5/25/2024

CHAPTER 4.
FISCAL POLICY AND FOREIGN
TRADE POLICY

Trinh Hoang Hong Hue, PhD

OUTLINE
4.1. Fiscal Policy

4.2. Automatic Fiscal Factors

4.3. Foreign Trade Policy

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4.1. Fiscal policy

• Fiscal policy is the way that a government changes budget revenues

and expenditures to influence economic activity.
• Goals: economic stabilization
• Tools: Changes in T and/or G => change(s) in (AD) => change in macro
variables such as: Y, unemployment and price level

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4.1. Fiscal policy

• Viewpoints on fiscal policy

Subjective fiscal policy: The government should proactively influence the
economy with fiscal policies (Keynes).
Automatic fiscal policy: The government only needs to use automatic
stabilizers and fiscal policy will automatically be implemented.

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4.1. Fiscal policy

Expansionary Fiscal Policy

- By increasing G and/or decreasing T
- Being used to avoid from recession
Subjective
Fiscal Policy
Contractionary Fiscal Policy
- By decreasing G and/or increasing T
- Being used to avoid high inflation rate

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IMPACTS OF SUBJECTIVE FISCAL POLICY

In order that 𝑌𝐸 = 𝑌𝑃 Way to do:
𝑌𝐸 < 𝑌𝑃

• Recession • Using expansionary • 𝑇𝑥 ↓, 𝑇𝑟 ↑ ⇒ 𝑇 ↓ ⇒

fiscal policy 𝑌𝑑 ↑ ⇒ 𝐶 ↑ ⇒
𝐴𝐷 ↑ ⇒ 𝑌𝐸 ↑
• 𝐺 ↑ ⇒ 𝐴𝐷 ↑ ⇒
𝑌𝐸 ↑

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IMPACTS OF SUBJECTIVE FISCAL POLICY

𝑌𝐸 > 𝑌𝑃 In order that 𝑌𝐸 = 𝑌𝑃 Way to do

• High Inflation Rate • Using • 𝑇𝑥 ↑, 𝑇𝑟 ↓ ⇒ 𝑇 ↑ ⇒

contractionary fiscal 𝑌𝑑 ↓ ⇒ 𝐶 ↓ ⇒ 𝐴𝐷 ↓
policy ⇒ 𝑌𝐸 ↓
• 𝐺 ↓ ⇒ 𝐴𝐷 ↓ ⇒ 𝑌𝐸 ↓

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4.1. Fiscal policy

Criteria Expansionary fiscal policy Contractionary Fiscal Policy
Characteristic A policy to increase government spending on A policy to cut spending on
goods and services or reduce tax revenue goods and services or increase
tax revenue.
Tool Increase government spending G Decrease government spending
Increase transfer payment Tr (subsidy G
payments, social insurance payments...) Decrease transfer payment
Reduce Tx tax Increase Tx tax
Change both expenditure G and net taxes T Change both expenditure G and
net taxes T
Goal Increase aggregate demand => increase Reduce output to fight inflation
national output to fight recession
Applicable cases When the economy has real output Yt < Yp When the economy has Yt > Yp
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Quantitative Fiscal policy

Goal: Changing G & T in order that Ye = Yp

When Y1 < Yp => ∆𝑌 = 𝑌𝑝 − 𝑌1

∆𝑌 AD
∆𝑌 = 𝑘. ∆𝐴𝐷0 or ∆𝐴𝐷0 =
𝑘 AD2
Whereas:
1 1
𝑘= = 𝐴𝐷02
∆𝐴𝐷0 AD1
1 − 𝐶𝑚 1 − 𝑇𝑚 − 𝐼𝑚 + 𝑀𝑚 1 − 𝐴D𝑚
𝐴𝐷01

∆𝑌
450
Y1 Yp Y
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Quantiative Fiscal policy

