Fiscal Policy and Economic Growth: Principles of Macroeconomics (ECON 1104)

Fiscal Policy and Economic Growth

Introduction to Fiscal Policy

Fiscal policy is a central tool in macroeconomics, used by governments to influence the economy's overall performance. It involves changes in government spending, transfer payments, and taxation to achieve macroeconomic objectives such as stable prices, high employment, and economic growth.

• Fiscal Policy: Refers to changes in federal government purchases, transfer payments, and taxes aimed at achieving national-level macroeconomic goals.

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

• Discretionary Fiscal Policy: Intentional actions by the government to change spending or taxes, often in response to economic shocks.

Federal Government Expenditures and Revenues

The composition and scale of federal government expenditures and revenues have evolved over time, especially during major economic events.

• Since the Great Depression, the federal government's share of total government spending has increased to about two-thirds to three-quarters.

• Federal expenditures as a percentage of GDP are now over 30%, with a smaller proportion spent on goods and services (mainly military).

Category	Percentage of Expenditures (2022)
Transfer payments (Social Security, Medicare, Unemployment)	~50%
Purchases (defense, parks, research)	~30%
Grants to state/local governments	~15%
Interest on federal debt	~5%

• Most federal revenues come from individual income taxes and payroll taxes earmarked for Social Security and Medicare.

• Corporate income taxes make up about 6.7% of federal receipts; the rest comes from excise taxes, tariffs, and other fees.

Social Security and Medicare: Long-Term Fiscal Challenges

Social Security and Medicare are major federal programs that face significant long-term funding challenges due to demographic changes and rising healthcare costs.

• These programs have reduced poverty among the elderly and improved health for the poor.

• However, an aging population and rising costs threaten their sustainability.

• Projected budget shortfall through 2092: nearly $16.8 trillion (present value).

• Potential solutions: increase taxes, decrease benefits, raise eligibility age, and reduce medical costs.

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

Mechanisms of Fiscal Policy

Fiscal policy affects the economy through changes in government purchases and taxes, which influence aggregate demand and, indirectly, aggregate supply.

• Government Purchases: Directly increase aggregate demand.

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

Types of Fiscal Policy

• Expansionary Fiscal Policy: Increasing government purchases or decreasing taxes to boost aggregate demand when real GDP is below potential GDP (reduces unemployment).

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

Fiscal Policy During the Covid-19 Pandemic

The pandemic caused both aggregate supply and demand shocks, leading to large-scale expansionary fiscal policy to restore real GDP to its potential, but at the cost of high inflation.

Countercyclical Fiscal Policy

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

• Effects assume ceteris paribus (all else equal), including monetary policy.

• Contractionary policy lowers inflation relative to what it would have been, but may not cause prices to fall.

Dynamic Aggregate Demand and Aggregate Supply Model

Static models assume constant potential GDP and price level, but dynamic models allow for changes over time, 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 returning the economy to full employment and reducing inflation.

Multipliers in Fiscal Policy

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: Resulting increase in consumption as recipients spend their increased income.

• Multiplier Effect: The process by which 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: $\text{Transfer payments multiplier} = \frac{\text{Change in equilibrium real GDP}}{\text{Change in transfer payments}}$

• The tax multiplier is negative: an increase in taxes decreases equilibrium real GDP.

• The tax multiplier is smaller (in absolute value) than the government purchases multiplier because tax cuts are partially saved.

• Transfer payments increase household disposable income, raising consumption and having a positive multiplier effect.

Multiplier Effect and Aggregate Supply

An increase in aggregate demand raises both real GDP and the price level, but the effect on real GDP is smaller when aggregate supply is upward sloping.

Limits to Fiscal Policy

• Timing Issues: Legislative and implementation delays can reduce effectiveness.

• Crowding Out: Increased government spending may reduce private spending by raising interest rates.

• In the long run, increases in government purchases do not affect real GDP, as reductions in private spending offset them.

Deficits, Surpluses, and Federal Government Debt

Definitions

• Budget Deficit: Government expenditures exceed tax revenue.

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

Federal Budget Deficit Trends

• The U.S. federal government rarely balances its budget, especially during recessions and wartime.

• Budget deficits increase during recessions due to falling tax receipts and rising automatic stabilizers (e.g., unemployment insurance).

Automatic Stabilizers in the Federal Budget

• Automatic stabilizers limit the severity of recessions by increasing government spending when GDP falls below potential.

• Cyclically adjusted budget deficit/surplus measures the deficit or surplus if the economy were at potential GDP.

• In 2009, the CBO estimated the budget deficit would be 7.6% of real GDP if GDP were at its potential.

Tables: Key Data and Estimates

Severity of the 2007–2009 Recession

Duration	Decline in Real GDP	Peak Unemployment Rate
Average postwar recessions	-1.7%	7.6%
Recession of 2007–2009	-4.0%	10.0%

Recessions Following Financial Crises (Carmen Reinhart & Kenneth Rogoff)

Economic Variable	Average Change	Average Duration (years)	Number of Countries
Unemployment Rate	+7%	4.8	14
Real GDP per capita	-9.3%	1.9	14
Real stock prices	-55.9%	3.4	22
Real house prices	-35.5%	6.0	21
Real government debt	+86%	3.3	13

CBO Estimates of the Effects of the Stimulus Package

Year	Change in Real GDP (%)	Change in Unemployment Rate (pp)	Change in Employment (millions)
2009	0.4 to 1.8	-0.1 to -0.5	0.3 to 1.3
2010	0.7 to 3.1	-0.4 to -1.1	0.9 to 3.7
2011	0.4 to 2.0	-0.2 to -1.4	0.6 to 3.6
2012	0.1 to 0.8	-0.1 to -0.6	0.1 to 1.2
2013	0.0 to 0.2	0.0 to -0.2	0.0 to 0.3
2014	0.0 to 0.2	0.0 to -0.2	0.0 to 0.3

Conclusion: The stimulus package reduced the severity of the recession but did not restore full employment.

Estimates of Government Purchases and Tax Multipliers

Economist/Source	Type of Multiplier	Size of Multiplier
Congressional Budget Office	Government purchases	0.5–2.5
Valerie Ramey (UCSD)	Military expenditure	0.6–1.1
Robert Barro (Harvard)	Military expenditure	0.4–0.5 after 1 year; 0.6–0.7 after 2 years
John Cogan & John Taylor (Stanford)	Permanent increase in purchases	0.4
Christina Romer & David Romer (Berkeley)	Tax	2–3
Congressional Budget Office	Tax	0.3–1.5 for 2-year cut (lower/middle income); 0.1–0.6 for 1-year cut (higher income)
Robert Barro (Harvard)	Tax	1.1

Estimating multipliers is difficult due to simultaneous changes in aggregate demand and supply.

Summary

• Fiscal policy is a powerful tool for stabilizing the economy and promoting growth, but its effectiveness is limited by timing, crowding out, and long-term sustainability concerns.

• Automatic stabilizers help moderate the business cycle, while discretionary policy can address severe shocks.

• Multipliers quantify the impact of fiscal actions, but their size varies depending on economic conditions and policy specifics.

• Long-term fiscal challenges, especially related to entitlement programs, require policy adjustments to ensure sustainability.