Fiscal Policy
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John Maynard Keynes and Fiscal
Policy
• John Maynard Keynes explained how a
deficiency in demand could arise in a
market economy.
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John Maynard Keynes and Fiscal
Policy
• He showed how and why the
government should intervene to achieve
macroeconomic goals.
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John Maynard Keynes and Fiscal
Policy
• He advocated aggressive use of fiscal
policy to alter market outcomes.
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Fiscal Policy
• Fiscal policy is the use of government
taxes and spending to alter
macroeconomic outcomes.
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Components of Aggregate
Demand
• The premise of fiscal policy is that a
given level of aggregate demand for
goods and services will not always
result in economic stability.
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Aggregate Demand
• Aggregate demand is the total quantity
of output demanded at alternative price
levels in a given time period, ceteris
paribus.
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Aggregate Demand
• The four major components of
aggregate demand are:
– Consumption (C)
– Investment (I)
– Government spending (G)
– Net exports (exports minus imports) (X-M)
AD = C + I + G + (X – M)
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Components of Aggregate
Demand
Total spending: $10 trillion
Government spending: 19%
Investment spending: 15%
Consumption spending: 70%
Net exports: –4%
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Consumption
• Consumption refers to expenditures by
consumers on final goods and services.
• Consumption expenditures account for
about two-thirds of total spending in
U.S. economy.
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Investment
• Investment refers to expenditures in a
given time period on:
– The production of new plant and
equipment (capital).
– Changes in business inventories.
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Government Spending
• Government spending includes
expenditures on all goods and services
provided by public sector.
• Income transfers are not included.
– Income transfers are payments to
individuals for which no services are
exchanged.
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Net Exports
• Net exports is the difference between
exports and imports.
• In 2002 the U.S. bought more goods
from abroad than foreigners bought
from U.S.
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Equilibrium
• Aggregate demand is not a single
number but instead a schedule of
planned purchases.
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Equilibrium
• Macro equilibrium is the combination
of price level and real output that is
compatible with both aggregate demand
and aggregate supply.
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Equilibrium
• There is no guarantee that AD will
always produce an equilibrium at full
employment and price stability.
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Equilibrium
• Sometimes there will be too little
demand and sometimes there will be
too much.
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Inadequate Demand
• AD could fall short of full employment
equilibrium.
• Some potential output will be unsold at
full employment.
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Excessive Demand
• AD could generate too much spending
causing the economy to produce at
more than full employment.
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PRICE LEVEL (average price)
The Desired Equilibrium
AS
c
P2
P*
a
b
Too little AD:
Unemployment
Too much AD:
Inflation
AD2
AD*
AD1
Q1
QF
REAL OUTPUT (quantity per year)
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The Nature of Fiscal Policy
• C + I + G + (X - M) seldom adds up to
exactly the right amount of aggregate
demand.
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The Nature of Fiscal Policy
• The use of government spending and
taxes to adjust aggregate demand is the
essence of fiscal policy.
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Fiscal Policy
DETERMINANTS
OUTCOMES
Jobs
Internal market
forces
AS
Prices
External shocks
Policy levers
Fiscal policy
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Growth
Output
AD
International
balances
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Fiscal Stimulus
• If AD falls short, there is a gap between
what the economy can produce and
what people want to buy.
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Fiscal Stimulus
• The GDP gap is the difference between
full-employment output and the amount
of output demanded at current price
levels.
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PRICE LEVEL (average price)
Deficient Demand
b
P1
a
GDP gap
AD1
Full employment
Equilibrium output
5.6
Q1
McGraw-Hill/Irwin
Current price level
6.0
QF
REAL GDP
($ trillions per year)
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More Government Spending
• Increased government spending is a
form of fiscal-policy stimulus.
– Fiscal stimulus — tax cuts or spending
hikes intended to increase (shift) aggregate
demand.
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Multiplier Effects
• An increase in spending results in
increased incomes.
• All income is either spent or saved.
– Saving – Income minus consumption; that
part of disposable income not spent.
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Multiplier Effects
• Each dollar spent is re-spent several
times.
• As a result, every dollar has a multiplied
impact on aggregate income.
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Multiplier Effects
• The marginal propensity to consume
(MPC) is the fraction of each additional
dollar of disposable income spent on
consumption.
change in consumption
MPC =
change in disposable income
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Multiplier Effects
• The marginal propensity to save
(MPS) is the fraction of each additional
dollar of disposable income not spent
on consumption
change in saving
MPS =
change in disposable income
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Multiplier Effects
• Spending and saving decisions are
connected.
MPS = 1 – MPC
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MPC and MPS
IN GOD WE
TRUST
MPS = .25
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IN GOD WE
TRUST
IN GOD WE
IN GOD WE
TRUST
TRUST
MPC = .75
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Multiplier Effects and the
Circular Flow
• The fiscal stimulus to aggregate
demand includes:
– The initial increase in government
spending.
– All subsequent increases in consumer
spending triggered by the government
outlays.
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Multiplier Effects and the
Circular Flow
• Income gets spent and re-spent in the
circular flow.
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The Circular Flow
5: Consumer
spending
increases
Product
markets
2: Sales increase
$100 billion
6: Sales increase
1: Government
spends $100
billion
Households
Government
Business firms
3: Increased jobs
and wages
4: More Income
McGraw-Hill/Irwin
Factor
markets
7: Multiplier
process
continues
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Spending Cycles
• A demand stimulus initiated by
increased government spending is a
multiple of the initial expenditure.
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The Multiplier Process at Work
Spending Cycles
First cycle
Second cycle
Third cycle
Fourth cycle
Fifth cycle
Sixth cycle

