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

Can Fiscal Policy Increase Economic Growth?

Introduction to Fiscal Policy and Economic Growth

Fiscal policy is a key tool used by governments to influence macroeconomic outcomes such as economic growth, employment, and price stability. The COVID-19 pandemic prompted the U.S. government to enact the largest discretionary policy actions in its history, distributing significant funds to households and businesses to mitigate recessionary effects.

• Discretionary policy actions are deliberate changes in government spending or taxation to achieve economic objectives.

• Large-scale fiscal interventions can have both short-term and long-term consequences, including increased budget deficits.

What Is Fiscal Policy?

Definition and Types of Fiscal Policy

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

• Automatic stabilizers are government spending and tax mechanisms that automatically increase or decrease with the business cycle (e.g., unemployment insurance payments rise during recessions).

• Discretionary fiscal policy involves intentional actions by the government to change spending or taxes.

The Federal Government’s Role in Expenditures and Revenues

Trends in Government Spending

• Since the Great Depression, the federal government’s share of total government expenditures has increased significantly, now comprising two-thirds to three-quarters of all government spending.

• As a percentage of GDP, federal expenditures are over 30%, but a smaller proportion is spent on direct purchases of goods and services.

Federal Government Expenditures (2022)

• Purchases: Defense, salaries of federal employees, national parks, scientific research.

• Transfer payments: Social Security, Medicare, unemployment insurance (about half of expenditures).

• Other expenditures: Grants to state/local governments, interest on federal debt.

Federal Government Revenues (2022)

• Majority from individual income taxes and payroll taxes (Social Security and Medicare).

• Corporate income taxes: ~6.7% of receipts.

• Other sources: Excise taxes, tariffs, fees.

Social Security and Medicare: Fiscal Time Bombs?

Challenges and Sustainability

• Social Security and Medicare reduce poverty among the elderly and improve health for the poor, but face long-term funding challenges due to an aging population and rising healthcare costs.

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

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

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

Mechanisms of Fiscal Policy

• Fiscal policy is enacted through changes in government purchases and taxes.

• Government purchases directly affect aggregate demand.

• Tax changes affect aggregate demand indirectly by altering disposable income and thus consumption.

Expansionary vs. Contractionary Fiscal Policy

• Expansionary fiscal policy: Increasing government purchases or decreasing taxes to boost aggregate demand, used when real GDP is below potential GDP (to decrease unemployment).

• Contractionary fiscal policy: Decreasing government purchases or increasing taxes to reduce aggregate demand, used when real GDP is above potential GDP (to decrease inflation).

Fiscal Policy and Economic Shocks

COVID-19 Pandemic Example

• Economic shutdowns caused both aggregate supply and demand shocks.

• Large expansionary fiscal policy shifted aggregate demand rightward, aiming to restore real GDP to potential, but resulted in high inflation.

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 price level rise
Rising inflation	Contractionary	Decrease government purchases or raise taxes	Real GDP and price level fall

Additional info: Countercyclical policy aims to smooth out the business cycle by acting against the direction of economic fluctuations.

Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model

Static vs. Dynamic Models

• Traditional models assume constant potential GDP and price level (static).

• Dynamic models account for changes in potential GDP and price level over time, providing a more realistic framework for fiscal policy analysis.

Expansionary and Contractionary Policy in the Dynamic Model

• 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 controlling inflation.

The Government Purchases, Tax, and Transfer Payments Multipliers

Understanding the Multiplier Effect

• Autonomous increase in aggregate demand: Direct result of increased government spending.

• Induced increase in aggregate demand: Result of increased income leading to higher consumption.

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

Example: The Multiplier Effect of an Increase in Government Purchases

Period	Additional Spending This Period	Cumulative Increase in Spending and Real GDP
1	$100 billion in government purchases	$100 billion
2	$50 billion in consumption spending	$150 billion
3	$25 billion in consumption spending	$175 billion
4	$12.5 billion in consumption spending	$187.5 billion
...	...	...
Total		$200 billion

Additional info: Each round of spending induces further consumption, but the effect diminishes over time due to saving.

Multipliers for Government Purchases and Taxes

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

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

The Transfer Payments Multiplier

• Transfer payments (e.g., stimulus checks) increase household disposable income, raising consumption and real GDP via the multiplier effect.

• This multiplier is positive but typically smaller than the government purchases multiplier.

The Effect of Changes in the Tax Rate

• 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.

The Multiplier Effect and Aggregate Supply

• An increase in aggregate demand raises both real GDP and the price level due to the upward-sloping short-run aggregate supply curve.

• The real GDP increase is smaller than the total increase in aggregate demand because some of the effect is absorbed by higher prices.

Multipliers Work in Both Directions

• Increases in government purchases or tax cuts have positive multiplier effects.

• Decreases in government purchases or tax increases have negative multiplier effects.

• Example: A reduction in defense spending affects contractors, suppliers, and workers, spreading throughout the economy.

Limits to Using Fiscal Policy to Stabilize the Economy

Challenges and Crowding Out

• Timing fiscal policy is difficult due to legislative and implementation delays.

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

Short-Run and Long-Run Effects of Crowding Out

• Short run: Temporary increases in government purchases partially offset by reduced private spending.

• Long run: No effect on real GDP; the reduction in private spending exactly offsets the increase in government purchases. The government sector becomes a larger share of the economy.

Why Was the Recession of 2007–2009 So Severe?

Severity and Comparison

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 are especially severe, with larger declines in GDP and higher unemployment rates.

Fiscal Policy in Action: The Stimulus Package of 2009

Implementation and Effectiveness

• 2008: Tax rebate of $95 billion increased current incomes, but only 33–40% was spent, resulting in $35 billion in increased spending.

• 2009: American Recovery and Reinvestment Act (ARRA) was the largest fiscal policy action to date ($840 billion), with two-thirds as spending increases and the rest as tax cuts/credits.

• Measuring effectiveness is difficult due to other influencing factors and political bias; CBO estimates are often used for neutrality.

CBO Estimates of the Effects of the Stimulus Package

Year	Change in Real GDP (percentage change)	Change in Unemployment Rate (percentage points)	Change in Employment (millions of people)
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	0.6 to 1.6	-0.2 to -1.4	0.6 to 1.6
2012	0.1 to 0.8	0.0 to -0.6	0.1 to 0.8
2013	0.0 to 0.2	0.0 to -0.2	0.0 to 0.2
2014	0.0 to 0.1	0.0 to -0.1	0.0 to 0.1

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

Estimates of the Sizes of Government Purchases and Tax Multipliers

Variation in Multiplier Estimates

Economists Making the Estimate	Type of Multiplier	Size of Multiplier
Congressional Budget Office	Government purchases	0.5–2.5
Valerie Ramey (UCSD)	Military expenditure	0.6–1.1
Christina Romer & David Romer (Berkeley)	Tax	2–3
Congressional Budget Office	Tax	0.3–1.5 (lower/middle income); 0.1–0.6 (higher income)

Additional info: Multiplier estimates vary widely due to differences in methodology and the simultaneous effects on aggregate demand and supply.

Deficits, Surpluses, and Federal Government Debt

Definitions and Trends

• Budget deficit: Government expenditures exceed tax revenue.

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

• The U.S. federal government usually runs a deficit, especially during recessions and wartime.

• Automatic stabilizers (e.g., increased transfer payments) help limit the severity of recessions.

Automatic Stabilizers in the Federal Budget

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

• In 2009, the CBO estimated the deficit would be 7.6% of GDP if at potential, with the remainder due to automatic stabilizers.