Understanding Fiscal Policy in Economics

1. Understanding Economics Chapter 12 Fiscal Policy Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 3 rd edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson

2. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Learning Objectives In this chapter, you will: 1. learn about expansionary and contractionary fiscal policies, which are used by governments seeking economic stability 2. analyze the multiplier effect of fiscal policy, as determined by the marginal propensities to consumer and withdraw 3. consider budget surpluses and deficits and their impact on public debt and public debt charges

3. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Stabilization Policies (a) Stabilization policy is government policy designed to lessen the effects of the business cycle can be either expansionary or contractionary expansionary policy attempts to reduce unemployment and stimulate output contractionary policy attempts to stabilize prices and reduce output

4. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Stabilization Policy and the Business Cycle Figure 12.1, Page 281 CONTRACTION EXPANSION Peak Trough Long-Run Trend of Potential Output Without stabilization policy With stabilization policy Real GDP Time

5. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Stabilization Policies (b) Stabilization policy can take the form of either fiscal policy or monetary policy fiscal policy uses taxes and government purchases expansionary fiscal policy involves more government purchases and/or lower taxes to shift AD rightward contractionary fiscal policy involves fewer government purchases and/or increased taxes to shift AD leftward monetary policy uses interest rates and the money supply

6. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Expansionary Fiscal Policy Figure 12.2, page 282 AS AD 0 AD 1 b a Potential Output Initial Recessionary Gap Real GDP (1997 $ billions) 800 780 0 170 160 Price Level (GDP deflator, 1997 = 100)

7. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Contractionary Fiscal Policy Figure 12.3 , Page 283 810 800 0 190 170 Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) AS AD 0 AD 1 Potential Output Initial Inflationary Gap d c

8. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Discretionary Policies Versus Automatic Stabilizers Discretionary policy is intentional government intervention in the economy Automatic stabilizers are built-in measures such as taxes and transfer payments to lessen the effects of the business cycle a contracting economy decreases net tax revenues which increases spending and incomes an expanding economy increases net tax revenues which decreases spending and incomes

9. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Multiplier Effect (a) The multiplier effect is the magnified impact of a spending change on AD an initial spending change produces income and part of this new income becomes new spending this process is repeated with each spending round smaller than the last

10. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Multiplier Effect (b) each new spending round is determined by the marginal propensity to consume (MPC) which measures the effect of an income change on domestic consumption each new spending round is also determined by the marginal propensity to withdraw (MPW) which measures the effect of an income change on withdrawals (with MPC and MPW always summing to one)

11. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Effect of a Rise in Government Purchases Figure 12.4, Page 287 2000 1000 0 1st round 2nd round 3rd round Later spending rounds Cycles of Spending Increase in Real Output 2000 1000 0 1st round 2nd round 3rd round Later spending rounds 500 Increase in Withdrawals $1000 $500 $250 $250 $250 $250 $500 $0

12. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Spending Multiplier The spending multiplier is the value by which an initial spending change is multiplied to give the total shift in the AD curve equals (1/MPW) The actual change in equilibrium output is less than the change in AD found using the spending multiplier because of price changes

13. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Multiplier Effect and Price Changes Figure 12.5, Page 289 Real GDP (1997 $ billions) 805 780 0 160 150 Price Level (GDP deflator, 1997 = 100) 810 AS AD 0 AD 1 a b c

14. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Changes in Government Purchases Versus Tax Changes A change in government purchases causes an initial spending change of the same amount (and in the same direction) A tax change has a smaller initial impact on spending (and in the opposite direction) the initial spending change is found by multiplying the tax change by the marginal propensity to consume (and then reversing the sign of this change)

15. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Benefits and Drawbacks of Fiscal Policy Fiscal policy has two main benefits it can be focused on particular regions it has a relatively direct impact on spending Fiscal policy has three main drawbacks it is subject to delays (recognition lag, decision lag, impact lag) it is closely related to public debt, which is the total amount owed by the federal government as a result of past borrowing

16. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Impact of Fiscal Policy (a) A government is running a balanced budget when its expenditures and revenues are equal budget surplus when its revenues exceed its expenditures budget deficit when its expenditures exceed its revenues

17. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Impact of Fiscal Policy (b) When a government has a budget deficit its debt increases by the same amount budget surplus its debt decreases by the same amount In the past the federal government tended to run budget deficits Because of past borrowing the federal government pays large public debt charges

18. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Fiscal Policy Guidelines There are three principles that can guide government fiscal policy annually balanced budgets cyclically balanced budgets functional finance

19. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Recent Fiscal Policy in Canada There has been a move from functional finance toward cyclically balanced budgets Total government deficits were highest during the early 1980s and 1990s the 1980s deficits were largely discretionary, while the 1990s deficits were related to automatic stabilizers the late 1990s budget surpluses were due to automatic stabilizers, lower interest rates, and government spending cuts

20. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Budget Balances Relative to GDP Figure 12.6, Page 295

21. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Impact of Government (a) When government is incorporated in the aggregate expenditures model, we will assume that both T is a lump- sum amount of $200 billion at every GDP level. Likewise G is $200 billion. While G is added directly to the AE line, the effect of taxes is indirect. With an MPC of .75, a $200 billion rise is taxes will cause C to fall by $150 billion at every GDP level.

22. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Impact of Government (b) Since AE rises by $200 billion due to G and falls by $150 billion due to T, the overall rise in the AE line is $50 billion. As a result, equilibrium GDP expands by $200 billion.

23. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Impact of Government (c) Figure A, Page 301 (continued in part (e)) 0 200 400 600 800 1000 1200 1400 50 200 350 500 650 800 950 1100 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 25 300 450 600 750 900 1050 1200 1350 200 400 600 800 1000 1200 1400 0 200 400 600 800 1000 1200 1400 GDP ($ billions) Expenditures ($ billions) AE 0 = C 0 + I + (X M) AE 1 = C 0 + I + G +(X M) AE 2 = C 1 + I + G +(X M) a c Change in C = -$150b. G = $200b. 45 Spending-Output Approach GDP C I X-M AE ($ billions) G 200 200 200 200 200 200 200 200

24. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Impact of Government (d) When government is incorporated in the injections-withdrawals approach, injections rise by $200 billion. There are two effects on withdrawals. Total withdrawals rise by $200 billion due to the addition of T. Total withdrawals fall because of a drop in saving. With an MPS of .25, a $200 billion rise in taxes causes S to fall by $50 billion. Overall, total withdrawals rise by $150 billion, while equilibrium output expands.

25. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Impact of Government (e) Figure A, Page 301 (continued from part (c)) S 0 + T + M S 1 + T + M S 0 + M I + X I + G + X Change in S = -$50b. T = $200b b d 200 400 600 800 1000 1200 1400 GDP ($ billions) 0 200 400 600 -200 Injections, Withdrawals ($ billions) 0 200 400 600 800 1000 1200 1400 -250 -200 -150 -100 -50 0 50 100 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 200 375 375 375 375 375 375 375 375 350 350 350 350 350 350 350 350 300 350 400 450 500 550 600 650 25 25 25 25 25 25 25 25 Injections-Withdrawals Approach GDP S T G X ($ billions) M S+T+M I I+G+X 600 600 600 600 600 600 600 600

26. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Balanced Budget Multiplier The impact of incorporating government on equilibrium GDP can be shown using the balanced budget multiplier. The change in output due to a change in both G and T by the same dollar amount (ie. $200 billion) is shown by the following formula: change in output = 1 x (change in G or T)

27. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Aggregate Demand and Aggregate Supply (a) The aggregate expenditures model can be interpreted using aggregate demand and aggregate supply if we remember that in this model the price level is assumed to be constant, so that AS is horizontal.

28. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Aggregate Demand and Aggregate Supply (b) Figure B, page 303 150 800 1000 1200 Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) AD 0 AD 1 AS e f

29. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Economist Extraordinaire (a) John Maynard Keynes created a theory to support governments combating the Great Depression emphasized the role of aggregate demand in determining output in the economy opposed the neoclassical view that involuntary unemployment is self- eradicating by presuming that workers exhibit money illusion and so they stop decreases in nominal wages

30. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. A Flexible Labour Market Figure A, Page 305 Involuntary Unemployment S L D L $6 5 (11 7) = +4 (9 9) = 0 Labour Demand and Supply Schedules Real Wage (in constant $) Involuntary Unemployment (surplus(+)) (millions of workers) Quantity of Labour (millions of workers) Real Wage (in constant $) Labour Demand and Supply Curves 0 2 4 5 7 9 11 1 2 3 4 5 6 3 1 6 8 10

31. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. An Inflexible Labour Market Figure B, page 306 Involuntary Unemployment S L D L Quantity of Labour (millions of workers) Nominal Wage (in current $) Labour Demand and Supply Curves 0 2 4 6 8 10 12 1 2 3 4 5 6 7 8 $8 7 (12 8) = +4 (10 10) = 0 Labour Demand and Supply Schedules Nominal Wage (in current $) Involuntary Unemployment (surplus(+)) (millions of workers)

32. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Economist Extraordinaire (b) Keynes opposed Says Law (which states that supply creates its own demand) by arguing that income levels rather than interest rates adjust to bring a balance between total injections and total withdrawals

33. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Debate Over Public Debt (a) Those support using public debt say public debt provides benefits by reducing the costs of unemployment about 60 percent of government debt is held by Canadians, or owed to ourselves when debt is used to create productive assets, it is not necessarily a problem there have been times in the past when public debt as a percent of GDP was higher

34. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. The Debate Over Public Debt (b) Those against using public debt say public debt charges rose until recently provincial and territorial debts need to be taken into account as well there are limits to how much taxes can be raised to pay public debt charges there are potential future burdens associated with the crowding-out effect and the amount of Canadas government debt held by foreigners

35. Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Public Debt and GDP Figure A, page 308 1926-1927 1936-1937 1946-1947 1956-1957 1966-1967 1976-1977 1986-1987 1996-1997 2001-2002 2.3 3.1 12.7 11.4 17.2 39.9 271.7 593.3 507.7 46 67 107 35 27 20 54 74 46 2.5 3.0 3.9 1.5 1.8 2.4 5.3 5.7 3.6 Year Public Debt (billions of current-year $) Public Debt (% of nominal GDP) Public Debt Charges (% of nominal GDP)

36. Understanding Economics Chapter 12 The End Copyright 2005 by McGraw-Hill Ryerson Limited. All rights reserved. 3 rd edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson