Macroeconomics

Dr. Karim Kobeissi

Arts, Sciences and Technology University in
Lebanon

Chapter 11: Fiscal Policy

Introduction
The governments tax and spending activities
influence
economic
outcome
(GDP).
Keynesian theory emphasizes the markets
lack of self adjustment, particularly in
recessions. If the market doesnt self adjust,
then the government may have to intervene.
Specifically, the government may have to use
its tax and spending power (fiscal policy) to
stabilize the macro economy.

Fiscal Policy
Refers to changes in government
expenditures and/or taxes to achieve
particular economic goals, such as low
unemployment rate, price stability, and
economic growth.
Government expenditures is the sum of
government
purchases
and
transfer
payments.

Fiscal Policy Definitions

Expansionary fiscal policy
refers to increases in
government expenditures
and/or decreases in taxes
to achieve macroeconomic
goals.
Contractionary
fiscal
policy
attempts
to
decrease
government
expenditures
and/or
increases in taxes to
achieve macroeconomic
goals.

A Key Assumption
In our discussion of fiscal policy, we assume that
any change in government spending is due to a
change in government purchases and not to a

change in transfer payments.

Demand-Side Fiscal Policy

A change in consumers consumption, business
investments, government purchases, or net
exports can change aggregate demand and
therefore shift the AD curve.
A change in taxes can affect consumers
consumption or business investment or both and
therefore can affect aggregate demand.

Fiscal Policy: A Keynesian

Perspective

Crowding Out
An economic concept where increased public sector
spending replaces, or drives down, private sector
spending. Crowding out refers to when government must
finance its spending with taxes and/or with deficit
spending, leaving businesses with less money and
effectively "crowding them out" .
One explanation of why crowding out occurs is
government financing of projects with deficit spending
through the use of borrowed money. Because the
government borrows such large amounts of capital, its
activities can increase interest rates. Higher interest rates
discourage individuals and businesses from borrowing
money, which reduces their spending and investment
activities.

Crowding Out
Complete Crowding Out occurs when the decrease in one or
more components of private spending completely offsets the
increase in government spending.
Incomplete Crowding Out occurs when the decrease in one
or more components of private spending only partially
offsets the increase in government spending.
Crowding out question the effectiveness of expansionary
demand-side fiscal policy:
In fact, if complete or incomplete crowding out occurs, it
follows that expansionary fiscal policy will have less impact
on aggregate demand and Real GDP than Keynesian theory
predicts.

 In Keynesian theory, expansionary

fiscal policy shifts the aggregate
demand curve to AD2 and moves
the economy to point 2.
If there is no crowding out,
expansionary
fiscal
policy
increases Real GDP and lowers the
unemployment rate.
If there is incomplete crowding
out, expansionary fiscal policy
increases Real GDP and lowers the
unemployment rate (point 2 ), but
not as much as in the case of zero
crowding out (point 2 ).

If there is complete crowding out,

expansionary fiscal policy has no
effect on the economy (point 1).

Keynesian Theory
& Crowding Out

The New Classical View of Fiscal Policy:

Crowding Out with No Increase in Interest Rates

Individuals respond to expansionary fiscal policy, a larger

deficit, and greater deficit-financing requirements by
thinking the following A larger deficit implies more debt
this year and higher future taxes. Ill simply save more in
the present so I can pay the higher future taxes required to
pay interest and to repay principal on the new debt. But,
of course, if Im going to save more, Ill have to consume
less.
1. Current consumption will fall as a result of expansionary
fiscal policy.
2. Budget deficits do not bring higher interest rates.

The New Classical View of

Expansionary Fiscal Policy
As
long
as
expansionary
fiscal policy is
translated into
higher
future
taxes, there will
be no change in
Real
GDP,
unemployment
rate, the price
level, or interest
rates.

Lags & Fiscal Policy

Economists argue that an economic policy that is based on the
ad hoc judgment of policymakers is not likely to have the
expected impact on the economy. By the time the full
impact of the policy is felt, the economic problem it was
designed to solve may no longer exist, may not exist to the
degree it once did, or it may have changed altogether.
There are lags in the execution of macroeconomic policy
because of:

1.
2.
3.
4.
5.

The Data Lag

The Recognition lag
The Legislative Lag
The Implementation Lag
The Effectiveness Lag

Lags & Fiscal Policy (con)

1. The Data Lag
Many macroeconomic data series such as GDP are only
available with a considerable lag, and they are subject to
big revisions. Because of this, information policy makers
use is retrospective, not contemporaneous. Getting
information about the current state of the economy is
difficult, we don't have good information until months
after the economy has already changed course.
2. The Recognition lag
Once the data are finally available it takes time to figure out
what they are saying. Is the downturn in employment in
this month's data temporary, or the beginning of a longer
term trend? If it's temporary, no need to act, but if it's
permanent, then action may be needed.

Lags & Fiscal Policy (con)

3.

The Legislative Lag

Once we've obtained the necessary data and concluded

something must be done, there can be considerable lags in
the legislative process as legislators debate the exact form
of the package, or oppose it altogether.
4. The Implementation lag
Once a policy is passed, it takes time to put it into place, e.g.
to set up the administration of the money, to deliver it to
the right agencies, to make the plans needed to spend it.

Lags & Fiscal Policy (con)

5. The Effectiveness Lag
After all of that, and the policy is finally put into place, it takes
time for policy to hit the economy and take effect. For
monetary policy it can be a year to a year and a half
before the peak effect of the policy is felt (though the
legislative lags are much shorter since the Federal Reserve
can act faster than congress). The effectiveness lag for
fiscal policy is a bit shorter, but still considerable, six

months at least.

