1. Fiscal Policy
Recall: Fiscal Policy- government’s choices regarding spending and taxes.
Defn:The federal budget is an annual statement of the revenues, outlays, and surplus or deficit of the gov.
Ques: What is meant by a balance budget?
National Debt is the sum of past budget deficits. (not to be mistaken with the deficit itself)
Ex. National debt in 08= debt of 08 + deficit of 08.
n.B the fiscal year runs from Oct. 1- Sep. 30
As a stabilization tool, fiscal policy has taken a back seat to monetary policy in recent years. But the sub-prime crisis has restored fiscal policy to center stage. Our text was almost at the printer when the crisis broke so we don’t have a fully up-to-date account of the fiscal package. Get the details (or ask your students to get the details of the 2008 fiscal stimulus package by going to

4. Fiscal Policy and the Supply Side (Potential GDP)
Supply-side effects are the effects of fiscal policy on potential GDP and aggregate supply.
Ex. The provision of public goods, labor market incentives (note: reduction in income can create a supply side effect).
Recall How does a reduction in income taxes impact the labor market, the full employment level, and potential GDP?
Defn: Tax wedge in the labor market is the gap between the before-tax wage rate and the after-tax wage rate.
Recall the tax incidence from Econ151.
All economists agree that supply-side effects occur. But there is disagreement about the size of these effects. The old “Reaganomics” held that the effects are very large. Almost no one hold this view today. Keynesians are the most skeptical. And President George Herbert Walker Bush called supply-side extremism “voodoo economics.”

5. 16.2 THE SUPPLY SIDE AND POTENTIAL GDP
The Effects of the Income Tax
The income tax
1. Decreases the supply of labor.
2. Creates a tax wedge between the wage rate that firms pay and workers receive.

6. THE SUPPLY SIDE AND POTENTIAL GDP
Note: There are other forms of taxes
Income tax 2) consumption tax 3) capital gains tax (tax on lending/interest rate tax)
These forms of tax add to the tax wedge, reducing potential GDP.
How does a tax on consumption impact potential GDP?
(hint: A tax on consumption is similar to a fall in real wage rate)
It reduces the incentive to provide labor.
The total tax wedge = income tax + consumption tax.
Ex. Tax on income is 15%, tax on consumption is 10%. What is the total tax wedge? How much goods and services can $100 of income buy?
(Assumption: The tax effects are all considered at once.)
Ed Prescott estimates the US tax wedge at about 45 percent. He estimates the UK tax wedge to be almost 60 percent and the French tax wedge to be an astonishing 80 percent (See American Economic Review, 2003). Prescott says that the differences in the tax wedges of the United States and Europe explain why Europeans take longer vacations and work shorter hours than Americans. Potential GDP per person is also lower in most of Europe than it is in the United States.

7. Tax on Interest Income
Recall: real interest rate= nominal rate – inflation.
And the real interest rate determines the loanable funds market (what is saved and invested)
Point: Capital gains tax are levied on nominal interest rate, savings and investment decisions are made upon the real after tax int. rate.
Ex. Suppose interest income tax is 10%.
Nominal interest rate = 30% and inflation = 5%
Nominal interest rate = 45% and inflation= 30%
What is the real after tax interest rate? What is the true tax rate? (hint: true rate= tax paid/real interest rate)
The effects of taxes on the supply of funds for investment are thought to be especially large, primarily because capital is foot-loose. It travels the world looking for the highest return. With a highly elastic supply of capital, taxes have a large effect on the equilibrium quantity. This fact poses an equity and efficiency tradeoff that you might like to have your class discuss.

8. Income Tax Revenues and the Laffer Curve
Laffer curve is the relationship between the tax rate and total tax revenue. As the tax rate rises, tax revenues rise, reach a maximum, and then fall.

9. THE SUPPLY SIDE AND POTENTIAL GDP
1. At a tax of t*, tax revenue is maximized.
2. For tax rates below t*, an increase in the tax rate increases tax revenue.
For example, the United States and United kingdom.
We don’t know that France, or any other country, is actually on the ‘wrong’ side of the Laffer curve. It is just speculation.
3. For tax rates above t*, an increase in the tax rate decreases tax revenue.
Perhaps France is an example.

10. Ques 1.
The government cuts income taxes. Explain this effect on the supply of labor, the demand for labor, the equilibrium level of employment, and potential GDP.
2.The government increases its outlays but keeps tax revenue unchanged. Explain what happens to savings, investment, the real interest rate, and the growth rate of rgdp.

11. Demand Side Fiscal Policy
Discretionary fiscal policy is a fiscal policy action that is initiated by an act of Congress.
For example
Automatic fiscal policy is a fiscal policy action that is triggered by the state of the economy.

12. Cyclical vs. Structural Deficit
Total Deficit = cyclical deficit + structural deficit
Cyclical deficit – the deficit brought about by automatic fiscal policy
Structural deficit- the deficit brought about by discretionary fiscal policy
( for example troubled asset relief program tarp)
Why is an increasing deficit and national debt bad?
Crowding out effect
Dollar devaluation (imports more expensive)
Possible higher future taxes

13. How should government stimulate the economy tax cuts or government spending?
Multipliers
government expenditure multiplier: magnification effect of a change in gov exp on A.D.
The tax multiplier is the magnification effect of a change in taxes on aggregate demand.
n.b The magnitude of the tax multiplier is smaller than the government expenditure multiplier.
Students don’t have much trouble grasping how discretionary fiscal policy works. They are able to see that changes in government spending and taxes have an impact on aggregate planned expenditure and on aggregate demand. Talk about the 2008 rebate checks here.

14. The balanced budget multiplier is the magnification effect on a
The balanced budget multiplier is the magnification effect on a.d of a simultaneous change in government expenditure and taxes that leaves the budget balance unchanged. (Recall a balanced budget)
Ques: is the balanced budget multiplier <,>, or = to zero?
Expansionary fiscal policy is a discretionary fiscal policy designed to increase a.d.
Contractionary fiscal policy is a discretionary fiscal policy designed to decrease A.D

15. Potential GDP is $10 trillion, real GDP is $9 trillion, and
1. There is a $1 trillion recessionary gap.
Use the opportunity to give the student practice with the AS-AD model, the work-horse of macroeconomics and the tool that we hope they will remember.
2. An increase in government expenditure or a tax cut increases expenditure by ∆E.

16. 3. The multiplier increases induced expenditure
3. The multiplier increases induced expenditure. The AD curve shifts rightward to AD1.
The price level rises to 110, real GDP increases to $10 trillion, and the recessionary gap is eliminated.

17. Potential GDP is $10 trillion, real GDP is $11 trillion, and
1. There is a $1 trillion inflationary gap.
2. A decrease in government expenditure or a tax rise decreases expenditure by ∆E.

18. 3. The multiplier decreases induced expenditure
3. The multiplier decreases induced expenditure. The AD curve shifts leftward to AD1.
The price level falls to 110, real GDP decreases to $10 trillion, and the inflationary gap is eliminated.

19. Limitations of Discretionary Fiscal Policy
Law-Making Time Lag
The amount of time it takes Congress to pass the laws needed to change taxes or spending.
Economic Forecasting
Fiscal policy changes take a long time to enact in Congress and yet more time to become effective.
So fiscal policy must target forecasts of where the economy will be in the future