Chapter 13 - Fiscal Policy.doc

204Miller• Economics Today, Nineteenth Edition Chapter 13Fiscal Policy205 Chapter 13 Fiscal Policy Overview Fiscal policy as a tool for economic stabilization was first proposed by Keynes, who argued that government tax and spending policies can have a significant impact on our national economy. How government can change nominal and real GDP by the use of discretionary fiscal policy is examined. This chapter examines the use of fiscal policy during contractionary and expansionary gaps. Offsets to fiscal policy such as the indirect crowding out and direct expenditure offsets, which can reduce its effectiveness, are presented. New classical economics and the Ricardian equivalence theorem are introduced. The chapter then discusses real-world problems of actually implementing fiscal policy, such as time lags. The actions of automatic stabilizers are explained, and what we really know about fiscal policy is questioned. Finally, the distinction between a deficit and the public debt is examined. Learning Objectives After studying this chapter, students should be able to: 13.1 Use traditional Keynesian analysis to evaluate the effects of discretionary fiscal policies 13.2 Discuss ways in which indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actions 13.3 List and define fiscal policy time lags and explain why they complicate efforts to engage in fiscal “fine-tuning” 13.4 Describe how certain aspects of fiscal policy function as automatic stabilizers for the economy Outline I. Discretionary Fiscal Policy: The discretionary changing of government expenditures and/or taxes in order to achieve national economic goals, such as high employment with price stability. It is a deliberate attempt to cause the economy to move to full employment and price stability more quickly than it otherwise might. A. Changes in Government Spending 1. When There Is a Recessionary Gap: An expansionary fiscal policy, which would cause the AD curve to shift to the right, is required. By increasing government expenditures, policymakers can shift the aggregate demand curve to the right, and the price level and real GDP will go up. (See Figure 13-1(a).) 2. When There Is an Inflationary Gap: A contractionary fiscal policy, which would cause the AD curve to shift to the left, is required. By decreasing government expenditures, policymakers can shift the aggregate demand curve to the right, and the price level and real GDP will go down. (See Figure 13-1(b).) B. Changes in Taxes: Holding all other things held constant, a rise in taxes creates a reduction in AD for one of three reasons: (1) it reduces consumption, (2) it reduces investment, or (3) it reduces net exports. 1. When the Current Short-Run Equilibrium Is to the Right of LRAS: An increase in taxes will cause AD to shift inward; real GDP and the price level index fall. (See Figure 13-2(b).) 2. When the Current Short-Run Equilibrium Is to the Left of LRAS: A decrease in taxes will cause AD to shift outward; real GDP and the price level will rise. (See Figure 13-2(a).) II. Possible Offsets to Fiscal Policy: Fiscal policy does not operate in a vacuum, so offsets can occur. A. Indirect Crowding Out: An increase in government spending without raising taxes creates additional government borrowing from the private sector or from foreigners. 1. Induced Interest Rate Changes: Deficit spending tends to crowd out private spending, reducing the positive effect of increased government spending on AD. Planned investment and consumption in the private sector decrease because of the rise in interest rates. (See Figure 13-3.) 2. The Firm’s Investment Decision: The rise in interest rates causes monthly loan payments to go up and discourages some firms from making investments. 3. Graphical Analysis (See Figure 13-4.) B. Planning for the Future: Ricardian Equivalence: The proposition that an increase in the government budget deficit has no effect on aggregate demand. (See Figure 13-4.) 1. Current Tax Cuts and Future Debts: The idea is that people’s horizons extend beyond this year, and they take into account the effects of today’s government policies on the future. If government spending increases without increasing taxes (increased budget deficit), taxes will have to be higher in the future and individual saving has to take place now to be able to pay this future tax liability. 2. The Ricardian Equivalence Theorem: In the extreme case, there is no long-run effect on AD. C. Restrained Consumption Effects of Temporary Tax Changes: The permanent income hypothesis proposes that an individual’s current flow of consumption depends on the individual’s permanent, or anticipated lifetime, income. For this reason, temporary tax cuts or one-time tax rebates will have restrained effects on real consumption spending. D. Direct Expenditure Offsets: Actions on the part of the private sector in spending income that offset fiscal policy actions. Any increase in government spending that competes with the private sector will have some offset effect. 1. The Extreme Case: In this case, the offset is dollar for dollar, so we merely end up with a relabeling of spending from private to public. Aggregate demand and GDP are unchanged. 2. The Less Extreme Case: To the extent that there are some offsets to fiscal policy, predicted changes in aggregate demand will be lessened and real output and the price level will be less affected. E. The Supply-Side Effects of Changes in Taxes 1. Altering Marginal Tax Rates: The government will not necessarily lose tax revenues by lowering marginal tax rates. The lower marginal rates will be applied to a growing tax base because of economic growth. This idea is illustrated by the Laffer curve. (See Figure 13-5.) 