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CHAPTER 10

Bringing in the Supply Side: Unemployment and Inflation?

217

8.One consequence of this self-correcting mechanism is that, if a surge in aggregate demand opens up an inflationary gap, the economy’s subsequent natural adjustment will lead to a period of stagflation—that is, a period in which prices are rising while output is falling.

9.An inward shift of the aggregate supply curve will cause output to fall while prices rise—that is, it will produce stagflation. Among the events that have caused such a shift are abrupt increases in the price of foreign oil.

10.Adverse supply shifts like this plagued the U.S. economy when oil prices skyrocketed in 1973–1974, in 1979–1980, and again in 1990, leading to stagflation each time.

11.But things reversed in 1997–1998, when falling oil prices and rising productivity shifted the aggregate supply curve out more rapidly than usual, thereby boosting real growth and reducing inflation simultaneously.

12.Inflation can be caused either by rapid growth of aggregate demand or by sluggish growth of aggregate supply. When fluctuations in economic activity emanate from the demand side, prices will rise rapidly when real output grows rapidly. But when fluctuations in economic activity emanate from the supply side, output will grow slowly when prices rise rapidly.

		| KEY TERMS		|
Aggregate supply curve 200		Inflation and the multiplier		204	Self-correcting mechanism 209
Productivity	202	Recessionary gap	205		Stagflation 210
Equilibrium of real GDP and the		Inflationary gap	205
price level	203

| TEST YOURSELF |

1.In an economy with the following aggregate demand and aggregate supply schedules, find the equilibrium levels of real output and the price level. Graph your solution. If full employment comes at $2,800 billion, is there an inflationary or a recessionary gap?

	Aggregate		Aggregate
	Quantity	Price	Quantity
	Demanded	Level	Supplied
	$3,200	90	$2,750
	3,100	95	2,900
	3,000	100	3,000
	2,900	105	3,050
2,800		110	3,075

NOTE: Amounts are in billions of dollars.

2.Suppose a worker receives a wage of $20 per hour. Compute the real wage (money wage deflated by the price index) corresponding to each of the following possible price levels: 85, 95, 100, 110, 120. What do you notice about the relationship between the real wage and the price level? Relate your finding to the slope of the aggregate supply curve.

3.Add the following aggregate supply and demand schedules to the example in Test Yourself Question 2 of Chapter 9 (page 192) to see how inflation affects the multiplier:

(1)		(2)	(3)	(4)
		Aggregate	Aggregate
		Demand	Demand
		When	When
	Price	Investment	Investment	Aggregate
	Level	Is $240	Is $260	Supply
	90	$3,860	$4,060	$3,660
	95	3,830	4,030	3,730
	100	3,800	4,000	3,800
	105	3,770	3,970	3,870
	110	3,740	3,940	3,940
115		3,710	3,910	4,010

Draw these schedules on a piece of graph paper.

a.Notice that the difference between columns (2) and (3), which show the aggregate demand schedule at two different levels of investment, is always $200. Discuss how this constant gap of $200 relates to your answer in the previous chapter.

b.Find the equilibrium GDP and the equilibrium price level both before and after the increase in investment. What is the value of the multiplier? Compare that to the multiplier you found in Test Yourself Question 2 of Chapter 9.

4.Use an aggregate supply-and-demand diagram to show that multiplier effects are smaller when the aggregate supply curve is steeper. Which case gives rise to more inflation—the steep aggregate supply curve or the flat one? What happens to the multiplier if the aggregate supply curve is vertical?

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218

PART 2

The Macroeconomy: Aggregate Supply and Demand

| DISCUSSION QUESTIONS |

1.Explain why a decrease in the price of foreign oil shifts the aggregate supply curve outward to the right. What are the consequences of such a shift?

2.Comment on the following statement: “Inflationary and recessionary gaps are nothing to worry about because the economy has a built-in mechanism that cures either type of gap automatically.”

3.Give two different explanations of how the economy can suffer from stagflation.

4.Why do you think wages tend to be rigid in the downward direction?

5.Explain in words why rising prices reduce the multiplier effect of an autonomous increase in aggregate demand.

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PART

FISCAL AND MONETARY POLICY

I n Part 2, we constructed a framework for understanding the macroeconomy. The basic theory came in three parts. We started with the determinants of the long-run growth rate

of potential GDP in Chapter 7, added some analysis of short-run fluctuations in aggregate demand in Chapters 8 and 9, and finally considered short-run fluctuations in aggregate supply in Chapter 10. Part 3 uses that framework to consider a variety of public policy issues— the sorts of things that make headlines in the newspapers and on television.