Goal: Changing G & T in order that Ye = Yp
• Case 1: Changing G and T unchanged => ∆𝑮 = ∆𝑨𝑫𝟎𝑮
• Case 2: Changing T, G unchanged
• ∆𝑌𝑑 = − ∆𝑇
• => ∆𝐶 = 𝐶𝑚. ∆𝑌𝑑 = −𝐶𝑚. ∆𝑇
∆𝐴𝐷0T
=> ∆𝐴𝐷0T = ∆𝐶 = −𝐶𝑚. ∆𝑇 => ∆𝑇 = −
𝐶𝑚

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Quantiative Fiscal policy

Goal: Changing G & T in order that Ye = Yp
• Case 3: Changing both G and T
∆𝐴𝐷0𝐺 is the change of AD caused by changing G
∆𝐴𝐷0T is the change of AD caused by changing T
∆𝐴𝐷0T
∆𝐺 = ∆𝐴𝐷0𝐺 ∆𝑇 = −
𝐶𝑚
Vì: ∆𝐴𝐷0𝐺 + ∆𝐴𝐷0T = ∆𝐴𝐷0
∆𝐺 + −𝐶𝑚. ∆𝑇 = ∆𝐴𝐷0
∆𝐺 − 𝐶𝑚. ∆𝑇 = ∆𝐴𝐷0

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Quantitative Fiscal policy

Goal 2: Changing G and T to keep AD unchanged

• Supposed that Ye = Yp, but the government needs to increase G.

=> The govt has to increase T to keep AD unchanged.
=> ∆𝐶 = 𝐶𝑚. ∆𝑌𝑑 = −𝐶𝑚. ∆𝑇
• In order to keep Ye = Yp, the decrease of C = the increase of G
∆𝐺
=> ∆𝐶 = −∆𝐺  −𝐶𝑚. ∆𝑇 = −∆𝐺 => ∆𝑇 =
𝐶𝑚

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Fiscal Policy and Aggregate Demand

• Fiscal policy: the setting of the level of govt spending and taxation by
govt policymakers
• Expansionary fiscal policy
• an increase in G and/or decrease in T
• shifts AD right
• Contractionary fiscal policy
• a decrease in G and/or increase in T
• shifts AD left
• Fiscal policy has two effects on AD...

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The Multiplier Effect

• If the govt buys $20b of planes from Boeing, Boeing’s
revenue increases by $20b.
• This is distributed to Boeing’s workers (as wages) and
owners (as profits or stock dividends).
• These people are also consumers and will spend a
portion of the extra income.
• This extra consumption causes further increases in
aggregate demand.
Multiplier effect: the additional shifts in AD
that result when fiscal policy increases income
and thereby increases consumer spending
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The Multiplier Effect

A $20b increase in G P
initially shifts AD
to the right by $20b.
The increase in Y AD2 AD3
AD1
causes C to rise, which
shifts AD further to the
P1
right.
$20 billion

Y1 Y2 Y3 Y

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Marginal Propensity to Consume

• How big is the multiplier effect?
It depends on how much consumers respond to increases in income.
• Marginal propensity to consume (MPC):
the fraction of extra income that households consume rather than
save
E.g., if MPC = 0.8 and income rises $100,
C rises $80.

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A Formula for the Multiplier

Notation: G is the change in G,
Y and C are the ultimate changes in Y and C
Y = C + I + G + NX identity
Y = C + G I and NX do not change
Y = MPC Y + G because C = MPC Y

1 solved for Y
Y = G
1 – MPC

The multiplier

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A Formula for the Multiplier

The size of the multiplier depends on MPC.

E.g., if MPC = 0.5 multiplier = 2
if MPC = 0.75 multiplier = 4
if MPC = 0.9 multiplier = 10
A bigger MPC means
1 changes in Y cause
Y = G
1 – MPC bigger changes in C,
which in turn cause
The multiplier more changes in Y.

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Other Applications of the Multiplier Effect

• The multiplier effect:

Each $1 increase in G can generate
more than a $1 increase in agg demand.
• Also true for the other components of GDP.
Example: Suppose a recession overseas reduces demand for U.S. net
exports by $10b.
Initially, agg demand falls by $10b.
The fall in Y causes C to fall, which further reduces agg demand and
income.

