Fiscal Policy

The use of government spending and/or taxing to alter Aggregate

Demand.

Fiscal Policy

• The Employment Act of 1946 committed the federal government to maintaining economic stability.

• The federal government must constantly monitor and analyze economic activity and act to maintain a non-inflationary growing economy through spending or taxing legislation.

Expansionary Fiscal Policy

• The Problem – the economy is below full-employment; in a recession

• The Solution - Expansionary fiscal policy – increase government spending (G )– reduce taxes (C )– enact both spending increases and tax cuts

• The Result– G or C or both increase causing AD to increase,

which causes output and employment to rise.– Creates a budget deficit

To Tax or Spend?

• Changing government spending is always more expansionary or contractionary than changing taxes. Why?– Part of any change in taxes comes from or

goes into savings.

Contractionary Fiscal Policy

• The Problem - the economy is past full-employment; it is experiencing inflation

• The Solution - Contractionary fiscal policy – reduce government spending (G )– increase taxes (C )– enact both spending cuts and tax increases

• The Result– G or C or both decrease causing AD to decrease,

which lowers price levels.– Creates a budget surplus

Discretionary versus Automatic Fiscal Policy

• If government has to pass a law or take some other specific action to change its tax and/or spending policies then government is stabilizing the economy through discretionary policy.

Discretionary versus Automatic Fiscal Policy

• If the policy change happens by itself as the economic situation changes, then it is known as an automatic stabilizer or a built-in stabilizer.

• Examples of automatic stabilizers are unemployment compensation during recessions and higher taxes during inflationary/expansionary periods.

Discretionary versus Automatic Fiscal Policy

• There is a direct relationship between GDP and net taxes.– Net taxes are taxes less transfer payments

(unemployment compensation, food stamps, TANF)

• As GDP rises our progressive tax system collects a greater percentage of income in taxes and vice versa.

• As GDP rises the need for transfer payments decreases and vice versa.

Problems and Complications of Fiscal Policy

• Problems of timing– recognition lag – time it takes to gather data

on economic activity– administrative lag – time it takes for

government (Congress) to pass legislation– operational lag – time it takes for money to

enter economy and take effect

Problems and Complications of Fiscal Policy

• Complications– Crowding Out

• Expansionary fiscal policy (deficit spending) will increase the interest rate and reduce consumer and business spending, thereby weakening or canceling the stimulus of expansionary policy.

Crowding Out Effect

• Interest rates (i) :. Investment (I) and Consumption (C) :. AD :.

output and employment

The Crowding Out Effect

Price Level

PL2

Q2Q3Q1

Real Interest

PL3

PL1

AS

AD1 AD3AD2

i1

i2

Q of LoansRGDP

i2

Q1Q2Q1

i1

Q2

Real Interest

Q of Investment

s

D1

D2

Id

Graph 1: At AD1 we are in a recession. Government cuts Taxes and increases Spending to move the economy to AD2.

Graph 2: Because the government is now deficit spending the demand for loanable funds increases causing interest rates to rise.

Graph 3: This increase in interest rates decreases Investment spending which causes AD to fall back to AD3 (Graph1 again).

AD/AS Investment Demand

Loanable Funds Mkt

Problems and Complications of Fiscal Policy

– Modifications of crowding out• If increased government spending raises

business profits expectations, the investment demand curve shifts right and there is little overall impact on investment spending.

• Also if the Federal Reserve accommodates fiscal policy by increasing the money supply, interest rates will not change.

Problems and Complications of Fiscal Policy

• Net Export Effect– As interest rates increase the

consequential change in the value of the dollar leads to a decrease in Net Exports

– NX :. AD :. output and employment

The Net Export Effect

Price Level

PL2

Q2Q3Q1

Real Interest

PL3

PL1

AS

AD1 AD3AD2

i1

i2

Q of LoansRGDP

e2

Q1 Q2Q1

e1

Q2

Price of USD

Q of USD

s

D1

D2

D

Graph 1: At AD1 we are in a recession. Government cuts Taxes and increases Spending to move the economy to AD2.

Graph 2: Because the government is now deficit spending the demand for loanable funds increases causing interest rates to rise.

Graph 3: This increase in interest rates Increases demand for the USD in the currency exchange markets causing the dollar to appreciate. The price of our goods in the international markets rise leading to a decrease in Exports and an

increase in Imports. Net exports decrease causing AD to decrease (AD3) on graph 1.

D2

sAD/AS

FEX MarketLoanable Funds Mkt

Problems and Complications of Fiscal Policy

• Political problems– State and local policy restraints

• Fiscal policy at lower levels tends to be pro-cyclical.

• In times of recessions because of constitutional or legislative restraints they may have to increase taxes and reduce spending.

Problems and Complications of Fiscal Policy

• Political problems– Other goals of Congress and

President• The need to provide public goods,

redistribute income, the elimination of budget deficits or war may make fiscal policy use untenable.

Problems and Complications of Fiscal Policy

• Political problems– Political business cycles

• Fiscal policy may be corrupted for political purposes and may cause economic fluctuations

To Tax or Spend

• Choosing between increasing spending or decreasing taxes; decreasing spending or increasing taxes is a political philosophy question.– Republicans prefer smaller government so

they would choose options that achieve that – tax cuts and reduced spending

– Democrats believe government has a vital role in the economy, so they would choose to increase taxes and increase spending

Financing Deficits

• Borrowing vs Creating New Money– Borrowing may drive up equilibrium interest

rates decreasing investment spending (Crowding Out Effect)

– Creating new money is the more expansionary

Disposing of Surpluses

• Debt Retirement vs Idle Surplus

• Debt retirement means paying back loans made to the government; money is put back into the economy causing more inflation

• Letting a surplus sit idle is more contractionary

If government spending exceeds government revenue (taxes) within one year it is called deficit spending

If government revenue exceeds government spending within one year it is called a budget surplus

Government Debt and Deficits

The Total Deficit or Surplus 1969 to 20162009 Projected deficit is $1.67 trillion.

The Federal Debt is the total of all budget deficits and budget surpluses in our history.

http://www.usdebtclock.org/