Lecture: Fiscal Policy
Lecture script · about 15–20 minutes spoken · Week 7
Opening
Here's a question you've probably heard argued at a dinner table. Can a government spend its way out of a downturn? And if it borrows to do it, what does the debt have to do with you?
You'll meet it in more places than you'd expect. A construction worker's next job may depend on whether a road project gets funded. A small-business owner wonders what a tax cut will mean for her shop's sales. A nursing student reads a headline about the national debt and wonders who pays it back. All three are asking about fiscal policy.
Here's where we are. In Week 2, Measuring Output, you met government purchases as a part of spending. In Week 5, Aggregate Demand & Aggregate Supply, you learned that a change in spending shifts the whole aggregate demand curve. And in Week 6, Business Cycles & Short-Run Fluctuations, you read a recession as a gap between where output is and where it could be. In this lecture we ask what a government's budget can do about that gap.
Here's the plan. I'll define fiscal policy and name its two directions. Then we'll follow one burst of spending around the economy and find the shortcut that adds it up. We'll compare a tax cut with a spending increase, meet the stabilizers that work with no vote, separate the deficit from the debt, and weigh the honest debate about whether to act. All the national numbers in this lecture are illustrative, built for this course, and measured in billions of dollars.
1. Fiscal policy and its two directions
Think about a household going through a rough patch. It has two levers. It can change what it spends, and it can change what it brings in. A government has the same two levers, on a much bigger scale.
Here's the term. Fiscal policy is the government's use of its spending and taxes to influence the whole economy; it is set by the legislature, not by the central bank. So when you hear about a budget bill or a tax law, that's fiscal policy. When you hear about the central bank and interest rates, that's a different lever, monetary policy, and it's coming in Weeks 9 to 11.
Fiscal policy can push in two directions. Expansionary fiscal policy is raising government spending or cutting taxes to add to total spending, which shifts the aggregate demand curve to the right. Contractionary fiscal policy is cutting government spending or raising taxes to reduce total spending, which shifts the aggregate demand curve to the left.
Picture the AD–AS diagram from Week 5, with real output along the bottom and the price level up the side. A new road project adds spending, so aggregate demand moves right, and the price level and real output both rise. A tax increase does the reverse: people spend less, aggregate demand moves left, and both fall.
Pause and try this. The legislature cuts the payroll tax, so take-home pay rises. Is that expansionary or contractionary, and which way does aggregate demand move?
Think about what happens to household spending first.
Here's the answer. It's expansionary, and aggregate demand shifts right. Lower taxes leave households more to spend, so consumption rises, and the price level and real output both go up.
2. The marginal propensity to consume
Suppose you get a surprise 100-dollar bonus at work. What do you do with it? Maybe you buy groceries and a concert ticket, and you put some in savings. Almost everyone spends part of an extra dollar and saves part of it.
Here's the term. The marginal propensity to consume is the fraction of an extra dollar of income that a household spends rather than saves, written MPC; at an MPC of 0.8, 80 cents of each extra dollar is spent. The word "marginal" means the next one. It's about the next dollar you earn, not every dollar.
Let's use the illustrative economy we'll follow all week. Its MPC is 0.8. Out of that 100-dollar bonus, 0.8 times 100 is 80 dollars spent. The saved fraction is 1 minus 0.8, which is 0.2, and 0.2 times 100 is 20 dollars saved. Add them back up, and 80 plus 20 is 100. Every extra dollar is either spent or saved.
Pause and try this. Someone reads an MPC of 0.8 as "people spend 80 percent of everything they earn." What's off about that?
Focus on the word "marginal."
Here's the answer. The MPC is only about the extra dollar. A household might spend nearly all of its regular pay on rent and food and still save a big share of a surprise bonus.
3. The rounds of re-spending
Picture a 20-dollar bill moving through a neighborhood. You pay a barber, who spends part of it at a food truck, whose owner spends part of that at a hardware store. Each new sale is a little smaller.
That's the engine behind this lecture. When the government spends, its spending is somebody's income. That person spends part of it, which becomes someone else's income, and the chain keeps going.
Let's run it. The government spends 20 on a road project. Remember, that's in billions of dollars. That 20 is income to the road crew and the firms that supply them. The crew spends 0.8 of it, and 0.8 times 20 is 16, spent at shops and cafés. The café owners and shopkeepers spend 0.8 of their new income, and 0.8 times 16 is 12.8. After three rounds, the running total is 20 plus 16 plus 12.8, which is 48.8, and the chain is still going.