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The Crowding-Out Effect

• Fiscal policy has another effect on AD
that works in the opposite direction.
• A fiscal expansion raises r,
which reduces investment,
which reduces the net increase in agg demand.
• So, the size of the AD shift may be smaller than the initial fiscal
expansion.
• This is called the crowding-out effect.

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How the Crowding-Out Effect Works

A $20b increase in G initially shifts AD right by $20b
Interest P
rate MS

AD2
r2 AD1 AD3

P1
r1
MD2 $20 billion

MD1
M Y1 Y3 Y2 Y

But higher Y increases MD and r, which reduces AD.

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Changes in Taxes
• A tax cut increases households’ take-home pay.
• Households respond by spending a portion of this extra income, shifting
AD to the right.
• The size of the shift is affected by the multiplier and crowding-out
effects.
• Another factor: whether households perceive the tax cut to be
temporary or permanent.
• A permanent tax cut causes a bigger increase in C – and a bigger shift in the
AD curve –
than a temporary tax cut.

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ACTIVE LEARNING 3
Exercise
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = 0.8 and there is no crowding out,
how much should Congress increase G
to end the recession?
B. If there is crowding out, will Congress need to
increase G more or less than this amount?

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ACTIVE LEARNING 3
Answers
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = .08 and there is no crowding out,
how much should Congress increase G
to end the recession?
Multiplier = 1/(1 – .8) = 5
Increase G by $40b
to shift agg demand by 5 x $40b = $200b.

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ACTIVE LEARNING 3
Answers
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
B. If there is crowding out, will Congress need to
increase G more or less than this amount?
Crowding out reduces the impact of G on AD.
To offset this, Congress should increase G by
a larger amount.

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ACTIVE LEARNING 1
The initial information of an economy is given as below:

Y1 = 1000; Yp = 1180; MPC= 0,75; multiplier k = 3.

How does the government do with fiscal policy?

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MULTIPLE CHOICE

1. If the government wants to expand aggregate demand, it can _________ government

purchases or _________ taxes.

a. increase; increase

b. increase; decrease
c. decrease; increase

d. decrease; decrease

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4.2. AUTOMATIC FISCAL POLICY (AUTOMATIC STABILIZERS)

• Automatic stabilizers are the factors that themself decrease fluctuations of the
business cycle.
• Progressive income tax, unemployment insurance benefits,… are automatic
stabilizers

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4.2. AUTOMATIC FISCAL POLICY (AUTOMATIC

STABILIZERS)

• Ex: Unemployment Insurance Benefits

• Recession=> unemployment rises=> Unemployment Insurance Benefits
rises => Tr rises = > T falls => Yd rises => C rises
=> Decreasing the recession

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Using Policy to Stabilize the Economy

• Since the Employment Act of 1946, economic stabilization has been a

goal of U.S. policy.
• Economists debate how active a role the govt should take to stabilize
the economy.

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The Case for Active Stabilization Policy

• Keynes: “Animal spirits” cause waves of pessimism and optimism

among households and firms, leading to shifts in aggregate demand
and fluctuations in output and employment.
• Also, other factors cause fluctuations, e.g.,
• booms and recessions abroad
• stock market booms and crashes
• If policymakers do nothing, these fluctuations are destabilizing to
businesses, workers, consumers.

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The Case for Active Stabilization Policy

• Proponents of active stabilization policy

believe the govt should use policy
to reduce these fluctuations:
• When GDP falls below its natural rate,
use expansionary monetary or fiscal policy
to prevent or reduce a recession.
• When GDP rises above its natural rate,
use contractionary policy to prevent or reduce an inflationary boom.

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Keynesians in the White House

1961:
John F Kennedy pushed for a
tax cut to stimulate agg demand.
Several of his economic advisors
were followers of Keynes.

2001:
George W Bush pushed for a
tax cut that helped the economy
recover from a recession that
had just begun.

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The Case Against Active Stabilization Policy

• Monetary policy affects economy with a long lag:

• Firms make investment plans in advance,
so I takes time to respond to changes in r.
• Most economists believe it takes at least
6 months for mon policy to affect output and employment.
• Fiscal policy also works with a long lag:
• Changes in G and T require Acts of Congress.
• The legislative process can take months or years.