2. Supply-side economics: The notion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward. III. Discretionary Fiscal Policy in Practice: Coping with Time Lags: The political process of fiscal policy and the various time lags involved in conducting fiscal policy create problems of achieving the policymakers’ goals. Policy Time Lags: A recognition time lag is the time required to gather information about the current state of the economy. An action time lag is the time required between recognizing an economic problem and putting policy into effect. The action time lag is short for monetary policy but quite long for fiscal policy, which requires congressional approval. The effect time lag is the time that elapses between the onset of policy and the results of that policy. B. Problems Posed by Time Lags: By the time a proposed change in fiscal policy works its way through the system, it may no longer be applicable and may even be harmful. IV. Automatic Stabilizers: Types of automatic (or nondiscretionary) fiscal policies that do not require new legislation on the part of Congress are provisions of the tax laws and certain entitlement programs that cause changes in desired aggregate demand. (See Figure 13-6.) A. The Tax System as an Automatic Stabilizer: As taxable income rises, marginal tax rates rise. The progressive nature of the personal and corporate income tax systems means that when the economy expands, tax collections increase faster than income, while during contractions, tax collections fall faster than income. B. Unemployment Compensation and Income Transfer Payments: As the economy contracts, unemployment compensation and welfare payments rise. As the economy expands, unemployment compensation and welfare payments fall. Disposable income does not fluctuate by as much as total income. C. Stabilizing Impact: The automatic stabilizers mitigate undesirable changes in disposable income, consumption, and the equilibrium level of national income. If disposable income is not allowed to fall as far as it would during a recession, the downturn will be moderated. If disposable income is not allowed to rise as rapidly as it would during an expansion, the boom will not get out of hand. D. What Do We Really Know about Fiscal Policy? 1. Fiscal Policy during Normal Times: Discretionary fiscal policy probably is not very effective at these times. Automatic stabilizers are probably the most useful. 2. Fiscal Policy during Abnormal Times: Fiscal policy can be important during these times. Consider some classic examples: the Great Depression and war periods. a. The Great Depression: When there is a substantial drop in GDP, such as in the Great Depression, fiscal policy can probably stimulate aggregate demand. However, there was in fact very little stimulation by government in the form of aggressive expansionary fiscal policy during this period. b. Wartime: War expenditures have little or no direct expenditure offsets, so war spending as part of expansionary fiscal policy usually has significant stimulative effects on aggregate demand. 3. The “Soothing” Effect of Keynesian Fiscal Policy: The knowledge by consumers and investors that the federal government can use fiscal policy to prevent another great depression may induce more buoyant and stable expectations, thereby smoothing investment decisions. Points to Emphasize Fiscal Policy Perspectives It is often helpful to give students some background into the origins of the idea that an important function of government is to stabilize the economy. The classical model, discussed in Chapter 11, argued that the economy, if left alone, will automatically tend to move to equilibrium real GDP at full employment (i.e., to the LRAS curve) in the long run. In the classical system, fiscal policy meant balanced budgets because the only effect of expansionary fiscal policy was to increase aggregate demand and thus cause inflation. One of Keynes’s most important contributions was his theoretical demonstration that it was possible to have macroeconomic equilibrium and unemployment simultaneously. This was a revolutionary breakthrough. Keynes convinced people that capitalism did not contain mechanisms that ensured full employment and price stability, especially in the short run. A full employment, price-stable equilibrium position happened only by chance. In fact, if such a rare situation occurred, nothing would guarantee that the economy would remain there. Because autonomous investment is highly volatile so are planned expenditures. It follows that capitalism itself is an unstable system. This was in direct contrast to the classical model that dominated economic thinking and policymaking up to that time. It is interesting to note that Keynes was not an anti-capitalist. To a large extent Keynes believed that by introducing proposals to “fine-tune” and adjust the economy with fiscal policy, the system could be saved. Keynes did not wish to replace capitalism. He merely viewed his role as providing methods for correcting for its instability. According to Keynes’s analysis, recessionary gaps were the rule rather than the exception. Neither the consumption nor investment schedules can be expected to shift automatically to eliminate these gaps. Fiscal policy was Keynes’s solution. He suggested that government expenditures be increased and taxes lowered during the Great Depression. In other words, government should engage in deficit spending, if necessary. In economics we learn to consider opportunity costs and trade-offs. If government expenditures rise, won’t the private sector contract? If workers are engaged in producing public goods, the opportunity cost is what society forgoes in private consumer or business goods. If there is widespread unemployment, the opportunity cost notion must be qualified. The opportunity cost of expanding the public sector is close to zero if those same workers would have been unemployed anyway. In fact, even if workers are engaged in digging holes and filling them, the opportunity cost is close to zero (forgone leisure would, however, be a cost) if those workers would have been otherwise unemployed. The benefit is social stability because people working on public works projects will not be rioting in the streets or causing social unrest. Automatic Stabilizers Automatic stabilizers stabilize planned spending by increasing government transfer payments and reducing tax receipts during recessions and decreasing government transfer payments and increasing tax payments in expansions automatically without any action by Congress. The effect is to cause or increase deficits automatically during a recession and to reduce deficits or create surpluses during expansions. As a consequence, one cannot infer either an expansionary or a contractionary fiscal policy from the mere existence of an actual budget deficit or surplus. Rather, budget deficits and surpluses that would occur if the actual rate of unemployment were to equal the natural rate of unemployment provide a better picture of the state of fiscal policy. For Those Who Wish to Stress Theory Crowding Out The crowding-out effect due to the interest rate effect is more likely to be significant in the case of a structural deficit rather than a deficit due to a recession. During a recession, the demand for money will decrease as the level of economic activity declines. The increase in government borrowing to finance the resulting deficit from the increase in spending and decreased revenues caused by the operation of the automatic stabilizers will simply replace the private demand, and the interest rate need not rise. Even the deficit caused by countercyclical discretionary