Each round is 0.8 of the one before. Add every round, and the total is 20 divided by 1 minus 0.8. That's 20 divided by 0.2, which is 100. A road project of 20 creates 100 of new output once every round is counted, in this simple model.
Pause and try this. Someone says the road project adds only 20 to output, because that's all the government spent. What did they miss?
Follow the money past its first stop.
Here's the answer. They missed the re-spending. The road crew spends 80 cents of every dollar, and each of those cents becomes someone else's paycheck, so output rises by far more than 20.
4. The spending multiplier
Adding round after round by hand is slow, so economists use a shortcut.
Here's the term. The spending multiplier is the number 1 ÷ (1 − MPC), which tells how many dollars of output one extra dollar of spending creates once every round of re-spending is added up. Said aloud, that's 1 divided by 1 minus the MPC. The bottom part, 1 minus the MPC, is the fraction that leaks into saving each round.
Let's run the shortcut. The MPC is 0.8, so 1 minus 0.8 is 0.2. Then 1 divided by 0.2 is 5. The change in output is 5 times the change in government spending, and 5 times 20 is 100. That's the same 100 the rounds gave us. Each dollar of new government spending becomes 5 dollars of output in the simple model.
The size of the multiplier depends on the MPC. At an MPC of 0.6, the multiplier is 2.5. At 0.75, it's 4. At 0.8, it's 5. And at 0.9, it's 10. The more of each extra dollar people spend, the longer the chain runs and the bigger the multiplier.
It works in reverse, too. A spending cut of 20 lowers output by 5 times 20, which is 100, and aggregate demand shifts left. And if an economy has a recessionary gap of 50, dividing 50 by the multiplier of 5 says a project of 10 would close it in the simple model.
Here's an honest caution. Real households also pay taxes and buy imports out of each extra dollar. Those leaks cut the chain short, so the real-world multiplier is smaller than this simple one, and economists still argue about how much smaller.
Pause and try this. Someone computes the multiplier at an MPC of 0.8 as 1 divided by 0.8 and gets 1.25. What went wrong?
Ask which part of each dollar cuts the chain short.
Here's the answer. They divided by the MPC instead of by 1 minus the MPC. Saving is what stops the chain, so the formula divides by 0.2 and gives 5.
5. A tax cut versus a spending increase
Imagine two ways to put 20 dollars into a neighborhood. In one, the city buys 20 dollars of paint for a community center. In the other, the city sends a resident a 20-dollar tax refund. The paint is spending right away. The resident saves part of the refund first, so the refund starts its chain one step smaller.
Here's the term. The tax multiplier is the number −MPC ÷ (1 − MPC), which tells how much output changes for each dollar change in taxes; it is negative because a tax increase lowers output and a tax cut raises it. Said aloud, that's minus the MPC, divided by 1 minus the MPC.
At an MPC of 0.8, that's minus 0.8 divided by 0.2, which is −4. Now cut taxes by 25. A tax cut is a negative change in taxes, so the change in output is −4 times −25, which is 100. Now cut taxes by 20 instead, the same size as the road project. That's −4 times −20, which is 80. The road project of 20 raised output by 100, and the tax cut of 20 raises it by only 80. The tax cut does 20 less, because households save a fifth of it before any of it is spent.
There's one more multiplier you'll meet in Week 9, and I want you to keep it fenced off. The money multiplier, 1 divided by the required reserve ratio, belongs to banking. It describes how bank lending can expand the money supply. It never answers a question about government spending or taxes.
Pause and try this. A friend says a spending increase of 20 and a tax cut of 20 must have the same effect, since the same dollars change hands. Using the multipliers, how would you answer?
Think about what households do first with a tax cut.
Here's the answer. They don't match. The spending raises output by 100 and the tax cut by 80, because part of a tax cut is saved before it's spent.
6. Automatic stabilizers
Picture a ride-share driver whose fares drop in a slow month. Two things happen without anyone voting. The income tax the driver owes falls along with the fares. And across town, a worker who loses a job starts collecting unemployment insurance. Both cushion spending when times are hard.
Here are the terms. Automatic stabilizers are taxes and transfer programs already on the books, such as income taxes and unemployment insurance, that cushion spending in a downturn and restrain it in a boom without any new law. And discretionary fiscal policy is a deliberate new decision by the legislature to change spending or taxes, as opposed to the automatic changes that happen under existing law.
