R. GLENN HUBBARD

1. R. GLENNHUBBARD ANTHONY PATRICKO’BRIEN Economics FOURTH EDITION

2. 27 Fiscal Policy CHAPTER Chapter Outline and Learning Objectives

3. Does Government Spending Create Jobs? • Part of the funding for the project to expand the Caldecott Tunnel in Northern California came from the American Recovery and Reinvestment Act (ARRA, often referred to as the “stimulus bill”), which President Barack Obama and Congress had enacted in early 2009 in an attempt to increase aggregate demand during the recession. • The ARRA is an example of discretionary fiscal policy aimed at increasing real GDP and employment. • A majority of economists agree that increased government spending leads to increased employment, but some argue that it merely shifts employment from one group of workers to another without increasing total employment. • AN INSIDE LOOK AT POLICY on page 936 discusses whether government-sponsored infrastructure spending is an effective means to create jobs in a slow-growing U.S. economy.

4. Economics in Your Life What Would You Do with $500? Suppose that the federal government announces that it will immediately mail you, and everyone else in the economy, a $500 tax rebate. In addition, you expect that in future years, your taxes will also be $500 less than they would otherwise have been. See if you can answer these questions by the end of the chapter: How will you respond to this increase in your disposable income? What effect will this tax rebate likely have on equilibrium real GDP in the short run?

5. What Is Fiscal Policy? 27.1 LEARNING OBJECTIVE Define fiscal policy.

6. Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. What Fiscal Policy Is and What It Isn’t Economists typically use the term fiscal policy to refer only to the actions of the federal government. State and local governments sometimes change their taxing and spending policies to aid their local economies, but these are not fiscal policy actions because they are not intended to affect the national economy. Automatic Stabilizers versus Discretionary Fiscal Policy Automatic stabilizers Government spending and taxes that automatically increase or decrease along with the business cycle. The word automatic in this case refers to the fact that changes in these types of spending and taxes happen without actions by the government. With discretionary fiscal policy, the government takes actions to change spending or taxes.

7. An Overview of Government Spending and Taxes • Federal government expenditures include purchases plus all other federal government spending. • In addition to purchases, there are three other categories of federal government expenditures: • Interest on the national debt, which represents payments to holders of the bonds the federal government has issued to borrow money. • Grants to state and local governments, which are payments made by the federal government to support government activity at the state and local levels. • Transfer payments, which include Social Security, Medicare, unemployment insurance, and programs to aid the poor, is the largest and fastest-growing category of federal expenditures.

8. Figure 27.1 The Federal Government’s Share of Total Government Expenditures, 1929–2010 Until the Great Depression of the 1930s, the majority of government spending in the United States occurred at the state and local levels. Since World War II, the federal government’s share of total government expenditures has been between two-thirds and three-quarters.

9. Figure 27.2 Federal Purchases and Federal Expenditures as a Percentage of GDP, 1950–2010 As a fraction of GDP, the federal government’s purchases of goods and services have been declining since the Korean War in the early 1950s. Total expenditures by the federal government—including transfer payments—as a fraction of GDP slowly rose from 1950 through the early 1990s and fell from 1992 to 2001, before rising again. The recession of 2007–2009 and the slow recovery that followed led to a surge in federal government expenditures causing them to rise to their highest level as a percentage of GDP since World War II.

10. Figure 27.3 Federal Government Expenditures, 2010 Federal government purchases can be divided into defense spending—which makes up 22.1 percent of the federal budget—and spending on everything else the federal government does—from paying the salaries of FBI agents, to operating the national parks, to supporting scientific research—which makes up 9.4 percent of the budget. In addition to purchases, there are three other categories of federal government expenditures:intereston the national debt, grants to state and local governments, and transfer payments. Transfer payments rose from about 25 percent of federal government expenditures in the 1960s to nearly 46.6 percent in 2010.

11. Figure 27.4 Federal Government Revenue, 2010 In 2010, individual income taxes raised 36.9 percent of the federal government’s revenues. Corporate income taxes raised 13.6 percent of revenue. Payroll taxes to fund the Social Security and Medicare programs rose from less than 10 percent of federal government revenues in 1950 to 40.0 percent in 2010. The remaining 9.6 percent of revenues were raised from excise taxes, tariffs on imports, and other sources.

