Fiscal Policy Chapter 12

Stabilization The United States government has 4 basic goals in terms of economic policy Full employment Price Stability High but sustainable growth Balanced Budget

Legislative Mandates Employment Act of 1946 Congress proclaims government’s role in promoting maximum employment, production, & purchasing power Creates Council of Economic Advisers Report to the President Joint Economic Committee of Congress to investigate economic problem of national interest

Fiscal Policy & the AD/AS Model Discretionary fiscal policy – Deliberate manipulation of taxes and spending by Congress – the economic options of the Federal government Expansionary fiscal policy is needed to or used to combat recession

Ways to fight recession Increase government spending (shifts AD to the right) Decrease taxes (shifts right) Increased spending and reduced taxes This will create a budget deficit assuming it was balanced to start

Contractionary Fiscal Policy What is Demand-Pull Inflation? Fights by decreasing government spending. The goal is to reduce price levels but maintain GDP (output) Increase taxes

Financing Deficits Borrowing – Government competes with private lending institutions for money. This however could drive up interest rates Print Money – Federal Reserve loans directly to the US Government by purchasing bonds

Disposing of Surpluses Debt Reduction is good however it may cause interest rates to fall and spark inflation Saving the surplus (Not bloody likely)

Built In Stability Arises because net taxes (minus transfer & subsidies) change with GDP. Spending needs to increase in a recession, decrease in an inflationary period Taxes will automatically rise w/ GDP because incomes rise. In turn, they decrease when GDP falls Transfers and subsidies rise when GDP falls

Automatic Stabilizers Depends on how progressive the corresponding tax system is. Automatic stability reduces instability but does not correct economic instability In other words, it will not prevent the problem from happening, but it will soften the blow when it does

Problems of Timing Recognition Lag – Elapsed time between beginning of a recession or inflation and awareness of the occurrence Administrative Lag – Difficulty in changing policy once the problem has been recognized Operational Lag – Difference in time between change in policy and its economic impact

Political Considerations Government has other goals other than economic stability and may conflict with stabilization. Examples? How do election cycles affect economic policy? State & Local finance policies may offset Federal efforts – Think Texas and its refusal of Federal stimulus funds

Deficit Spending Problems “Crowding Out” may occur w/ government deficit spending. Deficit spending will lead to higher interest rates which weakens spending which could cancel out benefits of fiscal policy Most economists argue that this will not occur during a recession

Leading Indicators Average workweek Unemployment claims Orders for consumer goods Vendor performance New orders for capital goods Building permits for houses Stock market prices Money Supply Interest Rates Consumer Expectations