An Applications Approach to Contemporary Economics By Robert J. Carbaugh 4th Edition

1. An Applications Approach to Contemporary EconomicsBy Robert J. Carbaugh4th Edition Chapter 13: Fiscal Policy and the Federal Budget

2. Fiscal Policy • Fiscal policy is the use of government expenditures and taxes to promote particular economic goals such as full employment, stable prices and economic growth. • Discretionary (tuy nghi) fiscal policy is the deliberate use of changes in government expenditures and taxation. • Automatic stabilizers consist of changes in government spending and tax revenues that occur automatically as the economy fluctuates. Carbaugh, Chap. 13

3. Discretionary Fiscal Policy • Expansionary fiscal policy: Increase government spending or cut taxes • Increases real output, employment and income • Is used to combat a recession • Contractionary fiscal policy: Decrease government spending or increase taxes. • Decreases real output, employment and income • Is used to fight inflation Carbaugh, Chap. 13

4. Fiscal Policy and Aggregate Demand • 1. Combating a recession: When the economy is in a recession, real output falls below its potential (full employment) output, the government can use expansionary fiscal policy to increase aggregate demand: • Increase government spending • Decrease taxes • Use combination of the two Carbaugh, Chap. 13

5. Fiscal Policy and Aggregate Demand • Combating a recession: • Example: MPC = 0.75 • What happens to aggregate demand and thus output if government: • 1. Increases its spending by $25 billion • 2. Cuts personal income tax by $25 billion • 3. how much should the G cut in tax to increase total income by $100bn • 4. how much should the G increase in tax to decrease total income by $100bn Carbaugh, Chap. 13

6. Disposable income • Disposable income = Income –taxes • Taxes increase, then Disposable income (DI) decreases • Taxes decrease, then Disposable income (DI) increase Carbaugh, Chap. 13

7. 100 0 700 800 900 Real output ($ bill.) Fiscal Policy Expansionary fiscal policy AS0 Price level (price index) Full employment output A B Increase in output AD0 AD1 Carbaugh, Chap. 13

8. Fiscal Policy and Aggregate Demand • 2.Combating inflation: When the economy has high inflation (e.g.. demand-pull inflation causes the real output higher than the economy’s potential or full-employment output), the government can use contractionary fiscal policy to reduce aggregate demand: • Decrease government spending • Increase taxes • Use combination of the two Carbaugh, Chap. 13

9. 120 110 0 Real output ($ bill.) Fiscal Policy Contractionary fiscal policy Fall in price level AS0 Price level (price index) B A AD1 AD0 Decrease in real output Full employment 1,100 900 Carbaugh, Chap. 13

10. Automatic Stabilizers • Automatic stabilizers consist of changes in government spending and tax revenues that occur automatically as the economy fluctuates. • The automatic stabilizers prevent aggregate demand from decreasing as much in a recession or increasing as much in an expansion, so as to stabilize the economy. • Automatic stabilizers: tax system, government transfer payments. Carbaugh, Chap. 13

11. Problems of Fiscal Policy • Timing lags • Irreversibility • Crowding-out effect • Foreign-trade effect Carbaugh, Chap. 13

12. Timing Lags (do tre ve thoi gian) • Recognition lag: A lag between the time when a recession or inflation begins and the time when it is aware of. It takes time for government to realize that there is a recession or inflation. • Administrative lag: A lag between the time when the need for fiscal action is recognized and the time when the action is taken. • Operational lag: A lag between the time when fiscal action is taken and the time when it has effect on real output, employment or the price level Carbaugh, Chap. 13

13. Irreversibility • It is difficult to reverse changes in government spending or taxes • Many expenditure programs and tax changes become permanent • Inflexibilities hinder the operation of fiscal policy Carbaugh, Chap. 13

14. Crowding-Out Effect (Tac dong chen lan) • When the economy is in a recession, government enacts expansionary fiscal policy by increasing government spending. • To finance government budget deficit, the government borrows funds in the money market. • The increase in the demand for money raises the interest rate. • Higher interest rate lower investment. Some investment will be crowded out(hat ra). • The crowded-out effect may weaken the stimulus of the expansionary fiscal policy. Carbaugh, Chap. 13

15. Fiscal Policy Crowding-out effect Government spending exceeds taxes, resulting in a budget deficit. As the demand for loanablefunds rises, interestrates increase. The government entersthe loanable funds marketand issues more securities. Firms and householdspurchase less machinery,equipment, autos, and homes.Thus government spendingcrowds out privatesector spending. Carbaugh, Chap. 13

16. Foreign Trade Effect • Suppose an expansionary fiscal policy is implemented to increase output • The expansionary fiscal policy can cause interest rate to rise • Higher interest rate attracts more international funds • Domestic currency appreciates that causes a fall in net export and thus output, so partially offset the expansionary fiscal policy Carbaugh, Chap. 13

17. Fiscal Policy and Aggregate Supply • Supply-side effects of changes in taxes: • Changes in tax rate will affect the incentive of people to work, save and invest. • Supply-side policy: • A decrease in marginal tax rates will cause people to work, save and invest more. Aggregate supply curve shifts to the right resulting in a higher output and a lower price level. • A decrease in marginal tax rates may also cause people to spend and thus increase aggregate demand. Output increases but the price level may increase as well. Carbaugh, Chap. 13

18. The goal of supply-sidetax cuts A more dismal view ofsupply-side tax cuts Fall in prices AS0 AS0 AS1 AS1 Price level (price index) Price level (price index) B 110 A 100 A 100 B AD1 90 AD0 AD0 Increase in real output 0 0 800 900 Real output (billion dollars) Real output (billion dollars) Fiscal Policy Supply-side fiscal policy Carbaugh, Chap. 13

19. Fiscal Policy and Aggregate Supply • Do cuts in tax rate cause tax revenues rise or fall? • Tax revenue = Tax rate x Taxable income • The Laffer curve shows the relationship between the income tax rate and the total tax revenue. • As the tax rate rises from 0 percent, total revenue rises, reaches the maximum and start to fall. Carbaugh, Chap. 13

20. 300 200 0 Tax rate (%) Fiscal Policy The Laffer Curve A Tax revenue ($ billions) B 85 100 48 Carbaugh, Chap. 13

21. Government budget • The main mechanism of fiscal policy is the federal budget. • Change in federal taxes or spendings are the tools for shifting ADC or ASC. • The use of federal budget to stabilize the economy suggests that federal budget will often be unbalanced. • Budget deficit • Budget surplus • Balanced budget Carbaugh, Chap. 13

22. Government Budget Government budget = Tax revenue – Government spending • If tax revenue = Government spending: Balanced government budget • If tax revenue > Government spending: Government budget surplus • If tax revenue < Government spending: Government budget deficit Carbaugh, Chap. 13

23. Fiscal Policy Deficits and surpluses of U.S. government Source: From Economic Report of the President,2005 Carbaugh, Chap. 13

24. Federal Deficit Federal debt held by the public 1940 $43.0 44.0% 1945 236.0 106.0 1955 227.0 57.0 1965 261.0 38.0 1975 3954.0 25.0 1985 1,500.0 36.0 1995 3,603.0 49.0 2000 3,410.0 35.0 2004 4,721.0 37.0 Federal Federal debt as Year debt (bill.) a % of GDP Source: Economic Report of the President, 2005 Carbaugh, Chap. 13

25. Federal deficit and federal debts • Federal deficit is the difference between federal spending and revenue in a given year. • federal debts represent the cumulative amount of outstanding borrowing from the public over the nation’s history • Main measure of federal debts is the debt held by the public. • The amount of borrower itself does not make a good indicator of the debt burden; it should be viewed in relation to the nation’ income (GDP). Carbaugh, Chap. 13

26. Sales and ownership of federal debts • Federal government borrows by issuing securities, most thru Treasury Department. • The securities are marketable. • These include: Treasury bills, notes and bonds with variety of maturities (1-30 months).\ • Who lend government? • US treasury and other federal ageencies (42%) • Private domestic investors ( 25%) • Foreign investors ( 24%) • Federal reserve banks ( 9%) Carbaugh, Chap. 13

27. federal debts: Good or bad? • Necessary if • Borrowing during recessions help the economy by maintaining income • Wartime borrowing: improve national defense • Federal borrowing for investment spending: building roads, bridges, training workers…. • Bad if not for purposes mentioned because cost may outweigh benefits: reduction of funds for investment, interest rates, …. Carbaugh, Chap. 13

28. Should there be a balanced-budget amendment? • Advantages: • Disadvantages • This would make recessions more freequent and severe. • Balabced budget requirement make recessions more painful and longer • By eliminating the automatic stabilizer that protect people in a downturn • By instead requiring measures to cut spending or increase taxes during slowdown when the economy is already suffering from the lack of demand. Carbaugh, Chap. 13

