lecture 24 ch21

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Fiscal Policy

The government can influence the behavior of the economy through fiscal policy

Definition- Fiscal policy is the setting of the level of government spending and taxation by government policymakers

When the Federal Reserve changes the money supply, they shift the aggregate demand curve indirectly by influencing the spending decisions of firms or households

When the Government changes the level of taxes, they shift the aggregate demand curve by indirectly by influencing the spending decisions of households and firms

Conversely, when the Government changes its own purchases of goods and services it shifts that aggregate demand curve directly

Effect from Fiscal Policy

Suppose the government wants to stimulate aggregate demand by increasing government purchases by $1 billion. By how much does aggregate demand shift?

There are two macroeconomics effects that cause the size of the shift in aggregate demand to differ from the change in government purchases:

The Multiplier Effect

The Crown-Out Effect

The Multiplier Effect

The multiplier effect suggest that aggregate demand could increase by more than an increase in government purchases

Definition- The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending

Because each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar, government purchases are said to have multiplier effect on aggregate demand

Furthermore, the multiplier effect arising from the response of consumer spending to increases in government spending could strengthen investment due to higher levels of consumer demand

The positive feedback from consumer demand to investment is called the investment accelerator

Marginal Propensity to Consumer

If an increase in government purchases leads to an increase in incomes for some individuals, will these individuals spend their entire income consuming goods and services?

On average no

Definitions- The marginal propensity to consume is the fraction of the extra income that a household consumes rather than saves

a marginal propensity to consume of 1000% means that a household consumes half of its additional income and saves none

a marginal propensity to consume of 50% means that a household consumes half of its additional income and saves half of its additional income

a marginal propensity to consume of 0% means that a household consumes none of its additional income and saves all of its additional income

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Multiplier Effect & Marginal Propensity to Consume

You will not need to calculate the multiplier effect or the marginal propensity to consume, as is done in the book. You just need to understand the concept

So, if the marginal propensity to consume is greater than 0% (meaning people consume at least a little more), then an increase in government purchases will have an even larger impact on aggregate demand

Furthermore, the larger the marginal propensity to consume the greater the multiplier effect on aggregate demand

In other words, if people consume all of their additional income (MPC=100%) this will have a larger impact than if people only consume 25% of additional income (MPC=25%)

Other Applications of the Multiplier Effect

The multiplier is an important concept in macroeconomics, because it shows how changes in spending can have an amplified effect on the overall economy

This effect actually applies to an event that alters spending on any components of GDP: consumption, investment, government purchases, or net exports

A small initial change in consumption, investment, government purchases, or net exports can end up having a large effect on aggregate demand and, therefore, the overall output of the economy

The Crowding-Out Effect

The crowding-out effect suggests that aggregate demand could increase by less than an increase in government purchases

Definition- The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending

An increase in government purchases leads to an increase in incomes for some individuals which increases their consumption of goods and services, the money demand curve increase (shifts right)

The right shift of the money demand causes interest rates to increase, and the increase in interest rates causes the quantity of goods and services demanded to decrease

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Multiplier vs. Crowding Out Effects

When the government increases its purchases, there are two effects on aggregate demand: the multiplier effect and the crowding out effect

The multiplier effect makes the shift in aggregate demand greater than the increase in government purchases

The crowd-out effect makes the shift in aggregate demand less than the increase in government purchases

Changes in Taxes

The other instrument the government could use to enact fiscal policy is to change the level of taxation

When the government cuts taxes, the shift of aggregate demand is again impacted by the multiplier effect and the crowding-out effects. Additionally, it is impacted by household perceptions about the permanency of the tax change

Tax cuts stimulate consumer spending causing earnings profits and to rise which further stimulates consumer spending causing earnings and profits to rise which further stimulates consumer spending

This is the multiplier effect

Higher incomes lead to higher money demand which ends to raise interest rates causing borrowing costs to rise which reduces investment spending

This is the crowding-out effect

Taxes and Household Perceptions

If households view tax cuts as being permanent, then they will view the tax cuts as permanently adding to their financials resources and, therefore, will increase spending by a large amount

This would have a larger impact on aggregate demand

If households view tax cuts as being temporary, then they will view the tax cuts as only adding a little to their financial resources and, therefore, will increase spending by only a small amount

This would have a smaller impact on aggregate demand

Active Stabilization Policy

Monetary and fiscal policy have been used to stabilize aggregate demand and, therefore, production and employment for about 70 years in the US

Economic stabilization has been explicit goal of US policy since the Employment Act of 1946. This act states, "it is the continuing policy and responsibility of the federal government to...promote full employment and production"

So, the government holds itself accountable for short-run macroeconomic fluctuations

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The Employment Act

There are two implications of this act:

The government should avoid being the cause of economic fluctuations

The government should respond to changes in the private economy to stabilize aggregate demand

The act was passed shortly after Keynes published his book, The General Theory of Employment, Interest, and Money

In his book, Keynes emphasized the role of aggregate demand in explaining short-run economic fluctuations

Keynes claimed that the government should actively stimulate aggregate demand when aggregate demand appeared insufficient to maintain production at its full-employment level

Critics of Stabilization Policy

In general, orthodox economists believe that stabilization policies should be used

There is really no debate about whether monetary policy should be used as both big schools of macroeconomic thought have shown that monetary policy can effectively limit the severity of economic recessions and depressions (The two big school about are RBC- Real Business Cycle and New Keynesians)

There is debate about whether fiscal policy should be used as one school of macroeconomic thought (RBC) argues that fiscal policy has not conclusively been shown to limit the severity of recessions and depressions

Today, Austrian 'economists' believe that stabilization policies should not be used (i.e. the Great Depression)

Most of these 'economists' do not follow the scientific method for hypothesis testing using data; so, the conclusions they draw are not based on empirical facts

Problem with Stabilization Policies

There is often a lag in policy setting relative to changing economic conditions

Because monetary policy works through changing interest rates and therefore investment spending, it can take a little time for firms to adjust to the changed interest rate environment

Fiscal policy, however, tends to lag changing economic conditions due to the political process

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Automatic Stabilizers

All economists agree that lags in the implementation of monetary policy reduce some of the efficacy

In other words, policy would be more effective if policymakers could avoid these lags. It's easier said than done, though

Definition- Automatic stabilizers are changes in fiscal policy that stimulates aggregate demand when the economy goes into a recession without policymakers

Ex. unemployment insurance, welfare benefits, and drops in tax rates due to falling incomes

Having policies like these in place help offset some of the lag in monetary and fiscal policy that can occur