Fiscal Policy Lecture notes 10 Instructor: MELTEM INCE

Fiscal Policy Fiscal policy is the use of the federal budget to achieve macroeconomic objectives, such as full employment, sustained long-term economic growth, and price level stability. Expenditures are classified as transfer payments, purchases of goods and services, and debt interest. Transfer payments are by far the largest expenditure, and are sources of persistent growth in expenditures.

Fiscal Policy The federal government’s budget balance equals tax revenue minus expenditure. If tax revenues exceed expenditures, the government has a budget surplus. If expenditures exceed tax revenues, the government has a budget deficit. If tax revenues equal expenditures, the government has a balanced budget.

Supply Side Effects Government debt is the total amount that the government has borrowed—that the government owes. It is the accumulation of all past deficits. Fiscal policy has important effects on employment and potential GDP called supply side effects.

The Supply Side: Investment, Saving, and Economic Growth A quick refresher of the national income accounting equations is needed. GDP = C + I + G + X – M. GDP = C + S + T. From these two equations, you can see that I = S + T – G + M – X.

The Supply Side: Investment, Saving, and Economic Growth The equation I = S + T – G + M – X says that investment, I, is financed by: Private domestic saving, S, Foreign saving, M – X, Government saving, T – G

The Supply Side: Investment, Saving, and Economic Growth Call saving S plus foreign saving M – X private saving, PS. Then investment is financed by the sum of private saving and government saving. That is I = PS + T – G

The Supply Side: Investment, Saving, and Economic Growth If taxes exceed government purchases, T > G, the government has a budget surplus and government saving is positive. If taxes are less than government purchases, T< G, the government budget is in deficit and government saving is negative.

The Supply Side: Investment, Saving, and Economic Growth Because government saving is part of total saving, the direct effect of a government budget deficit is a decrease in total saving. When total saving decreases, the real interest rate rises and the equilibrium quantity of investment decreases. The tendency to a government budget deficit to decrease investment is called a crowding-out effect.

Stabilizing the Business Cycle Fiscal policy action that seek to stabilize the business cycle work by changing aggregate demand. These policy actions can be: Discretionary Automatic Discretionary fiscal policy is a policy action that is initiated by an act of Congress. Automatic fiscal policy is a change in fiscal policy triggered by the state of the economy.

Stabilizing the Business Cycle The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on aggregate demand. The tax multiplier is the magnification effect a change in taxes on aggregate demand. An increase in taxes decreases disposable income, which decreases consumption expenditure and decreases aggregate expenditure and real GDP.

Stabilizing the Business Cycle Expansionary fiscal policy is an increase in government purchases or a decrease in taxes. Contractionary fiscal policy is a decrease in government purchases or an increase in taxes.