fiscal policy may have no interest rate effect in this case. A structural deficit will have an interest rate effect since the government borrowing will occur even when the economy is at or very near full employment. Limitations of Fiscal Policy Government expenditures made on goods or services that consumers would have purchased anyway will not cause any net change in total planned expenditures. Similarly, if the government makes investment in such areas as parks, mail service, and education that compete with the private sector, autonomous net investment will fall correspondingly. In short, increases in governmental expenditures may well cause counterbalancing (or near counterbalancing) expenditure reductions in the private sector. The automatic stabilizers also tend to reduce the effect of discretionary fiscal policy. For example, if a recession induces policymakers to increase governmental expenditures, any beneficial results will automatically be lessened. This is true because as incomes start rising, governmental transfers automatically fall (less unemployment compensation, fewer welfare payments, less food stamp outlays, etc.), and tax payments automatically rise because as people earn more income they pay taxes, and the effects are compounded by a progressive tax structure and unemployment compensation and Social Security taxes rise. Similar analysis indicates that fiscal policy attempts to reduce inflation automatically lead to counterbalancing increases in governmental transfers and reductions in taxes. It is important for students to realize that these qualifications to the analysis of the short-run effects of discretionary fiscal policy make it just a short step to the conclusion that the effectiveness of fiscal policy can be called into question. Fiscal Policy: Long Run versus the Short Run In the AS-AD model of fiscal policy presented in the chapter, there are significantly different effects of fiscal policy in the short run as compared to the long run insofar as the level of real GDP and employment are concerned. In the long run, the only effect of fiscal policy (or any other change in AD) is a change in the price level, other things being equal. Regardless of whether AD is increased or decreased, real GDP returns to its long-run equilibrium level on LRAS. In the short run, real GDP and employment will increase with an increase in AD and decrease with a decrease in AD, other things being equal. Students may wonder why fiscal policy is relevant if all it does is change the price level in the long run. Keynes gave the answer when he said, “In the long run, we are all dead.” What he apparently meant was that it simply takes too long in some instances for these forces to work themselves out to end a depression or severe recession. Keynes felt that social stability would be a benefit of the use of fiscal policy to stabilize the economy. As an example of Keynes view is that the Great Recession of 2007–2009 was “over” by the third quarter of 2009 because after this quarter real GDP increased well into 2010. Yet a deflationary gap continued to exist after the recession ended as evidenced by the unemployment rate, which rose to 4.8 percent in the fourth quarter of 2007 to an average of 10 percent in the fourth quarter of 2009, and was still 9.7 percent for the second quarter of 2010. (Source: Bureau of Labor Statistics.) Forecasts of high unemployment rates suggest high unemployment rates for the next year or two. Paul Samuelson—1915–2009—Economist Paul Samuelson was the first American to win the Nobel Prize in economics; he was awarded the prize in 1970 for his extensive work in applying mathematics to questions of static and dynamic equilibrium and for “raising the level of analysis in economic science.” Samuelson has been a consistent advocate of Keynesian economics. He has long believed that discretionary fiscal policy must be used to reduce unemployment. For example, during President Kennedy’s administration, Samuelson headed a task force established to suggest ways to reverse the business slump of that period. He recommended higher government expenditures for the military and for social services, coupled with a tax cut. Under President Johnson, he worked on a task force that developed Great Society social spending programs. Samuelson must be considered a modern Keynesian, for he believes that the monetary sector of the economy cannot be ignored when discussing macroeconomic questions. During the early 1970s, when the federal government imposed wage-price controls in an effort to halt inflation, he was in favor of them—provided that they were only temporary. He has never been an advocate of permanent wage-price controls because of the distortions they would impart to the economic workings of the price system. Whenever the discussion of another Great Depression comes up, Samuelson is adamant that it will never recur. He believes that if a great depression started to develop, the government would step in and “turn the tide.” Samuelson has written extensively in varied fields. When his scientific papers were collected, they filled three volumes. His principles of economics textbook went through 14 editions. For a number of years, he wrote a Newsweek column, in which he was cast as a left-of-center economist among the three economists writing. If one were to place him within the spectrum of economists today, he would probably be right in the middle. He was certainly not as enthusiastic a Keynesian as many of his colleagues, for he emphasized that the private market—as well as government—has an important role to play in promoting a healthy, modern economy. Further Questions for Class Discussion 1. If time lags associated with the use of fiscal policy are significant, should discretionary fiscal policy be used to counter recessions? Although this is a normative question, it is possible to examine the consequences of the use of fiscal policy. For relatively short or minor recessions, the effects of fiscal policy are more likely to be pro-cyclical because of the long recognition and effect time lags. For a severe recession or depression due to a significant demand or supply shock with high levels of unemployment, fiscal policy might be useful because the recovery time could be longer. In a situation such as the Great Depression, fiscal policy would be far less likely to be pro-cyclical. 