Let's see the cushion in one illustrative household. It pays a 20% income tax, and its monthly income falls from 5,000 dollars to 4,000. Before the drop, its tax was 0.20 times 5,000, which is 1,000, so it kept 4,000 after tax. After the drop, its tax is 0.20 times 4,000, which is 800, so it keeps 3,200. Its income fell by 1,000, but its after-tax income fell by only 800. The tax bill shrank on its own, and the household keeps spending a bit more than it otherwise could.
The cushion works in a boom, too, when rising tax bills take some steam out of spending.
Pause and try this. In a slump, income-tax collections fall and unemployment payments rise. Is that an automatic stabilizer or discretionary fiscal policy?
Ask yourself whether anyone had to vote.
Here's the answer. It's an automatic stabilizer. Both changes happen under laws already in place, with no new decision by the legislature.
7. The deficit and the debt
Picture a bathtub with the faucet running. The faucet's flow is measured per minute. The water level is measured at one moment. A government's budget works the same way.
Here are the terms. A budget deficit is the amount by which government spending exceeds revenue in one year; it is a flow, measured per year, and the government borrows to cover it. The national debt is the total the government owes at a point in time from past borrowing not yet repaid; it is a stock, and each year's deficit adds to it. The deficit is the faucet. The debt is the water level.
Let's run the illustrative budget, again in billions of dollars. The government collects revenue of 400 and spends 450. Spending minus revenue is 450 minus 400, which is 50. That's the deficit for the year, a flow. The government started the year owing 1,000. It borrows the 50 to cover the deficit, so by the end of the year it owes 1,000 plus 50, which is 1,050. That's the debt, a stock.
A deficit adds to the debt. That's arithmetic, not a school of thought. A smaller deficit still adds to the debt, only more slowly.
Pause and try this. A headline says the government "cut the debt" because this year's deficit shrank. Is that right?
Think about the faucet and the water level.
Here's the answer. No. A smaller deficit still adds to the debt. Turning the faucet down isn't the same as draining the tub.
8. The case for and against fiscal action
Picture a town in a slump, with empty shop aisles, idle cranes, and people who want more hours. Should the government step in with a big spending program? Careful economists answer differently, so I'll give you both cases at full strength.
First, two more terms. Crowding out is the worry that government borrowing competes with private borrowers for saving, pushes up interest rates, and reduces private investment, offsetting part of a fiscal stimulus. And policy lags are the delays between a change in the economy and a policy's effect on it. There's the time to recognize the problem, the time to decide and pass a response, and the time for the response to take effect.
Here's the Keynesian case for action. In a recessionary gap, workers and machines sit idle. Extra spending puts them back to work, and the multiplier spreads the gain. With so much slack, the extra borrowing pushes interest rates up only a little, so crowding out is small. And waiting has a cost: every month the gap stays open, people lose jobs and income they won't get back.
Here's the classical and monetarist case for caution. Government borrowing draws on the same pool of saving that firms use to build and equip. It can push up interest rates and crowd out private investment, offsetting part of the stimulus. Lags are long, too. It takes time to spot a downturn, more time to pass a bill, and more time for a project to break ground. By then the economy may have recovered, and the extra spending can push it too far. And every deficit adds to the debt.
Notice what's positive and what's normative here. How big crowding out is, and how long lags run, are positive questions evidence can test. Whether lost jobs now matter more than a larger debt later is a normative question that rests on values. Both sides agree on the arithmetic. They differ on the sizes and on the values, and this course leaves the verdict to the evidence and to you.
Pause and try this. Sort this claim: "Extra government borrowing raises interest rates and reduces private investment." Is it positive or normative?
Ask whether evidence could test it.
Here's the answer. It's positive. It's a claim about how the economy works, so data can test whether it holds and how large the effect is.
Closing
Let's pull it together. Fiscal policy is the legislature's spending and taxes, and it shifts aggregate demand right or left. The MPC is the share of the next dollar that gets spent, and the rounds of re-spending add up. The spending multiplier turns a road project of 20 into 100 of output in the simple model. A tax cut is weaker dollar for dollar, and the money multiplier stays in banking. Automatic stabilizers work with no vote. The deficit is the faucet, and the debt is the water level. And the debate over acting is about sizes and values.
Next in this module, you'll find the Readings & Resources page, the lecture tutorial, the practice set, and the quiz. Then Week 8, Midterm Review & Exam, gathers everything from Weeks 1 to 7, one calculation and one curve at a time.
Built with The Course Maker · samples.thecoursemaker.com