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Chapter 11 225
Managing Aggregate Demand: Fiscal Policy

increment in government spending leads to a $1,000 billion increment in GDP. So, when a
20 percent income tax is included in our model, the multiplier is only $1,000/$400 5 2.5,
as we concluded above.
So we now have noted two different ways in which taxes modify the multiplier analysis:
• Tax changes have a smaller multiplier effect than spending changes by govern-
ment or others.
• An income tax reduces the multipliers for both tax changes and changes in spending.

Automatic Stabilizers
The size of the multiplier may seem to be a rather abstract notion with little practical im-
portance. But that is not so. Fluctuations in one or another of the components of total
spending”C, I, G, or X 2 IM”occur all the time. Some come unexpectedly; some are
even difficult to explain after the fact. We know from Chapter 9 that any such fluctuation
will move GDP up or down by a multiplied amount. Thus, if the multiplier is smaller,
GDP will be less sensitive to such shocks”that is, the economy will be less volatile.
Features of the economy that reduce its sensitivity to shocks are called automatic An automatic stabilizer
is a feature of the economy
stabilizers. The most obvious example is the one we have just been discussing: the per-
that reduces its sensitivity
sonal income tax. The income tax acts as a shock absorber because it makes disposable in-
to shocks, such as sharp
come, and thus consumer spending, less sensitive to fluctuations in GDP. As we have just
increases or decreases in
seen, when GDP rises, disposable income (DI) rises less because part of the increase in GDP spending.
is siphoned off by the U.S. Treasury. This leakage helps limit any increase in consumption
spending. When GDP falls, DI falls less sharply because part of the loss is absorbed by the
Treasury rather than by consumers. So consumption does not drop as much as it otherwise
might. Thus, the much-maligned personal income tax is one of the main features of our
modern economy that helps ensure against a repeat performance of the Great Depression.
But our economy has other automatic stabilizers as well. For example, Chapter 6
discussed the U.S. system of unemployment insurance. This program also serves as an au-
tomatic stabilizer. When GDP drops and people lose their jobs, unemployment benefits
prevent disposable incomes from falling as dramatically as earnings do. As a result,
unemployed workers can maintain their spending better, and consumption fluctuates less
than employment does.
The list could continue, but the basic principle remains the same: Each automatic stabi-
lizer serves, in one way or another, as a shock absorber, thereby lowering the multiplier.
And each does so quickly, without the need for any decision maker to take action. In a
word, they work automatically.
A case in point arose when the U.S. economy sagged in fiscal year 2008. The budget
deficit naturally rose as tax receipts came in lower than had been expected. While there was
much hand-wringing over the rising deficit, most economists viewed it as a good thing in
the short run: The automatic stabilizers were propping up spending, as they should.

Government Transfer Payments
To complete our discussion of multipliers for fiscal policy, let us now turn to the last
major fiscal tool: government transfer payments. Transfers, as you will remember, are pay-
ments to individuals that are not compensation for any direct contribution to production.
How are transfers treated in our models of income determination”like purchases of
goods and services (G) or like taxes (T)?
The answer to this question follows readily from the circular flow diagram on page 156
or the accounting identity on page 157. The important thing to understand about transfer
payments is that they intervene between gross domestic product (Y) and disposable
income (DI) in precisely the opposite way from income taxes. They add to earned income
rather than subtract from it.
Specifically, starting with the wages, interest, rents, and profits that constitute national
income, we subtract income taxes to calculate disposable income. We do so because these
taxes represent the portion of incomes that consumers earn but never receive. But then we

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Part 3
226 Fiscal and Monetary Policy

must add transfer payments because they represent sources of income that are received
although they were not earned in the process of production. Thus:
Transfer payments function basically as negative taxes.
As you may recall from Chapter 8, we use the symbol T to denote taxes minus trans-
fers. Thus, giving consumers $1 in the form of transfer payments is treated in the 45° line
diagram in the same way as a $1 decrease in taxes.

What we have learned already has some bearing on the debate between the
Republicans and Democratic in 2008. Remember that the Democrats wanted to
rescind some of the Bush tax cuts for wealthy taxpayers and spend the funds on
items such as government health insurance programs. We have just learned that
the multiplier for T is smaller than the multiplier for G. That means that an in-
crease in government spending balanced by an equal increase in taxes”which
comes close to what the Democrats proposed”should raise total spending.
Next, consider the claim that the portions of the Bush tax cuts that went to wealthy
individuals would not stimulate much spending. This assertion presumes that the rich
have very low marginal propensities to consume, as many people naturally assume.
Remember, a lower MPC leads to a lower multiplier. But the data actually suggest that
the rich are spendthrifts, just like the rest of us. That said, poor families probably do
have extremely high MPCs, so tax cuts for the poor would probably give rise to some-
what larger multipliers than tax cuts for the rich.