29. 130 125 120 115 110 105 100 95 90 85 650 700 750 800 850 900 950 Real output ($ bill.) Fiscal Policy Expansionary fiscal policy and the multiplier Direct effect of an increase in government spending Indirect effect of increased consumption spending AS0 Price level (price index) B A C AD2 AD1 AD0 Carbaugh, Chap. 13

30. Expansionary fiscal policy and the multiplier • Notice that the particular increase in Aggregate Demand take place within the horizontal region of ASC, where the price level is constant. • → Thus the real output will increase by the full amonut of the multiplier. But unemployment falls because firms will employ workers who were laid off during the recession. Carbaugh, Chap. 13

31. Question 3 • A tax reduction for households tends to increase consumption spending and also aggregate demand. Given an upward-sloping aggregate supply curve, the increase in aggregate demand results in an increase in output and also an increase in the price level. • However, a tax reduction may also improve incentives to work, save, and invest, which would cause the aggregate supply curve to increase. • An increase in aggregate supply results in an increase in output but a decrease in the price level. • If aggregate demand increases by a greater (smaller) amount than aggregate supply, the economy’s price level will increase (decrease). Carbaugh, Chap. 13

32. Question 4 • . Discretionary fiscal policy is the deliberate use of changes in government expenditures and taxation to affect aggregate demand and influence the economy’s performance in the short run. • The main advantage of using fiscal policy is that it has the potential to stabilize the economy’s output and price level. Recessions and inflation can be combated. • The main disadvantage is that fiscal policy may not work very well in practice. Among the problems facing fiscal policy are timing lags, irreversibility, inflationary bias, the crowding-out effect, and the foreign-trade effect Carbaugh, Chap. 13

33. Question 5 • Discretionary fiscal policy is based on the multiplier principle. • If, for example, the government purchases its Air Force aircraft from Boeing, its profits and employment increase. As Boeing workers realize larger paychecks and the firm’s owners realize higher dividends, they respond by purchasing products such as automobiles from Ford Motor Company. Therefore, Ford realizes higher profits and hires additional workers, and consumer spending again increases. Each round of added spending increases aggregate demand. When all of these effects are combined, the total impact on the quantity of goods and services demanded will be larger than the initial stimulus from increased government expenditures, according to the multiplier effect. Carbaugh, Chap. 13

34. Question 7 • A balanced budget amendment could make recessions more severe. Suppose the economy enters a period of increasing unemployment and declining incomes that results in decreasing tax revenues. • To balance its budget, the government must either increase taxes or decrease spending. Both of these policies cause aggregate demand to decrease, which would tend to shove the economy even deeper into the recession. Carbaugh, Chap. 13

35. Question 8 • According to Keynesian economists, a tax cut increases the take-home pay of households, which results in an increase in consumption spending and an increase in aggregate demand. • According to supply-side economists, a tax cut increases the returns to working, saving, and investment and thus causes the aggregate supply curve to increase. In addition to these economic effects, supply-siders also believe that the government needs to look at tax revenues. • If the tax rate were zero, for instance, the economy’s output could be very high, but tax revenues would be zero and the government would not have funding for the provision of public goods and services. Carbaugh, Chap. 13

36. Question 9 • When there is a crowding-out effect, private spending (consumption spending or investment) decreases as a result of increased government expenditures and subsequent budget deficits. Because of crowding out, expansionary fiscal policy is less effective in combating recession than it could be. • Crowding out would most likely take place when spending is robust and money is tight. Carbaugh, Chap. 13

37. Question 10 • . To combat a recession, government would enact an expansionary fiscal policy by increasing expenditures or decreasing taxes. • To combat inflation, government would enact a contractionary fiscal policy by decreasing expenditures or increasing taxes. Carbaugh, Chap. 13

38. Question 11 • Given an upward-sloping aggregate supply curve, a tax cut that increases aggregate supply would cause national output to increase and the price level to decline. • However, critics of supply-side economics maintain that the impact of a tax cut on incentives to work, save, and invest may not be as large as supply-side advocates maintain. • Moreover, supply-side advocates may underestimate the effects of tax cuts on aggregate demand. Lastly, the tax cut may result in falling tax revenues, depending on where the economy is on the Laffer Curve. Carbaugh, Chap. 13