1 © Pearson Education 2011

Economics,
Arab World Edition
R. Glenn Hubbard, Anthony Patrick O’Brien,
Ashraf Eid, Amany El Anshasy,

Chapter 23
Fiscal Policy

2 © Pearson Education 2011

 Arab Governments to
the Rescue
Learning Objectives
23.1 Define fiscal policy.
Arab governments relied on
enhancing their public expenditures, 23.2 Explain how fiscal policy affects
aggregate demand and how the
and some of them decreased their government can use fiscal policy to
taxes, to overcome the negative stabilize the economy.
consequences of the recent
23.3 Explain how the government
economic crisis. purchases and tax multipliers work.

23.4 Discuss the difficulties that can arise

in implementing fiscal policy.

23.5 Define federal budget deficit and

federal government debt and explain
how the federal budget can serve as
an automatic stabilizer.

23.6 Discuss the effects of fiscal policy in

the long run.

APPENDIX Apply the multiplier formula.

3 © Pearson Education 2011

 Learning Objective 23.1

Fiscal Policy
What Fiscal Policy Is and What It Isn’t
Fiscal policy Changes in federal taxes
and purchases that are intended to achieve
macroeconomic policy objectives, such as
high employment, price stability, and high
rates of economic growth.

Automatic Stabilizers versus Discretionary Fiscal Policy

Automatic stabilizers Government
Chapter 23: Fiscal Policy

spending and taxes that automatically

increase or decrease along with the
business cycle.

4 © Pearson Education 2011

 Learning Objective 23.1

Fiscal Policy
An Overview of Government Spending and Taxes

FIGURE 23-1
Government Purchases as a
Percentage of GDP in the
Arab World, 1975–2009
Chapter 23: Fiscal Policy

5 © Pearson Education 2011

 Learning Objective 23.1

Fiscal Policy
An Overview of Government Spending and Taxes
FIGURE 23-2
Government Purchases as a
Percentage of GDP in Selected
Arab Countries, 1975–2009
Chapter 23: Fiscal Policy

6 © Pearson Education 2011

 Learning Objective 23.1

Fiscal Policy
An Overview of Government Spending and Taxes

FIGURE 23-3
Government
Revenues as a
Percentage of GDP,
1999–2008
Chapter 23: Fiscal Policy

7 © Pearson Education 2011

 Learning Objective 23.2
The Effects of Fiscal Policy
on Real GDP and the Price Level
Expansionary and Contractionary Fiscal Policy: An Initial Look
FIGURE 23-4
Fiscal Policy
Chapter 23: Fiscal Policy

8 © Pearson Education 2011

 Expansionary and Contractionary Fiscal Policy

Expansionary fiscal policy involves increasing government purchases

or decreasing taxes.

An increase in government purchases will increase aggregate demand

directly, because government expenditures are a component of
aggregate demand. A cut in taxes has an indirect effect on aggregate
demand. Cutting the individual income tax will increase household
disposable income and consumption spending. Cutting taxes on
Chapter 23: Fiscal Policy

business income can increase aggregate demand by increasing

business investment.
 Expansionary and Contractionary Fiscal Policy

Contractionary fiscal policy involves decreasing government

purchases or increasing taxes. Policymakers use
contractionary fiscal policy to reduce increases in aggregate
demand that seem likely to lead to inflation.
Chapter 23: Fiscal Policy
 Learning Objective 23.2
The Effects of Fiscal Policy
on Real GDP and the Price Level
Using Fiscal Policy to Influence Aggregate Demand:
A More Complete Account
FIGURE 23-5
An Expansionary
Fiscal Policy
Chapter 23: Fiscal Policy

11 © Pearson Education 2011

 Learning Objective 23.2
The Effects of Fiscal Policy
on Real GDP and the Price Level
Using Fiscal Policy to Influence Aggregate Demand:
A More Complete Account
FIGURE 23-6
A Contractionary
Fiscal Policy
Chapter 23: Fiscal Policy

12 © Pearson Education 2011

 Learning Objective 23.2
The Effects of Fiscal Policy
on Real GDP and the Price Level
A Summary of How Fiscal Policy Affects Aggregate Demand

Table 23-1
Countercyclical Fiscal Policy

ACTIONS BY CONGRESS
PROBLEM TYPE OF POLICY AND THE PRESIDENT RESULT
Recession Expansionary Increase government Real GDP and the price
spending or cut taxes level rise.

