Chapter 16: Fiscal Policy – Study Notes for Macroeconomics

Chapter 16: Fiscal Policy

16.1 What Is Fiscal Policy?

Fiscal policy is a key tool used by the federal government to influence the overall economy. It involves changes in government purchases, transfer payments, and taxes to achieve macroeconomic objectives such as stable growth, low unemployment, and controlled inflation.

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

• Automatic Stabilizers: Certain government spending and taxes automatically increase or decrease with the business cycle (e.g., unemployment insurance payments rise during recessions).

• Discretionary Fiscal Policy: Intentional actions by the government to change spending or taxes (e.g., stimulus checks during a recession).

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

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

Fiscal policy affects the economy primarily through its impact on aggregate demand. The government can use fiscal policy to stabilize the economy by adjusting spending and taxes.

• Government Purchases: Directly affect aggregate demand.

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

• Expansionary Fiscal Policy: Increases government purchases or decreases taxes to boost aggregate demand when real GDP is below potential GDP (reducing unemployment).

• Contractionary Fiscal Policy: Decreases government purchases or increases taxes to reduce aggregate demand when real GDP is above potential GDP (reducing inflation).

• Example: The government may enact expansionary fiscal policy during a recession to restore long-run equilibrium.

Table: Countercyclical Fiscal Policy

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

Additional info: These effects assume ceteris paribus (all else equal), including unchanged monetary policy.

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

While static models assume constant potential GDP and price levels, the dynamic aggregate demand and aggregate supply (AD-AS) model allows for changes over time, providing a more realistic analysis of fiscal policy effects.

• Expansionary Fiscal Policy: Used when projected aggregate demand is insufficient to maintain full employment; increases aggregate demand and raises the price level.

• Contractionary Fiscal Policy: Used when projected aggregate demand is excessive, risking high inflation; decreases aggregate demand to maintain full employment.

16.4 The Government Purchases, Tax, and Transfer Payments Multipliers

Fiscal policy changes have multiplied effects on real GDP due to the multiplier process, where an initial change in spending leads to further rounds of income and consumption changes.

• Autonomous Increase: The initial change in aggregate demand from government spending.

• Induced Increase: The subsequent increases in consumption as recipients of new income spend more.

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

Key Multipliers and Formulas

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

• Tax Multiplier: $\text{Tax multiplier} = \frac{\text{Change in equilibrium real GDP}}{\text{Change in taxes}}$ Note: The tax multiplier is negative; an increase in taxes decreases equilibrium real GDP.

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

Example: If each increase in spending induces half as much consumption spending, a $100 billion increase in government purchases results in an additional $100 billion in induced consumption spending over time.

The Effect of Changes in the Tax Rate

• The tax multiplier applies to changes in the amount of taxes, not the tax rate.

• Decreases in tax rates increase disposable income and the size of the multiplier effect, as more income becomes available for consumption.

• Example: The Making Work Pay Tax Credit (2009–2010) reduced taxes for individuals, increasing disposable income and consumption.

16.5 The Limits to Using Fiscal Policy to Stabilize the Economy

There are several challenges to using fiscal policy for economic stabilization:

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

• Crowding Out: Increased government spending may reduce private spending by raising interest rates and decreasing investment, consumption, and net exports.

Example: The 2007–2009 recession was especially severe due to its origins in a financial crisis, which tend to result in deeper and longer recessions.

16.6 Deficits, Surpluses, and Federal Government Debt

The federal budget can be in deficit or surplus, and these positions have implications for the economy and fiscal policy.

• Budget Deficit: Government expenditures exceed tax revenue.

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

• Federal Debt: The total accumulation of past deficits minus surpluses.

• Automatic Stabilizers: During recessions, deficits increase automatically as tax revenues fall and spending on programs like unemployment insurance rises.

• Cyclically Adjusted Budget: The deficit or surplus that would exist if the economy were at potential GDP.

Example: In 2009, the U.S. federal budget deficit was 9.3% of GDP, partly due to automatic stabilizers.

Table: Federal Government Revenue, 2022

Source	Percentage of Total Revenue
Individual income taxes	52.7%
Social insurance taxes	29.6%
Corporate income taxes	6.7%
Other taxes and fees	11.0%

16.7 Long-Run Fiscal Policy and Economic Growth

While fiscal policy is often used for short-run stabilization, it can also influence long-run economic growth, primarily through supply-side effects.

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

• Tax Wedge: The difference between pre-tax and post-tax returns to economic activity; a large tax wedge can reduce economic activity and real GDP.

• Marginal Tax Rates: Higher marginal rates can discourage work and investment.

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

Formula for Real GDP Growth: $\text{Growth rate of real GDP} = \text{Growth rate of hours worked} + \text{Growth rate of labor productivity}$

Online Appendix: A Closer Look at the Multiplier

This section develops a simple model to calculate the government purchases and tax multipliers, and examines how these are affected by tax rates and openness to trade.

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

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

• Government Purchases Multiplier (with taxes): $\text{Multiplier} = \frac{1}{1 - MPC(1 - t)}$

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

Balanced Budget Multiplier: If government purchases and taxes both increase by the same amount, real GDP increases by that amount in the short run.

Summary Table: Key Fiscal Policy Multipliers

Multiplier	Formula	Sign
Government Purchases	$\frac{1}{1 - MPC}$	Positive
Tax	$-\frac{MPC}{1 - MPC}$	Negative
Transfer Payments	Similar to tax multiplier (positive)	Positive

Additional info: The actual size of multipliers depends on the marginal propensity to consume, tax rates, and openness to trade.