Nth cycle
McGraw-Hill/Irwin
Change in Spending
During Cycle
Cumulative Increase
in Spending
$100.00
75.00
56.25
42.19
31.64
23.73

$100.00
175.00
231.25
273.44
305.08
328.81

400.00
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Multiplier Formula
• The multiplier is the multiple by which
an initial change in aggregate spending
will alter total expenditure after an
infinite number of spending cycles.
Multiplier = 1/(1-MPC)
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Multiplier Formula
• The multiplier process at work:
Total
initial change
change in = multiplier X in government
spending
spending
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Multiplier Formula
• Every dollar of fiscal stimulus has
multiplied impact on aggregate demand.
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PRICE LEVEL (average price)
Multiplier Effects
P1
Direct impact of rise
in government
spending + $100
Indirect impact
billion
via increased
consumption
+ $300 billion
b
AD1
5.6
Q1
McGraw-Hill/Irwin
5.7
a
AD2
Current price level
AD3
6.0
QF
REAL GDP
($ trillions per year)
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Tax Cuts
• Rather than increasing its own
spending, government can cut taxes to
increase consumption or investment
spending.
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Tax Cuts
• Lowering taxes increases disposable
income.
– Disposable income is after-tax income of
consumers.
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Taxes and Consumption
• If MPC is greater than zero, consumers
spend some of a tax cut.
Initial increase in consumption =
MPC X tax cut
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Taxes and Consumption
• The cumulative increase in aggregate
demand equals a multiple of the tax
induced change in consumption.
Cumulative change in spending =
multiplier X initial change in consumption
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Taxes and Consumption
• A tax cut that increases disposable
incomes stimulates consumer spending.
• The cumulative increase in aggregate
demand is a multiple of the initial tax
cut.
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Taxes and Investment
• Tax cuts can increase investment
spending by increasing the expectations
of after-tax profits.
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Taxes and Investment
• Taxes were reduced in 1964 and in
1981 to stimulate spending.
• President Bush pushed for even larger
tax cuts in 2001, 2002, and 2003.
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Inflation Worries
• Whenever the aggregate supply curve
is upward sloping an increase in
aggregate demand increases prices as
well as output.
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Inflation Worries
• Clinton raised taxes partly because he
feared inflationary pressures were
building.
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Fiscal Restraint
• Fiscal restraint may be the proper policy
when of inflation threatens.
– Fiscal restraint — tax hikes or spending
cuts intended to reduce aggregate
demand.
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PRICE LEVEL (average price)
Fiscal Restraint
AS
P1
Budget cuts and tax
hikes decrease AD
P2
AD3
AD4
REAL OUTPUT (quantity per year)
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Budget Cuts
• Cutbacks in government spending
directly reduce aggregate demand.
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Multiplier Cycles
• Government cutbacks have multiplied
effect on aggregate demand.
Cumulative reduction in spending =
multiplier X initial budget cut
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Tax Hikes
• Tax hikes reduce disposable income
and thus reduce consumption.
• Shift the aggregate demand curve to the
left.
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Tax Hikes
• Tax increases have been used to “cool”
the economy.
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Tax Hikes
• The Equity and Fiscal Responsibility Act
of 1982 increased taxes to reduce
inflationary pressures.
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Tax Hikes
• President Clinton restrained aggregate
demand in 1993 with tax increase, but
increased AD in 1997 with a five-year
package of tax cuts.
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Fiscal Guidelines
• The policy goal is to match aggregate
demand with the full employment
potential of the economy.
• The fiscal strategy for attaining that goal
is to shift the aggregate demand curve
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Fiscal Policy Guidelines
Problem
Unemployment
(recession)
Solution
Increase
aggregate
demand
Inflation
Reduce
aggregate
demand
McGraw-Hill/Irwin
Method
Increase
government
spending
Cut taxes
Cut government
spending
Raise taxes
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Unbalanced Budgets
• The use of the budget to manage
aggregate demand implies that the
budget will often be unbalanced.
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Budget Deficit
• The amount by which government
expenditures exceed government
revenues in a given time period.
Budget Deficit = government spending > tax
revenues
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Budget Deficit
• The government borrows money to pay
for deficit spending.
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Budget Deficit
• The federal government ran significant
budget deficits between 1970 and 1997.
• The deficit peaked at nearly $300 billion
in 1992.
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Budget Surplus
• Budget surplus — An excess of
government revenues over government
expenditures in a given time period.
Budget deficit = government spending
< tax revenues
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Budget Surplus
• By 1998, a combination of growing tax
revenues and slower government
spending created a budget surplus.
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BILLIONS OF DOLLARS
Unbalanced Budgets
280
240
200
160
120
80
40
0
– 40
– 80
– 120
– 160
– 200
– 240
– 280
Budget surpluses
Budget deficits
1972
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1976
1980
1984
1988
1992
1996
2000
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Countercyclical Policy
• In Keynes’ view, an unbalanced budget
is perfectly appropriate if macro
conditions call for a deficit or surplus.
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Fiscal Policy
End of Chapter 12
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