MODULE 30 (66) Fiscal Policy: the Basics

What You Will Learn Why fiscal policy is an important tool for managing economic fluctuations Which policies constitute expansionary fiscal policy and which constitute contractionary fiscal policy 1 2

Government Spending and Tax Revenue for Some High-Income Countries in 2007 Figure Caption: Figure 30-1 (66-1): Government Spending and Tax Revenue for Some High-Income Countries in 2007 We focus on 2007 because it was a “normal” year, not a year of deep economic slump. Government spending and tax revenue are represented as a percentage of GDP. Sweden has a particularly large government sector, representing more than half of its GDP. The U.S. government sector, although sizable, is smaller than those of Canada and most European countries. Source: OECD.

Taxes, Government Purchases of Goods and Services, Transfers, and Borrowing Funds flow into the government in the form of taxes and government borrowing Funds flow out of the government in the form or government purchases of goods and services and government transfers to households

Sources of Tax Revenue in the U.S., 2007 Figure Caption: Figure 30-2 (66-2): Sources of Tax Revenue in the United States, 2007 Personal income taxes, taxes on corporate profits, and social insurance taxes account for most government tax revenue. The rest is a mix of property taxes, sales taxes, and other sources of revenue. Source: Bureau of Economic Analysis.

Government Spending in the U.S., 2008 Figure Caption: Figure 30-3 (66-3): Government Spending in the United States, 2007 The two types of government spending are purchases of goods and services and government transfers. The big items in government purchases are national defense and education. The big items in government transfers are Social Security and the Medicare and Medicaid health care programs. (Numbers do not add to 100% due to rounding.) Source: Bureau of Economic Analysis. 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 transfers, or government purchases of goods and services to shift the aggregate demand curve. Notes to the Instructor: The two types of government spending are purchases of goods and services and government transfers. The big items in government purchases are national defense and education. The big items in government transfers are Social Security and health care programs.

Expansionary and Contractionary Fiscal Policy Expansionary fiscal policy increases aggregate demand and can take one of three forms: an increase in government purchases of goods and services a cut in taxes an increase in government transfers Contractionary fiscal policy reduces aggregate demand and can take one of three forms: a reduction in government purchases of goods and services an increase in taxes a reduction in government transfers

Expansionary and Contractionary Fiscal Policy Expansionary Fiscal Policy Can Close a Recessionary Gap Expansionary fiscal policy increases aggregate demand. Figure Caption: Figure 20.4: Expansionary Fiscal Policy Can Close a Recessionary Gap At E1 the economy is in short-run equilibrium where the aggregate demand curve AD1 intersects the SRAS curve. At E1, there is a recessionary gap of YE − Y1. An expansionary fiscal policy—an increase in government purchases, a reduction in taxes, or an increase in government transfers—shifts the aggregate demand curve rightward. It can close the recessionary gap by shifting AD1 to AD2, moving the economy to a new short-run equilibrium, E2, which is also a long-run equilibrium. Recessionary gap 9 of 17

Expansionary and Contractionary Fiscal Policy Contractionary Fiscal Policy Can Eliminate an Inflationary Gap Contractionary fiscal policy reduces aggregate demand. Figure Caption: Figure 20.5: Contractionary Fiscal Policy Can Eliminate an Inflationary Gap At E1 the economy is in short-run equilibrium where the aggregate demand curve AD1 intersects the SRAS curve. At E1, there is an inflationary gap of Y1 − YE . A contractionary fiscal policy—reduced government purchases, an increase in taxes, or a reduction in government transfers—shifts the aggregate demand curve leftward. It can close the inflationary gap by shifting AD1 to AD2, moving the economy to a new short-run equilibrium, E2, which is also a long-run equilibrium. Inflationary gap 10 of 17

Can Expansionary Fiscal Policy Actually Work? There are three arguments against the use of expansionary fiscal policy: Government spending always crowds out private spending Government borrowing always crowds out private investment spending Government budget deficits lead to reduced private spending

A Cautionary Note: Lags in Fiscal Policy In the case of fiscal policy, there is an important reason for caution: there are significant lags in its use. Realize the recessionary/inflationary gap by collecting and analyzing economic data  takes time Government develops a spending plan takes time Implementation of the action plan (spending the money  takes time)

Economics in Action What was in the Recovery Act?

Summary Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve. Expansionary fiscal policy shifts the aggregate demand curve rightward. Contractionary fiscal policy shifts the aggregate demand curve leftward. There are three arguments against the use of expansionary fiscal policy: Government spending always crowds out private spending Government borrowing always crowds out private investment spending Government budget deficits lead to reduced private spending