2. Suppose the government wished to combat a deflationary gap by the use of fiscal policy. In which case would planned expenditures increase by more and why? (a) Tax decreases lower taxes by significantly less for higher-income persons than for lower-income persons, or (b) tax decreases lower taxes by significantly more for lower-income persons than for higher-income persons? Total planned expenditures will increase by more in case (b). Lower income persons are likely to have a higher MPC than do higher-income persons and thus the increase in planned spending out of after-tax income would be greater, and the size of the multiplier would be larger. 3. What effect would tax increases on business profits have on aggregate demand? Firms look at after-tax profits when making an investment decision. An increase in taxes on profits leads to a fall in after-tax profits, ceteris paribus. Thus planned investment would decrease and aggregate demand would decrease. 4. During the period 2007–2009, the U.S. deficit increased dramatically, largely as a result of tax cuts and large-scale federal expansionary spending policy. Yet, interest rates did not increase. How might the fact that the worst recession since the Great Depression was going on help explain why massive bond sales by the U.S. government did not result in crowding out? In a major recession, businesses experience large unplanned increases in inventories and falling profits. As they cut back on production, they need to borrow less to finance inventory investment. Lower expected profits and sales decrease the demand for investment. As a result, business demand for loans in the bond markets decreases. In this period, it appears that federal government borrowing largely replaced business borrowing. The result was that interest rates and bond prices did not change. 5. The federal government enacted a prescription drug benefit for Medicare recipients during the first term of the second Bush administration. Would you predict that total spending on prescription drugs would increase by the amount of increased spending by Medicare? It would be unlikely that total spending on prescription drugs would increase by the amount of new federal spending. Some seniors who were already paying for their prescriptions would reduce spending on drugs by the amount of their benefits. Some private medigap policies that cover prescriptions will stop paying for drugs by an amount equal to the Medicare drug benefit. Thus there will be a direct expenditure offset. 6. In the 2010 off-year election, Republican candidates for Congress promised to lower taxes and lower government spending, while the Democratic candidates promised to repeal some of the Bush tax cuts, that is, raise taxes, and increase government spending. Both parties’ candidates argued that their planned fiscal policy would stimulate the economy. Which party, if either, was right? Assume that each of the parties’ tax and spending changes would be roughly equal in the size of their effects on aggregate demand. Answer: Neither was right. A decrease in government spending would decrease aggregate demand, while a tax cut would increase aggregate demand. Ceteris paribus the Republican proposal would have no effect on equilibrium GDP. Increasing taxes will decrease aggregate demand while increasing government spending will increase aggregate demand. Ceteris paribus the Democratic proposal would have no effect on equilibrium GDP. Answers to Questions for Critical Analysis Higher Government Research and Development Generates Offsetting Spending Cuts (p. 288) If a government agency decided to fund construction of a private hospital in an area in which other private hospitals already are just breaking even why might one of the other private hospitals cancel plans to expend the size of its facility? If the existing private hospitals are just breaking even, the prospect of making losses among hospitals in the area would increase with construction of yet another private hospital. Hence, the existing private hospitals might cancel plans to expand the sizes of their facilities if a government agency decided to fund construction of a new private hospital. Bounded Rationality and Variations in the Effects of Fiscal Policy on Real GDP? (p. 291) Based on Schwinn’s conclusions, is the government likely to be able to boost real GDP with an increase in government spending if it has raised and lowered its expenditures a number of times in previous months? Explain your reasoning. If the government varied its expenditures often, people with bounded rationality would struggle to decide how to respond to changes in real disposable income. Their delayed responses in real consumption spending would lower the effect of an increase in the government spending on real GDP. You Are There Why Are Several States Cutting the Duration of Unemployment Compensation? (pp. 292–293) 1. How does unemployment compensation function as an automatic stabilizer? Unemployment compensation functions as an automatic stabilizer by providing income transfer payments to those who have become unemployed. 2. Why do you suppose that many economists perceive a trade-off between short-term stabilization benefits of unemployment compensation and a contribution to a higher unemployment rate in the long run? Unemployment compensation acts as an automatic stabilizer during an economic downturn, but it also reduces the incentive of the unemployed to seek employment, hence resulting in a higher unemployment in the long run. Issues and Applications Which Governments Conduct Fiscal Stabilization Most Effectively? (pp. 293–294) 1. Other things being equal, what features of a nation’s economy do you think would tend to contribute to a higher value for its stabilization coefficient? (Hint: Consider the chapter’s discussion of the reasons fiscal policy actions tend to have larger effects on real GDP.) Other things being equal, a nation with less indirect crowding out and direct fiscal offsets, or shorter policy time lags, tends to have a higher value for its stabilization coefficient. 2. Why do you suppose that some economist have argued that a key determinant of a nation’s stabilization coefficient value is whether its government relies to a greater extent on automatic fiscal stabilizers instead of discretionary policy actions? Automatic fiscal stabilizers tend to have shorter policy action time lags than discretionary policy actions. Fiscal policy actions with shorter policy time lags tend to have more effects on real GDP. Research Project 1. To learn more about the stabilization coefficient, see the Web Links in MyEconLab. 