McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 09Fiscal Policy

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Chapter Outline

• Nondiscretionary And Discretionary Fiscal Policy

• Using Fiscal Policy To Counteract “Shocks”

• Evaluating Fiscal Policy• Obama Stimulus Plan• Kick It Up a Notch: Aggregate

Supply Shocks

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Fiscal Policy

• Fiscal Policy is the purposeful movement in government spending or tax policy designed to direct an economy

• Discretionary Fiscal Policy: government spending and tax changes enacted at the time of the problem to alter the economy

• Nondiscretionary Fiscal Policy: that set of policies that are built into the system to stabilize the economy

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How Nondiscretionary Fiscal Policy Works

• Nondiscretionary fiscal policy consists of policies that are built into the system so that an expansionary or contractionary stimulus can be given automatically.

• The welfare state and the progressive income tax serve as the built-in policies.• If the economy is in recession, those who lose

their jobs are granted unemployment and welfare benefits and they owe less in taxes.

• If the economy is growing at an unsustainable rate, people are making a lot of money and are faced with higher tax rates and there are fewer people eligible for government benefits.

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How Discretionary Fiscal Policy Works

• If we are in a recession the fiscal policy to stimulate the economy would consist of• Increases in government spending• Decreases in taxes

• If we are in an inflationary period the fiscal policy to contract the economy would consist of• Decreases in government spending• Increases in taxes

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Expansionary Fiscal Policy

AS

AD

RGDP

PI

RGDP*

PI*

AD’

RGDP’

PI’

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Contractionary Fiscal Policy

AS

AD

RGDP

PI

PI*

RGDP*

AD’

PI’

RGDP’

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Shocks

• A Shock is any unanticipated economic event.• Aggregate Demand Shock: an

unexpected event which causes aggregate demand to increase or decrease, e.g. the Sept 11, 2001 terrorist attacks.

• Aggregate Supply Shock: an unexpected event which causes aggregate supply to increase or decrease, e.g. Iraq’s 1990 invasion of Kuwait and threat to Saudi Arabia.

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Nondiscretionary and Discretionary Fiscal Policy Combats a Recession

ASPI

RGDP

AD1

RGDP*

PI*

AD2

Shock

AD3 DFP

NDFP

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Nondiscretionary and Discretionary Fiscal Policy Combats an Overheated

EconomyAS

PI

RGDP

AD1

RGDP*

PI*AD2

Shock

AD3

NDFP

DFP

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Evaluating Nondiscretionary Fiscal Policy

• Most economists believe that the built-in stabilizers have had a modestly positive effect on diminishing the severity of modern recessions.

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The Mistiming of Discretionary Fiscal Policy

• Recognition Lag: the time it takes to measure the state of the economy

• Administrative Lag: the time it takes for Congress to agree on a course of action with the president

• Operational Lag: the time it takes for the full impact of a government program or tax change to have its effect on the economy

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Political Problems with Fiscal Policy

• Expansionary bias is the problem where politicians are more willing to deal with recessions with tax cuts and spending increases than they are to deal with inflationary pressures with tax increases and spending cuts.

• The Political Business Cycle suggests that politically motivated fiscal policy is used for short term gain just prior to elections.

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The Rise, Fall and Rebirth of Discretionary Fiscal Policy

• Between 1975 and 2001 fiscal policy was pretty much abandoned as a mechanism for controlling the economy.

• Monetary policy was used to expand or contract prices and GDP.

• In 2001, the impending recession motivated tax rebates and the Sept. 11 attacks motivated a variety of tax cut and spending increase ideas in Congress.

• In 2003, the continuing slow growth motivated a renewal of the tax credit rebate idea.

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Growth Rates by Presidential Terms First Second Third Fourth

Truman -0.5% 8.7% 7.7% 3.8%

Eisenhower I 4.6% -0.7% 7.1% 1.9%

Eisenhower II 2.0% -1.0% 7.1% 2.5%

Kennedy/Johnson 2.3% 6.1% 4.4% 5.8%

Johnson 6.4% 6.5% 2.5% 4.8%

Nixon I 3.1% 0.2% 3.4% 5.3%

Nixon II/ Ford 5.8% -0.5% -0.2% 5.3%

Carter 4.6% 5.6% 3.2% 0.2%

Reagan I 2.5% -1.9% 4.5% 7.2%

Reagan II 4.1% 3.5% 3.4% 4.1%

Bush GHW 3.5% 1.9% -0.2% 3.3%

Clinton I 2.7% 4.0% 2.5% 3.7%

Clinton II 4.5% 4.2% 4.4% 3.7%

Bush GW I 0.8% 1.9% 3.0% 4.0%

Bush GW II 3.2% 3.3% 2.2% -2.8%

Obama 0.2% 2.8%

Average 3.1% 2.8% 3.7% 3.5%

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The 2003 Rebate

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Obama Stimulus Plan

Stimulus Plan Element

Amount in

MillionsNon-Discretionary Fiscal Policy: Unemployment, Welfare, Medicaid $135,832

Aid to States $53,600

Discretionary Fiscal Policy: Tax Cuts $301,135 Discretionary Fiscal Policy: Spending Increases $300,047

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Kick it Up a Notch

Aggregate Supply Shocks

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Nondiscretionary and Discretionary Fiscal in the Wake of a Negative Aggregate Supply

Shock

AS1PI

RGDP

AD1

RGDP*

PI*

Shock

AS2

AD2

NDFP

AD3

DFP

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AS1PI

RGDP

AD1

RGDP*

PI*

Nondiscretionary and Discretionary Fiscal in the Wake of a Positive Aggregate Supply

Shock

Shock AS2

AD2

NDFP