FISCAL POLICYNOT “PHYSICAL” POLICY

DISCRETIONARY FISCAL POLICY Fiscal Policy: Using Government Spending (G) and/or Taxes (T) to

fine-tune the macroeconomy.

Goals (“Countercyclical”): To reduce unemployment during recessions,

or to reduce inflation during periods of over-expansion.

Which part of the national government has the power to tax and spend? Congress (see Article I, Section 8, Clause I)

“The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States…”

“Discretionary”: Congress must act (pass a law) for the change to occur.

THE BUDGET

The Tools of Fiscal Policy

Government Spending (G)

Taxes (T): “tax revenues”

G = T “Balanced Budget”

G > T “Budget Deficit”

G < T “Budget Surplus”

(Don’t confuse these with Trade Surpluses/Deficits later in the course.)

EXPANSIONARY FISCAL POLICY (“FISCAL STIMULUS”)

Appropriate during recessions Goal: to address/fix unemployment

Let’s illustrate on the board, and include the effects on: AD

Equilibrium PL and GDP (so inflation and unemployment)

The Budget

What about the Spending Multiplier?

AN EXAMPLE FROM MY TRIP TO MONTANA

CONTRACTIONARY FISCAL POLICY (“FISCAL TIGHTENING” OR “FISCAL AUSTERITY”)

Appropriate during over-expansion Goal: to address/fix inflation

Let’s illustrate on the board, and include the effects on: AD Equilibrium PL and GDP (so inflation and unemployment) The Budget What about the Spending Multiplier?

A SAMPLE TIMED WRITINGSuppose that in the US the unemployment rate is 3% and inflation is 12%.

a) Draw a properly labeled Aggregate Supply and Aggregate Demand model to illustrate this economy.

b) Explain how Congress could use government spending to address the problem identified above.

c) Explain how Congress could use taxation to address the problem identified above.

d) Show how these changes would affect equilibrium price level and equilibrium GDP.

e) How would this affect the budget?

HOW MUCH STRONGER IS “G” THAN “T”?THE BALANCED BUDGET MULTIPLIER

Suppose the MPC is 0.75 and the government increases spending on jet fighters by $800 B.

Show the total/final effect on GDP.

Now Congress decides to pay for the jets by increasing taxes by a lump sum of $800 B.

Show the total final effect on GDP.

What is the cumulative effect?

The “Balanced Budget Multiplier” is always Whether the changes in G and T are positive or negative.

= 1

BUILT-IN / PASSIVE / AUTOMATIC / NON-DISCRETIONARYFISCAL POLICY (“STABILIZERS”)

Changes in G or T that happen without deliberate action by Congress.

There are others, but let’s look at the Graduated Income Tax system and Transfers.

“WEAKENERS” OF FISCAL POLICY

Crowding Out: Government borrowing “crowds out” private investment

Reverse Crowding Out: the opposite Don’t call it “Crowding In”. That’s a different concept for another

class.

The Net Export Effect

Both of these are a little easier if you remember that they weaken the original purpose of fiscal policy.

SAMPLE PROBLEM

Suppose Congress borrows to finance a round of fiscal stimulus. How would this affect the international value of the dollar and net exports?

A.Weaker dollar; increase Xn

B.Weaker dollar; decrease Xn

C.Stronger dollar; increase Xn

D.Stronger dollar; decrease Xn

SUPPLY SIDE ECONOMICS

LOWER TAXES

Also called “Reaganomics”

Taxes are a disincentive to work, invest, and save,

so decreasing taxes should cause more work, investment, and saving. All of these increase the Aggregate Supply curve, in theory.

But:

Does it work?

If so, how long does it take?