Rising Inflation Contractionary Decrease government Real GDP and the price
spending or raise taxes level fall.
Chapter 23: Fiscal Policy

13 © Pearson Education 2011

 Learning Objective 23.3

The Government Purchases and Tax Multipliers

Multiplier effect The series of

induced increases in consumption
spending that results from an initial
increase in autonomous expenditures.
Chapter 23: Fiscal Policy

14 © Pearson Education 2011

 Learning Objective 23.3

The Government Purchases and Tax Multipliers

FIGURE 23-7
The Multiplier Effect
and Aggregate Demand

The shift to the right

from AD1, to the
dotted AD curve
represents the impact
of the initial increase
of US$100 billion in
government
purchases. Because
this initial increase in
government
Chapter 23: Fiscal Policy

purchases raises
incomes and leads to
further increases in
consumption
spending, the
aggregate demand
curve will ultimately
shift from AD1, all the
way to AD2.

15 © Pearson Education 2011

 Learning Objective 23.3

The Government Purchases and Tax Multipliers

FIGURE 23-8
The Multiplier Effect
of an Increase in
Government Purchases
Chapter 23: Fiscal Policy

16 © Pearson Education 2011

 Learning Objective 23.3

The Government Purchases and Tax Multipliers

The ratio of the change in equilibrium real GDP to

the initial change in government purchases is
known as the government purchases multiplier:

Change in equilibrium real GDP

Government purchases multiplier
Change in government purchases

The expression for this tax multiplier is:

Chapter 23: Fiscal Policy

Change in equilibrium real GDP

Tax multiplier
Change in taxes

17 © Pearson Education 2011

 Learning Objective 23.3

The Government Purchases and Tax Multipliers

The Effect of Changes in Tax Rates

A cut in tax rates affects equilibrium real GDP

through two channels:
(1) A cut in tax rates increases the disposable
income of households, which leads them to
increase their consumption spending, and
(2) a cut in tax rates increases the size of the
Chapter 23: Fiscal Policy

multiplier effect.

18 © Pearson Education 2011

 Learning Objective 23.3

The Government Purchases and Tax Multipliers

Taking into Account the Effects of Aggregate Supply

FIGURE 23-9
The Multiplier Effect
and Aggregate Supply
Chapter 23: Fiscal Policy

19 © Pearson Education 2011

 Learning Objective 23.3

The Government Purchases and Tax Multipliers

The Multipliers Work in Both Directions

Increases in government purchases and cuts in

taxes have a positive multiplier effect on
equilibrium real GDP.
Decreases in government purchases and
increases in taxes also have a multiplier effect
on equilibrium real GDP, only in this case, the
effect is negative.
Chapter 23: Fiscal Policy

20 © Pearson Education 2011

 Learning Objective 23.3

Solved Problem 23-3

Fiscal Policy Multipliers

Briefly explain whether you agree or disagree with

the following statement: “Real GDP is currently
$12.2 trillion, and potential real GDP is $12.4
trillion. If Congress and the president would
increase government purchases by $300 billion or
cut taxes by $200 billion, the economy could be
brought to equilibrium at potential GDP.”

Change in equilibrium real GDP

Chapter 23: Fiscal Policy

Government purchases multiplier

Change in government purchases

21 © Pearson Education 2011

 Learning Objective 23.4
The Limits of Using Fiscal Policy
to Stabilize the Economy
Does Government Spending Reduce Private Spending?

Crowding out A decline in private

expenditures as a result of an
increase in government purchases.
Chapter 23: Fiscal Policy

22 © Pearson Education 2011

 Learning Objective 23.4
The Limits of Using Fiscal Policy
to Stabilize the Economy
Crowding Out in the Short Run

FIGURE 23-10
An Expansionary Fiscal Policy
Increases Interest Rates
Chapter 23: Fiscal Policy

23 © Pearson Education 2011

 Learning Objective 23.4
The Limits of Using Fiscal Policy
to Stabilize the Economy
Crowding Out in the Short Run

FIGURE 23-11
The Effect of Crowding Out
in the Short Run
Chapter 23: Fiscal Policy

24 © Pearson Education 2011

 Learning Objective 23.4

Making
the Is Losing Your Job Good
for Your Health?
Connection
Chapter 23: Fiscal Policy

Recent research shows that, surprisingly,

the health of people who are temporarily
unemployed may improve.

25 © Pearson Education 2011

 Learning Objective 23.5

Deficits, Surpluses, and Federal Government Debt

Budget deficit The situation in which

the government’s expenditures are
greater than its tax revenue.

