Chapter 12 – Government and Fiscal Policy Read pages 245 – 262 I Government and the Economy Government Purchases includes purchases of goods and services produced by firms as well as production by agencies themselves. 1) Does not include transfer payments. 2) Federal+State+ Local was around 19.5% of GDP until dropping to 17% recently.

B) Transfer Payments are the provision of aid or money to an individual who is not required to provide anything in exchange. 1) Not counted as part of government expenditures since it ends up in consumers hands and is part of consumer spending. 2) Rises in recessions and falls in expansions. 3) Recently has been around 10% if GDP.

C) Taxes 1) Bulk of Federal Taxes come from Income taxes and payroll taxes. 2) Bulk of State and local come from property and sales taxes. D) Budget Balance 1) A Budget surplus occurs if government revenues exceed expenditures. 2) A budget deficit occurs if government expenditures exceed revenues.

3) If the surplus is zero, we say the government has a balanced budget. E) The national debt is the sum of all past federal deficits, minus any surpluses. 1) National debt as a percentage of GDP peaked during World War II around 120% and declined until 1980. 1) National debt recently has been around 55% which is somewhat below average relative to other countries.

II The Use of Fiscal Policy To Stabilize the Economy Automatic Stabilizers are government programs that tend to reduce fluctuations in GDP automatically. 1) Income taxes. 2) Transfer payments

B) Discretionary Fiscal Policy Tools. 1) Changes in Government Purchases. Directly stimulates demand. 2) Changes in Business Taxes – Investment tax credits. Stimulates investment spending. 3) Changes in income taxes. Stimulates consumer spending. 4) Changes in transfer payments. Stimulates consumer spending.

C) Because price changes may result from a change in fiscal policy, the net effect will be less than the full multiplier effect.

III Issues in Fiscal Policy There are difficulties in using fiscal policy for economic stabilization. Lags – 1) Recognition lag can be long for both types of policy. 2) Implementation lag is long relative to monetary policy. 3) Impact lag is short relative to monetary policy. 4) Automatic stabilizers minimize both the recognition lag and the implementation lag since the policies automatically adjust to economic conditions.

B) Crowding Out 1) The tendency for an expansionary fiscal policy to reduce other components of aggregate demand is called crowding out. 2) Basic mechanism. a) Expansionary fiscal policy will increase debt. b) This drives up interest rates. c) This leads to, i) less investment, ii) higher demand and lower supply for dollars. d) (ii) leads to higher exchange rate and thus less exports.

C) Choice of Policy 1) Fiscal conservatives prefer spending cuts during inflationary gaps and tax cuts during recessionary gaps. 2) Fiscal liberals prefer tax increases during inflationary gaps and spending increases during recessionary gaps. 3) Supply-side economists prefer policies that promote long-run aggregate supply growth. 4) Even when there is agreement on fiscal policy (e.g. tax cuts) there is disagreement on what form it should take.

D) The Impact of the National Debt There are several common views about whether the size of the national debt is a problem. 1) Assets and Liabilities. National debt accounting fails to account for the governments assets. 2) Size of the debt relative to GDP is what is important, not the absolute size. 3) Government does not have to worry about going bankrupt the way a private individual does.

4) Deficits and the Issues of Burden Shifting. a) Certainly the debt crowds out investment and leads to a reduced future productive capacity. b) There is greater controversy regarding whether current consumption by the government hurts future generations. 1) One group of economists claim it does not since the current generation pays for it via an opportunity cost. 2) Another group claims this is not true since the current generation would have consumed something else and further the future generation has to pay for the interest thus costing them an opportunity.