Fiscal Policy: The BasicsFiscal Policy: The Basics

12-112-1

How big is the Government?• To see how big of a role the government

plays in the economy we need to see what percentage of the GDP is represented by the government sector

• United States Government plays a smaller role compared to other countries

• But it still plays a big role!

Fiscal Policy: The Basics

Remember the Flow!• In Chapter 7 we saw the Circular-flow

with Government• Funds flow into the government in the

form of :– Taxes– Borrowing

• Funds flow out:– Spending (purchases)– Transfer payment

An Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

Sources of Tax Revenue in theUnited States, 2004

Government Spending in theUnited States, 2004

Social insurance programs are government programs intended to protect families against economic hardship.

The Government Budget and Total Spending• Fiscal policy is the use of taxes, government Fiscal policy is the use of taxes, government

transfers, or government purchases of goods transfers, or government purchases of goods and services to shift the aggregate demand and services to shift the aggregate demand curve.curve.

Change a Variable

Change a variable Change a variable Shift the CurveShift the Curve

Government Budget & Total Spending• Government directlydirectly controls one of the

variables in GDP

GDP = C + I + + X - IMGG

Consumer Spending and Taxes• Taxes affect Consumer spending

Disposable Income = Total Income + Transfer payment - Taxes

• A fall in the Disposable Income leads to a fall in ConsumptionConsumption

• An Increase in the Disposable Income leads to an increase in ConsumptioConsumption

Why?

• Why would the government want to shift the Aggregate demand curve?

Expansionary Fiscal PolicyExpansionary Fiscal Policy Can Close a Recessionary Gap

Expansionary fiscal policy increases aggregate demand.

Recessionary gap

Why?

• Why would the government want to shift the Aggregate demand curve inward and shrink everyone’s income?

Contractionary Fiscal PolicyContractionary Fiscal Policy Can Eliminate an Inflationary Gap

Contractionary fiscal policy decreases aggregate demand.

Inflationary gap

Lags in Fiscal PolicyLags in Fiscal PolicyIn the case of fiscal policy, there is an In the case of fiscal policy, there is an

important reason for caution: there are important reason for caution: there are significant significant lags lags in its use.in its use.Realize the recessionary/inflationary gap Realize the recessionary/inflationary gap

by collecting and analyzing economic by collecting and analyzing economic data data takes time takes time

Government develops an action planGovernment develops an action plan takes timetakes time

Implementation of the action plan Implementation of the action plan takes takes timetime