Budget surplus The situation in

which the government’s expenditures
are less than its tax revenue.
Chapter 23: Fiscal Policy

26 © Pearson Education 2011

 Learning Objective 23.5

Deficits, Surpluses, and Government Debt

FIGURE 23-12
Budget Deficit/Surplus as a
Percent of GDP, 2000–2008
Chapter 23: Fiscal Policy

27 © Pearson Education 2011

 Learning Objective 23.5

Deficits, Surpluses, and Government Debt

How the Budget Can Serve as an Automatic Stabilizer

Cyclically adjusted budget deficit or

surplus The deficit or surplus in the
government’s budget if the economy
were at potential GDP.
Chapter 23: Fiscal Policy

28 © Pearson Education 2011

 Learning Objective 23.5

Making
the Did Fiscal Policy Fail during
the Great Depression?
Connection FEDERAL
CYCLICALLY
ACTUALFEDERAL ADJUSTED
CYCLICALLY
ADJUSTED
GOVERNMENT BUDGET DEFICIT BUDGET DEFICIT BUDGET DEFICIT
EXPENDITURES OR SURPLUS OR SURPLUS OR SURPLUS AS
(BILLIONS OF (BILLIONS OF (BILLIONS OF A PERCENTAGE
DOLLARS DOLLARS) DOLLARS) OF GDP

1929 $2.6 $1.0 $1.24 1.20%

Although government
1930 2.7 0.2 0.81 0.89
spending increased
1931 4.0 -2.1 -0.41 -0.54
during the Great
Depression, the 1932 3.0 -1.3 0.50 0.85
cyclically adjusted 1933 3.4 -0.9 1.06 1.88
budget was in surplus 1934 5.5 -2.2 0.09 0.14
most years. 1935 5.6 -1.9 0.54 0.74
Chapter 23: Fiscal Policy

1936 7.8 -3.2 0.47 0.56

1937 6.4 0.2 2.55 2.77
1938 7.3 -1.3 2.47 2.87
1939 8.4 -2.1 2.00 2.17

Sources: E. Cary Brown, “Fiscal Policy in the ’Thirties: A Reappraisal,” American Economic Review, Vol. 46,
No. 5, December 1956, pp. 857–879; Larry Peppers, “Full Employment Surplus Analysis and Structural Changes,”
Explorations in Economic History, Vol. 10, Winter 1973, pp. 197–210; and Bureau of Economic Analysis.

29 © Pearson Education 2011

 Learning Objective 23.5

Deficits, Surpluses, and Government Debt

Should the Federal Budget Always Be Balanced?

Although many economists believe that it is

a good idea for the federal government to
have a balanced budget when the economy
is at potential GDP, few economists believe
that the federal government should attempt
to balance its budget every year.
Chapter 23: Fiscal Policy

30 © Pearson Education 2011

 Learning Objective 23.5

Deficits, Surpluses, and Government Debt

The Government Debt

FIGURE 23-13
Net Public Domestic Debt
as Percent of GDP in
Egypt, 2001-2010
Chapter 23: Fiscal Policy

31 © Pearson Education 2011

 Learning Objective 23.5

Deficits, Surpluses, and Government Debt

Is Government Debt a Problem?

Debt can be a problem for a government

for the same reasons that debt can be a
problem for a household or a business.
Chapter 23: Fiscal Policy

32 © Pearson Education 2011

 Learning Objective 23.6

The Effects of Fiscal Policy in the Long Run

The Long-Run Effects of Tax Policy

Tax wedge The difference between

the pretax and posttax return to an
economic activity.

We can look briefly at the effects on aggregate supply

of cutting each of the following taxes:

• Individual income tax.

• Corporate income tax.
Chapter 23: Fiscal Policy

• Taxes on dividends and capital gains.

Tax Simplification
In addition to the potential gains from cutting individual
taxes, there are also gains from tax simplification.
33 © Pearson Education 2011
 Learning Objective 23.6

Making
the Should Arab Non-Oil Based
Economies Adopt the “Flat Tax”?
Connection

YEAR FLAT TAX

COUNTRY FLAT TAX RATE WAS INTRODUCED
The flat tax Estonia 26% 1994
would simplify Lithuania 33 1994
tax preparation. Latvia 25 1995
Russia 13 2001
Serbia 14 2003
Chapter 23: Fiscal Policy

Ukraine 13 2004
Slovakia 19 2004
Georgia 12 2005
Romania 16 2005

34 © Pearson Education 2011

 Learning Objective 23.6

The Effects of Fiscal Policy in the Long Run

The Economic Effect of Tax Reform
FIGURE 23-14
The Supply-Side Effects
of a Tax Change
Chapter 23: Fiscal Policy

35 © Pearson Education 2011

 An Inside LOOK How Severe is the Lebanese Public
Debt?
EU Commission: Fiscal policy in Lebanon 'unsustainable'

The fiscal policy in

Lebanon is considered
unsustainable because
of the large national debt
as a percent to GDP
Chapter 23: Fiscal Policy

36 © Pearson Education 2011

 Key Terms

Automatic stabilizers
Budget deficit
Budget surplus
Crowding out
Cyclically adjusted budget
deficit or surplus
Fiscal policy
Multiplier effect
Chapter 23: Fiscal Policy