At several points in earlier chapters, beginning with our list of Ideas for Beyond the Final

Exam in Chapter 1, we suggested that the government may be able to manage aggregate demand by using its fiscal and monetary policies. Chapters 11–13 pick up and build on that suggestion. You will learn how the government tries to promote rapid growth and low unemployment while simultaneously limiting inflation—and why its efforts do not always succeed. Then, in Chapters 14–16, we turn explicitly to a number of important con-

troversies related to the government’s stabilization policy. How should the Federal Reserve do its job? Why is it considered so important to reduce the budget deficit? Is there a tradeoff between inflation and unemployment?

By the end of Part 3, you will be in an excellent position to understand some of the most important debates over national economic policy—not only today but also in the

years to come.

C H A P T E R S

	11		| Managing Aggregate		14	| The Debate over Monetary
				Demand: Fiscal Policy		and Fiscal Policy
	12		| Money and the Banking		15	| Budget Deficits in the Short
				System		and Long Run
		13	| Managing Aggregate		16	| The Trade-Off between
				Demand: Monetary Policy		Inflation and Unemployment

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MANAGING AGGREGATE DEMAND:

FISCAL POLICY

Next, let us turn to the problems of our fiscal policy. Here the myths are legion and the truth hard to find.

JOHN F. KENNEDY

I n the model of the economy we constructed in Part 2, the government played a rather passive role. It did some spending and collected taxes, but that was about it.

We concluded that such an economy has only a weak tendency to move toward an equilibrium with high employment and low inflation. Furthermore, we hinted that well-designed government policies might enhance that tendency and improve the economy’s performance. It is now time to expand on that hint—and to learn about some of the difficulties that must be overcome if stabilization policy is to succeed.

We begin in this chapter with fiscal policy. The next three chapters take up the government’s other main tool for managing aggregate demand, monetary policy.

The government’s fiscal policy is its plan for spending and taxation. It is designed to steer aggregate demand in some desired direction.

C O N T E N T S

	ISSUE: AGGREGATE DEMAND, AGGREGATE	PLANNING EXPANSIONARY FISCAL POLICY	ISSUE: THE PARTISAN DEBATE ONCE MORE
	SUPPLY, AND THE CAMPAIGN OF 2008	PLANNING CONTRACTIONARY	Toward an Assessment of Supply-Side Economics
	INCOME TAXES AND THE CONSUMPTION	FISCAL POLICY	| APPENDIX A | Graphical Treatment of Taxes
	SCHEDULE	THE CHOICE BETWEEN SPENDING POLICY	and Fiscal Policy
			Multipliers for Tax Policy
	THE MULTIPLIER REVISITED	AND TAX POLICY
	The Tax Multiplier	ISSUE REDUX: DEMOCRATS VERSUS	| APPENDIX B | Algebraic Treatment of Taxes
	Income Taxes and the Multiplier		and Fiscal Policy
		REPUBLICANS
	Automatic Stabilizers	SOME HARSH REALITIES
	Government Transfer Payments
	ISSUE REVISITED: THE 2008 DEBATE OVER	THE IDEA BEHIND SUPPLY-SIDE TAX CUTS
		Some Flies in the Ointment
	TAXES AND SPENDING

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PART 3

Fiscal and Monetary Policy

ISSUE:	AGGREGATE DEMAND, AGGREGATE SUPPLY, AND THE CAMPAIGN OF 2008

As this book went to press, the 2008 campaign for the White House was in full swing although the name of the Democratic candidate (either Barack Obama or Hillary Clinton) had not yet been determined. One of the main economic issues between either Democrat and the Republican John McCain was what to do about the tax cuts that President Bush and the Republican Congress had enacted during Mr. Bush’s first term—and which are scheduled to

expire in 2010. Both Mr. Obama and Ms. Clinton advocated repeal of many of the tax cuts, especially those that benefited mainly upper-income people. But Mr. McCain opposed this change in fiscal policy, arguing that doing so would damage economic growth in two ways: by reducing consumer spending (and, thus, aggregate demand), and by impairing incentives to earn more income (thus reducing aggregate supply).

