Chapter 15: Fiscal Policy - HKU Business School

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Chapter 15: Fiscal PolicyYulei LuoSEF of HKUApril 9, 2012

Learning Objectives1. De ne scal policy.2. Explain how scal policy a ects aggregate demand and howthe government can use scal policy to stabilize the economy.3. Use the dynamic aggregate demand and aggregate supplymodel to analyze scal policy.4. Explain how the government purchases and tax multiplierswork.5. Discuss the di culties that can arise in implementing scalpolicy.6. De ne federal budget de cit and federal government debt andexplain how the federal budget can serve as an automaticstabilizer.7. Discuss the e ects of scal policy in the long run.

What Fiscal Policy Is and What It Isn’tIFiscal policy (FP): Changes in federal taxes and purchasesthat are intended to achieve macroeconomic policy objectives:high employment, price stability, and high rates of economicgrowth.IThe gov. can a ect the levels of both AD and AS throughFP. Since WWII, the federal gov. has committed tointervening in the economy to promote maximumemployment, production, and purchasing power.IRestrict the term scal policy to refer only to the actions ofthe federal gov (NOT state and local Gov.) because they areintended to a ect the national economy.INot all actions of the federal gov are FP actions because someof them are not intended to achieve macro policy goals.IE.g., the increases in the defense and homeland security (HS)spending are not FP, but part of defense and HS policy.

15.1 LEARNING OBJECTIVEWhat is Fiscal Policy?Define fiscal policy.An Overview of Government Spending and TaxesFigure 15-1The Federal Government’sShare of Total GovernmentExpenditures, 1929–2008Chapter 15: Fiscal PolicyUntil the Great Depression of the1930s, the majority of governmentspending in the United Statesoccurred at the state and locallevels. Since World War II, thefederal government’s share of totalgovernment expenditures hasbeen between two-thirds andthree-quarters.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.6 of 50

15.1 LEARNING OBJECTIVEWhat is Fiscal Policy?Define fiscal policy.An Overview of Government Spending and TaxesFigure 15-2Chapter 15: Fiscal PolicyFederal Purchases andFederal Expenditures asa Percentage of GDP,1950–2008As a fraction of GDP, thefederal government’spurchases of goods andservices have been decliningsince the Korean War in theearly 1950s.Total expenditures by thefederal government— includingtransfer payments—as afraction of GDP slowly rosefrom 1950 through the early1990s and fell from 1992 to2001, before rising again.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.7 of 50

15.1 LEARNING OBJECTIVEWhat is Fiscal Policy?Define fiscal policy.An Overview of Government Spending and TaxesFigure 15-3Chapter 15: Fiscal PolicyFederal GovernmentExpenditures, 2008Federal government purchases canbe divided into defense spending—which makes up about 24 percentof the federal budget—andspending on everything else thefederal government does—frompaying the salaries of FBI agents,to operating the national parks, tosupporting scientific research—which makes up about 9 percent ofthe budget.In addition to purchases, there arethree other categories of federalgovernment expenditures: intereston the national debt, grants to stateand local governments, andtransfer payments. Transferpayments rose from about 25percent of federal governmentexpenditures in the 1960s to nearly45 percent in 2008.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.8 of 50

15.1 LEARNING OBJECTIVEWhat is Fiscal Policy?Define fiscal policy.An Overview of Government Spending and TaxesFigure 15-4Chapter 15: Fiscal PolicyFederal GovernmentRevenue, 2008In 2008, individual incometaxes raised about 44 percentof the federal government’srevenues.Corporate income taxes raisedabout 11 percent of revenue.Payroll taxes to fund the SocialSecurity and Medicareprograms rose from less than10 percent of federalgovernment revenues in 1950to almost 38 percent in 2008.The remaining 7 percent ofrevenues were raised fromexcise taxes, tariffs on imports,and other fees.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.9 of 50

Distinction bw. automatic stabilizers and discretionary FPIAutomatic stabilizers: Government spending and taxes thatautomatically increase or decrease along with the businesscycle:IIIE.g., when the economy is in expansion, gov spending on UIpayments to unemployed workers will automatically decrease.Similarly, during the expansion, income is rising, and theamount the gov collects in taxes will increase.Discretionary FP: The gov. takes actions to change spendingor taxes. E.g., the tax cuts passed by Congress in 2001.

