consumers consumption, businessinvestments, government purchases, or net

exports can change aggregate demand and

therefore shift the AD curve.

A change in taxes can affect consumers

consumption or business investment or both andtherefore can affect aggregate demand.


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Fiscal Policy: A Keynesian

Perspective


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Crowding Out An economic concept where increased public sector

spending replaces, or drives down, private sectorspending. Crowding out refers to when government mustfinance its spending with taxes and/or with deficitspending, leaving businesses with less money andeffectively "crowding them out" .

One explanation of why crowding out occurs isgovernment financing of projects with deficit spendingthrough the use of borrowed money. Because thegovernment borrows such large amounts of capital, itsactivities can increase interest rates. Higher interest ratesdiscourage individuals and businesses from borrowingmoney, which reduces their spending and investmentactivities.


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Crowding Out Complete Crowding Out occurs when the decrease in one or

more components of private spending completely offsets the

increase in government spending.

Incomplete Crowding Out occurs when the decrease in one

or more components of private spending only partially

offsets the increase in government spending.

Crowding out question the effectiveness of expansionary

demand-side fiscal policy:

In fact, if complete or incomplete crowding out occurs, it

follows that expansionary fiscal policy will have less impact

on aggregate demand and Real GDP than Keynesian theory

predicts.


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Keynesian Theory

& Crowding Out

In Keynesian theory, expansionaryfiscal policy shifts the aggregatedemand curve to AD2 and movesthe economy to point 2.

If there is no crowding out,expansionary fiscal policyincreases Real GDP and lowers theunemployment rate.

If there is incomplete crowdingout, expansionary fiscal policyincreases Real GDP and lowers theunemployment rate (point 2), butnot as much as in the case of zero

crowding out (point 2

).

If there is complete crowding out,expansionary fiscal policy has noeffect on the economy (point 1).


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The New Classical View of Fiscal Policy:Crowding Out with No Increase in Interest Rates

Individuals respond to expansionary fiscal policy, a largerdeficit, and greater deficit-financing requirements bythinking the following Alarger deficit implies more debtthis year and higher future taxes. Illsimply save more in

the present so I can pay the higher future taxes required topay interest and to repay principal on the new debt. But,of course, if Imgoing to save more, Illhave to consumeless.

1. Current consumption will fall as a result of expansionaryfiscal policy.

2. Budget deficits do not bring higher interest rates.


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The New Classical View of

Expansionary Fiscal Policy

As long as

expansionary

fiscal policy is

translated intohigher future

taxes, there will

be no change in

Real GDP,unemployment

rate, the price

level, or interest

rates.


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Lags & Fiscal PolicyEconomists argue that an economic policy that is based on the

ad hoc judgment of policymakers is not likely to have theexpected impact on the economy. By the time the fullimpact of the policy is felt, the economic problem it wasdesigned to solve may no longer exist, may not exist to thedegree it once did, or it may have changed altogether.

There are lags in the execution of macroeconomic policybecause of:

1. The Data Lag

2. The Recognition lag

3. The Legislative Lag

4. The Implementation Lag

5. The Effectiveness Lag


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Lags & Fiscal Policy (con)1. The Data Lag

Many macroeconomic data series such as GDP are onlyavailable with a considerable lag, and they are subject tobig revisions. Because of this, information policy makersuse is retrospective, not contemporaneous. Gettinginformation about the current state of the economy isdifficult, we don't have good information until monthsafter the economy has already changed course.

2. The Recognition lag

Once the data are finally available it takes time to figure outwhat they are saying. Is the downturn in employment inthis month's data temporary, or the beginning of a longerterm trend? If it's temporary, no need to act, but if it's

permanent, then action may be needed.

L & F i l P l i ( )


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L a g s & F i s c a l P o l i c y ( c o n )

3. The Legislative Lag

Once we've obtained the necessary data and concluded

something must be done, there can be considerable lags in

the legislative process as legislators debate the exact form

of the package, or oppose it altogether.

4. The Implementation lag

Once a policy is passed, it takes time to put it into place, e.g.

to set up the administration of the money, to deliver it to

the right agencies, to make the plans needed to spend it.


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Lags & Fiscal Policy (con)5. The Effectiveness Lag

After all of that, and the policy is finally put into place, it takes

time for policy to hit the economy and take effect. For

monetary policy it can be a year to a year and a half

before the peak effect of the policy is felt (though the

legislative lags are much shorter since the Federal Reserve

can act faster than congress). The effectiveness lag for

fiscal policy is a bit shorter, but still considerable, six

months at least.


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Lags & Fiscal Policy (con)

The government

has moved the

economy from

point 1 to point 2,

and not, as theyhad hoped, from

point 1 to point 1.


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Demand-Side Fiscal Policy: Return to the

Keynesian Model

It would seem that under

the conditions of no lags

and zero crowding out,

expansionary fiscalpolicy either

increasing government

spending or cutting

taxes will work at

removing the economy

from a recessionary gap.