2. To read about whether values of stabilization coefficients might be related to nations’ economic growth rates, see the Web Links in MyEconLab. Appendix D—Fiscal Policy: A Keynesian Perspective The Keynesian approach to fiscal policy emphasizes the underpinnings of the components of aggregate demand; it assumes that government expenditures are not substitutes for private expenditures and that current taxes are the only taxes taken into account by consumers and firms; and it focuses on the short run, so the price level is constant. I. Changes in Government Spending: As government spending increases, the C + I + G + X line shifts upward, causing aggregate demand and real GDP to increase. (See Figure D-1.) II. Changes in Taxes: As current taxes increase, the C + I + G + X line shifts downward, causing aggregate demand and real GDP to decrease. (See Figure D-2.) III. The Balanced-Budget Multiplier: The balanced-budget multiplier is equal to 1 because an increase in government spending and taxes by the same amount raises real spending by exactly the amount of the rise in government spending. Answers to Problems 13-1. Suppose that Congress and the president decide that the nation’s economic performance is weakening and that the government should “do something” about the situation. They make no tax changes but do enact new laws increasing government spending on a variety of programs. a. Prior to the congressional and presidential action, careful studies by government economists indicated that the Keynesian multiplier effect of a rise in government expenditures on equilibrium real GDP per year is equal to 3. In the 12 months since the increase in government spending, however, it has become clear that the actual ultimate effect on real GDP will be less than half of that amount. What factors might account for this? b. Another year and a half elapses following passage of the government spending boost. The government has undertaken no additional policy actions, nor have there been any other events of significance. Nevertheless, by the end of the second year, real GDP has returned to its original level, and the price level has increased sharply. Provide a possible explanation for this outcome. a. A key factor that could help explain why the actual effect may have turned out to be lower is the crowding-out effect. Also, some government spending may have entailed direct expenditure offsets that reduced private expenditures on a dollar-for-dollar basis. In addition, indirect crowding out may have occurred. Because the government did not change taxes, it probably sold bonds to finance its increased expenditures, and this action likely pushed up interest rates, thereby discouraging private investment. Furthermore, the increase in government spending likely pushed up aggregate demand, which may have caused a short-run increase in the price level. This, in turn, may have induced foreign residents to reduce their expenditures on U.S. goods. It also could have reduced real money holdings sufficiently to discourage consumers from spending as much as before. On net, therefore, real GDP rose in the short run but not by the full amount predicted by the basic multiplier effect. b. In the long run, as the increased spending raised aggregate demand, wages and other input prices likely increased in proportion to the resulting increase in the price level. Thus, in the long run, the aggregate supply schedule was vertical, and the increase in government spending induced only a rise in the price level. 13-2. Suppose that Congress enacts a significant tax cut with the expectation that this action will stimulate aggregate demand and push up real GDP in the short run. In fact, however, neither real GDP nor the price level changes significantly as a result of the tax cut. What might account for this outcome? There are two possible explanations. One is that to continue spending at the same pace even after cutting taxes, the government had to borrow to finance the resulting deficit. Consequently, market interest rates rose, thereby causing a crowding-out effect: an offsetting fall in private spending. Another potential explanation is that people behaved in a way predicted by the Ricardian equivalence theorem. That is, they realized that the tax reduction today would entail a future tax increase to repay debt that the government incurred. Thus, people saved the amount of the tax reduction instead of spending it, so that aggregate demand did not change. 13-3. Explain how time lags in discretionary fiscal policymaking could thwart the efforts of Congress and the president to stabilize real GDP in the face of an economic downturn. Is it possible that these time lags could actually cause discretionary fiscal policy to destabilize real GDP? Because of the recognition time lag entailed in gathering information about the economy, policymakers may be slow to respond to a downturn in real GDP. Congressional approval of policy actions to address the downturn may be delayed; hence, an action time lag may also arise. Finally, there is an effect time lag because policy actions take time to exert their full effects on the economy. If these lags are sufficiently long, it is possible that by the time a policy to address a downturn has begun to have its effects, real GDP may already be rising. If so, the policy action may push real GDP up faster than intended, thereby making real GDP less stable. 13-4. Determine whether each of the following is an example of a situation in which a direct expenditure offset to fiscal policy occurs. a. In an effort to help rejuvenate the nation’s railroad system, a new government agency buys unused track, locomotives, and passenger and freight cars, many of which private companies would otherwise have purchased and put into regular use. b. The government increases its expenditures without raising taxes. To cover the resulting budget deficit, it borrows more funds from the private sector, thereby pushing up the market interest rate and discouraging private planned investment spending. c. The government finances the construction of a classical music museum that otherwise would never have received private funding. Situation a is an example of a direct expenditure offset because the government purchases exactly offset private purchases that otherwise would have taken place. Situation b is an example of indirect crowding out, and in situation c no direct expenditure offset occurs. 13-5. Determine whether each of the following is an example of a situation in which there is indirect crowding out resulting from an expansionary fiscal policy action. a. The government provides a subsidy to help keep an existing firm operating, even though a group of investors otherwise would have provided a cash infusion that would have kept the company in business. b. The government reduces its taxes without decreasing its expenditures. To cover the resulting budget deficit, it borrows more funds from the private sector, thereby pushing up the market interest rate and discouraging private planned investment spending. c. Government expenditures fund construction of a high-rise office building on a plot of land where a private company otherwise would have constructed an essentially identical building. Situation b is an example of indirect crowding out because the reduction in private expenditures takes place indirectly in response to a change in the interest rate. In contrast, situations a and c are examples of direct expenditure offsets. 