IThe gov can also use stabilization policy through changes ingov. spending and taxes to o set the e ects of BC on theeconomy.IChanges in gov. spending and taxes lead to changes in AD, sothey can a ect the levels of real GDP, employment, and thePL.IWhen the economy is in a recession, increases in gov.purchases or decreases in taxes will increase AD directly orindirectly. Consequently, the in‡ation rate may increase whenAD is increasing faster than AS.

The Effects of Fiscal Policyon Real GDP and the Price LevelExpansionary and Contractionary Fiscal Policy15.2 LEARNING OBJECTIVEExplain how fiscal policy affectsaggregate demand and how thegovernment can use fiscal policy tostabilize the economy.Chapter 15: Fiscal PolicyFigure 15-5Fiscal PolicyIn panel (a), the economy begins in recession at point A, withreal GDP of 14.2 trillion and a price level of 98. Anexpansionary fiscal policy will cause aggregate demand toshift to the right, from AD1 to AD2, increasing real GDP from 14.2 trillion to 14.4 trillion and the price level from 98 to 100(point B).In panel (b), the economy begins at point A, with real GDPat 14.6 trillion and the price level at 102. Because realGDP is greater than potential GDP, the economy willexperience rising wages and prices. A contractionary fiscalpolicy will cause aggregate demand to shift to the left, fromAD1 to AD2, decreasing real GDP from 14.6 trillion to 14.4 trillion and the price level from 102 to 100 (point B).Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.11 of 50

15.2 LEARNING OBJECTIVEThe Effects of Fiscal Policyon Real GDP and the Price LevelExplain how fiscal policy affectsaggregate demand and how thegovernment can use fiscal policy tostabilize the economy.A Summary of How Fiscal PolicyAffects Aggregate DemandTable 15-1Chapter 15: Fiscal PolicyCountercyclical Fiscal PolicyACTIONS BY CONGRESSAND THE PRESIDENTRESULTPROBLEMTYPE OF POLICYRecessionExpansionaryIncrease governmentspending or cut taxesReal GDP and the pricelevel rise.Rising inflationContractionaryDecrease governmentspending or raise taxesReal GDP and the pricelevel fall.Don’t Let This Happen to YOU!Don’t Confuse Fiscal Policy and Monetary PolicyYOUR TURN: Test your understanding by doing related problem 2.6 at the endof this chapter.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.12 of 50

Fiscal Policy in the Dynamic AggregateDemand and Aggregate Supply Model15.3 LEARNING OBJECTIVEUse the dynamic aggregatedemand and aggregate supplymodel to analyze fiscal policy.Figure 15-6Chapter 15: Fiscal PolicyAn Expansionary Fiscal Policyin the Dynamic ModelThe economy begins in equilibrium atpoint A, at potential real GDP of 14.0trillion and a price level of 100.Without an expansionary policy,aggregate demand will shift from AD1 toAD2(without policy), which is not enough tokeep the economy at potential GDPbecause long-run aggregate supply hasshifted from LRAS1 to LRAS2. Theeconomy will be in short-run equilibriumat point B, with real GDP of 14.3 trillionand a price level of 102.Increasing government purchases orcutting taxes will shift aggregatedemand to AD2(with policy). The economywill be in equilibrium at point C, with realGDP of 14.4 trillion, which is itspotential level, and a price level of 103.The price level is higher than it wouldhave been if expansionary fiscal policyhad not been used.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.13 of 50

Fiscal Policy in the Dynamic AggregateDemand and Aggregate Supply Model15.3 LEARNING OBJECTIVEUse the dynamic aggregatedemand and aggregate supplymodel to analyze fiscal policy.Figure 15-7Chapter 15: Fiscal PolicyA Contractionary FiscalPolicy in the Dynamic ModelThe economy begins in equilibrium atpoint A, with real GDP of 14.0trillion and a price level of 100.Without a contractionary policy,aggregate demand will shift from AD1to AD2(without policy), which results in ashort-run equilibrium beyondpotential GDP at point B, with realGDP of 14.5 trillion and a price levelof 105.Decreasing government purchasesor increasing taxes can shiftaggregate demand to AD2(with policy)The economy will be in equilibrium atpoint C, with real GDP of 14.4trillion, which is its potential level,and a price level of 103.The inflationrate will be 3 percent as opposed tothe 5 percent it would have beenwithout the contractionary fiscalpolicy.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.14 of 50

The Government Purchases MultiplierIThe initial increase in gov. purchases (as a component of AD,autonomous expenditures) will lead to additional increases inincome and spending.IIE.g., when using 100 billion to build subways, the gov. hiresprivate rms. These rms will hire more workers and the newlyhired workers will increase their spending on consumptiongoods. Sellers of these goods will increase their production andemployment. At each step, real GDP and income increases,thereby increasing consumption and AD.Multiplier e ect The series of induced increases inconsumption spending that results from an initial increase inautonomous expenditures.

