Chapter 16: Fiscal Policy – Macroeconomics Study Notes

Fiscal Policy

16.1 What Is Fiscal Policy?

Fiscal policy is a key tool used by the federal government to influence macroeconomic outcomes. It involves changes in government purchases, transfer payments, and taxes to achieve objectives such as economic growth, low unemployment, and price stability.

• Definition: Fiscal policy refers to changes in federal government purchases, transfer payments, and taxes intended to achieve macroeconomic policy objectives.

• Automatic Stabilizers: Some government spending and taxes automatically increase or decrease with the business cycle. Example: Unemployment insurance payments rise during recessions.

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

Additional info: State taxes and spending are generally not aimed at national-level objectives.

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

Fiscal policy affects aggregate demand and can be used to stabilize the economy. Congress and the president implement fiscal policy through changes in government purchases and taxes.

• Government Purchases: Directly affect aggregate demand.

• Taxes: Affect income, which in turn influences consumption and aggregate demand indirectly.

• Expansionary Fiscal Policy: Increasing government purchases or decreasing taxes to boost real GDP when it is below potential.

• Contractionary Fiscal Policy: Decreasing government purchases or increasing taxes to reduce inflation when real GDP is above potential.

Example: During the Covid-19 recession, the U.S. government enacted large discretionary fiscal policy actions, distributing around $800 billion directly to households.

16.3 Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model

The dynamic aggregate demand and aggregate supply (AD-AS) model provides a more realistic analysis of fiscal policy by allowing for changes in potential GDP and the price level over time.

• Static Model: Assumes constant potential GDP and price level.

• Dynamic Model: Accounts for changes in potential GDP and price level, improving understanding of fiscal policy effects.

• Expansionary Policy: Increases aggregate demand, raising both real GDP and the price level.

• Contractionary Policy: Decreases aggregate demand, ideally reducing inflation.

16.4 The Government Purchases, Tax, and Transfer Payments Multipliers

Multipliers measure the total effect of changes in government purchases, taxes, or transfer payments on equilibrium real GDP.

• Autonomous Increase: Direct increase in aggregate demand from government spending.

• Induced Increase: Subsequent increases in consumption due to higher income.

• Multiplier Effect: The process by which a change in autonomous expenditure leads to a larger change in real GDP.

Multiplier Type	Formula
Government purchases multiplier	$\frac{\text{Change in equilibrium real GDP}}{\text{Change in government purchases}}$
Tax multiplier	$\frac{\text{Change in equilibrium real GDP}}{\text{Change in taxes}}$
Transfer payments multiplier	$\frac{\text{Change in equilibrium real GDP}}{\text{Change in transfer payments}}$

Example: The American Rescue Plan (2021) sent $1,400 checks to many people, increasing disposable income and consumption.

16.5 The Limits to Using Fiscal Policy to Stabilize the Economy

Implementing fiscal policy faces several challenges, making it less effective than monetary policy for stabilization.

• Timing Issues: Legislative delays (Congress must agree) and implementation delays (projects take time to start).

• Crowding Out: Increased government spending may reduce private expenditures.

Definition: Crowding out is a decline in private expenditures resulting from increased government purchases.

16.6 Deficits, Surpluses, and Federal Government Debt

Fiscal policy affects the federal budget, which can be in deficit or surplus, and contributes to government debt.

• Budget Deficit: Government expenditures exceed tax revenue.

• Budget Surplus: Government expenditures are less than tax revenue.

• Federal Debt: The accumulation of past deficits.

• Automatic Stabilizer: The budget can help stabilize the economy automatically as tax revenues and expenditures change with the business cycle.

Additional info: The federal government often runs a deficit, especially during recessions or wartime.

16.7 Long-Run Fiscal Policy and Economic Growth

Fiscal policy can also target long-run economic growth, often through supply-side policies that affect aggregate supply.

• Supply-Side Economics: Policies aimed at increasing incentives to work, save, invest, and start businesses, often by changing taxes.

• Tax Wedge: The difference between the pretax and posttax return to an economic activity. A large tax wedge can reduce economic activity and real GDP.

• Marginal Tax Rates: Higher marginal tax rates can lead to larger behavioral responses, affecting labor supply, investment, and savings.

• Tax Simplification: Simplifying the tax code can increase economic efficiency by reducing compliance costs and distortions.

Formula: Real GDP growth can be expressed as:

• $\text{Real GDP} = \text{hours worked} \times \left(\frac{\text{Real GDP}}{\text{hours worked}}\right)$

• $\text{Growth rate of Real GDP} = \text{Growth rate of hours worked} + \text{Growth rate of labor productivity}$

Online Appendix: A Closer Look at the Multiplier

The appendix develops an econometric model for determining real GDP and explores how multipliers are affected by tax rates and openness to trade.

• Basic Consumption Function: $C = C_0 + MPC(Y - T)$

• Equilibrium Condition: $Y = C + I + G$

• Government Purchases Multiplier: $\frac{1}{1 - MPC}$

• Tax Multiplier: $-\frac{MPC}{1 - MPC}$

• Balanced Budget Multiplier: $\frac{AG}{1 - MPC} + \frac{AT \times MPC}{1 - MPC}$

• Effect of Tax Rate: Lower tax rates lead to larger multipliers.

• Open Economy Multiplier: $\frac{1}{1 - MPC(1 - t) + MPI}$, where MPI is the marginal propensity to import.

Additional info: In an open economy, a higher propensity to import reduces the multiplier effect of government purchases.