13-6. The U.S. government is in the midst of spending more than $1 billion on seven buildings containing more than 100,000 square feet of space to be used for study of infectious diseases. Prior to the government’s decision to construct these buildings, a few universities had been planning to build essentially the same facilities using privately obtained funds. After construction on the government buildings began, however, the universities dropped their plans. Evaluate whether the government’s $1 billion expenditure is actually likely to push U.S. real GDP above the level it would have reached in the absence of the government’s construction spree. There is a direct expenditure offset, so the government’s $1 billion expenditure will not alter real GDP relative to the level it would have reached if the universities had otherwise expended $1 billion to construct the buildings. 13-7. Determine whether each of the following is an example of a discretionary fiscal policy action. a. A recession occurs, and government-funded unemployment compensation is paid to laid-off workers. b. Congress votes to fund a new jobs program designed to put unemployed workers to work. c. The Federal Reserve decides to reduce the quantity of money in circulation in an effort to slow inflation. d. Under powers authorized by an act of Congress, the president decides to authorize an emergency release of funds for spending programs intended to head off economic crises. Situation b is an example of a discretionary fiscal policy action because this is a discretionary action by Congress. So is situation d because the president uses discretionary authority. Situation c is an example of monetary policy, not fiscal policy, and situation a is an example of an automatic stabilizer. 13-8. Determine whether each of the following is an example of an automatic fiscal stabilizer. a. A federal agency must extend loans to businesses whenever an economic downturn begins. b. As the economy heats up, the resulting increase in equilibrium real GDP per year immediately results in higher income tax payments, which dampen consumption spending somewhat. c. As the economy starts to recover from a severe recession and more people go back to work, government-funded unemployment compensation payments begin to decline. d. To stem an overheated economy, the president, using special powers granted by Congress, authorizes emergency impoundment of funds that Congress had previously authorized for spending on government programs. Situation a is an example of an automatic fiscal stabilizer because the government’s loans occur automatically. So are situations b, because tax payments automatically change with variations in real GDP, and c, because unemployment payments change automatically. Situation d, however, is an example of a president making discretionary use of available economic policymaking powers. 13-9. Consider the diagram below, in which the current short-run equilibrium is at point A, and answer the questions that follow. a. What type of gap exists at point A? b. If the marginal propensity to save equals 0.20, what change in government spending financed by borrowing from the private sector could eliminate the gap identified in part (a)? Explain. a. There is a recessionary gap, because at point A equilibrium real GDP of $18.5 trillion is below the long-run level of $19.0 trillion. b. The spending increase must shift the AD curve rightward by $1 trillion, or by the multiplier, which is 1/0.20 = 5, times the increase in spending. Government spending must rise by $200 billion, or $0.2 trillion. 13-10. Consider the accompanying diagram, in which the current short-run equilibrium is at point A, and answer the questions that follow. a. What type of gap exists at point A? b. If the marginal propensity to consume equals 0.75, what change in government spending financed by borrowing from the private sector could eliminate the gap identified in part (a)? Explain. a. There is an inflationary gap, because at point A equilibrium real GDP of $18.8 trillion is above the long-run level of $18.0 trillion. b. The spending decrease must shift the AD curve leftward by $1.6 trillion, or by the multiplier, which is 1/0.25 = 4, times the decrease in spending. Government spending must decline by $400 billion, or $0.4 trillion. 13-11. Currently, a government’s budget is balanced. The marginal propensity to consume is 0.80. The government has determined that each additional $10 billion it borrows to finance a budget deficit pushes up the market interest rate by 0.1 percentage point. It has also determined that every 0.1-percentage-point change in the market interest rate generates a change in planned investment expenditures equal to $2 billion. Finally, the government knows that to close a recessionary gap and take into account the resulting change in the price level, it must generate a net rightward shift in the aggregate demand curve equal to $200 billion. Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase its expenditures? (Hint: How much private investment spending will each $10 billion increase in government spending crowd out?) Because the MPC is 0.80, the multiplier equals 1/(1 ? MPC) = 1/0.2 = 5. Recall that the aggregate demand curve is derived by shifting the C + I + G + X curve, which means that shifting the AD curve a particular distance rightward requires an appropriate upward shift of the C + I + G + X curve. Net of indirect crowding out, therefore, total autonomous expenditures must rise by $40 billion in order to shift the aggregate demand curve rightward by $200 billion. If the government raises its spending by $50 billion, the market interest rate rises by 0.5 percentage point and thereby causes planned investment spending to fall by $10 billion, which results in a net rise in total autonomous expenditures equal to $40 billion. Consequently, to accomplish its objective the government should increase its spending by $50 billion. 