Fiscal Policy

It is important to clarify from the start that there are two separate bodies which conduct economic policy in a country: The government and the Federal Reserve Bank.

When we speak of the government, we include the administration (the president and his cabinet), the Senate and Congress. Representatives are elected to office by the public. When we speak of the Federal Reserve System, we refer to a committee of 12 individuals who are not elected to office by the public. When we discuss monetary policy, we will take a closer look at how these individuals are selected and appointed to serve at the Federal Reserve Bank.

Fiscal policy refers to managing government spending and taxes for the purpose of inducing desired changes in aggregate spending by consumers and firms. The government conducts fiscal policy.

Monetary Policy refers to managing the money supply and interest rates for the purpose of inducing desired changes in aggregate spending by consumers and firms. The Federal Reserve Bank conducts monetary policy. There is a long lag between the time a fiscal policy decision is made and when it is actually put into effect. This will turn out to be a main difference between fiscal and monetary policies. Start preparing a document which summarizes the main similarities and differences between fiscal and monetary policies as this may appear as a question in the final exam.

Another main difference between fiscal and monetary policies. Fiscal policy decision makers are democratically elected and come from a wide variety of backgrounds and political inclinations.

The tools of fiscal policy (government spending and taxes) are used to manage aggregate demand.

When the government is concerned with unemployment, fiscal policyis used to increase AE and AD thus it is called expansionary. The idea is for the government to either increase government spending (the government increases its purchases of goods and services) or to decrease taxes (the government gives consumers and firms a tax break in order to induce an increase in their spending on goods and services).

Assume that the economy starts at equilibrium, if the government increases government spending, say purchases more equipment for the military, the manufacturers of military equipment see an unexpected increase in sales, their inventories drop below the desired level and they react by increasing production. This increase in production requires and increase in employment or in hours worked. Thus reducing unemployment and increasing national income. Individuals who make now more money or who now have a job they did not have before, spend part of this income purchasing goods and services -TV sets, cars, furniture,etc.-. Manufacturers of these consumer goods see inventories decrease, and they too increase production and hire more workers or more hours, generating another round of increases in income, consumption and spending.

In summary, when the government increases spending, it creates a snow ball effect similar to that generated with an increase in investment or in autonomous consumption. For this reason, the multiplied effect of an increase in government spending is the same as that for an increase in investment or autonomous consumption and thus we will use the same expression we used (for changes in investment and autonomous consumption) for the government spending multiplier: 1/ 1-mpc.

So far, we have used the multiplier in three different ways:

  1. When autonomous consumption changes by Da, we calculate the change in equilibrium income/output as: DY = Da (1/ 1-mpc).
  2. When investment changes by DI, we calculate the change in equilibrium income/output as: DY =DI (1/ 1-mpc).

and now we added the government:

  1. When Government spending changes by DG, we calculate the change in equilibrium income/output as: DY = DG (1/ 1-mpc)

Example:

Suppose that the economy starts at equilibrium and the mpc = 0.8. What would be the effect of a 200 increase in government spending once all the rounds of the multiplier process are complete?

To calculate the change in equilibrium output, we use the following expression:

DY = DG (1/ 1-mpc) replace DG with 200 and mpc with 0.8, to get:

DY = 200 (1/ 1-0.8)

DY = 200 (1/ 0.2)

DY = 200 (5)

DY = 1000.

Equilibrium output/income increases by 1000 when the government spends an extra 200 in goods.

When the government is concerned with unemployment, fiscal policy should be expansionary. An expansionary fiscal policy aims at increasing aggregate demand for goods and services. The government can either increase government spending (the government increases its purchases of goods and services) or decrease taxes (the government gives consumers and firms a tax break in order to induce an increase in their spending on goods and services). We will explore next the effect of a change in taxes:

Assume that the economy starts at equilibrium, if the government decreases taxes, consumers now have more "disposable" income (after tax income) to spend. Consumers will then purchase more goods and services -say cars, big ticket items, etc.- the manufacturers of these goods then see an unexpected increase in sales, their inventories drop below the desired level and they react by increasing production. This increase in production requires and increase in employment or in hours worked. Thus reducing unemployment and increasing national income. Individuals who make now more money or who now have a job they did not have before, spend part of this income purchasing goods and services -TV sets, cars, furniture,etc.- Now manufacturers of these consumer goods see inventories decrease, and they too increase production and hire more workers or more hours, generating another round of increases in income, consumption and spending. The difference here is that ALL the increase in spending is from consumers. Before, part of the increase in spending was an increase in government purchases and part the resulting increase consumption. When taxes change, all the change in spending generated comes from consumers.