12. MakingtheConnection Is Spending on Social Security and Medicare a Fiscal Time Bomb? The Social Security and Medicare programs have been very successful in reducing poverty among elderly Americans, but in recent years, the ability of the federal government to finance current promises has been called into doubt. Falling birthrates after 1965 have meant long-run problems for the Social Security system, as the number of workers per retiree has continually declined. Congress has attempted to deal with this problem by raising the age to receive full benefits from 65 to 67 and by increasing payroll taxes. The long-term financial situation for Medicare is an even greater cause for concern than is Social Security. As Americans live longer and as new—and expensive—medical procedures are developed, the projected expenditures under the Medicare program will eventually far outstrip projected tax revenues.

13. MakingtheConnection Is Spending on Social Security and Medicare a Fiscal Time Bomb? If current projections are accurate, policymakers are faced with the choice of significantly restraining spending on these programs, greatly increasing taxes on households and firms, or implementing some combination of spending restraints and tax increases. Note: The graph gives the Congressional Budget Office’s “alternative fiscal scenario” of future spending. • Your Turn:Test your understanding by doing related problems 1.6 and 1.7 at the end of this chapter. MyEconLab

14. The Effects of Fiscal Policy on Real GDP and the Price Level 27.2 LEARNING OBJECTIVE Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilize the economy.

15. Expansionary and Contractionary Fiscal Policy Figure 27.5a Fiscal Policy The economy begins in recession at point A, with real GDP of $14.2 trillion and a price level of 98. An expansionary fiscal policy will cause aggregate demand to shift to the right, from AD1to AD2, increasing real GDP from $14.2 trillion to $14.4 trillion and the price level from 98 to 100 (point B). Expansionary fiscal policy involves increasing government purchases or decreasing taxes. Cutting the individual income tax will increase household disposable income, the income households have available to spend after they have paid their taxes, and consumption spending.

16. Expansionary and Contractionary Fiscal Policy Figure 27.5b Fiscal Policy The economy begins at point A, with real GDP at $14.6 trillion and the price level at 102. Because real GDP is greater than potential GDP, the economy will experience rising wages and prices. A contractionary fiscal policy will cause aggregate demand to shift to the left, from AD1 to AD2, decreasing real GDP from $14.6trillion to $14.4 trillion and the price level from 102 to 100 (point B). Contractionary fiscal policy involves decreasing government purchases or increasing taxes. Policymakers use contractionary fiscal policy to reduce increases in aggregate demand that seem likely to lead to inflation.

17. A Summary of How Fiscal Policy Affects Aggregate Demand Table 27.1 Countercyclical Fiscal Policy The table isolates the effect of fiscal policy by holding constant monetary policy and all other factors affecting the variables involved. In other words, we are again invoking the ceteris paribus condition. A contractionary fiscal policy causes the price level to rise by less than it would have without the policy. Don’t Let This Happen to You Don’t Confuse Fiscal Policy and Monetary Policy Though their goals are the same, their effects on the economy differ as governments use fiscal policy to affect spending and taxation, while central banks use monetary policy to affect interest rates. • Your Turn:Test your understanding by doing related problem 2.6 at the end of this chapter. MyEconLab

18. Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model* 27.3 LEARNING OBJECTIVE Use the dynamic aggregate demand and aggregate supply model to analyze fiscal policy. *This section may be omitted without loss of continuity.

19. The overview of fiscal policy we just finished contains a key idea: Congress and the president can use fiscal policy to affect aggregate demand, thereby changing the price level and the level of real GDP. The discussion of expansionary and contractionaryfiscal policy illustrated by Figure 27.5 is simplified, however, because it ignores two important facts about the economy: The economy experiences continuing inflation, with the price level rising every year. The economy experiences long-run growth, with the LRAS curve shifting to the right every year. A dynamic aggregate demand and aggregate supply modeltakes these two facts into account, providing us with a more complete understanding of fiscal policy.