13-12. A government is currently operating with an annual budget deficit of $40 billion. The government has determined that every $10 billion reduction in the amount it borrows each year would reduce the market interest rate by 0.1 percentage point. Furthermore, it has determined that every 0.1-percentage-point change in the market interest rate generates a change in planned investment expenditures in the opposite direction equal to $5 billion. The marginal propensity to consume is 0.75. Finally, the government knows that to eliminate an inflationary gap and take into account the resulting change in the price level, it must generate a net leftward shift in the aggregate demand curve equal to $40 billion. Assuming that there are no direct expenditure offsets to fiscal policy, how much should the government increase taxes? (Hint: How much new private investment spending is induced by each $10 billion decrease in government spending?) Because the MPC is 0.75, the multiplier equals 1/(1 ? MPC) = 1/0.25 = 4. Recall that the aggregate demand curve is derived by shifting the C + I + G + X curve, which means that shifting the AD curve a particular distance rightward requires an appropriate upward shift of the C + I + G + X curve. Net of indirect effects on planned investment spending, therefore, total autonomous expenditures must decline by $10 billion in order to shift the aggregate demand curve rightward by $40 billion. If the government reduces its spending by $20 billion, the market interest rate rises by 0.2 percentage point and thereby causes planned investment spending to fall by $10 billion, which results in a net decline in total autonomous expenditures equal to $10 billion. Consequently, to accomplish its objective the government should decrease its spending by $20 billion. 13-13. Assume that the Ricardian equivalence theorem is not relevant. Explain why an income-tax-rate cut should affect short-run equilibrium real GDP. A cut in the tax rate should induce a rise in consumption that leads to a short-run increase in equilibrium real GDP. 13-14. Suppose that Congress enacts a lump-sum tax cut of $750 billion. The marginal propensity to consume is equal to 0.75. Assuming that Ricardian equivalence holds true, what is the effect on equilibrium real GDP? On saving? Under Ricardian equivalence, equilibrium real GDP does not change. People save the entire $750 billion, which they recognize they will have to repay, along with interest, at a future date. 13-15. In May and June of 2008, the federal government issued one-time tax rebates—checks returning a small portion of taxes previously paid—to millions of U.S residents, and U.S. real disposable income temporarily jumped by nearly $500 billion. Household real consumption spending did not increase in response to the short-lived increase in real disposable income. Explain how the logic of the permanent income hypothesis might help to account for this apparent non-relationship between real consumption and real disposable income in the late spring of 2008. According to the logic of the permanent income hypothesis, these small, one-time payments did not raise people’s average lifetime disposable incomes. Instead of using the funds to increase their consumption spending, people applied them toward paying down outstanding debts or to their savings. Hence, consumption spending did not rise in response to the temporary increase in real disposable income. 13-16. It is late 2019, and the U.S. economy is showing signs of slipping into a potentially deep recession. Government policymakers are searching for income-tax-policy changes that will bring about a significant and lasting boost to real consumption spending. According to the logic of the permanent income hypothesis, should the proposed income-tax-policy changes involve tax increases or tax reductions, and should the policy changes be short-lived or long-lasting? The permanent income hypothesis suggests that a long-lived tax reduction would be more likely to boost real consumption spending. 13-17. Recall that the Keynesian spending multiplier equals 1/ (1 – MPC). Suppose that in panel (a) of Figure 13-1, the government determined that the amount by which the AD curve had to be shifted directly rightward from point E 1 was equal to $1.0 trillion. If the government decided that a $0.2 trillion increase in real government spending was required to generate this shift, what must be the value of the MPC? The government must have determined that the multiplier is equal to the change in real GDP induced by higher government spending at an unchanged price level divided by the increase in government spending, or $1.0 trillion / $0.2 trillion = 5. The value of MPC that yields this value for the multiplier is 0.8. That is, 1 / (1 – MPC) = 1 / (1 – 0.8) = 1 / 0.2 = 1/(1/5) = 5. 13-18. Recall that the Keynesian spending multiplier equals 1/ (1 – MPC). Suppose that in panel (b) of Figure 13-1, the government knows that the MPC is equal to 0.75 and that the amount of the horizontal distance that the AD curve had to be shifted directly leftward from point E1 was equal to $1.0 trillion. What is the reduction in real government spending required to have generated this shift? The multiplier equals 1 / (1 – MPC) = 1 / (1 – 0.75) = 1 / 0.25 = 1/(1/4) = 4. Therefore, the necessary decrease in real government spending must have been equal to ?$1.0 trillion / 4 = ?$0.25 trillion. 13-19. Recall that the Keynesian spending multiplier equals 1/ (1 – MPC). Suppose that in Figure 13-4, the MPC is equal to 0.9. In addition, the amount of the horizontal leftward shift from AD2 to AD3 caused by a crowding-out effect on planned investment spending was $0.5 trillion, or $500 billion. How much investment spending was crowded out? The multiplier equals 1 / (1 – MPC) = 1 / (1 – 0.9) = 1 / 0.1 = 1/(1/10)= 10. Therefore, the amount of investment crowded out to have generated the $500 billion decrease in economy-wide total planned expenditures must have been equal to $500 billion / 10 = $50 billion. 13-20. Every 1-percentage-point increase in the marginal income tax rate induces some workers to supply less labor, which cuts real GDP by $0.2 trillion. At the same time, each 1-percentage-point increase in the marginal income tax rate causes spendable income to drop, which induces some workers to supply labor that yields $0.1 trillion more in real GDP. Is the net outcome consistent with the supply-side view? Why? The first, $0.2 trillion drop in real GDP results from a reduced opportunity cost of leisure. In contrast, the second, a $0.1 trillion rise in real GDP results from the fact that the drop in spendable income shifts the demand curve for leisure inward to the left. The fact that the net outcome is a $0.1 trillion fall in real GDP (+$0.1 trillion ?$0.2 trillion = ?$0.1 trillion) is consistent with the supply-side theory. 