Chapter 13 Chapter 12 in 4th edition

1
Chapter 13 (Chapter 12 in 4th edition)

• Learning objectives
• What is the impact of fiscal policy on the
  economy?
• At the end of this class you should be able to
• Define the two instruments of fiscal policy.
• Derive the government expenditure and lump-sum
  tax multipliers.
• Define automatic stabilizers, and discuss their
  impact on the business cycle.
• Examine the effects of a balanced budget rule.

2
Introduction

• The budget is defined as B T G
• If B0 the budget is balanced
• If Blt0 there is a budget deficit
• If Bgt0 there is a budget surplus
• The Government Debt is the sum of all previous
  deficits that have not yet been repaid.
• Fiscal policy concerns the use of government
  expenditures (G) and/or government revenues,
  taxes (T), as policy instruments to influence the
  overall behavior of the economy.

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U.S. Budget Overview

• Taxes can be separated into four large
  components. The value of these components in
  1997 was
• Personal Income Taxes 673 bn
• Social Insurance Taxes 536 bn
• Corporate Income Taxes 176 bn
• Indirect Taxes 120 bn
• Expenditure can be separated into three large
  components. Government Expenditure in 1997 was
• Transfer Payments 1,060 bn
• Purchases of Goods and Services 324 bn
• Debt interest 247 bn

4
U.S. Budget Overview (Cont...)

• Today the US budget shows a surplus, although it
  showed a deficit for most of the last 20 years.
• Most countries in the world have budget deficits
• What are the consequences of having a budget
  deficit?
• The risk of a large budget deficit is the
  crowding out of private investment. Although the
  Barro-Ricardo effect predicts that there will be
  no crowding out at all, some of the assumptions
  they make are not true in reality. So some
  crowding out does happen.

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Fiscal Policy Multipliers

• Fiscal policy can be discretionary or automatic
• A discretionary policy is initiated at the
  discretion of the government or of congress
• An automatic policy is one that results as a
  consequence of the state of the economy
• We are going to look at the impact of
  discretionary government policy.
• We assume that the only kind of taxes that are
  imposed are lump sum taxes to simplify the
  analysis.
• There are two fiscal policy multipliers
• The government expenditure multiplier
• The lump sum tax multiplier

6
Fiscal Policy Multipliers (cont.)

• We know from the previous chapter that the
  government expenditure multiplier is 1/(1-MPC).
• So if G increases by x, output Y increases by
  x/(1-MPC) .
• We also know that taxes reduce the effect of the
  expenditure multiplier.
• What is the effect of an increase in the lump sum
  tax? Let the economy be at equilibrium with
  as the level of GDP and T the lump sum tax.

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Fiscal Policy Multipliers (cont.)

• If the tax is now increased by then the new
  equilibrium level of GDP is given as
  follows
• So the change in the equilibrium level of GDP is

8
Fiscal Policy Multipliers (cont.)

• And we can compute the lump-tax multiplier as
  follows
• Notice that when taxes increase, the equilibrium
  level of GDP decreases.
• Automatic Stabilizers
• Automatic stabilizers are mechanisms that
  stabilize real GDP without explicit action from
  the government
• They exist because some taxes and expenditures
  can automatically change as GDP changes
• If GDP declines, tax revenue typically declines
  and transfers typically increase

9
Automatic Stabilizers (cont.)

• Remember that the tax multiplier has a negative
  sign
• - MPC / (1-MPC)
• The transfers (dole) multiplier is MPC / (1-MPC)
• Therefore, if taxes decrease, output increases
  and if transfers increase output increases.
• During a recession, taxes decrease, while
  transfers increase. Therefore output tends to
  increase, thereby diminishing the effects of the
  recession.
• Similarly, during an expansion, taxes increase,
  while transfers decrease. Therefore output tends
  to decrease, thereby containing the overheating
  economy.
• Thus taxes and transfers provide a stabilizing
  effect during both recessions and expansions.
  Since no explicit government action is required,
  these are called automatic stabilizers.

10
Automatic Stabilizers (cont.)

• What would happen if there was a balanced budget
  rule?
• A Balanced Budget Rule would require the budget
  to be balanced every year.
• Since tax revenue declines during a recession,
  and transfer payments increase, the government
  will have to cut expenditure to balance the
  budget. This will drive GDP down even further,
  through the government expenditure multiplier,
  causing an even deeper recession.
• Similarly during an expansion, balancing the
  budget will cause output to rise by more than the
  normal cyclical expansion.
• This will reduce and possibly eliminate the
  automatic stabilizing properties of fiscal policy.