Objectives for Chapter 18: Fiscal Policy

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Objectives for Chapter 18: Fiscal Policy (This is a technical chapter and may require two class periods.)

At the end of Chapter 18, you will be able to answer the following:

1. How is the government purchases multiplier calculated? (Review) How is the

taxation multiplier calculated? Why is it lower than the government purchases

multiplier? How is the transfers multiplier calculated?

  1. Given some gaps and marginal propensities to consume, calculate how much

government purchases, taxes, or transfers should be changed.

3. Explain why an equal increase (decrease) in government purchases and net taxes

(taxes minus transfers) has an expansionary (contractionary) effect.

4. What is the balanced budget multiplier?

5. Explain why discretionary fiscal policy has not been very effective in reducing

recessions in the United States.

6. What are the “time lags”?

7. What is meant by "automatic stabilization"? What are the main automatic


8. What is meant by "official budget deficit"? by "structural deficit"? Why is the

structural budget deficit a better measure of the intent of fiscal policy?

9. What does it mean that "fiscal policy is expansionary (or contractionary)"? How

does one determine whether fiscal policy is expansionary or contractionary?

10. In what ways might budget deficits be bad for an economy? In what ways might they

be good for an economy?

11. What is meant by “crowding-out”?

12. Explain the relation between the budget deficits and the trade deficits.

13. What is meant by the "national debt"? What is the difference between "budget

deficit" and "national debt"? What is the difference between "gross national debt" and

"net national debt"?

14. What is the difference between a Treasury bill, a Treasury note, and a Treasury


15. What has been the trend of the national debt in total and in relation to GDP?

16. To whom is the national debt owed? How is the national debt financed?

17. Is it true that the burden of repaying the national debt is being passed on to our

children? Why?

18. Is it true that the national debt could bring the nation into bankruptcy? Why?

Chapter 18: Fiscal Policy Part I (latest revision June 2006)

In 1946, with World War II over and with the Great Depression only recently ended, Congress passed the Employment Act. This act committed the government of the United States to “promote maximum employment, production, and purchasing power”. The President was mandated to issue a report each year explaining how he will achieve these goals (this report is called The Economic Report of the President). A new agency, the Council of Economic Advisers, was created to advise the President in writing this report. Although “maximum employment” was not defined in the act, the federal government was for the first time committed to manage the American economy in an attempt to bring about “full employment”. The role of the federal government in the American economy has been very different since the passage of this act. From that time forward, any President who failed to achieve good economic performance would be considered a failed President. “Good economic performance” requires low rates of unemployment, low rates of inflation, and high rates of economic growth. Presidents Ford, Carter, and Bush (41) were defeated in their re-election campaigns in large part because they did not achieve “good economic performance”.

The main tools available to the President and the Congress to achieve “good economic performance” are those of fiscal policy. Fiscal policy involves changes in government spending (discussed in Chapter 16) and in tax revenues (discussed in Chapter 17 --- notice that the government calls them “revenues”). The difference between government spending and tax revenues determines the amount of budget deficit or budget surplus. As we will see in this chapter, fiscal policy is of two types: discretionary and automatic. Discretionary fiscal policy, which involves deliberate decision-making by the government, receives most of the public’s attention. It is associated with the ideas of Keynes. But while the public pays little attention to automatic fiscal policy, it has been the more effective of the two types.

Despite the commitment of the government to “maximum employment” in 1946, the first use of discretionary fiscal policy did not come until the early 1960s with the Presidency of John F. Kennedy, who brought into his administration the first group of economic advisers who were Keynesians. President Kennedy had been elected in large part because of the high unemployment and slow economic growth that existed in 1960. As we will see, his discretionary fiscal policy involved reducing taxes in order to reduce unemployment and increase economic growth rates. Reducing tax revenues also meant increasing budget deficits. For the first time, these budget deficits were seen as an acceptable means to lower unemployment. The use of discretionary fiscal policy that began in the early 1960s has been used consistently since that time. So for example, in 2001, facing rising unemployment and slow economic growth, President George W. Bush also proposed to reduce taxes and to accept the resulting budget deficits.

In this chapter, we will first examine discretionary fiscal policy. We will explain how it operates, give an example, and then explain why it has generally not been very successful in achieving good economic performance. Second, we will examine automatic fiscal policy. We will explain how it operates and the effects it has had on overall economic performance. Third, we shall examine the effects of budget deficits and surpluses. Finally, we will examine the national debt – the accumulation of all of the budget deficits.
1. Discretionary Fiscal Policy
Discretion” refers to deliberate choice on the part of the government. One such choice involves the amount of discretionary government spending --- purchases and transfers. Let us begin with government purchases and first review a concept we have already learned --- the government purchases multiplier. In Chapter 13, government purchases were deliberately increased by $1,000. Let us review that case now. The marginal propensity to consume in that example was 0.8. What we discovered was that Real GDP increased by $5,000, not by $1,000. How did this happen? In Chapter 13, we assumed that the government spent the additional $1000 buying computers from Dell. This gave Dell $1000 of additional income. That additional income went to the company’s workers, owners, and suppliers. What did they do with their additional $1000 of income? With a marginal propensity to consume of 0.8, they would increase their consumption by $800 (.8 times $1000). We called this induced consumption. The other $200 of additional income was saved. The workers, owners, and suppliers of Dell spent an additional $800 buying goods at Sears. This provided an additional $800 of income for the workers, owners, and suppliers of Sears. What did they do with this additional income? The answer is that they spent $640 of it (0.8 times $640) and saved the other $160. So we have another $640 of induced consumption. The workers, owners, and suppliers of Sears spent $640 of additional income buying food at Vons. This gave the workers, owners, and suppliers of Vons an additional $640 of income. What did they do with this additional income? The answer is that they spent an additional $512 (0.8 times $640) and saved the other $128. So we have yet another $512 of induced consumption. In each succeeding round, consumers spent 80% of the addition to their income and saved the rest. When all rounds were completed, total spending rose by $5000.
Let us summarize. +1000 Purchases by the Government

+ 800 Induced Consumption by Dell

+ 640 Induced Consumption by Sears

+ 512 Induced Consumption by Vons

………. _______

= +5000 Increase in Equilibrium Real GDP

We know the sum was $5,000 because we knew the multiplier formula.


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