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The Case Against Active Stabilization Policy

• Due to these long lags, critics of active policy argue that such policies
may destabilize the economy rather than help it:
By the time the policies affect agg demand,
the economy’s condition may have changed.
• These critics contend that policymakers should focus on long-run
goals like economic growth and low inflation.

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Automatic Stabilizers
• Automatic stabilizers:
changes in fiscal policy that stimulate
agg demand when economy goes into recession,
without policymakers having to take any deliberate
action

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Automatic Stabilizers: Examples

• The tax system
• In recession, taxes fall automatically,
which stimulates agg demand.
• Govt spending
• In recession, more people apply for public assistance (welfare, unemployment
insurance).
• Govt spending on these programs automatically rises, which stimulates agg
demand.

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MULTIPLE CHOICE
2. Which of the following is an example of an automatic stabilizer? When the economy
goes into a recession,
a. more people become eligible for unemployment insurance benefits.
b. stock prices decline, particularly for firms in cyclical industries.
c. Congress begins hearings about a possible stimulus package.
d. the Fed changes its target for the federal funds rate.

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MULTIPLE CHOICE

3. If actual output is 100 and potential output is 150, the government should

a. Increase budget expenditures and reduce tax revenues

b. Reduce budget expenditures and reduce tax revenues

c. Increase budget spending and increase tax revenue

d. Reduce budget spending and increase tax revenue.

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MULTIPLE CHOICE

4. Which of the following is considered an automatic stabilizer of the economy:

a. Exports

b. Progressive income taxes and subsidies

c. Investment

d. Cumulative income taxes

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Fiscal Policy and Aggregate Supply

• Most economists believe the short-run effects of
fiscal policy mainly work through agg demand.
• But fiscal policy might also affect agg supply.
• Recall one of the Ten Principles from Chap 1:
People respond to incentives.
• A cut in the tax rate gives workers incentive to work
more, so it might increase the quantity of g&s
supplied and shift AS to the right.
• People who believe this effect is large are called
“Supply-siders.”

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Fiscal Policy and Aggregate Supply

• Govt purchases might affect agg supply. Example:
• Govt increases spending on roads.
• Better roads may increase business productivity, which increases
the quantity of g&s supplied, shifts AS to the right.
• This effect is probably more relevant in the long run: it takes
time to build the new roads and put them into use.

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4.3. FOREIGN TRADE POLICY

=> Aim to increase exports and restrict imports

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4.3. FOREIGN TRADE POLICY

POLICY OF INCREASING EXPORTS (∆𝑿)
Type equation here. 𝐴𝐷
𝐴𝐷2

• Affecting national output 𝐴𝐷1

: ∆𝐴𝐷0𝑋 = ∆𝑋
 ∆𝑌 = 𝑘. ∆𝐴𝐷0𝑋 = 𝑘. ∆𝑋
• Affecting foreign trade
X rises => Y rises => M rises
𝑴 = 𝑴𝒐 + 𝑴𝒎. 𝒀
Y rise => ∆𝑀 = 𝑀𝑚. ∆𝑌 = 𝑀𝑚. 𝑘. ∆𝑋 ∆𝑌
3 cases: 450
𝑌1 𝑌2
𝑌
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4.3. FOREIGN TRADE POLICY

POLICY OF INCREASING EXPORTS (∆𝑿)
M
X, M
𝑋2
• Case 1: 𝑀𝑚. 𝑘 < 1∆𝑀 < ∆𝑋
𝑋1
Propensity to be surplus
Y
𝑌1 𝑌2
AD 𝐴𝐷2 • Case 2: 𝑀𝑚. 𝑘 > 1∆𝑀 > ∆𝑋

𝐴𝐷1
Propensity to be deficit
• Case 3: 𝑀𝑚. 𝑘 = 1∆𝑀 = ∆𝑋
Trade unchanged

∆𝒀
450
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𝑌1 𝑌2 Y

ACTIVE LEARNING 2

THE FUNCTIONS ARE GIVEN AS BELOW:

• 𝐶 = 100 + 0,75𝑌𝑑 𝐼 = 50 + 0,05𝑌 𝐺 = 300
• 𝑇 = 40 + 0,2𝑌 𝑀 = 70 + 0,15𝑌 𝑋 = 150
a. Compute the equilibrium output.
b. Give comments on the trade at the equilibrium output.
c. Supposed that exports increase by 100, Give comments on the
trade after this change

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4.3. FOREIGN TRADE POLICY

POLICY OF IMPORT RESTRICTION (∆M)

• Import restriction aims to improve the foreign trade.

