12 C H A P T E R FISCAL POLICY

Council of Economic Advisors (CEA) Joint Economic Committee (JEC) LEGISLATIVE MANDATES Employment Act of 1946 Council of Economic Advisors (CEA) Joint Economic Committee (JEC)

Expansionary Fiscal Policy FISCAL POLICY AND THE AD-AS MODEL Two Options Discretionary Fiscal Policy Non-Discretionary Fiscal Policy Expansionary Fiscal Policy Increase Government Spending Tax Reductions Combinations of the Two

EXPANSIONARY FISCAL POLICY the multiplier at work... $5 billion initial increase in spending Full $20 billion increase in aggregate demand Price level P1 AD2 AD1 $485 $505 Real GDP (billions)

CONTRACTIONARY FISCAL POLICY the multiplier at work... P4 $5 billion initial decrease in spending Price level P3 Full $20 billion decrease in aggregate demand AD4 AD3 $515 Real GDP (billions)

FINANCING OF DEFICITS AND DISPOSING OF SURPLUSES Borrowing vs. New Money Borrowing From The Public Money Creation Debt Retirement vs. Idle Surplus Debt Reduction Impounding Which Policy Option? G or T?

BUILT-IN STABILITY Net tax revenues vary directly with GDP Transfer payments behave the opposite way as tax collections Automatic or Built-In Stabilizers Economic Importance

Government Expenditures, BUILT-IN STABILITY T Surplus Government Expenditures, G, and Tax Revenues, T G Deficit GDP1 GDP2 GDP3 Real Domestic Output, GDP

BUILT-IN STABILITY Tax Progressivity Progressive Tax System Proportional Tax System Regressive Tax System The more progressive the tax system, the greater the economy’s built-in stability

EVALUATING FISCAL POLICY Full-Employment Budget Cyclical Deficit Recent U.S. Deficits & Surpluses Actual Deficit or Surplus Full-Employment Deficit or Surplus Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 -3.9% -4.5 -4.7 -3.9 -2.9 -2.2 -1.4 -0.3 +0.8 +1.4 +2.4 -2.1% -2.6 -3.0 -2.0 -1.9 -1.2 -0.9 -0.4 +0.3 +1.1

FULL-EMPLOYMENT DEFICITS No Change in Fiscal Policy T1 G, and Tax Revenues, T (billions) Government Expenditures, a b $500 475 450 425 G c GDP2 GDP1 Year 2 Year 1 Real Domestic Output, GDP

FULL-EMPLOYMENT DEFICITS Discretionary Fiscal Policy Tax Decrease G, and Tax Revenues, T (billions) Government Expenditures, d e $500 475 450 425 G f h g GDP4 GDP3 Year 4 Year 3 Real Domestic Output, GDP

GLOBAL PERSPECTIVE BUDGET DEFICITS OR SURPLUSES AS A PERCENTAGE OF GDP, 1999 -8 -6 -4 -2 0 2 4 Denmark Canada Sweden United Kingdom United States Germany Italy France Czech Republic Hungary Japan Source: Organization for Economic Development and Cooperation

PROBLEMS, CRITICISMS, AND COMPLICATIONS Problems of Timing Recognition Lag Administrative Lag Operational Lag A Political Business Cycle? Offsetting State & Local Finance Crowding-Out Effect

FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION AS Fiscal Policy: Pure & Simple Price level P1 AD1 AD2 $495 $515 Real GDP (billions)

FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION AS Fiscal Policy and the Crowding-Out Effect or the Net Export Effect AD1 Price level P1 AD2 AD’2 $495 $505 $515 Real GDP (billions)

FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION AS Fiscal Policy And Inflation Price level P1 AD1 AD2 $495 $505 $515 Real GDP (billions)

FISCAL POLICY IN THE OPEN ECONOMY Shocks Originating from Abroad Net Export Effect

Impact upon... Saving and Investment Work Incentives Risk Taking SUPPLY-SIDE FISCAL POLICY Emphasis on Expansionary Tax Cuts Impact upon... Saving and Investment Work Incentives Risk Taking

SUPPLY-SIDE FISCAL POLICY AS1 AS2 Price level P2 P3 P1 AD2 AD1 Q1 Q2 Q3 Real domestic output, GDP

Forecasting the Future The Leading Indicators Average Workweek Initial Claims for Unemployment Insurance New Orders for Consumer Goods Vendor Performance New Orders for Capital Goods Building Permits for Houses Stock Prices Money Supply Interest-Rate Spread Consumer Expectations

Forecasting the Future Chapter Conclusions The Leading Indicators Average Workweek Initial Claims for Unemployment Insurance New Orders for Consumer Goods Vendor Performance New Orders for Capital Goods Building Permits for Houses Stock Prices Money Supply Interest-Rate Spread Consumer Expectations

KEY TERMS fiscal policy Employment Act of 1946 Council of Economic Advisers (CEA) expansionary fiscal policy budget deficit contractionary fiscal policy budget surplus built-in stabilizer progressive tax system proportional tax system regressive tax system full-employment budget cyclical deficit political business cycle crowding-out effect net export effect supply-side fiscal policy Copyright McGraw-Hill/Irwin, 2002 BACK END

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