The Government Purchasesand Tax Multipliers15.4 LEARNING OBJECTIVEExplain how the governmentpurchases and tax multipliers work.Figure 15-8The Multiplier Effect andAggregate DemandChapter 15: Fiscal PolicyAn initial increase in governmentpurchases of 100 billion causesthe aggregate demand curve toshift to the right, from AD1 to thedotted AD curve, and representsthe impact of the initial increaseof 100 billion in governmentpurchases.Because this initial increaseraises incomes and leads tofurther increases in consumptionspending, the aggregate demandcurve will ultimately shift furtherto the right, to AD2.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.16 of 50

The Government Purchasesand Tax Multipliers15.4 LEARNING OBJECTIVEExplain how the governmentpurchases and tax multipliers work.Figure 15-9The Multiplier Effectof an Increase in GovernmentPurchasesChapter 15: Fiscal PolicyFollowing an initial increase in government purchases,spending and real GDP increase over a number of periodsdue to the multiplier effect.The new spending and increased real GDP in each periodis shown in green, and the level of spending from theprevious period is shown in orange.The sum of the orange and green areas represents thecumulative increase in spending and real GDP. In total,equilibrium real GDP will increase by 200 billion as aresult of an initial increase of 100 billion in governmentpurchases.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.17 of 50

15.4 LEARNING OBJECTIVEThe Government Purchasesand Tax MultipliersExplain how the governmentpurchases and tax multipliers work.The ratio of the change in equilibrium real GDP tothe initial change in government purchases isknown as the government purchases multiplier:Government purchases multiplier Change in equilibrium real GDPChange in government purchasesChapter 15: Fiscal PolicyThe expression for the tax multiplier is:Tax multiplier Change in equilibrium real GDPChange in taxesCopyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.18 of 50

The E ect of Changes in Tax RatesIA change in tax rates has more complicated e ects on realGDP than does a tax cut of a xed amount.IThe higher the tax rate, the smaller the multiplier e ect. Thereason is that the higher the tax rate, the smaller the availableamount of any increase in income caused by an increase ingov purchases.IA cut in tax rates a ects equilibrium GDP through twochannels:1. A cut in tax rates increases the disposable income, whichincreases consumption,2. a cut in tax rates increases the size of the multiplier e ect.

The Government Purchasesand Tax Multipliers15.4 LEARNING OBJECTIVEExplain how the governmentpurchases and tax multipliers work.Taking into Account the Effects of Aggregate SupplyFIGURE 15-10Chapter 15: Fiscal PolicyThe Multiplier Effectand Aggregate SupplyThe economy is initially at pointA.An increase in governmentpurchases causes the aggregatedemand curve to shift to the right,from AD1 to the dotted AD curve.The multiplier effect results in theaggregate demand curve shiftingfurther to the right, to AD2 (pointB).Because of the upward-slopingsupply curve, the shift inaggregate demand results in ahigher price level. In the newequilibrium at point C, both realGDP and the price level haveincreased. The increase in realGDP is less than indicated by themultiplier effect with a constantprice level.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.20 of 50

15.4 LEARNING OBJECTIVESolved Problem15-4AExplain how the governmentpurchases and tax multipliers work.Chapter 15: Fiscal PolicyThe Multiplier and Shifts in theAggregate Demand CurveCopyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.21 of 50

15.4 LEARNING OBJECTIVESolved Problem15-4AExplain how the governmentpurchases and tax multipliers work.Chapter 15: Fiscal PolicyThe Multiplier and Shifts in theAggregate Demand Curve (continued)YOUR TURN: For more practice, do related problem 4.6 at the end of this chapter.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.22 of 50

The Multipliers Work in Both DirectionsIIncreases in government purchases and cuts in taxes have apositive multiplier e ect on equilibrium real GDP.IDecreases in government purchases and increases in taxes alsohave a multiplier e ect on equilibrium real GDP, only in thiscase, the e ect is negative.

