Fiscal Policy

Del Mar College, John Daly

2002 South-Western Publishing, A Division of Thomson Learning

Expenditures & Tax Revenues

If expenditures are greater than tax
revenues, a budget deficit exists.
If tax revenues are greater than
expenditures, a budget surplus exists
If expenditures equals tax revenues, a
balanced budget exists.

Fiscal Policy
Refers to changes in government
expenditures and/or taxes to achieve
particular economic goals, such as low
unemployment, price stability, and
economic growth.
Government expenditures is the sum of
government purchases and transfer
payments.

Fiscal Policy Definitions

Expansionary fiscal policy
refers to increases in
government expenditures
and/or decreases in taxes
to achieve macroeconomic
goals.
Contractionary fiscal
policy attempts to
decrease government
expenditures and/or
increases in taxes to
achieve macroeconomic
goals.

Fiscal Policy Definitions

Discretionary Fiscal
Policy is deliberate
changes of government
expenditures and/or taxes
to achieve particular
economic goals.
Automatic Fiscal Policy is
changes in government
expenditures and/or taxes
that occur automatically
without (additional)
congressional action.

Two Key Assumptions

In our discussion of fiscal policy, we only
deal with discretionary fiscal policy.
We assume that any change in government
spending is due to a change in government
purchases and not to a change in transfer
payments.

Demand-Side Fiscal Policy

A change in consumption, investment,
government purchases, or net exports can
change aggregate demand and there fore
shift the AD curve.
A change in taxes can affect consumption or
investment or both and there for can affect
aggregate demand.

Fiscal Policy: A Keynesian

Perspective

Crowding Out
Refers to a decrease in private expenditures that
occurs as a consequence of increased government
spending or the financing needs of a budget
deficit.
Economists who believe the crowding out
phenomenon exists argue that because of the direct
substitution of public services for consumer
spending or because of higher interest rates,
increases in government spending induce
consumers and investors to spend less.

Crowding Out
Complete Crowding Out occurs when the decrease
in one or more components of private spending
completely offsets the increase in government
spending.
Incomplete Crowding Out occurs when the
decrease in one or more components of private
spending only partially offsets the increase in
government spending.
Whether we are dealing with complete or
incomplete crowding out, the crowding out effect
suggests that expansionary fiscal policy will have
less impact on aggregate demand and Real GDP
than Keynesian theory predicts.

 In Keynesian theory,
expansionary fiscal policy
shifts the aggregate
demand curve to AD2 and
moves the economy to
point 2.
If there is no crowding out,
expansionary fiscal policy
increases Real GDP and
lowers the unemployment
rate.
If there is incomplete
crowding out,
expansionary fiscal policy
increases Real GDP and
lowers the unemployment
rate, but not as much as in
the case of zero crowding
out.
If there is complete
crowding out,
expansionary fiscal policy
has no effect on the

Keynesian Theory &

Crowding Out

Crowding Out, The Interest Rate,

And Foreign Loanable Funds
Many economists argue that foreigners in search
of the highest rates of return will help finance the
deficit by lending funds to the federal government
through their purchases of U.S. Treasury
securities.
Before foreigners buy US Treas8ury securities,
they must exchange their domestic currency for
US dollars.
The dollar will then appreciate in value relative to
other currencies.
This makes foreign goods cheaper for Americans
and American goods more expensive for
foreigners.

Crowding Out, The Interest Rate,

And Foreign Loanable Funds
Some of the crowding
out of private
expenditures will
come in the form of a
decrease in net
exports.

The New Classical View of

Fiscal Policy: Crowding Out with No
Increase in Interest Rates
Individuals respond to expansionary fiscal policy, a larger
deficit, and greater deficit-financing requirements by
thinking the following A larger deficit implies more debt
this year and higher future taxes. Ill simply save more in
the present so I can pay the higher future taxes required to
pay interest and to repay principal on the new debt. But, of
course, if Im going to save more, Ill have to consume less.
Current consumption will fall as a result of expansionary
fiscal policy.
Deficits do not bring higher interest rates.

The New Classical View of

Expansionary Fiscal Policy
As long as
expansionary
fiscal policy is
translated into
higher future
taxes, there will
be no change in
Real GDP,
unemployment,
the price level,
or interest rates.

Lags And Fiscal Policy

1.
2.
3.
4.
5.
.

The Data Lag

The Wait-And-See Lag
The Legislative Lag
The Transmission Lag
The Effectiveness Lag
Some economists argue that discretionary fiscal
policy is not likely to have the impact on the
economy that policymakers hope. By the time
the full impact of the policy is felt, the economic
problem it was designed to solve may no longer
exist, may not exist to the degree it once did, or
it may have changed altogether.

Lags And Fiscal Policy

The government
has moved the
economy from
point 1 to point 2,
and not, as they
had hoped, from
point 1 to point 1.

Demand-Side Fiscal Policy: Return to the

Keynesian Model
It would seem that
under the conditions
of no lags and zero
crowding out,
expansionary fiscal
policy either
increasing
government spending
or cutting taxes will
work at removing the
economy from a
recessionary gap.

Demand-Side Fiscal Policy: Return to the

Keynesian Model
If government
knows the
difference between
Q1 and QN (so that
it knows how
much to change
Real GDP) and it
knows the MPC,
then it can use
fiscal policy to get
the economy out
of a recessionary
gap and producing
Natural Real GDP.

Demand-Side Fiscal Policy: Return to the

Keynesian Model
If the government
doesnt know the
actual MPC and it
doesnt know the
actual difference
between Q1 and
QN, then fiscal
policy isnt likely
to work as
intended.

Tax Cuts Instead: Are Things

Any Different?
An important equation:
Real GDP = -MPC(m) x T
A dollar spend by government is a dollar
spent; a dollar tax cut is a dollar partly
saved and partly spent. In order to get the
same change in Real GDP, government has
to cut taxes more than it has to raise
purchases.

Q&A
How does crowding out question the
effectiveness of expansionary demand-side
fiscal policy?
Do budget deficits raise interest rates?
How can an increase in the size of the
federal budget deficit affect the trade
deficit?

Supply-Side Fiscal Policy

All other things held constant, lower marginal tax
rates increase the incentive to engage in
productive activities relative to leisure and tax
avoidance activities.
Given a cut in marginal tax rates two things will
happen: Individuals will have more disposable
income; the amount of money they can earn by
working increases.
In the analysis of marginal tax rates and aggregate
supply, we implicitly assume that in the aggregate,
a marginal tax rate cut increases work activity.

The Predicted Effect of a Permanent

Marginal Tax Rate Cut on Aggregate
Supply

The Laffer Curve: Tax Rates and

Tax Returns
If income tax rates were lowered, would it
increase or decrease tax revenue?
There are two tax rates at which zero tax
revenues will be collected 0 and 100%.
An increase in tax rates could cause tax
revenues to increase.
A decrease in tax rates could cause tax
revenues to increase.

The Laffer Curve: Tax Rates and

Tax Returns

The Laffer Curve: Implications

We assume that as the tax rate is reduced, the tax
base expands. The rationale is that individuals work
more, invest more, and enter into more exchanges,
and shelter less income from taxes and lower tax
rates.
How much does the tax base expand following the
tax rate reduction?
Tax revenues increase if a tax reduction is made in
the downward-sloping portion of the curve (between
points B and C); tax revenues decrease following a
tax rate reduction in the upward sloping portion of
the curve (between points A and B).

Q&A
Give an arithmetical example to illustrate
the difference between the marginal and
average tax rates.
If income tax rates rise, will income tax
revenue rise as well?