• Import restriction used by: tax, quota, currency depreciation,…

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4.3. FOREIGN TRADE POLICY

POLICY OF IMPORT RESTRICTION (∆M)
• Affecting Y
∆𝑌 = 𝑘. ∆𝐴𝐷0 = 𝑘. −∆𝑀 > 0

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ACTIVE LEARNING 3

The functions of economy’s components are given as below:

𝐶 = 70 + 0.75𝑌𝑑 𝐼 = 100 + 0.2𝑌 𝐺 = 320
𝑋 = 500 𝑀 = 350 + 0.25𝑌 T = 200 + 0,1Y
a. Compute the equilibrium output
b. Supposed that export rises by 20, investment rises by 10 and consumption
rises by 50. Compute the new equilibrium output.

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EXERCISE 1
1. The functions of economy’s components are given as below :
C = 0.8Yd + 1,000 T = 0.25Y + 500 G = 1,500
M = 0.1Y + 1,000 X = 400 I = 500
a. Compute the eq’m output. How is the govt budget?
b. Use the multiplier to compute the new eq’m output when the govt rises by
100. Do you have any comments on the govt budget?
c. If the govt doesn’t change G, how much T will be decreased to achieve the
same level output in question (b).
d. From the question (a), If the govt increases T and G each by 100 how much
will the eq’m output change?
e. Which kind of the above fiscal policies you support most? Why?
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EXERCISE 2
2. The functions of economy’s components are given as below : (Unit:
billion USD)
C = 100 + 0.8Yd I = 300 G = 250
X = 300 M = 50 + 0.12Y T = 0.1Y Yp = 2500
a. Compute the eq’m output
b. Give comments on the govt budget and trade surplus at the eq’m
output.
c. Supposed that export rises by 20, will the trade balanced?
d. In order that Yt = Yp, which kind of fiscal policy will be used? Quantify
the fiscal policy in this situation (3 cases).
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CONCLUSION

• Policymakers need to consider all the effects of their

actions. For example,
• When Congress cuts taxes, it should consider the short-run
effects on agg demand and employment, and the long-run
effects
on saving and growth.
• When the Fed reduces the rate of money growth, it must
take into account not only the long-run effects on inflation
but the short-run effects on output and employment.

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CHAPTER SUMMARY

• In the theory of liquidity preference,

the interest rate adjusts to balance
the demand for money with the supply of money.
• The interest-rate effect helps explain why the aggregate-
demand curve slopes downward:
an increase in the price level raises money demand,
which raises the interest rate, which reduces investment,
which reduces the aggregate quantity of goods &
services demanded.

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CHAPTER SUMMARY

• An increase in the money supply causes the interest rate

to fall, which stimulates investment and shifts the
aggregate demand curve rightward.
• Expansionary fiscal policy – a spending increase or tax
cut – shifts aggregate demand to the right.
Contractionary fiscal policy shifts aggregate demand to
the left.

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CHAPTER SUMMARY

• When the government alters spending or taxes, the

resulting shift in aggregate demand can be larger or
smaller than the fiscal change:
• The multiplier effect tends to amplify the effects of fiscal
policy on aggregate demand.
• The crowding-out effect tends to dampen the effects of
fiscal policy on aggregate demand.

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CHAPTER SUMMARY

• Economists disagree about how actively policymakers

should try to stabilize the economy.
• Some argue that the government should use
fiscal and monetary policy to combat destabilizing
fluctuations in output and employment.
• Others argue that policy will end up destabilizing the
economy because policies work with long lags.

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