The Government Purchasesand Tax Multipliers15.4 LEARNING OBJECTIVEExplain how the governmentpurchases and tax multipliers work.Chapter 15: Fiscal PolicyFiscal Policy in Action:The Obama Administration Faces the Recession of 2007-2009FIGURE 15-11The 2009 Stimulus PackageCongress and President Obama intended the spending increases and tax cuts in the stimulus package to increaseaggregate demand and help pull the economy out of the 2007–2009 recession. Panel (a) shows how the increases inspending were distributed, and panel (b) shows how the tax cuts were distributed.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.24 of 50

15.4 LEARNING OBJECTIVESolved Problem15-4BExplain how the governmentpurchases and tax multipliers work.Fiscal Policy MultipliersBriefly explain whether you agree or disagree withthe following statement: “Real GDP is currently 14.2 trillion, and potential real GDP is 14.4trillion. If Congress and the president wouldincrease government purchases by 200 billion orcut taxes by 200 billion, the economy could bebrought to equilibrium at potential GDP.”Chapter 15: Fiscal PolicyGovernment purchases multiplier Change in equilibrium real GDPChange in government purchasesYOUR TURN: For more practice, do related problem 4.7 at the end of thischapter.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.25 of 50

Making Economists in the Obamathe Administration EstimateConnection the Size of the Multiplier15.4 LEARNING OBJECTIVEExplain how the governmentpurchases and tax multipliers work.Chapter 15: Fiscal PolicyAs time passes, economists will bebetter able to assess the economiceffect of the Obama administration’sstimulus package and to refine theirestimates of the multiplier.By how much did real GDPincrease as a result of increasedfederal spending on highways?YOUR TURN: Test your understanding by doing related problems 4.3 and 4.4 atthe end of this chapter.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.26 of 50

Timing is also Important to Conduct Fiscal PolicyIIf the gov. decides to increase spending or cut taxes to ght arecession that is about to end, the e ect may be to increasethe in‡ation rate.IIf the gov. decides to reduce spending or increase taxes toslow down the economy that actually already moved intorecession can make the recession longer and deeper.IGetting timing right can be more di cult with FP than withMP. The Fed then plays a larger role in stabilizing theeconomy because it can quickly change MP i.r.t. changingeconomic conditions.

Does Government Spending Reduce Private Spending?IUsing gov spending to increase AD cause a potential problem.ICrowding out: A decline in private expenditures(consumption, investment, or net exports) as a result of anincrease in government purchases.

The Limits of Using Fiscal Policyto Stabilize the Economy15.5 LEARNING OBJECTIVEDiscuss the difficulties that canarise in implementing fiscal policy.Crowding Out in the Short RunFigure 15-12An Expansionary Fiscal PolicyIncreases Interest RatesChapter 15: Fiscal PolicyIf the federal government increasesspending, the demand for money willincrease from Money demand1 toMoney demand2 as real GDP andincome rise.With the supply of money constant, at 950 billion, the result is an increasein the equilibrium interest rate from 3percent to 5 percent, which crowds outsome consumption, investment, andnet exports.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.28 of 50

The Limits of Using Fiscal Policyto Stabilize the Economy15.5 LEARNING OBJECTIVEDiscuss the difficulties that canarise in implementing fiscal policy.Crowding Out in the Short RunFigure 15-13Chapter 15: Fiscal PolicyThe Effect of CrowdingOut in the Short RunThe economy begins in arecession, with real GDP of 14.2 trillion (point A).In the absence of crowding out,an increase in governmentpurchases will shift aggregatedemand to AD2(no crowding out) andbring the economy toequilibrium at potential realGDP of 14.4 trillion (point B).But the higher interest rateresulting from the increasedgovernment purchases willreduce consumption,investment, and net exports,causing aggregate demand toshift to AD2(crowding out) . Theresult is a new short-runequilibrium at point C, with realGDP of 14.3 trillion, which is 100 billion short of potentialreal GDP.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.29 of 50

Crowding Out in the Long RunIEconomists disagree on the extent of crowding out in the SR.Most economists agree that the LR crowding out e ect of apermanent increase in gov spending is complete and thedecline in C , I , and NE , exactly o sets the increases in gov.purchases, and AD remains unchanged.ITo understand crowding out in the LR, recall that in the LR,the economy returns to potential GDP. If gov purchases areincreased permanently, in the LR, private expenditures mustfall the same amount to keep the potential GDP at the samelevel.

De cits, Surpluses, and Federal Government DebtIThe Fed gov’s budget shows the relationship bw itsexpenditures and its tax revenue.IBudget de cit: The situation in which the government’sexpenditures are greater than its tax revenue.IBudget surplus: The situation in which the government’sexpenditures are less than its tax revenue.

