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Changes in Transfer Payments

25 April, 2016 - 09:12

Changes in transfer payments, like changes in income taxes, alter the disposable personal income of households and thus affect their consumption, which is a component of aggregate demand. A change in transfer payments will thus shift the aggregate demand curve because it will affect consumption. Because consumption will change by less than the change in disposable personal income, a change in transfer payments of some amount will result in a smaller change in real GDP than would a change in government purchases of the same amount. As with income taxes, a $200-billion increase in transfer payments will shift the aggregate demand curve to the right by less than the $200-billion increase in government purchases that we saw in Figure 27.8.

The following Table 27.3 summarizes U.S. fiscal policies undertaken to shift aggregate demand since the 1964 tax cuts. We see that expansionary policies have been chosen in response to recessionary gaps and that contractionary policies have been chosen in response to inflationary gaps. Changes in government purchases and in taxes have been the primary tools of fiscal policy in the United States.

Table 27.3 Fiscal Policy in the United States Since 1964 The table lists the major proposed uses of discretionary policy over the last four decades.

Year

Situation

Policy response

1968

Inflationary gap

A temporary tax increase, first recommended by President Johnson’s Council of Economic Advisers in 1965, goes into effect. This one-time surcharge of 10% is added to individual

1969

Inflationary gap

President Nixon, facing a continued inflationary gap, orders cuts in government purchases.

1975

Recessionary gap

Resident Fort, facing a continued inflationary gap, orders cuts in government purchases.

1981

Recessionary gap

President Reagan had campaigned on a platform of increased defense spending and a sharp cut in income taxes. The tax cuts are approved in 1981 and are implemented over a period of three years. The increased defense spending begins in 1981. While the Reagan administration rejects the use of fiscal policy as a stabilization tool, its policies tend to increase aggregate demand early in the 1980s.

1992

Recessionary gap

Resident Bush had rejected the use of expansionary fiscal policy during the recession of 1990-1991. Indeed, he agreed late in 1990 to a cut in government purchases and a tax increase. In a campaign year, however, he orders a cut in withholding rates designed to increase disposable personal income in 1992 and to boost consumption.

1993

Recessionary gap

President Clinton calls for a $16-billion jobs package consisting of increased government purchases and tax cuts aimed at stimulating investment. The president says the plan will create 500,000 new jobs. The measure is rejected by Congress.

2001

Recessionary gap

President Bush campaigned to reduce taxes in order to reduce the size of government and encourage long-term growth. When he took office in 2001, the economy was weak and the $1.35-billion tax cut was aimed at both long-term tax relief and at stimulating the economy in the short term. It included, for example, a personal income tax rebate of $300 to $600 per household. With unemployment still high a couple of years into the expansion, another tax cut was passed in 2003.

2008

Recessionary gap

Fiscal stimulus package of $150 billion to spur economy. It included $100 billion in tax rebates and $50 in tax cuts for businesses.

2009

Recessionary gap

Fiscal stimulus package of $787 billion included tax cuts and increased government spending passed in early days of President Obama’s administration.

 

KEY TAKEAWAYS

  • Discretionary fiscal policy may be either expansionary or contractionary.
  • A change in government purchases shifts the aggregate demand curve at a given price level by an amount equal to the initial change in government purchases times the multiplier. The change in real GDP, however, will be reduced by the fact that the price level will change.
  • A change in income taxes or government transfer payments shifts the aggregate demand curve by a multiple of the initial change in consumption (which is less than the change in personal disposable income) that the change in income taxes or transfer payments causes. Then, the change in real GDP will be reduced by the fact that the price level will change.
  • A change in government purchases has a larger impact on the aggregate demand curve than does an equal change in income taxes or transfers.
  • Changes in business tax rates, including an investment tax credit, can be used to influence the level of investment and thus the level of aggregate demand.

TRY IT!

Suppose the economy has an inflationary gap. What fiscal policies might be used to close the gap? Using the model of aggregate demand and aggregate supply, illustrate the effect of these policies.

Case in Point: Post–World War II Experiences with Fiscal Policy in the United States

Christina Romer, tapped by Barack Obama to head the Council of Economic Advisers, has a long history of writing on economic history. Much of her work focuses on the macroeconomic performance of the United States economy over the past 100-plus years and hence also involves painstaking work to construct historical data series.

One such study titled “Changes in Business Cycles: Evidence and Explanations” draws on a number of her research efforts to compare economic fluctuations before World War I to those after World War II in order to see if the advent of macroeconomic stabilization policy has affected macroeconomic performance. After first showing that macroeconomic performance has not improved as markedly as we might think (excluding the interwar period when “all hell broke loose in the American economy”), she does conclude that monetary and fiscal policies to influence aggregate demand since World War II have “served to dampen many recessions and counteract some shocks entirely.”

She notes that before World War I, changes in macroeconomic policy could not have affected economic performance, because the government was simply too small, with, for example, government spending as a percent of GNP averaging between 1.5% and 2.5% between 1901 and 1916. During that period, the government did operate under specified monetary standards and banking regulations, but the Federal Reserve was not created until 1914, so there was no monetary institution to respond to macroeconomic instability. Thus, macroeconomic policy can truly be seen as a post–World War II phenomenon.

Germaine to the focus on fiscal policy in this chapter, Romer found that discretionary fiscal policy after World WarII contributed 0.5 percentage points to the rate of growth of real GDP in years following the troughs of recessions, while automatic stabilizers contributed 0.85 percentage points. Adding in the average contribution of monetary policy of 1.5 percentage points, macroeconomic policy in total contributed 2.85 percentage points to the average actual growth of GDP in the years following troughs of 4.6%. She also concluded that macroeconomic policies likely prevented some recessions or near-recessions. For example, automatic stabilizers muted fluctuations in years of extreme changes in GDP, up or down, by 1 to 2 percentage points in absolute value and fluctuations in years of moderate changes in GDP by about 0.5 percentage points in absolute value.

Especially in light of the active use of both monetary and fiscal policies to counter the recession that began in December 2007, she also found that there has been a rise in policy-induced recessions and that this phenomenon explains both why output and other macroeconomic variables have not been more stable in the past half-century and why post–World War II business cycles have been in the moderate range. In particular, she argues that the Fed has generally been too expansionary when the economy was growing, which has led to inflation. Then the Fed has used contractionary policy to reduce inflation. She concludes, “In essence, we have replaced the prewar boom-bust cycle driven by animal spirits and financial panics with the postwar boom-bust cycle driven by policy.”

Source: Christina Romer, “Changes in Business Cycles: Evidence and Explanations,” Journal of Economic Perspectives 13, no. 2 (Spring 1999): 23–44.

ANSWER TO TRY IT! PROBLEM

Fiscal policies that could be used to close an inflationary gap include reductions in government purchases and transfer payments and increases in taxes. As shown in Panel (b) of Figure 27.8, the goal would be to shift the aggregate demand curve to the left so that it will intersect the short-run aggregate supply curve at YP.