Lags & Fiscal Policy (con)

The

government

has

moved

economy

the
from

point 1 to point 2,
and not, as they

had hoped, from

point 1 to point 1.

Demand-Side Fiscal Policy: Return to the

Keynesian Model
It would seem that under
the conditions of no lags
and zero crowding out,
expansionary
fiscal
policy

either
increasing government
spending or cutting
taxes will work at
removing the economy
from a recessionary gap.

The Marginal Propensity to Consume (MPC)

The proportion of an aggregate raise in pay that a consumer spends on
the consumption of goods and services, as opposed to saving it.

Marginal propensity to consume is a component of Keynesian

macroeconomic theory and is calculated as the change in

consumption divided by the change in income [C / Y]. If

consumption increases by 80 cents for each additional dollar of

income, then MPC is equal to 0.8 / 1 = 0.8.

Demand-Side Fiscal Policy: Return to the Keynesian Model

If

government

knows

the

difference

between Q1 and QN (so that it knows

how much to change Real GDP;

Real GDP) and it knows the MPC

multiplier (m) = [1 (1- MPC)], then it

can use fiscal policy (Taxes) to get the

economy out of a recessionary gap and

producing Natural Real GDP.

Hypothetical Example # 1 (Case of Recession)

Suppose Q1 = $1600 billions; QN = $2400 billions; MPC = 0.75 m=4.
Real GDP = - [(m) x T] T = - [ Real GDP / m ]
= - [(2400 -1600) /4 ]
= - $ 200 billions .
Starting from an initial situation where Q1 = $1600 billions, and in
order to reach a final situation where QN (the natural employment or

full employment GDP) = $2400 billions, the government has to

reduce the taxes by: $ 200 billions.

Hypothetical Example # 2 (Case of Expansion)

Suppose Q1 = $3000 billions; QN = $1800 billions; MPC = 0.75 m=4.
Real GDP = - [(m) x T] T = - [ Real GDP / m ]
= - [(1800 -3000) /4 ]
= + $ 300 billions .
Starting from an initial situation where Q1 = $3000 billions, and in
order to reach a final situation where QN (the natural employment or

full employment GDP) = $1800 billions, the government has to

increase the taxes by: $ 300 billions.

Hypothetical Example # 3 (Case of Recession)

Suppose AD1= $600 billions; AD2= $1000 billions; MPC =
0.75 m = 4.
AD = (m) x Fiscal Stimulus Fiscal Stimulus = [ AD / m ]
= [(1000 -600) /4 ]
= $ 100 billions .
Starting from an initial situation where AD1= $600 billions, and in

order to reach a final situation where AD2= $1000 billions, the

government has to spend an additional amount of $ 100 billions.

Demand-Side Fiscal Policy: Return to the

Keynesian Model
If the government
doesnt know the
actual MPC and it
doesnt know the
actual
difference
between Q1 and QN,
then fiscal policy
isnt likely to work
as intended.

Tax Cuts Instead: Are Things Any Different?

A dollar spend by the government is a dollar
spent whereas a dollar tax cut is a dollar
partly saved and partly spent In order to
get the same change in Real GDP,

government has to cut taxes more than it

has to increase spending.

Marginal Tax Rate - Definition

The amount of tax paid on an additional dollar of

income. The marginal tax rate for an individual will

increase as income rises. This method of taxation

aims to fairly tax individuals based upon their

earnings, with low income earners being taxed at a

lower rate than higher income earners.

Marginal Tax Rate = ( Tax payment)/( Taxable Income)

Supply-Side Fiscal Policy

All other things held constant, lower marginal tax rates

increase the incentive to engage in productive activities

relative to leisure and tax avoidance activities.

If the government cut the marginal tax rate The amount

of money individuals can earn by working will increases.
Therefore, we can implicitly assume that a cut in marginal
tax rate will increases work activity The aggregate
outcome (Supply Side) will increase Real GDP will
increase.

The Predicted Effect of a Permanent Marginal

Tax Rate Cut on Aggregate Supply

The Laffer Curve: The Relationship Between

Tax Rates and Tax Returns
If income tax rates were lowered, would it increase
or decrease tax revenue? ? ?
There are two tax rates at which zero tax revenues will be
collected 0 and 100% (people would choose not to work
because everything they earned would go to the
government).

An INCREASE in tax rates could cause tax revenues to

increase.
A DECREASE in tax rates could cause tax revenues to
increase.

The Laffer Curve: The Relationship Between Tax

Rates and Tax Returns
The Laffer curve shows the relationship between tax rates and
tax revenue collected by governments. The curve suggests
that, as taxes increase from low levels, tax revenue collected
by the government also increases. It also shows that tax rates
increasing after a certain point (B) would cause people not to

work as hard or not at all, thereby reducing tax revenue.

Tax revenues = (Tax base) x (the average Tax rate)

The Laffer Curve: The Relationship Between

Tax Rates and Tax Returns

The Laffer Curve: Implications

1) Tax revenues increase if a tax reduction is made in the
downward-sloping portion of the curve (between points B
and C); tax revenues decrease following a tax rate
reduction in the upward sloping portion of the curve
(between points A and B).

2) We assume that as the tax rate is reduced, the tax

base expands. The rationale is that individuals work
more, invest more, and enter into more exchanges,
and shelter less income from taxes and lower tax
rates.
How much does the tax base expand following the
tax rate reduction? ? ? ?