Chapter 15: Fiscal PolicyDeficits, Surpluses, andFederal Government Debt15.6 LEARNING OBJECTIVEDefine federal budget deficit andfederal government debt andexplain how the federal budget canserve as an automatic stabilizer.Figure 15-14The Federal Budget Deficit, 1901–2009During wars, government spending increases far more than tax revenues, increasing the budget deficit. The budgetdeficit also increases during recessions, as government spending increases and tax revenues fall.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.33 of 50

How the Federal Budget Can Serve as an AutomaticStabilizerIIn fact, most of the increase in the federal budget de citduring recessions take places without Congress or thepresident taking any action because of the e ect of Auto.Stabilizers.IBecause budget de cits automatically increase duringrecessions and reduce during expansions, economists oftenlook at the Cyclically adjusted budget de cit or surplus whichis the de cit or surplus in the federal gov’s budget if theeconomy were at potential GDP.IIt provides a better measure of the e ects of scal policy onthe economy than the actual budget de cit or surplus.

15.6 LEARNING OBJECTIVEMakingDefine federal budget deficit andfederal government debt andexplain how the federal budget canserve as an automatic stabilizer.Did Fiscal Policy Fail duringthethe Great Depression?Chapter 15: Fiscal PolicyConnectionAlthough government spendingincreased during the GreatDepression, the cyclically adjustedbudget was in surplus most years.CYCLICALLYADJUSTEDBUDGET DEFICITOR SURPLUS ASA PERCENTAGEOF GDPYEARFEDERALGOVERNMENTEXPENDITURES(BILLIONS OFDOLLARS1929 2.6 1.0 FEDERALCYCLICALLYBUDGET DEFICIT ADJUSTED BUDGETOR SURPLUSDEFICIT OR(BILLIONS OFSURPLUS (BILLIONSDOLLARS)OF DOLLARS)1.20%YOUR TURN: Test your understanding by doing related problem 6.7 at the endof this chapter.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.35 of 50

Should the Federal Budget Always Be Balanced?IFew economists believe that the gov should attempt tobalance its budget every year:IDuring a recession (expansion), the federal budgetautomatically moves into de cit (surplus). To bring thebudget back into balance, the gov would have to increase(cut) taxes or cut (increase) spending, but these actionswould reduce (increase) AD, thereby making the recessionworse (raising the risk of higher in‡ation).

Deficits, Surpluses, andFederal Government DebtThe Federal Government Debt15.6 LEARNING OBJECTIVEDefine federal budget deficit andfederal government debt andexplain how the federal budget canserve as an automatic stabilizer.Figure 15-15The Federal GovernmentDebt, 1901–2009Chapter 15: Fiscal PolicyThe federal government debtincreases whenever the federalgovernment runs a budgetdeficit. The large deficitsincurred during World Wars Iand II, the Great Depression,and the 1980s and early 1990sincreased the ratio of debt toGDP.The large deficits of 2008 and,especially, 2009 caused theratio to spike up to its highestlevel since 1949.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.37 of 50

Is the Government Debt a Problem?IDebt can be a problem for a gov for the same reasons thatdebt can be a problem for a HH or a rm.IIf a family is unable to make the monthly payments on itshouse, it will have to default on the loan and will lose itshouse. The fed gov. is in no danger of defaulting on its debtbecause the gov. can raise the funds through taxes to makethe interest payments on the debt.IInterest payments accounts for 10% of total federalexpenditures. At this level, tax increases or signi cantcutbacks on other types of spending are not required.IIn the LR, crowding out of investment means a lower capitalstock may occur if an increasing debt drives up IRs. Lowerinvestment reduces the capacity of the economy to produceG&S.

The Long-Run E ects of Tax PolicyISome FP actions are intended to have LR e ects byexpanding the productive capacity of the economy andincreasing the rate of EG.ITax wedge: The di erence between the pre-tax and post-taxreturn to an economic activity.IWe can brie‡y look at the e ects on AS of cutting each of thefollowing taxes:1. Individual income tax. Reducing the marginal tax rates onindividual income will reduce the tax wedge faced by: (1)workers, thereby increasing the quantity of labor supply; (2)savers, thereby increasing the amount saved; (3) entrepreneurs,thereby increasing the number of new businesses.

I2. (cont.) Corporate income tax. Cutting the marginal CI taxrate would encourage investment by increasing the returncorporations receive from new investments. At the same time,it also increase the pace of technological process.3. Taxes on dividends and capital gains. Lowering the tax rateson dividends and capital gains increases the supply of loanablefunds from hhs to rms, increasing saving and investment andlowering the equilibrium real IR.

