FISCALPOLICY

Definition of Fiscal Policy

a government

policy for dealing

with the budget

(especially with

taxation and

borrowing)

FISCAL POLICY AND THE AD-AS MODEL

Two Options• Discretionary Fiscal Policy • Non-Discretionary Fiscal

PolicyExpansionary Fiscal PolicyTo Reduce Unemployment…• Increase Government

Spending• Tax Reductions• Combinations of the Two

Pri

ce le

vel

Real GDP (billions)

EXPANSIONARY FISCAL POLICY

Full $20 billionincrease in aggregatedemand

AD2 AD1

$5 billion initialincrease in spending

the multiplier at work...

P1

$490 $510

AS

To Reduce Inflation…• Decrease Government

Spending• Tax Increases• Combinations of the

Two

FISCAL POLICY AND THE AD-AS MODEL

Contractionary Fiscal Policy

Pri

ce le

vel

Real GDP (billions)

CONTRACTIONARY FISCAL POLICY

Full $20 billiondecrease in aggregatedemand

AD3 AD4

$5 billion initialdecrease in spending

the multiplier at work...

P2

$510 $522

AS

P1

FINANCING OF DEFICITS ANDDISPOSING OF SURPLUSES

•Borrowing vs. New Money•Borrowing From The Public•Money Creation

•Debt Retirement vs. Idle Surplus•Debt Reduction•Impounding

Which Policy Option? G or T?

BUILT-IN STABILITYNet tax revenues vary

directly with GDPTransfer payments behave

the opposite way as tax collections

Automatic or Built-In Stabilizers

Economic Importance

BUILT-IN STABILITY

GDP1 GDP2 GDP3

Real Domestic Output, GDP

Gov

ern

men

t E

xpen

dit

ure

s,G

, an

d T

ax R

even

ues

, T

Deficit

Surplus

T

G

BUILT-IN STABILITY

Tax Progressivity• Progressive Tax System• Proportional Tax System• Regressive Tax System

The more progressive the tax system, the greater the economy’s built-in stability.

FULL-EMPLOYMENT DEFICITS

GDP2 GDP1

Real Domestic Output, GDP

Gov

ernm

ent

Exp

endi

ture

s,G

, and

Tax

Rev

enue

s, T

(bi

llio

ns)

G

T1

(Year 1)(Year 2)

ab

c$500 475 450 425

No Change inFiscal Policy

FULL-EMPLOYMENT DEFICITS

GDP4 GDP3

Real Domestic Output, GDP

Gov

ernm

ent

Exp

endi

ture

s,G

, and

Tax

Rev

enue

s, T

(bi

llio

ns) T2

G

T1

Year 3Year 4

de

f$500 475 450 425

DiscretionaryFiscal PolicyTax Decrease

h

g

EVALUATING FISCAL POLICYFull-Employment BudgetCyclical DeficitRecent U.S. Deficits & Surpluses

Year

ActualDeficit orSurplus

Full-EmploymentDeficit orSurplus

1990199119921993199419951996199719981999200020012002

-3.9%-4.5%-4.7%-3.9%-2.9%-2.2%-1.4%-0.3%+0.8%+1.4%+2.4%+1.3%-1.5%

-2.1%-2.4%-2.9%-2.8%-2.1%-2.0%-1.3%-0.9%-0.4%+0.3%+1.1%+0.8%-1.5%

-6 -4 -2 0 2 4

Italy

Sweden

Canada

United Kingdom

France

United States

Ireland

Norway

Japan

GLOBAL PERSPECTIVEBUDGET DEFICITS OR SURPLUSESAS A PERCENTAGE OF GDP, 2002

Source: Organization for Economic Development and Cooperation

PROBLEMS, CRITICISMS,AND COMPLICATIONS

•Problems of Timing•Recognition Lag•Administrative Lag•Operational Lag

•Political Considerations•Political Business Cycles

•Offsetting State & Local Finance•Crowding-Out Effect

FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION

Fiscal Policy:No Complications

Pri

ce le

vel

Real GDP (billions)

AD1 AD2

P1

$490 $510

AS

FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION

Fiscal Policy:ShowingCrowding-out Effector Net ExportEffectP

rice

leve

l

Real GDP (billions)

AD1 AD2

P1

$490 $510

AS

AD’2

$504

FISCAL POLICY IN THEOPEN ECONOMY

Shocks Originating from Abroad

Net Export Effect

Forecasting the FutureThe Leading Indicators• Average Workweek• Initial Claims for Unemployment

Insurance• New Orders for Consumer Goods• Vendor Performance• New Orders for Capital Goods• Building Permits for Houses• Stock Prices• Money Supply• Interest-Rate Spread• Consumer Expectations