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The Marginal Propensity to Consume (MPC)

The proportion of an aggregate raise in pay that a consumer spends on

the consumption of goods and services, as opposed to saving it.

Marginal propensity to consume is a component of Keynesian

macroeconomic theory and is calculated as the change in

consumption divided by the change in income [C / Y]. If

consumption increases by 80 cents for each additional dollar of

income, then MPC is equal to 0.8 / 1 = 0.8.


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Demand-Side Fiscal Policy: Return to the Keynesian Model

If government knows the difference

between Q1 and QN (so that it knows

how much to change Real GDP;

Real GDP) and it knows the MPC

multiplier (m) = [1 (1- MPC)], then it

can use fiscal policy (Taxes) to get the

economy out of a recessionary gap and

producing Natural Real GDP.


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Hypothetical Example # 1 (Case of Recession)

Suppose Q1= $1600 billions; QN= $2400 billions; MPC = 0.75m=4.

Real GDP = - [(m) x T]T = - [Real GDP / m ]

= - [(2400 -1600) /4 ]

= - $ 200 billions .

Starting from an initial situation where Q1 = $1600 billions, and in

order to reach a final situation where QN (the natural employment or

full employment GDP) = $2400 billions, the government has to

reduce the taxes by: $ 200 billions.


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Hypothetical Example # 2 (Case of Expansion)

Suppose Q1= $3000 billions; QN= $1800 billions; MPC = 0.75m=4.

Real GDP = - [(m) x T]T = - [Real GDP / m ]

= - [(1800 -3000) /4 ]

= + $ 300 billions .

Starting from an initial situation where Q1 = $3000 billions, and in

order to reach a final situation where QN (the natural employment or

full employment GDP) = $1800 billions, the government has to

increase the taxes by: $ 300 billions.


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Hypothetical Example # 3 (Case of Recession)

Suppose AD1= $600 billions; AD2= $1000 billions; MPC =

0.75m = 4.

AD = (m) x Fiscal StimulusFiscal Stimulus = [AD /m]

= [(1000 -600) /4 ]

= $ 100 billions .

Starting from an initial situation where AD1= $600 billions, and in

order to reach a final situation where AD2= $1000 billions, the

government has to spend an additional amount of $ 100 billions.


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Demand-Side Fiscal Policy: Return to the

Keynesian Model If the government

doesnt know the

actual MPC and itdoesnt know theactual differencebetween Q1and QN,

then fiscal policyisnt likely to workas intended.


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Tax Cuts Instead: Are Things Any Different?

A dollar spend by the government is a dollar

spent whereas a dollar tax cut is a dollar

partly saved and partly spent In order to

get the same change in Real GDP,

government has to cut taxes more than it

has to increase spending.


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Marginal Tax Rate - Definition

The amount of tax paid on an additional dollar of

income. The marginal tax rate for an individual will

increase as income rises. This method of taxation

aims to fairly tax individuals based upon their

earnings, with low income earners being taxed at a

lower rate than higher income earners.Marginal Tax Rate = ( Tax payment)/( Taxable Income)


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Supply-Side Fiscal Policy

All other things held constant, lower marginal tax rates

increase the incentive to engage in productive activities

relative to leisure and tax avoidance activities.

If the government cut the marginal tax rate The amount

of money individuals can earn by working will increases.

Therefore, we can implicitly assume that a cut in marginal

tax rate will increases work activity The aggregate

outcome (Supply Side) will increase Real GDP will

increase.


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The Predicted Effect of a Permanent Marginal

Tax Rate Cut on Aggregate Supply

Th L ff C Th R l ti hi B t


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The Laffer Curve: The Relationship Between

Tax Rates and Tax Returns

If income tax rates were lowered, would it increaseor decrease tax revenue? ? ?

There are two tax rates at which zero tax revenues will becollected 0 and 100% (people would choose not to work

because everything they earned would go to thegovernment).

An INCREASE in tax rates could cause tax revenues toincrease.

A DECREASE in tax rates could cause tax revenues to

increase.

The Laffer Curve: The Relationship Between Tax


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The Laffer Curve: The Relationship Between Tax

Rates and Tax Returns

The Laffer curve shows the relationship between tax rates and

tax revenue collected by governments. The curve suggests

that, as taxes increase from low levels, tax revenue collected

by the government also increases. It also shows that tax rates

increasing after a certain point (B) would cause people not to

work as hard or not at all, thereby reducing tax revenue.

Tax revenues = (Tax base) x (the average Tax rate)

Th L ff C Th R l ti hi B t


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The Laffer Curve: The Relationship Between

Tax Rates and Tax Returns


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The Laffer Curve: Implications

1) Tax revenues increase if a tax reduction is made in thedownward-sloping portion of the curve (between points Band C); tax revenues decrease following a tax ratereduction in the upward sloping portion of the curve(between points A and B).

2) We assume that as the tax rate is reduced, the taxbase expands. The rationale is that individuals workmore, invest more, and enter into more exchanges,

and shelter less income from taxes and lower taxrates.

How much does the tax base expand following thetax rate reduction? ? ? ?

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