We will have more to say about the campaign debate later. But first imagine that you were
a member of the U.S. Congress trying to decide whether to use fiscal policy to stimulate
the economy back in 2001”and, if so, by how much. Suppose the economy would have
had a GDP of $6,000 billion if the government simply reenacted the previous year™s
budget. Suppose further that your goal was to achieve a fully-employed labor force and
that staff economists told you that a GDP of approximately $7,000 billion was needed to
reach this target. Finally, just to keep the calculations simple, imagine that the price level
was fixed. What sort of budget would you have voted for?
This chapter has taught us that the government has three ways to raise GDP by $1,000 bil-
lion. Congress can close the recessionary gap between actual and potential GDP by
• raising government purchases
• reducing taxes
• increasing transfer payments
Figure 3 illustrates the problem, and its cure through higher govern-
ment spending, on our 45° line diagram. Figure 3(a) shows the equilib-
rium of the economy if no changes are made in the budget. With an
expenditure multiplier of 2.5, you can figure out that an additional
$400 billion of government spending would be needed to push GDP up
by $1,000 billion and eliminate the gap ($400 3 2.5 5 $1,000).
So you might vote to raise G by $400 billion, hoping to move the
C 1 I 1 G 1 (X 2 IM) line in Figure 3(a) up to the position indicated in
Figure 3(b), thereby achieving full employment. Or you might prefer to
achieve this fiscal stimulus by lowering taxes. Or you might opt for
Source: © R. J. Matson, Roll Call

more generous transfer payments. The point is that a variety of budg-
ets are capable of increasing GDP by $1,000 billion. Figure 3 applies
equally well to any of them. President George W. Bush favored tax cuts,
which is the tool the U.S government relied on in 2001. Especially after
the September 11 terrorist attacks, encouraging consumers to spend
their tax cuts became a national priority. (See the cartoon to the left.)

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Chapter 11 227
Managing Aggregate Demand: Fiscal Policy

F I GU R E 3
Potential Potential
45° 45° Fiscal Policy to
Eliminate a
Recessionary Gap
Real Expenditure

Real Expenditure
C + I + G1 +
C + I + G0 + (X “ IM ) C + I + G0 +
(X “ IM ) (X “ IM )


5,000 6,000 7,000 5,000 6,000 7,000
Real GDP Real GDP
(a) (b)

NOTE: Figures are in billions of dollars per year.

The preceding example assumed that the basic problem of fiscal policy is to close a reces-
sionary gap, as was surely the case in 2001 and then again in 2008. But only two years ear-
lier, in 1999, most economists believed that the major macroeconomic problem in the United
States was just the opposite: Real GDP exceeded potential GDP, producing an inflationary
gap. And some people believed that an inflationary gap emerged once again in 2006 and
2007 when the unemployment rate dropped to around 4.5 percent. In such a case, govern-
ment would wish to adopt more restrictive fiscal policies to reduce aggregate demand.
It does not take much imagination to run our previous analysis in reverse. If an
inflationary gap would arise from a continuation of current budget policies, contrac-
tionary fiscal policy tools can eliminate it. By cutting spending, raising taxes, or by
some combination of the two, the government can pull the C 1 G 1 I 1 (X 2 IM)
schedule down to a noninflationary position and achieve an equilibrium at full
Notice the difference between this way of eliminating an inflationary gap and the nat-
ural self-correcting mechanism that we discussed in the last chapter. There we observed
that, if the economy were left to its own devices, a cumulative but self-limiting process of
inflation would eventually eliminate the inflationary gap and return the economy to full
employment. Here we see that we need not put the economy through the inflationary
wringer. Instead, a restrictive fiscal policy can avoid inflation by limiting aggregate
demand to the level that the economy can produce at full employment.

In principle, fiscal policy can nudge the economy in the desired direction equally well by
changing government spending or by changing taxes. For example, if the government
wants to expand the economy, it can raise G or lower T. Either policy would shift the total
expenditure schedule upward, as depicted in Figure 3(b), thereby raising equilibrium
GDP on the demand side.
In terms of our aggregate demand-and-supply diagram, either policy shifts the aggre-
gate demand curve outward, as illustrated in the shift from D0D0 to D1D1 in Figure 4 on
the next page. As a result, the economy™s equilibrium moves from point E to point A. Both
real GDP and the price level rise. As this diagram points out,

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Licensed to:
Part 3
228 Fiscal and Monetary Policy

Any combination of higher spending and lower taxes that produces the same aggregate
F I GU R E 4
demand curve leads to the same increases in real GDP and prices.
Expansionary Fiscal
How, then, do policy makers decide whether to raise spending
or to cut taxes? The answer depends mainly on how large a pub-
lic sector they want to create”a major issue in the long-running
debate in the United States over the proper size of government.
The small-government point of view, typically advocated
D0 by conservatives, says that we are foolish to rely on the public
sector to do what private individuals and businesses can do
Price Level

better. Conservatives believe that the growth of government
interferes too much in our everyday lives, thereby curtailing
Rise in E
our freedom. Those who hold this view can argue for tax cuts
price level
when macroeconomic considerations call for expansionary fis-
cal policy, as President Bush did, and for lower public spending
when contractionary policy is required.
Rise in
An opposing opinion, expressed more often by liberals, holds
real GDP D0
that something is amiss when a country as wealthy as the United
States has such an impoverished public sector. In this view,
Real GDP
America™s most pressing needs are not for more fast food and
video games but, rather, for better schools, better transportation
Permission, Cartoon Features Syndicate
SOURCE: From The Wall Street Journal”

infrastructure, and health insurance for all of our citizens. People on this side of
the debate believe that we should increase spending when the economy needs


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