It would seem that an increase in government spending and a tax cut should have the SAME effect on equilibrium output...the process seems to be the same...but:

In the example we used above, government spending increased by 200. Suppose instead that the government gives this 200 to consumers -in the form of a tax cut- to spend. So in principle, the only difference is that instead of the government spending an extra 200 now consumers have an extra 200 to spend.

In our example, we used mpc = 0.8. This means that consumers spend 80% of any increase in income.

MPC = DC/DY. When the mpc is 0.8 then the change in consumption (DC) that results from a 200 increase in income (DY =200) is DY* mpc =$160. So, the original increase in spending is NOT 200 as it was in the example where government spending increases by 200. Consumers, DO NOT spend the entire tax cut but only 80% of it. This increase in spending, is multiplied the same as the increase in government spending, but the total effect at the end is SMALLER because the original jump in spending is smaller ($160 instead of $200).

An increase in spending of $160 will be turn into 160 *(1/1-0.8) of extra spending after all rounds of the multiplier are completed. In summary, a 200 tax cut becomes an $800 increase in total spending and equilibrium output/income instead of the $1000 increase generated by the 200 increase in government spending. The "tax multiplier" is SMALLER because consumers SAVE part of the tax cut rather than spending the entire amount.

So now we add one more multiplier to our list:

  1. When autonomous consumption changes by Da, we calculate the change in equilibrium income/output as: DY = DA (1/ 1-mpc).
  2. When investment changes by DI, we calculate the change in equilibrium income/output as: DY = DI (1/ 1-mpc).
  1. When Government spending changes by DG, we calculate the change in equilibrium income/output as: DY = DG (1/ 1-mpc)

and now we add the tax multiplier:

  1. When taxes change by DT, we calculate the change in equilibrium income/output as: DY =DT (- mpc / 1-mpc).

Compare the tax multiplier with the government spending multiplier:

  1. The tax multiplier is smaller because consumers tend to save a portion of the tax cut.
  2. The tax multiplier is negative because:

Consider the following calculations:

If the MPC is

The Government Spending Multiplier is:

The Tax Multiplier is:

If we add the government spending multiplier and the tax multiplier we get:

0.9

10.00

-9.00

1

0.8

5.00

-4.00

1

0.75

4.00

-3.00

1

0.7

3.33

-2.33

1

0.65

2.86

-1.86

1

0.6

2.50

-1.50

1

The government spending multiplier and the tax multiplier always add to ONE. So, once you know one multiplier, you can use this short cut to calculate the other.

In the test, you will be asked to use these multipliers to find the change in equilibrium output. Also, you will be asked to calculate the equilibrium value of output/income from equations for consumption, investment and government spending. Slides 33 and 34 show the step by step process for calculating equilibrium output/income.

When government spending and taxes are changed in the same direction (both increase or both decrease) and by the same amount. In this case, when taxes and spending both increase by the same amount (or decrease by the same amount), the size of the deficit or surplus the government had before remains the same. For this reason this multiplier is called the "balanced budget multiplier", not because if reflects a change in spending and taxes which, balance the budget (eliminates the deficit/surplus) but because it reflects a change in spending and taxes which leave the deficit/surplus unchanged.

Example: Assume the mpc is 0.8 and the government increases BOTH government spending and taxes by 200. If we were to calculate the effect of these changes separately, we would get:

DY = DG (1/ 1-mpc) = 200 (1/1-0.8) = 200 (5) = 1,000 An increase of 200 in G causes equilibrium output to increase by 1,000.

DY = DT (- mpc / 1-mpc) = 200 (-0.8/1-0.8) = 200 (-4) = -800. An increase of 200 in T causes equilibrium output to decrease by 800.

So if we put these effects together, the net effect on equilibrium output would be an increase of 200. Thus, when the change in taxes and government spending is the same (value and sign), equilibrium output changes by this same amount. So we can write:

DT = DG = DY