CHAPTER 11
(MACRO CHAPTER 11)
Fiscal Policy
FUNDAMENTAL QUESTIONS
1. How can fiscal policy eliminate a GDP gap?
OVERVIEW AND OBJECTIVES
The primary purpose of this chapter is to present the principles of fiscal policy. The appendix explores
the concept of the balanced-budget multiplier.
There are several unique features in this chapter. First, fiscal policy is presented within the aggregate
supply–aggregate demand model. Second, the chapter demonstrates how fiscal policy works with the
After reading and reviewing this chapter, the student should be able to:
1. Define fiscal policy.
5. Define discretionary fiscal policy.
65. Explain the effects of budget deficits.
80 Chapter 11: Fiscal Policy
KEY TERM REVIEW
crowding out
discretionary fiscal policy
LECTURE OUTLINE AND TEACHING STRATEGIES
I. Fiscal Policy and Aggregate Demand
Fiscal policy involves the taxing and spending policies of the government.
A. Shifting the aggregate demand curve: Changes in government spending (directly) and taxes
(indirectly through consumption) shift the aggregate demand curve because they determine
B. Multiplier effects: A change in government spending or taxes may have a multiplier effect
on real GDP. The extent to which this occurs depends on price-level effects and the manner
in which the government finances its spending.
C. Government spending financed by tax increases: Government spending increases aggregate
expenditures directly, but higher taxes lower aggregate expenditures indirectly.
Teaching Strategy: Work through the balanced-budget effects graphically, assuming first
have an impact on capital accumulation, thus shifting the long-run aggregate supply curve.
D. Government spending financed by borrowing: Borrowing to finance government spending
can limit the increase in aggregate demand.
Teaching Strategy: The following exercise can be used to illustrate the concept of
Chapter 11: Fiscal Policy 81
II. Fiscal Policy in the United States
A. The historical record: Fiscal policy has two components: discretionary fiscal policy and
automatic stabilizers.
B. Deficits and the national debt: A deficit represents a net increase in the national debt.
1. Deficits, interest rates, and investment: Increased government borrowing raises interest
rates, which can depress investment.
III. Fiscal Policy in Different Countries
A. Government spending: This has accounted for a growing share of gross domestic product in
OPPORTUNITIES FOR DISCUSSION
1. What are some of the concerns expressed by the public regarding proposed health care changes?
How is this an example of fiscal policy decision making?
2. Why doesn’t an increase in aggregate demand translate directly into an increase in real GDP?
3. In what ways do the methods that the government chooses to finance its spending influence the
ANSWERS TO EXERCISES
1. The GDP gap may be eliminated by increasing aggregate demand so that the
AD
curve intersects
the
AS
curve at the potential level of real GDP. The steeper the slope of the
AS
curve, the greater
the increase in
AD
required to move to the equilibrium level of real GDP.
82 Chapter 11: Fiscal Policy
2. Government spending can be financed through tax increases, borrowing, and creating money.
4. Automatic stabilizers are those elements of fiscal policy that change automatically in value when
real GDP changes. A progressive tax system acts as an automatic stabilizer because as the
economy expands and incomes rise, tax revenues increase, thereby moving the budget toward a
5. In the developing countries, the government plays a larger role in investment spending than it
6. Because government spending increases expenditures directly, but taxes decrease expenditures
indirectly and by less than the change in taxes. The multiple by which real GDP increases
7. A larger fiscal deficit causes domestic interest rates to rise. This attracts foreign investors, who
8. Deficits grow during recessions because transfer payments rise and tax revenues fall.
9. Progressive: The tax rate rises as income rises. Regressive: The tax rate falls as income rises.
10. A value-added tax is a general sales tax collected at each stage of production. A VAT is a tax on
consumption and thus contributes to the government’s revenue. Individuals who evade income
Chapter 11: Fiscal Policy 83
12. The recessionary gap is the amount that aggregate expenditures must increase to close the GDP
gap.
13. Taxes must fall by $75 to close the GDP gap because with an MPC of .8, an increase in disposable
income of $75 (the result of a tax reduction) increases consumption spending by $60, which is a
sufficient increase in aggregate spending to close the recessionary gap.
16. $1,625
ANSWERS TO STUDY GUIDE HOMEWORK
1. Changing government spending and taxes; the president (executive branch) and Congress
(legislative branch).
84 Chapter 11: Fiscal Policy
ACTIVE LEARNING EXERCISES
This exercise should lead to lively discussion about the harmful effects of a government budget deficit.
A government budget deficit may be harmful because:
1. ______________________________________________________________________________
2. ______________________________________________________________________________