Chapter 9 Fiscal Policy

CHAPTER OUTLINE Nondiscretionary And Discretionary Fiscal Policy Using Fiscal Policy To Counteract “Shocks” Evaluating Fiscal Policy Obama Stimulus Plan Kick It Up a Notch: Aggregate Supply Shocks

Fiscal Policy Fiscal Policy is the purposeful movement in government spending or tax policy designed to direct an economy Discretionary Fiscal Policy: government spending and tax changes enacted at the time of the problem to alter the economy Nondiscretionary Fiscal Policy: that set of policies that are built into the system to stabilize the economy

How Nondiscretionary Fiscal Policy Works Nondiscretionary fiscal policy consists of policies that are built into the system so that an expansionary or contractionary stimulus can be given automatically. The welfare state and the progressive income tax serve as the built-in policies. If the economy is in recession, those who lose their jobs are granted unemployment and welfare benefits and they owe less in taxes. If the economy is growing at an unsustainable rate, people are making a lot of money and are faced with higher tax rates and there are fewer people eligible for government benefits.

How Discretionary Fiscal Policy Works If we are in a recession the fiscal policy to stimulate the economy would consist of Increases in government spending Decreases in taxes If we are in an inflationary period the fiscal policy to contract the economy would consist of Decreases in government spending Increases in taxes

Expansionary Fiscal Policy AS AD RGDP PI RGDP* PI* AD’ RGDP’ PI’

Contractionary Fiscal Policy AS AD RGDP PI PI* RGDP* AD’ PI’ RGDP’

Shocks A Shock is any unanticipated economic event. Aggregate Demand Shock: an unexpected event which causes aggregate demand to increase or decrease, e.g. the Sept 11, 2001 terrorist attacks. Aggregate Supply Shock: an unexpected event which causes aggregate supply to increase or decrease, e.g. Iraq’s 1990 invasion of Kuwait and threat to Saudi Arabia.

Nondiscretionary and Discretionary Fiscal Policy Combats a Recession AS PI RGDP AD1 RGDP* PI* AD3 DFP NDFP AD2 Shock

Nondiscretionary and Discretionary Fiscal Policy Combats an Overheated Economy AS PI RGDP AD1 RGDP* PI* AD2 Shock AD3 NDFP DFP

Evaluating Nondiscretionary Fiscal Policy Most economists believe that the built-in stabilizers have had a modestly positive effect on diminishing the severity of modern recessions.

The Mistiming of Discretionary Fiscal Policy Recognition Lag: the time it takes to measure the state of the economy Administrative Lag: the time it takes for Congress to agree on a course of action with the president Operational Lag: the time it takes for the full impact of a government program or tax change to have its effect on the economy

Political Problems with Fiscal Policy Expansionary bias is the problem where politicians are more willing to deal with recessions with tax cuts and spending increases than they are to deal with inflationary pressures with tax increases and spending cuts. The Political Business Cycle suggests that politically motivated fiscal policy is used for short term gain just prior to elections

The Rise, Fall and Rebirth of Discretionary Fiscal Policy Between 1975 and 2001 fiscal policy was pretty much abandoned as a mechanism for controlling the economy. Monetary policy was used to expand or contract prices and GDP. In 2001, the impending recession motivated tax rebates and the Sept. 11 attacks motivated a variety of tax cut and spending increase ideas in Congress. In 2003, the continuing slow growth motivated a renewal of the tax credit rebate idea.

Growth Rates by Presidential Terms First Second Third Fourth Truman -0.5% 8.7% 7.7% 3.8% Eisenhower I 4.6% -0.7% 7.1% 1.9% Eisenhower II 2.0% -1.0% 2.5% Kennedy/Johnson 2.3% 6.1% 4.4% 5.8% Johnson 6.4% 6.5% 4.8% Nixon I 3.1% 0.2% 3.4% 5.3% Nixon II/ Ford -0.2% Carter 5.6% 3.2% Reagan I -1.9% 4.5% 7.2% Reagan II 4.1% 3.5% Bush GHW 3.6% Clinton I 2.9% 3.7% Clinton II Bush GW I 1.1% 1.8% Bush GW II 2.7% -0.3% Obama -3.1% 2.4% 2.2% Average

Obama Stimulus Plan Amount in Millions Stimulus Plan Element $135,832 Non-Discretionary Fiscal Policy: Unemployment, Welfare, Medicaid $135,832 Aid to States $53,600 Discretionary Fiscal Policy: Tax Cuts $301,135 Discretionary Fiscal Policy: Spending Increases $300,047

Did the Obama Stimulus Work? Counterfactual required to answer Counterfactual: What would have happened had the policy not been pursued. Evidence is mixed Some studies show “Significantly positive” impact Others show “Mostly Positive” or “Mildly Positive” impact Still others show “no impact”

Aggregate Supply Shocks Kick it Up a Notch Aggregate Supply Shocks

Nondiscretionary and Discretionary Fiscal in the Wake of a Negative Aggregate Supply Shock AS2 AS1 PI RGDP AD1 RGDP* PI* AD3 DFP AD2 NDFP

Nondiscretionary and Discretionary Fiscal in the Wake of a Positive Aggregate Supply Shock AS1 PI RGDP AD1 RGDP* PI* Shock AS2 AD2 NDFP