Tax wedge

37 © Pearson Education 2011

 Appendix
A Closer Look at the Multiplier

An Expression for Equilibrium Real GDP

(1) C = 1,000 + 0.75 (Y−T) Consumption function

(2) I = 1,500 Planned investment function
(3) G = 1,500 Government purchases function
(4) T = 1,000 Tax function
(5) Y = C + I + G Equilibrium condition
Chapter 23: Fiscal Policy

38 © Pearson Education 2011

 Appendix
A Closer Look at the Multiplier

An Expression for Equilibrium Real GDP

The letters with “bars” represent fixed or autonomous values

that do not depend on the values of other variables. So, C
represents autonomous consumption, which had a value of
1,000 in our original example. Now, solving for equilibrium
we get:
Y C MPC (Y T ) I G
or,
Chapter 23: Fiscal Policy

Y MPC (Y ) C ( MPC T ) I G
or,
Y (1 MPC ) C ( MPC T ) I G
or,
C ( MPC T ) I G
Y
1 MPC
39 © Pearson Education 2011
 Appendix
A Formula for the Government Purchases Multiplier

C ( MPC T ) I G
Y
1 MPC

G
Y
1 MPC
Chapter 23: Fiscal Policy

Y 1
Government purchases multiplier
G 1 MPC

40 © Pearson Education 2011

 Appendix
A Formula for the Tax Multiplier

C ( MPC T ) I G
Y
1 MPC

MPC T
Y
1 MPC
Chapter 23: Fiscal Policy

Or:

Y MPC
The tax multiplier
T 1 MPC
41 © Pearson Education 2011
 Appendix
The “Balanced Budget” Multiplier

1 MPC
The balanced budget multiplier , or 1
1 MPC
Chapter 23: Fiscal Policy

42 © Pearson Education 2011

 Appendix
The Effects of Changes in Tax Rates on the Multiplier

C C MPC (1 t )Y

Y 1
Government purchases multiplier
G 1 MPC 1 t
Chapter 23: Fiscal Policy

43 © Pearson Education 2011

 Appendix
The Multiplier in an Open Economy

We can define the marginal propensity to import (MPI) as the

fraction of an increase in income that is spent on imports. So,
our expression for imports is:
Imports = MPI x Y
We can substitute our expressions for exports and imports into
the expression we derived earlier for equilibrium real GDP:
Y C MPC (1 t )Y I G Exports MPI Y
Chapter 23: Fiscal Policy

where the expression Exports MPI Y represents net exports.

We can now find an expression for the government purchases
multiplier by using the same method as we did previously:

Y 1
Government purchases multiplier
G 1 - [MPC (1 - t ) - MPI ]
44 © Pearson Education 2011
 A Closer Look at the Multiplier

An Expression for Equilibrium Real GDP

(1) C = 1,000 + 0.75 (Y−T) Consumption function

(2) I = 1,500 Planned investment function
(3) G = 1,500 Government purchases function
(4) T = 1,000 Tax function
(5) Y = C + I + G Equilibrium condition
Chapter 23: Fiscal Policy

45 © Pearson Education 2011

 1- calculate a value of equilibrium real GDP?
1,000+0.75(Y-1,000)+1,500+1,500
Y= 3,250+0.75Y
1Y-0.75Y=3250
0.25Y= 3,250
0.25 0.25
Y= 13,000
2- Find the government purchase multiplier?
1/1-MPC
= 1/1-0.75
=4
Chapter 23: Fiscal Policy

3- Find the tax multiplier?

= -MPC/ 1-MPC
= -0.75/1-0.75
= -3
 If you have information about an economy:
Y=C+I+G+NX
C=100+0.75Yd
I= 200
G=100
T=0.25Y
X=100
M=25+0.15Y
Chapter 23: Fiscal Policy

1- Find the multiplier?

2-calculate a value of equilibrium real GDP?

 1- Find the multiplier?
Y 1
= Government purchases multiplier
G 1 - [MPC (1 - t ) - MPI ]
= 1/1-[0.75(1-0.25)-0.15]
= 1.702
2-calculate a value of equilibrium real GDP?
Y=C+I+G+NC
Y= (100+0.75Yd)+(200)+(100)+(100-25+0.15Y)
Y= (100+0.75•Y-0.25Y)+400-(25+0.15Y)
Y= 100+0.75Y-0.1875Y+400-25-0.15Y
Y-0.4125Y= 475+0.4125Y-0.4125Y
Chapter 23: Fiscal Policy

0.5875Y=475
0.5875 0.5875
Y= 808.5
Chapter 23: Fiscal Policy