Chapter 16: Fiscal Policy – Macroeconomic Study Notes

Chapter 16: Fiscal Policy

16.1 What Is Fiscal Policy?

Fiscal policy refers to the use of federal government spending and taxation to influence macroeconomic outcomes such as growth, employment, and price stability. It is a key tool for managing aggregate demand in the economy.

• Definition: Fiscal policy consists of changes in federal taxes and expenditures designed to achieve macroeconomic objectives.

• Components: Changes in government spending (G) and taxes. State and local policies are generally not aimed at national objectives.

• Automatic Stabilizers: Certain government spending and taxes automatically adjust with the business cycle. Example: Unemployment insurance payments increase during recessions.

• Discretionary Fiscal Policy: Deliberate actions by the government to change spending or taxes.

16.1 Federal Government Expenditures and Revenue

The federal government plays a major role in total government spending, especially since the Great Depression. Its expenditures and revenues are crucial for fiscal policy.

• Federal Share: Now accounts for two-thirds to three-quarters of total government spending.

• Expenditures:

  • Purchases (G): Defense, salaries, national parks, scientific research.

  • Transfer Payments: Social Security, Medicare/Medicaid, unemployment insurance.

  • Other: Interest payments, grants to state/local governments.

• Revenue:

  • Individual income taxes (largest source)

  • Corporate income taxes

  • Social insurance taxes

  • Other taxes: excise, tariffs, fees

Expenditure Type	Examples
Purchases (G)	Defense, salaries, parks, research
Transfer Payments	Social Security, Medicare, unemployment
Other	Interest, grants

Revenue Source	Examples
Individual Income Taxes	Wages, salaries
Corporate Income Taxes	Business profits
Social Insurance Taxes	Payroll taxes
Other	Excise, tariffs, fees

16.2 The Effects of Fiscal Policy on Real GDP and the Price Level

Fiscal policy affects aggregate demand, which in turn influences real GDP and the price level. The government uses fiscal policy to stabilize the economy and achieve full employment and growth.

• Goals: Full employment, positive economic growth rates.

• Tools:

  • Government Spending: Directly increases aggregate demand.

  • Taxes: Changes disposable income, indirectly affecting aggregate demand.

• Expansionary Fiscal Policy:

  • Increase government purchases (G), increase transfer payments, decrease taxes.

  • Used when real GDP is below potential GDP to decrease unemployment.

  • Shifts aggregate demand curve to the right.

• Contractionary Fiscal Policy:

  • Decrease government purchases (G), decrease transfer payments, increase taxes.

  • Used when real GDP is above potential GDP to decrease inflation.

  • Shifts aggregate demand curve to the left.

Problem	Type of Policy	Actions	Result
Recession	Expansionary	Increase purchases or cut taxes	Real GDP and price level rise
Rising inflation	Contractionary	Decrease purchases or raise taxes	Real GDP and price level fall

16.4 The Government Purchases, Tax, and Transfer Payments Multipliers

Multipliers measure how changes in government spending, taxes, or transfer payments affect equilibrium real GDP. The multiplier effect amplifies the impact of fiscal policy.

• Autonomous Increase: Initial change in aggregate demand from government action.

• Induced Increase: Resulting changes in consumption due to higher income.

• Multiplier Effect: A change in autonomous expenditure leads to a larger change in real GDP.

• Formulas:

  • Government purchases multiplier: $\text{Government purchases multiplier} = \frac{\text{Change in equilibrium real GDP}}{\text{Change in government purchases}}$

  • Tax multiplier: $\text{Tax multiplier} = \frac{\text{Change in equilibrium real GDP}}{\text{Change in taxes}}$

  • Transfer payments multiplier: $\text{Transfer payments multiplier} = \frac{\text{Change in equilibrium real GDP}}{\text{Change in transfer payments}}$

• Tax Multiplier: Negative value; an increase in taxes decreases equilibrium real GDP.

• Transfer Payments Multiplier: Positive value; increases in transfer payments raise disposable income and consumption.

• Practice Example: If the government purchases multiplier is 2, a $100 million increase in purchases raises equilibrium real GDP by $200 million.

16.5 The Limits to Using Fiscal Policy to Stabilize the Economy

Fiscal policy faces practical limitations that can reduce its effectiveness in stabilizing the economy.

• Timing Issues:

  • Legislative Delay: Time required for Congress to approve actions.

  • Implementation Delay: Large projects may take months or years to begin.

• Crowding Out: Increased government spending can reduce private expenditures (consumption, investment, net exports) by raising interest rates and decreasing total savings.

• Short-Run Effects: The initial increase in spending may be partially offset by crowding out.

16.6 Deficits, Surpluses, and Federal Government Debt

The federal budget can be in deficit, surplus, or balance, affecting the level of government debt and serving as an automatic stabilizer.

• Budget Deficit: Expenditures > tax revenue.

• Budget Surplus: Expenditures < tax revenue.

• Balanced Budget: Expenditures = tax revenue.

• Federal Government Debt: Total value of outstanding Treasury securities; increases with persistent deficits.

• Ownership of National Debt:

  • Intragovernmental holdings (Social Security trust fund, etc.)

  • Federal Reserve

  • U.S. banks and public

  • Foreign holders (China, Japan, UK, etc.)

Budget Status	Definition
Deficit	Expenditures > Tax revenue
Surplus	Expenditures < Tax revenue
Balanced	Expenditures = Tax revenue

Debt Holder	Share (%)
Intragovernmental holdings	~40
Federal Reserve	~17.5
U.S. public/banks	~28.6
Foreign holders	~23

Case Studies in Fiscal Policy

Real-world examples illustrate the application and effects of fiscal policy.

• American Recovery and Reinvestment Act of 2009 (ARRA):

  • Expansionary policy: Increased government spending and tax cuts.

  • Affected aggregate demand: Increased.

  • Affected price levels: Likely increased.

  • Affected unemployment: Decreased.

• Budget Sequestration (2013):

  • Contractionary policy: Automatic spending cuts.

  • Affected aggregate demand: Decreased.

  • Affected price levels: Likely decreased or slowed growth.

  • Affected unemployment: Increased or slowed job growth.

• Japan's "Abenomics" Fiscal Stimulus:

  • Expansionary policy: Increased public works, tax incentives.

  • Affected aggregate demand: Increased.

  • Affected price levels: Intended to increase (combat deflation).

  • Affected unemployment: Decreased.

• Austerity Measures in Eurozone (Greece):

  • Contractionary policy: Spending cuts, tax increases.

  • Affected aggregate demand: Decreased.

  • Affected price levels: Likely decreased.

  • Affected unemployment: Increased.

Additional info: These notes expand on the original slides by providing definitions, formulas, and context for fiscal policy, multipliers, and real-world applications. Tables have been recreated for clarity and completeness.