Chapter 13 Fiscal Policy “Democracy will defeat the economist at every turn at its own game” – Harold Innis, Canadian Economist and Historian

Governments can do plenty to stabilize the economy – not only during downturns when unemployment is high, but also during inflationary upswings. Governments can use certain policies to achieve economic stability; for example, they can spend more money or reduce taxes to cause changes in total spending and aggregate demand. This chapter examines the theory behind such policies and their outcomes.

Stabilization Policy Government policy designed to lessen the effects of the business cycle, particularly unemployment and inflation Goal Keep the economy as close as possible to its potential output To smooth out business cycle - the closer the economy stays to the long-run trend of potential output, the lower will be the social costs of unemployment and inflation to the country’s citizens

Business Cycle

2 Types of Stabilization Policy Expansionary policies: government policies designed to reduce unemployment and stimulate output  when output is below its potential  Injections > withdrawal Contractionary policies: government policies designed to stabilize prices and reduce output  when the economy is booming  Withdrawal > injections

2 Categories of Stabilization Policy Fiscal policy – government stabilization policy that uses taxes and government purchases as its tools  also known as budgetary policy  Usually applied to a fiscal year: the 12 month period to which a budget applies Monetary Policy – government stabilization policy that uses interest rates and the money supply as its tools

Types of Stabilization Policy

Two methods used on Fiscal Policy The government makes changes on 2 factors to influence aggregate demand, thus the equilibrium price and quantity Government Spending Immediate effect on aggregate demand (direct injection/withdrawal) Tax Rate Less immediate effect on aggregate demand (Indirect injection/withdrawal)

Expansionary Fiscal Policy Government Spending Increases Tax Rate Decreases Encourage households and business spending Consumption & investment increase

Contractionary Fiscal Policy Government spending Decreases Tax rate Increases Reduce household’s disposable income and businesses’ profits Consumption & investment decrease

Discretionary Policy vs. Automatic Stabilizers Discretionary policy: intentional government intervention in the economy i.e.budgeted changes in spending/ taxation Automatic stabilizers: built-in measures that lessen the effect of the business cycle i.e. Taxation & transfer programs  progressive income taxes, unemployment insurance, welfare payments

Net Tax Revenues = taxes collected – transfers & subsidies During a period of expansion… Net tax revenues increase (leakage) Spending and aggregate demand decrease During a period of contraction… Net tax revenues decrease Spending and aggregate demand increase

How Does Automatic Stabilizer work? Contracting Economy 1. Household incomes & business profits fall 2. Taxes collected by government fall 3. Government transfer payments & subsidies increase (job lost & business suffers) 4. Decline in net tax revenues  spending & aggregate demand increase 5. Economy pushed towards its potential output

How Does Automatic Stabilizer work? Expanding Economy 1. Personal incomes & business profits increase 2. Governments collect more taxes 3. Government transfer payments & subsidies reduced (high employment, businesses prosper) 4. Spending & aggregate demand decrease 5. Economy pushed back down to its potential output

The Spending Multiplier Used to estimate the impact of government policies on the economy in terms of dollar values The Multiplier Effect: the magnified impact of a spending change on AD Assumes price level stays constant The Spending Effect: value by which an initial spending change is multiplied to give the total change in outputs shift in the AD curve

Multiplier Effect - 1. Marginal propensity to consume (MPC) – effect on domestic consumption of a change in income - Explains “if income increase x amount, how much extra will be spent on domestic goods and services?” - Applies to individual households and the economy as a whole

Multiplier Effect - 2. Marginal propensity to withdraw (MPW) - Effect of withdrawing – saving, imports and taxes – of a change in income MPC + MPW =1 Always!! Because income is either spent on domestic consumption or withdrawn from the circular flow

Spending Multiplier formulas

How does the Multiplier Effect work?

Multiplier Effect

Effect of a Tax Cut Tax adjustment has a smaller initial effect on spending compared to government purchases i.e. assume MPC = 0.5 Tax cut increases Spender A’s income by $1000 (after tax)  initial change in spending on domestic items = $500 Government purchases  initial change in spending on domestic items = $1000

What if Price Levels Vary? Recall: slope of the aggregate supply curve is steeper as it reaches or surpasses the potential output level If AD curve shifts from AD0 to AD1 the price level rises proportionally more than the output does Expansionary fiscal policy is less effective when the economy is close to its potential If AD curve shifts to the left, the price level falls proportionally more than the output does

What if Price Levels Vary?

!! Multiplier Effect is just a theory, it is not definite because of possible changes in price level, However, it is still useful to indicate the Maximum change in equilibrium output following a certain fiscal policy !!

Benefits of Fiscal Policy #1. Regional Focus Discretionary fiscal policy can be targeted on particular regions to balance out regional differences in economy situations During a recession, new government purchases or tax cuts can be targeted to regions where unemployment rates are highest In a boom, spending cuts and tax hikes can be concentrated on the regions where inflation is at its worst

Benefits of Fiscal Policy #2. Impact on Spending Fiscal policy has a more straightforward impact than monetary policy The first spending adjustment is assured since the government itself initiates the change

Drawbacks of Fiscal Policy #1. Delays through 3 time lags Recognition lag: the amount of time it takes policy- makers to realize that a policy is needed Decision lag: the amount of time needed to formulate and implement an appropriate policy Impact lag: the amount of time between a policy’s implementation and its having an effect on the economy

Drawbacks of Fiscal Policy #2. Political Visibility Highly visible and therefore often affected by political as well as economic considerations Voters and political parties are likely to respond more favourably to expansionary policies regardless of the appropriateness of these policies for the economy

Drawbacks of Fiscal Policy #3. Public Debt The total amount owed by the federal government as a result of its past borrowing The government has to pay public debt charges each year and has not been able to reduce the public debt just by paying only the interest

Impact of Fiscal Policy Budget Surpluses and Deficits Balanced Budget Expenditures = revenues Budget Surplus Revenues > expenditures Surplus amount = revenue – expenditures Budget Deficit Expenditures > Revenues Deficit amount = expenditures – revenue

Impact of Fiscal Policy Budget Surplus and Deficit's impact on Public Debt Amount of deficit = amount increase in public debt Amount of surplus = amount reduced in public debt

Fiscal Policy Guidelines Annually Balanced Budget Revenues and expenditures should balance each year Cyclically Balanced Budget Government revenues and expenditures should balance over the course of one business cycle Functional Finance Government budgets should be geared to the yearly needs of the economy

Discussion