20. Figure 27.6 An Expansionary Fiscal Policy in the Dynamic Model The economy begins in equilibrium at point A, at potential real GDP of $14.0 trillion and a price level of 100. Without an expansionary policy, aggregate demand will shift from AD1to AD2(without policy), which is not enough to keep the economy at potential GDP because long-run aggregate supplyhas shifted from LRAS1to LRAS2. The economy will be in short-run equilibrium at point B, with real GDP of $14.3 trillion and a price level of 102. Increasing government purchases or cutting taxes will shift aggregate demand to AD2(with policy). The economy will be in equilibrium at point C, with real GDP of $14.4 trillion, which is its potential level, and a price level of 103. The price level is higher than it would have been without an expansionary fiscal policy.

21. Figure 27.7 A Contractionary Fiscal Policy in the Dynamic Model The economy begins in equilibrium at point A, with real GDP of $14.0 trillion and a price level of 100. Without a contractionary policy, aggregate demand will shift from AD1 to AD2(without policy), which results in a short-run equilibrium beyond potential GDP at point B, with real GDP of $14.5 trillion and a price level of 105. Decreasing government purchases or increasing taxes can shift aggregate demand to AD2(with policy). The economy will be in equilibrium at point C, with real GDP of $14.4 trillion, which is its potential level, and a price level of 103. The inflation rate will be 3 percent, as opposed to the 5 percent it would have been without the contractionary fiscal policy.

22. The Government Purchases and Tax Multipliers 27.4 LEARNING OBJECTIVE Explain how the government purchases and tax multipliers work.

23. Economists refer to the initial increase in government purchases as autonomous because it is a result of a decision by the government and is not directly caused by changes in the level of real GDP. The increases in consumption spending that result from the initial autonomous increase in government purchases are induced because they are caused by the initial increase in autonomous spending. Multiplier effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures.

24. Figure 27.8 The Multiplier Effect and Aggregate Demand An initial increase in government purchases of $100 billion causes the aggregate demand curve to shift to the right, from AD1 to the dashed AD curve, and represents the effect of the initial increase of $100 billion in government purchases. Because this initial increase raises incomes and leads to further increases in consumption spending, the aggregate demand curve will ultimately shift further to the right, to AD2.

25. The Multiplier Effect of an Increase in Government Purchases Figure 27.9 Following an initial increase in government purchases, spending and real GDP increase over a number of periods due to the multiplier effect. The new spending and increased real GDP in each period is shown in green, and the level of spending from the previous period is shown in orange. The sum of the orange and green areas represents the cumulative increase in spending and real GDP. In total, equilibrium real GDP will increase by $200 billion as a result of an initial increase of $100 billion in government purchases.

26. The ratio of the change in equilibrium real GDP to the initial change in government purchases is known as the government purchases multiplier: Tax cuts also have a multiplier effect. With the tax rate remaining unchanged, the expression for the tax multiplier is The tax multiplier is a negative number because changes in taxes and changes in real GDP move in opposite directions: An increase in taxes reduces disposable income, consumption, and real GDP, and a decrease in taxes raises these. We would expect the tax multiplier to be smaller in absolute value than the government purchases multiplier.

27. The Effect of Changes in Tax Rates A change in tax rates has a more complicated effect on equilibrium real GDP than does a tax cut of a fixed amount. The higher the tax rate, the smaller the multiplier effect. A cut in tax rates affects equilibrium real GDP through two channels: A cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending. A cut in tax rates increases the size of the multiplier effect.

28. Taking into Account the Effects of Aggregate Supply Figure 27.10 The Multiplier Effect and Aggregate Supply The economy is initially at point A. An increase in government purchases causes the aggregate demand curve to shift to the right, from AD1to the dashed AD curve. The multiplier effect results in the aggregate demand curve shifting further to the right, to AD2(point B). Because of the upward-sloping supply curve, the shift in aggregate demand results in a higher price level. In the new equilibrium at point C, both real GDP and the price level have increased. The increase in real GDP is less than indicated by the multiplier effect with a constant price level.

29. The Multipliers Work in Both Directions Increases in government purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP. Decreases in government purchases and increases in taxes also have a multiplier effect on equilibrium real GDP, but in this case, the effect is negative. We look more closely at the government purchases multiplier and the tax multiplier in the appendix to this chapter.

