Fiscal policy choices

Policy Choices Expansionary Fiscal Policy – to increase economic activity (lower unemployment) by any combination of tax cuts expenditure increases Contractionary Fiscal Policy – to reduce inflationary pressures by any combination of tax increase expenditure decreases

Questions for discussion Imagine that in the economy we spend about $60 million every day ($45M by the private sector - households and firms, $15M by government). If the government increased spending to $17M would the total spending in the economy rise to $62 million? Why or why not?

Questions for discussion Thinking of the previous example. What might happen to the economy if government stopped spending the extra $2 million a day? A) Would the private sector make-up the difference and spending stay at $62M? B) Would the total spending just go back to $60M? C) Would total spending fall to $58M?

Crowding Out Some economists think that the new spending would not raise the total amount in the economy. In a tight economy, the market may not be able to fit in any more spending They believe that the government spending would take the place of private spending – thus crowding it out. If crowding out occurs, the decrease in federal spending, combined with the decrease in private spending would double the effect of the cut leaving total spending of $58M

Questions for discussion If the government wanted to increase consumer spending by reducing taxes, whose taxes should it cut first and why? A) people in the lowest 20% of incomes B) people in the middle 40-60% of incomes C) people in the top 20% of income

Questions for discussion 4. If the government wanted to increase business activity by reducing taxes, whose taxes should it cut first and why? A) businesses B) people in the middle 40-60% incomes C) people in the top 20% of income

Questions for discussion 5. If the government wanted to increase consumer spending by increasing transfer payments (money give directly to individuals) what should it do first and why? A) increase social security benefits by 2% B) extend unemployment benefits for longer than 26 weeks? C) increase food stamp amounts by 5%

Laffer Curve Economist Arthur Laffer predicted that at a certain point, higher taxes would produce less revenue (since fewer people could afford to pay it).

Laffer Curve challenges Think of cigarette taxes. Raising the tax by $2 per pack brings in extra revenue at first but as people quit smoking when they can’t afford it, the total taxes brought in over time goes down. The challenge is that you never really know if your tax rate is in the prohibitive range unless you change it.

Surpluses, Deficits and Debts Surplus – When the government collects more in revenue than it spends in one year. Deficit - When the government spends more in one year than it collects in revenue. This is the amount owed in one year. Debt – The sum of all past surpluses and deficits. This is the total amount owed.

How the Government borrows money When the government spends more than it collects in revenue (runs a deficit). It borrows the money. The U.S. Treasury sells bonds (T-bills) to investors and agrees to pay back the amount it borrows with interest.

Who buys the government bonds? Some bonds are held by the Social Security Administration to pay for future retirees. Many bonds are purchased by pension funds and insurance companies. Some bonds are purchase by private investors both inside and outside the United States.

Debt clock How large is the debt of the United States right this minute? Click on the Debt Clock

Questions for discussion 6. If the government wants to make a large expansion of a program (pre-k, healthcare, veterans education benefits, go to war) which is too big to be offset by cuts elsewhere, should it A) borrow the money, adding to the debt? B) raise taxes, possibly contracting the economy? Why?

Is the debt a problem? Some economists believe that as long as the economy is growing, the % of the debt compared to the total economy stays the same. So it isn’t a problem. Other economists see the debt as crowding out other investment choices for current investors (i.e. they buy government bonds instead or investing in U.S. stocks). This would make it a problem now. Some economists worry that the size of the debt will restrict the ability of the government to make fiscal policy changes in the future. This could make it a problem in the future What do you think?