Fiscal Policy and Its Macroeconomic Effects

Fiscal Policy

What Is Fiscal Policy?

Fiscal policy refers to the use of government spending, transfer payments, and taxation to influence macroeconomic outcomes such as real GDP, unemployment, and inflation. It is a primary tool for managing economic fluctuations and achieving policy objectives.

• Discretionary Fiscal Policy: Deliberate changes in government purchases or taxes to influence aggregate demand.

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

• Federal Government Expenditures: Include defense, salaries, transfer payments (Social Security, Medicare), grants to state/local governments, and interest on debt.

• Federal Government Revenue: Primarily from individual income taxes and payroll taxes (Social Security, Medicare), with smaller shares from corporate income taxes, excise taxes, tariffs, and other sources.

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

How Fiscal Policy Affects Aggregate Demand

Fiscal policy influences aggregate demand (AD) through changes in government purchases and taxes:

• Government Purchases: Directly increase AD.

• Taxes: Affect disposable income, which influences consumption and thus AD indirectly.

Expansionary Fiscal Policy

• Increases government purchases or decreases taxes to boost AD.

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

Contractionary Fiscal Policy

• Decreases government purchases or increases taxes to reduce AD.

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

Case Study: The Covid-19 Pandemic

• Economic shutdowns caused both aggregate supply (SRAS) and aggregate demand (AD) to shift left.

• Large expansionary fiscal policy shifted AD right, helping restore GDP but contributing to 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 the price level rise
Rising inflation	Contractionary	Decrease government purchases or raise taxes	Real GDP and the price level fall

Additional info: The effects assume other factors, including monetary policy, remain constant. Contractionary policy typically lowers inflation rather than causing outright deflation.

Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model

Dynamic AD-AS Model and Fiscal Policy

The dynamic AD-AS model incorporates changes in potential GDP and the price level over time, providing a more realistic framework for analyzing fiscal policy.

• Expansionary Policy: Used when projected AD growth is insufficient for full employment; increases AD and the price level.

• Contractionary Policy: Used when projected AD growth is excessive, risking high inflation; decreases AD and stabilizes the price level.

The Government Purchases, Tax, and Transfer Payment Multipliers

The Multiplier Effect

The multiplier effect describes how an initial change in autonomous expenditure (such as government purchases) leads to a larger change in real GDP due to induced increases in consumption.

• Autonomous Increase: Direct effect of government spending.

• Induced Increase: Additional consumption resulting from higher incomes.

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
...	...	...
n	0	$200 billion

Formulas for Multipliers

• Government Purchases Multiplier: $\frac{\Delta Y}{\Delta G} = \frac{1}{1 - MPC}$

• Tax Multiplier: $\frac{\Delta Y}{\Delta T} = -\frac{MPC}{1 - MPC}$

• Transfer Payments Multiplier: $\frac{\Delta Y}{\Delta TR} = \frac{MPC}{1 - MPC}$

Example: If MPC = 0.75, the government purchases multiplier is 4, and the tax multiplier is -3.

Multiplier Effect and Aggregate Supply

When aggregate demand increases, both real GDP and the price level rise due to the upward-sloping short-run aggregate supply (SRAS) curve.

Balanced Budget Multiplier

If government purchases and taxes are increased by the same amount, the net effect on GDP is equal to the change in government purchases:

• $\Delta Y = \Delta G$

This is because the government purchases multiplier is always one greater (in absolute value) than the tax multiplier.

Incorporating Tax Rates

When taxes depend on income (tax rate t), the government purchases multiplier becomes:

• $\frac{1}{1 - MPC(1 - t)}$

Lower tax rates increase the size of the multiplier.

The Multiplier in an Open Economy

When imports depend on income, the multiplier is further reduced. The formula becomes:

• $\frac{1}{1 - MPC(1 - t) + MPI}$

Where MPI is the marginal propensity to import. A higher MPI means a smaller multiplier, as more spending leaks abroad.

Summary 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