One of the government’s goals is to stabilize the economy Ch.12 FISCAL POLICY One of the government’s goals is to stabilize the economy  prevent unemployment and/or inflation FISCAL POLICY is government manipulation of tax collections & government spending in order to: increase output and/or increase employment (reduce unemployment) (Fiscal policy can also fight inflation, but monetary policy is more often utilized.) Legislative Mandates The Great Depression / acceptance of Keynesian economics led to the idea that government actions can be taken to stabilize the economy Employment Act of 1946  commits the government to use all practicable means to promote maximum employment, production, and purchasing power  created the Council of Economic Advisers (assists and advises the President)  created the Joint Economic Committee (congressional committee) to investigate economic problems of national interest  Jason Furman, Chairman

FISCAL POLICY WITHIN THE AD/AS MODEL DISCRETIONARY FISCAL POLICY the deliberate manipulation of taxes and government spending to alter real domestic output and employment, control inflation, and stimulate economic growth. “Discretionary” means the changes are at the option of the government. Other policies (e.g. tax codes and unemployment benefits) lead to “autonomous fiscal policy” Expansionary Policy when the economy is experiencing recession, government may: 1. increase in government spending (AD shifts right) 2. decrease taxes (raises income, consumption rises by MPC; AD shifts to right)  government often uses a combination; in both cases, multiplier impact is felt. Expansionary fiscal policy often creates a budget deficit. Contractionary policy when demand‑pull inflation occurs, government may: 1. decrease government spending 2. increase taxes Contractionary fiscal policy may create a budget surplus.

Financing deficits (expansionary policy) Borrowing Gov’t competes with private borrowers for funds.  increase in demand may increase interest rates;  private borrowing (& investment) may be ”crowded out”, offsetting expansion Money creation (monetary – not fiscal – policy) The “crowding out” effect can be avoided if the government creates money, but this may cause inflation. Disposing of surpluses (contractionary policy) Reduce debt Potential to cause interest rates to fall and stimulate spending; potential for inflation. Impounding letting the surplus funds remain idle

Autonomous Fiscal Policy (i.e. Automatic Stabilizers) Problems, Criticisms and Complications Timing Problems (“lags”): Recognition lag: elapsed time between the beginning of recession (or inflation) and awareness of the recession (or inflation). Administrative lag: difficulty in changing policy after a problem has been recognized Operational lag: elapsed time between change in policy and its economic impact Political considerations: Government has many goals in addition to economic stability; goals often conflict “political business cycle” may destabilize the economy State and local finance policies may offset federal stabilization policies. the crowding‑out effect may be caused by fiscal policy. http://www.youtube.com/watch?v=hhQygVx6V5M&feature=related Autonomous Fiscal Policy (i.e. Automatic Stabilizers) http://www.youtube.com/watch?v=RGlt0nEQdRI&feature=channel Crowding out / lags

The spending multiplier is 5 ( 1 ÷ 0.2). 12-2 Assume that a hypothetical economy with an MPC of 0.80 is experiencing severe recession. By how much would government spending have to increase to shift the aggregate demand curve rightward by $25 billion? The spending multiplier is 5 ( 1 ÷ 0.2). The increase in government spending would have to be $5 billion. How large a tax cut would be needed to achieve this same increase in aggregate demand? Why the difference? The tax multiplier is –4 (– 0.8 ÷ 0.2). The tax cut would have to be $6.25 billion in order to generate $5 billion in spending, as $1.25 billion is saved. Determine one possible combination of government spending increases and tax decreases that would accomplish this same goal. One combination: a $1 billion increase in government spending and a $5 billion tax cut. Another possibility: a $4 billion increase in government spending and a $1.25 billion tax cut. 12-3 What are government’s fiscal policy options for ending severe demand-pull inflation? Use the aggregate demand-aggregate supply model to show the impact of these policies on the price level. Options are to reduce government spending, increase taxes, or some combination of both. Which of these fiscal policy options do you think a “conservative” economist might favor? A “liberal”? A “conservative” economist might favor cuts in government spending since this would reduce the size of government. A “liberal” economist might favor a tax hike; it would preserve government spending programs.

FALSE. The truth is the opposite. 12-5 Designate each statement true or false and justify your answer. a. Expansionary fiscal policy during a depression will have a greater positive effect on real GDP if government borrows the money to finance the budget deficit than if it creates new money to finance the deficit. FALSE. The truth is the opposite. If government creates new money during a depression, the danger of inflation is low. New expenditures will be felt through increased aggregate demand as government’s net spending increases. If the government finances its deficit by borrowing, there is danger that this will crowd out private borrowing and investment spending. The resulting reduction in private spending offsets the expansionary effect of the fiscal deficit. b. Contractionary fiscal policy during severe demand-pull inflation will be more effective if gov’t impounds the budget surplus rather than using the surplus to pay off some of its past debt. TRUE. When the government impounds the surplus, these funds are removed from the spending flow. If the government uses the surplus to pay of some of its past debt, money is returned to the private sector and at least a portion of it will be pumped into the economy in new expenditures. These expenditures offset the contractionary effect of the budget surplus.

12‑10 Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. It takes time to ascertain the direction in which the economy is moving (recognition lag), to get a fiscal policy enacted into law (administrative lag); and for the policy to have its full effect on the economy (operational lag). Meanwhile, other factors may change, rendering inappropriate a particular fiscal policy. Nevertheless, discretionary fiscal policy is a valuable tool in preventing severe recession or severe demand-pull inflation. Explain the notion of a political business cycle. A political business cycle is the concept that politicians are more interested in reelection than in stabilizing the economy. Before the election, they enact tax cuts and spending increases to please voters even though this may fuel inflation. After the election, they apply the brakes to restrain inflation; the economy will slow and unemployment will rise. In this view the political process creates economic instability. What is the crowding‑out effect and why is it relevant to fiscal policy? The crowding-out effect is the reduction in investment spending caused by the increase in interest rates arising from an increase in government spending, financed by borrowing. The increase in G was designed to increase AD but the resulting increase in interest rates may decrease I. Thus the impact of the expansionary fiscal policy may be reduced. In what respect is the net export effect similar to the crowding‑out effect? The next export effect also arises from the higher interest rates accompanying expansionary fiscal policy. The higher interest rates make U.S. bonds more attractive to foreign buyers. The inflow of foreign currency to buy dollars to purchase the bonds drives up the international value of the dollar, making imports less expensive for the United States, and U.S. exports more expensive for people abroad. Net exports in the United States decline, and like the crowding-out effect, diminish the expansionary fiscal policy.