30. Solved Problem27.4 Fiscal Policy Multipliers Briefly explain whether you agree with the following statement: “Real GDP is currently $14.2 trillion, and potential real GDP is $14.4 trillion. If Congress and the president would increase government purchases by $200 billion or cut taxes by $200 billion, the economy could be brought to equilibrium at potential GDP.” Solving the Problem Step 1: Review the chapter material. Step 2: Explain how the necessary increase in purchases or cut in taxes is less than $200 billion because of the multiplier effect. The statement is incorrect because it does not consider the multiplier effect. Because of the multiplier effect, an increase in government purchases or a decrease in taxes of less than $200 billion is necessary to increase equilibrium real GDP by $200 billion. For instance, assume that the government purchases multiplier is 2 and the tax multiplier is −1.6. We can then calculate the necessary increase in government purchases as follows:

31. Solved Problem27.4 Fiscal Policy Multipliers And the necessary change in taxes: • Your Turn:For more practice, do related problem 4.6 at the end of this chapter. MyEconLab

32. The Limits of Using Fiscal Policy to Stabilize the Economy 27.5 LEARNING OBJECTIVE Discuss the difficulties that can arise in implementing fiscal policy.

33. Getting the timing right can be more difficult with fiscal policy than with monetary policy for two main reasons: • The delays caused by the legislative process can be very long. • Even after a change in fiscal policy has been approved, it takes time to implement the policy. Does Government Spending Reduce Private Spending? The size of the multiplier effect may be limited if the increase in government purchases causes one of the nongovernment, or private, components of aggregate expenditures—consumption, investment, or net exports—to fall. Crowding out A decline in private expenditures as a result of an increase in government purchases.

34. Crowding Out in the Short Run Figure 27.11 An Expansionary Fiscal Policy Increases Interest Rates If the federal government increases spending, the demand for money will increase from Money demand1 to Money demand2 as real GDP and income rise. With the supply of money constant, at $950 billion, the result is an increase in the equilibrium interest rate from 3 percent to 5 percent, which crowds out some consumption, investment, and net exports.

35. Figure 27.12 The Effect of Crowding Out in the Short Run The economy begins in a recession, with real GDP of $14.2 trillion (point A). In the absence of crowding out, an increase in government purchases will shift aggregate demand to AD2(no crowding out) and bring the economy to equilibrium at potential realGDP of $14.4 trillion (point B). But the higher interest rate resulting from the increased government purchases will reduce consumption, investment, and net exports, causing aggregate demand to shift to AD2(crowding out). The result is a new short-run equilibrium at point C, with real GDP of $14.3 trillion, which is $100 billion short of potential real GDP.

36. Crowding Out in the Long Run The long-run effect of a permanent increase in government spending is complete crowding out, where the decline in investment, consumption, and net exports exactly offsets the increase in government purchases, and aggregate demand remains unchanged. In the long run, the economy returns to potential GDP. Fiscal Policy in Action: Did the Stimulus Package of 2009 Work? Congress enacted a tax cut totaling $95 billion that took the form of rebates of taxes already paid that were sent to taxpayers between April and July 2008. One-time tax rebates increase consumers’ current income but not their permanent income, which reflects their expected future income. Since only a permanent decrease in taxes increases consumers’ permanent income, a tax rebate is likely to increase consumption spending less than would a permanent tax cut.

37. American Recovery and Reinvestment Act of 2009 The 2009 Stimulus Package Figure 27.13 Congress and President Obama intended the spending increases and tax cuts in the stimulus package to increase aggregate demand and help pull the economy out of the 2007–2009 recession. Panel (a) shows how the increases in spending were distributed, and panel (b) shows how the tax cuts were distributed.

38. How Can We Measure the Effectiveness of the Stimulus Package? To judge the effectiveness of the stimulus package, we have to measure its effects on real GDP and employment, holding constant all other factors affecting real GDP and employment. CBO Estimates of the Effects of the Stimulus Package Table 27.2

39. MakingtheConnection Why Was the Recession of 2007–2009 So Severe? The recession of 2007-2009 was accompanied by a significant financial crisis, which the U.S. economy had not experienced since the Great Depression of the 1930s. The table below shows the average change in key economic variables during the period following a financial crisis for a number of countries, including the United States during the Great Depression and European and Asian countries in the post–World War II era. Note: Compiled while it was still under way, data for the United States during the 2007–2009 recession are not included.