The two Democrats rejected both claims. With regard to aggregate supply, they argued that the alleged incentive effects of lower tax rates were minuscule. With regard to aggregate demand, they made two arguments: First, that wealthy taxpayers do not spend much of the money they receive from their tax cuts anyway, and second, that eliminating the tax cuts for the rich would enable the government to spend more on more important priorities, such as universal health care. On balance, they maintained (without using the term), aggregate demand would rise, not fall.

The debate over whether to repeal or extend the Bush tax cuts thus revolved around three concepts that we will study in this chapter:

•The multiplier effects of tax cuts versus higher government spending

•The multiplier effects of different types of tax cuts (e.g., those for the poor versus those for the rich)

•The incentive effects of tax cuts

By the end of the chapter, you will be in a much better position to form your own opinion on this important public policy issue.

Charlie Neibergall	Rick Bowmer	Doug Mills
SOURCE: © AP Images /	SOURCE: © AP Images /	SOURCE: © AP Images /

INCOME TAXES AND THE CONSUMPTION SCHEDULE

To understand how taxes affect equilibrium gross domestic product (GDP), we begin by recalling that taxes (T) are subtracted from gross domestic product (Y) to obtain disposable income (DI):

DI 5 Y 2 T

and that disposable income, not GDP, is the amount actually available to consumers and is therefore the principal determinant of consumer spending (C). Thus, at any given level of

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Managing Aggregate Demand: Fiscal Policy

223

GDP, if taxes rise, disposable income falls—and hence so does consumption. What we have just described in words is summarized graphically in Figure 1:

Any increase in taxes shifts the consumption schedule downward, and any tax reduction shifts the consumption schedule upward.

Of course, if the C schedule moves up or down, so does the C 1 I 1 G 1 (X 2 IM) schedule. And we know from Chapter 9 that such a shift will have a multiplier effect on aggregate demand. So it follows that

An increase or decrease in taxes will have a mutiplier effect on equilibrium GDP on the demand side. Tax reductions increase equilibrium GDP, and tax increases reduce it.

	Tax Cut
Spending	C
	Tax
	Increase
Real Consumer
	Real GDP

So far, this analysis just echoes our previous analysis of

the multiplier effects of government spending. But there is one important difference. Government purchases of goods and services add to total spending directly—through the G component of C 1 I 1 G 1 (X 2 IM). But taxes reduce total spending only indirectly— by lowering disposable income and thus reducing the C component of C 1 I 1 G 1 (X 2 IM). As we will now see, that little detail turns out to be quite important.

FIGURE 1

How Tax Policy Shifts

the Consumption

Schedule

THE MULTIPLIER REVISITED

To understand why, let us return to the example used in Chapter 9, in which we learned that the multiplier works through a chain of spending and respending, as one person’s expenditure becomes another’s income. In the example, the spending chain was initiated by Microhard’s decision to spend an additional $1 million on investment. With a marginal propensity to consume (MPC) of 0.75, the complete multiplier chain was

$1,000,000 1 $750,000 1 $562,500 1 $421,875 1 . . . .

5 $1,000,000 (1 1 0.75 1 (0.75)2 1 (0.75)3 1 . . .) 5 $1,000,000 3 4 5 $4,000,000.

Thus, each dollar originally spent by Microhard eventually produced $4 in additional spending.

The Tax Multiplier

Now suppose the initiating event was a $1 million tax cut instead. As we just noted, a tax cut affects spending only indirectly. By adding $1 million to disposable income, it increases consumer spending by $750,000 (assuming that the MPC is 0.75). Thereafter, the chain of spending and respending proceeds exactly as before, to yield:

$750,000 1 $562,500 1 $421,875 1 . . . .

5 $750,000 (1 1 0.75 1 (0.75)2 1 . . .) 5 $750,000 3 4 5 $3,000,000.

Notice that the mutiplier effect of each dollar of tax cut is 3, not 4. The reason is straightforward. Each new dollar of additional autonomous spending—regardless of whether it is C or I or G—has a multiplier of 4. But each dollar of tax cut creates only 75 cents of new consumer spending. Applying the basic expenditure multiplier of 4 to the 75 cents of first-round spending leads to a multiplier of 3 for each dollar of tax cut. This numerical example illustrates a general result:1

1 You may notice that the tax multiplier of 3 is the spending multiplier of 4 times the marginal propensity to consume, which is 0.75. See Appendix B for an algebraic explanation.

