10 Fiscal Policy

THE ROLE OF FISCAL POLICY fiscal policy Changes in government taxes and spending that affect the level of GDP. expansionary policies Government policy actions that lead to increases in aggregate demand. Examples: contractionary policies Government policy actions that lead to decreases in aggregate demand. Examples:

THE MULTIPLIERS Spending Multiplier The ratio of the total shift in aggregate demand to the initial shift in aggregate demand based on a change in the level of spending. spending multiplier Tax Multiplier The ratio of the total shift in aggregate demand to the initial shift in aggregate demand based on a change in the level of taxes.

THE ROLE OF FISCAL POLICY Fiscal Policy and its impact on Aggregate Demand

THE ROLE OF FISCAL POLICY Fiscal Policy and its impact on Aggregate Demand

THE ROLE OF FISCAL POLICY The Limits to Stabilization Policy stabilization policies Policy actions taken to move the economy closer to full employment or potential output.  Possible Pitfalls in Stabilization Policy LAGS

THE ROLE OF FISCAL POLICY The Limits to Stabilization Policy inside lags The time it takes to formulate a policy. outside lags The time it takes for the policy to actually work. LAGS FORECASTING UNCERTAINTIES

THE FEDERAL BUDGET Federal Spending discretionary spending The spending programs that Congress authorizes on an annual basis. entitlement and mandatory spending Spending that Congress has authorized by prior law, primarily providing support for individuals.

THE FEDERAL BUDGET The Federal Deficit and Fiscal Policy budget deficit The amount by which government spending exceeds revenues in a given year. budget surplus The amount by which government revenues exceed government expenditures in a given year.

THE FEDERAL BUDGET Automatic Stabilizers automatic stabilizers Taxes and transfer payments that stabilize GDP without requiring policy makers to take explicit action. The increased federal budget deficit works through three channels: 1 Increased transfer payments such as unemployment insurance, food stamps, and other welfare payments increase the income of some households, partly offsetting the fall in household income. 2 Other households whose incomes are falling pay less in taxes, which partly offsets the decline in their household income. Because incomes do not fall as much as they would have in the absence of the deficit, consumption spending does not decline as much. 3 Because the corporation tax depends on corporate profits and profits fall in a recession, taxes also fall on businesses. Lower corporate taxes help to prevent businesses from cutting spending as much as they would otherwise during a recession. permanent income An estimate of a household’s long-run average level of income.

FISCAL POLICY IN U.S. HISTORY The Depression Era The Kennedy Administration The Vietnam War Era The Reagan Administration