Tax Simpli cationIThere are also gains from tax simpli cation because it can:IIreduces the resources used to deal with tax payments. E.g.,some resources used by the tax preparation industry can beused to produce other G&S.increase economic e ciency by reducing the number ofdecisions made by hhs and rms to reduce their tax payments.The decisions of HHs and rms are distorted by the complexityof the tax code.

15.7 LEARNING OBJECTIVEMaking Should the United StatesDiscuss the effects of fiscal policyin the long run.the Adopt the “Flat Tax”?ConnectionChapter 15: Fiscal PolicyCOUNTRYFLAT TAX RATEYEAR FLAT TAXWAS 04Georgia122005Romania162005The flat tax would simplify taxpreparation.YOUR TURN: Test your understanding by doing related problem 7.7 at the endof this chapter.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.40 of 50

The Effects of FiscalPolicy in the Long Run15.7 LEARNING OBJECTIVEDiscuss the effects of fiscal policyin the long run.The Economic Effect of Tax ReformFigure 15-16Chapter 15: Fiscal PolicyThe Supply-Side Effectsof a Tax ChangeThe economy’s initialequilibrium is at point A.With no tax change, the longrun aggregate supply curveshifts to the right, from LRAS1to LRAS2. Equilibrium movesto point B, with the price levelfalling from P1 to P2 and realGDP increasing from Y1 to Y2.With tax reductions andsimplifications, the long-runaggregate supply curve shiftsfurther to the right, to LRAS3,and equilibrium moves topoint C, with the price levelfalling to P3 and real GDPincreasing to Y3.Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.41 of 50

How Large Are Supply-Side E ects?IMost economists would agree that there are supply-side e ectsto reducing taxes: Decreasing marginal income tax rates willincrease the quantity of labor supplied, cutting the corporateincome tax will increase investment spending, and so on.IWhat is the magnitude of these e ects? Some economiststhink that the e ects are limited. E.g., many people work anumber of hours set by their employer and can’t adjust‡exibly i.r.t. the changes in the tax rate. Similarly, saving andinvestment are a ected much more by changes in income andchanges in expectations of the future pro tability. Someeconomists argue that tax changes may have larger e ects onAD. Considerable debate on this issue.

KeyTermsIFiscal policyIMultiplier e ectIAutomatic stabilizersIBudget de cit; Budget surplusICrowding outICyclically adjusted budget de cit or surplusITax wedge

LEARNING OBJECTIVEAppendixApply the multiplier formula.A Closer Look at the MultiplierAn Expression for Equilibrium Real GDPConsumption function(2) I 1,500Planned investment function(3) G 1,500Government purchases function(4) T 1,000Tax function(5) Y C I GEquilibrium conditionChapter 15: Fiscal Policy(1) C 1,000 0.75 (Y T)Copyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.45 of 50

LEARNING OBJECTIVEAppendixApply the multiplier formula.A Closer Look at the MultiplierAn Expression for Equilibrium Real GDPThe letters with “bars” represent fixed or autonomous valuesthat do not depend on the values of other variables. So, Crepresents autonomous consumption, which had a value of1,000 in our original example. Now, solving for equilibriumwe get:Y C MPC (Y T ) I Gor:Chapter 15: Fiscal PolicyY MPC (Y ) C ( MPC T ) I Gor:Y (1 MPC ) C ( MPC T ) I Gor:Y C ( MPC T ) I G1 MPCCopyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.46 of 50

LEARNING OBJECTIVEAppendixApply the multiplier formula.A Closer Look at the MultiplierA Formula for the GovernmentPurchases MultiplierΔC ( MPC ΔT ) Δ I ΔGΔY 1 MPCChapter 15: Fiscal PolicyΔGΔY 1 MPCΔY1Government purchases multiplier ΔG 1 MPCCopyright 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.47 of 50

LEARNING OBJECTIVEAppendixApply the multiplier formula.A Closer Look at the MultiplierA Formula for the Tax MultiplierΔC ( MPC ΔT ) Δ I ΔGΔY 1 MPC MPC ΔTΔY 1 MPCChapter 15

Chapter 15: Fiscal Policy The Effects of Fiscal Policy on Real GDP and the Price Level Expansionary and Contractionary Fiscal Policy Figure 15-5. Fiscal Policy. Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilize the economy. In

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