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Fiscal and Monetary Policy

The multiplier for changes in taxes is smaller than the multiplier for changes in government purchases because not every dollar of tax cut is spent.

Income Taxes and the Multiplier

But this is not the only way in which taxes force us to modify the multiplier analysis of Chapter 9. If the volume of taxes collected depends on GDP—which, of course, it does in reality—there is another.

To understand this new wrinkle, return again to our Microhard example, but now assume that the government levies a 20 percent income tax—meaning that individuals pay 20 cents in taxes for each $1 of income they receive. Now when Microhard spends $1 million on salaries, its workers receive only $800,000 in after-tax (that is, disposable) income. The rest goes to the government in taxes. If workers spend 75 percent of the $800,000 (because the MPC is 0.75), spending in the next round will be only $600,000. Notice that this is only 60 percent of the original expenditure, not 75 percent—as was the case before.

Thus, the multiplier chain for each original dollar of spending shrinks from

	1 (0.75)2 1 (0.75)3	1		1			4
1 1 0.75		1 . . . 5		5		5
			1 2 0.75		0.25

in Chapter 9’s example to

1	1 0.6 1 (0.6)2 1 (0.6)3	1		1			2.5
		1 . . . 5		5		5
			1 2 0.6		0.4

now. This is clearly a large reduction in the multiplier. Although this is just a numerical example, the two appendixes to this chapter show that the basic finding is quite general:

The multiplier is reduced by an income tax because an income tax reduces the fraction of each dollar of GDP that consumers actually receive and spend.

We thus have a third reason why the oversimplified multiplier formula of Chapter 9 exaggerates the size of the multiplier: It ignores income taxes.

	FIGURE 2	REASONS WHY THE OVERSIMPLIFIED FORMULA OVERSTATES THE MULTIPLIER
	The Multiplier in	1. It ignores variable imports, which reduce the size of the multiplier.
	the Presence of an	2. It ignores price-level changes, which reduce the multiplier.
	Income Tax			3. It ignores income taxes, which also reduce
		45		the size of the multiplier.
				The last of these three reasons is the most im-
		C + I + G1	+ (X – IM )	portant one in practice.
				This conclusion about the multiplier is
		E1
				shown graphically in Figure 2, which can use-
	Expenditure			fully be compared to Figure 10 of Chapter 9
		C + I + G0	+ (X – IM )	(page 186). Here we draw our C 1 I 1 G 1
				(X 2 IM) schedules with a slope of 0.6, reflect-
	Real			ing an MPC of 0.75 and a tax rate of 20 percent,
				rather than the 0.75 slope we used in Chapter 9.
	$400			Figure 2 then illustrates the effect of a $400 bil-
				lion increase in government purchases of goods
	E0			and services, which shifts the total expenditure
				schedule from C 1 I 1 G0 1 (X 2 IM) to C 1
				I 1 G1 1 (X 2 IM). Equilibrium moves from
				point E0 to point E1—a GDP increase from
	6,000	7,000	8,000	Y 5 $6,000 billion to Y 5 $7,000 billion.
		Real GDP		Thus, if we ignore for the moment any
				increases in the price level (which would fur-
	NOTE: Figures are in billions of dollars per year.			ther reduce the multiplier), a $400 billion

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CHAPTER 11

Managing Aggregate Demand: Fiscal Policy

225

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 government 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 importance. 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 stabilizers. The most obvious example is the one we have just been discussing: the personal income tax. The income tax acts as a shock absorber because it makes disposable income, and thus consumer spending, less sensitive to fluctuations in GDP. As we have just seen, when GDP rises, disposable income (DI) rises less because part of the increase in GDP 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 automatic 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 stabilizer 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.

An AUTOMATIC STABILIZER

is a feature of the economy that reduces its sensitivity to shocks, such as sharp increases or decreases in spending.

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 payments 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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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 transfers. 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.

ISSUE REVISITED:

THE 2008 DEBATE OVER TAXES AND SPENDING

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 increase 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 somewhat larger multipliers than tax cuts for the rich.

PLANNING EXPANSIONARY FISCAL POLICY

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 billion. Congress can close the recessionary gap between actual and potential GDP by

•raising government purchases

•reducing taxes

•increasing transfer payments

Source: © R. J. Matson, ROLL CALL

Figure 3 illustrates the problem, and its cure through higher government spending, on our 45° line diagram. Figure 3(a) shows the equilibrium 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 more generous transfer payments. The point is that a variety of budgets 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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