13-21. A government has found that 2 months elapse before it can identify a problem to address with a policy action. It has found that 1 month is required to determine the appropriate policy action. Finally, it has concluded that the total time required between the initial presence of the problem and the effects of a policy action to be realized is 12 months. What is the remaining policy time lag and its duration? The first policy time lag is the recognition time lag of 2 months, and the second is the action time lag of 1 month. The remaining policy time lag is the effect time lag. The duration of all three lags, from the initial presence of the problem to effects of a policy action, equals 12 months. Hence, the duration of the effect time lag is 12 months – 2 months – 1 month = 9 months. 13-22. In Figure 13-6, explain why a budget deficit naturally tends to arise at a real GDP level such as Y2 to the left of Yf? When real GDP declines, so do the government’s real tax revenues. At the same time, a decrease in real GDP generates more government payments of benefits in the form of unemployment compensation and income transfer payments. Consequently, at a sufficiently low level of real GDP such as Y2, the sum of benefits paid out will exceed tax revenues, and a budget deficit results. Appendix D D-1. Assume that equilibrium real GDP is $18.2 trillion and full-employment equilibrium (FE) is $18.55 trillion. The marginal propensity to save is 1/7. Answer the questions using the data in the following graph. a. What is the marginal propensity to consume? b. By how much must new investment or government spending increase to bring the economy up to full employment? c. By how much must government cut personal taxes to stimulate the economy to the full-employment equilibrium? a. The marginal propensity to consume is equal to 1 – MPS, or 6/7. b. The required increase in equilibrium real GDP is $0.35 trillion, or $350 billion. The multiplier equals 1/(1 ? MPC) = 1/MPS = 1/(1/7) = 7. Hence, investment or government spending must increase by $50 billion to bring about a $350 billion increase in equilibrium real GDP. c. The multiplier relevant for a tax change equals ?MPC/(1 ? MPC) = ?MPC/MPS = ?(6/7)/(1/7) = ?6. Thus, the government would have to cut taxes by $58.33 billion to induce a rise in equilibrium real GDP equal to $350 billion. D-2. Assume that MPC = 4/5 when answering the following questions. a. If government expenditures rise by $2 billion, by how much will the aggregate expenditure curve shift upward? By how much will equilibrium real GDP per year change? b. If taxes increase by $2 billion, by how much will the aggregate expenditure curve shift downward? By how much will equilibrium real GDP per year change? a. The aggregate C + I + G + X curve shifts up by $2 billion. The multiplier equals 1/(1 ? MPC) = 1/(1 ? 4/5) = 1/(1/5) = 5. Hence, equilibrium real GDP increases by $2 billion times 5, or $10 billion. b. A tax increase of $2 billion reduces disposable income by $2 billion and hence reduces consumption by an amount equal to the MPC times this decline in disposable income, or 0.8 × $2 billion = $1.6 billion. Consequently, the C + I + G + X curve shifts downward by $1.6 billion. As discussed in part a, the multiplier is 5, so equilibrium real GDP declines by $1.6 billion multiplied by 5, or by $8 billion. D-3. Assume that MPC = 4/5 when answering the following questions. a. If government expenditures rise by $1 billion, by how much will the aggregate expenditure curve shift upward? b. If taxes rise by $1 billion, by how much will the aggregate expenditure curve shift downward? c. If both taxes and government expenditures rise by $1 billion, by how much will the aggregate expenditure curve shift? What will happen to the equilibrium level of real GDP? d. How does your response to the second question in part (c) change if MPC = 3/4? If MPC = 1/2? a. The C + I + G + X curve shifts up by $1 billion. The multiplier equals1 /( 1 ? MPC) = 1/ (1 ? 4/5) = 1/(1/5) = 5. Thus, equilibrium real GDP increases by $1 billion times 5, or $5 billion. b. A tax increase of $1 billion reduces disposable income by $2 billion and hence reduces consumption by an amount equal to the MPC times this decline in disposable income, or by 0.8 × $1 billion = 0.8 billion. Hence, the C + I + G + X curve shifts downward by $0.8 billion. As discussed in part a, the multiplier is 5, so equilibrium real GDP declines by $0.8 billion multiplied by 5, or by $4 billion. c. As noted in part a, the C + I + G + X curve shifts upward by $1 billion as a result of the increase in government spending, but as discussed in part b, it shifts back downward by $0.8 billion as a consequence of the increase in taxes. The net amount of the shift is an upward shift equal to $0.2 billion. As discussed in part a, the multiplier is 5, so equilibrium real GDP rises by $0.2 billion multiplied by 5, or by $1 billion. d. With an MPC of ¼, the multiplier equals 1 /( 1 ? MPC) = 1/(1 ? 3/4) = 1/(1/4) = 4. The C + I + G + X curve shifts upward by $1 billion due to the $1 billion increase in government spending. It shifts back downward by 0.75 × $1 billion = $0.75 billion due to the tax increase. The net upward shift of the C + I + G curve, therefore, is $1 billion ?$0.75 billion = $0.25 billion. The resulting increase in equilibrium real GDP equals $0.25 billion × 4 = $1 billion, so the answer is the same as in part c. With an MPC of ½, the multiplier equals 1 /( 1 ? MPC) = 1/(1 – 1/2) = 1/(1/2) = 2. The C + I + G + X curve shifts upward by $1 billion due to the $1 billion increase in government spending. It shifts back downward by 0.50 × $1 billion = $0.50 billion due to the tax increase. The net upward shift of the C + I + G curve, therefore, is $1 billion ?$0.50 billion = $0.50 billion. The resulting increase in equilibrium real GDP equals $0.50 billion × 2 = $1 billion, so the answer is the same as in part c. Selected References Barro, Robert J., Macroeconomics, 3rd ed., New York: John Wiley and Sons, 1990. Buchanan, James and R.E. Wagner, Democracy in Deficit, New York: Academic Press, 1977. Culbertson, John M., “The Use and Abuse of Fiscal Policy,” in Full Employment of Stagnation, New York: McGraw-Hill, 1964, pp. 83–94. Gordon, Robert J., Macroeconomics, 4th ed., Boston: Little, Brown and Company, 1987. Hanse, Alvin H. Hansen, A Guide to Keynes, New York: McGraw-Hill, 1953. Klein, Lawrence R., The Keynesian Revolution, 2nd ed., New York: Macmillan, 1966. Miller, Roger L. and David D. VanHoose, Modern Money and Banking, 3rd ed., New York: McGraw-Hill, 1993. Miller, Roger L. and Robert W. Pulsinelli, Macroeconomics, New York: Harper & Row, 1986. Smithies, Arthur and J. Keith Butters, eds., Readings in Fiscal Policy, Homewood, IL: Irwin, 1955, Vol. 20, September 1965, pp. 316–318. ©2018 Education, Inc. ©2018 Education, Inc. ©2018 Education, Inc.