40. MakingtheConnection Why Was the Recession of 2007–2009 So Severe? The table below shows some key indicators for the 2007–2009 U.S. recession compared with other U.S. recessions of the post–World War II period: The recession lasted nearly twice as long as the average of earlier postwar recessions, GDP declined by more than twice the average, and the peak unemployment rate was about one-third higher than the average. Because most people did not see the financial crisis coming, they also failed to anticipate the severity of the 2007–2009 recession. • Your Turn:Test your understanding by doing related problem 5.6 at the end of this chapter. MyEconLab

41. The Size of the Multiplier: A Key to Estimating the Effects of Fiscal Policy Table 27.3 Estimates of the Size of the Multiplier

42. The Size of the Multiplier: A Key to Estimating the Effects of Fiscal Policy Table 27.3 Estimates of the Size of the Multiplier (Continued)

43. Deficits, Surpluses, and Federal Government Debt 27.6 LEARNING OBJECTIVE Define federal budget deficit and federal government debt and explain how the federal budget can serve as an automatic stabilizer.

44. Budget deficit The situation in which the government’s expenditures are greater than its tax revenue. Budget surplus The situation in which the government’s expenditures are less than its tax revenue.

45. The Federal Budget Deficit, 1901–2011 Figure 27.14 During wars, government spending increases far more than tax revenues, increasing the budget deficit. The budget deficit also increases during recessions, as government spending increases and tax revenues fall. Note: The value for 2011 is an estimate prepared by the Congressional Budget Office in June 2011.

46. How the Federal Budget Can Serve as an Automatic Stabilizer Discretionary fiscal policy can increase the federal budget deficit during recessions by increasing spending or cutting taxes to increase aggregate demand. Most of the increase in the federal budget deficit during a typical recession takes place without Congress and the president taking any action, but is instead due to the effects of the automatic stabilizers. Deficits occur automatically during recessions for two reasons: During a recession, wages and profits fall, causing government tax revenues to fall. The government automatically increases its spending on transfer payments when the economy moves into recession. Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

47. MakingtheConnection Did Fiscal Policy Fail during the Great Depression? When Franklin D. Roosevelt became president in 1933, federal government expenditures increased as part of his New Deal program, and there was a federal budget deficit during each remaining year of the decade, except for 1937. Some economists and policymakers at the time argued that because the economy recovered slowly despite increases in government spending, fiscal policy had been ineffective. Economic historians have argued, however, that despite the increases in government spending, Congress and the president had not, in fact, implemented an expansionary fiscal policy during the 1930s. Roosevelt’s reluctance to allow the actual budget deficit to grow too large helps explain why the cyclically adjusted budget remained in surplus, as the following table demonstrates.

48. MakingtheConnection Did Fiscal Policy Fail during the Great Depression? Note: All variables are nominal rather than real. • Your Turn:Test your understanding by doing related problem 6.8 at the end of this chapter. MyEconLab

49. Solved Problem27.6 The Effect of Economic Fluctuations on the Budget Deficit The federal government’s budget deficit was $207.8 billion in 1983 and $185.4 billion in 1984. A student comments, “The government must have acted during 1984 to raise taxes or cut spending or both.” Do you agree? Briefly explain. • Solving the Problem • Step 1: Review the chapter material. • Step 2: Explain how changes in the budget deficit can occur without Congress and the president acting. • If Congress and the president take action to raise taxes or cut spending, the federal budget deficit will decline, but it will also decline automatically when GDP increases, even if the government takes no action, because: • Rising household incomes and firm profits result in higher tax revenues. • Falling unemployment reduces government spending on unemployment insurance and other transfer payments. • So, you should disagree with the comment because a falling deficit does not mean that the government must have acted to raise taxes or cut spending. • Although you don’t have to know it to answer the question, GDP did increase from $3.5 trillion in 1983 to $3.9 trillion in 1984. • Your Turn:For more practice, do related problem 6.6 at the end of this chapter. MyEconLab

50. Should the Federal Budget Always Be Balanced? Many economists believe that it is a good idea for the federal government to have a balanced budget when the economy is at potential GDP. But few economists believe that the federal government should attempt to balance its budget every year because it might have to take actions that would destabilize the economy. Some economists argue that the federal government should normally run a deficit, even at potential GDP.