Fiscal Policy

 Fiscal policy refers to government policies, like taxes, government purchases, and laws. –Taxation policies –Government purchasing (buying nuclear weapons) –Government investment (buying capital, like roads, schools, hydroelectric dams)  Fiscal policies also have indirect influences: interest rates, foreign exchange, private investment, consumer expenditure  (“Monetary” policy refers to use of Fed’s tools to affect money supply.)

Overview of Fiscal Policy  Government income derives from taxes (personal income tax, business taxes, etc.)  Government spends according to budget: surplus, deficit, or balanced budget  Government purchases  Transfer payments  National debt is sum of all past federal deficits and surpluses (measure outright, and as % of GDP)

Types of Fiscal Policies  Discretionary –Polices that are chosen specifically to influence the economy –Change government purchases: shift AD –Change in business taxes: lower factor costs and shift SRAS –Change income taxes: encourage or discourage consumption –Change in transfer payments: encourage or discourage consumption  Automatic Stabilizers –Unemployment benefits –Welfare

Issues with Fiscal Policy  Lags –Recognition Lag –Implementation Lag –Impact Lag  “Crowding Out”: fiscal policies inherently limit their effectiveness –Increasing government spending increases deficit –Which requires government to borrow, and thereby increase interest rates –Higher rates discourage investment –Net effect is that G increases, but I decreases, leaving AD little changed  Policy choices: governments are run by politicians, with differing agendas and philosophies

Issues with Fiscal Policy  “Supply-side Economics:” fiscal policy to shift LRAS –lower taxes to encourage people to work, businesses to invest to create capital –Wealth will “trickle down” to poorer classes –Controversial: appears to favor the wealthy and big business, but may actually work –Remember: Lowering taxes will require lower spending or increased debt  National Debt –Huge or small? Measure outright, or measure as % of GDP?

Expansionary Fiscal Policies  Examples: –Personal income tax cuts –Increased spending  What are the effects on –Price level –rGDP? –Interest rates? –Foreign exchange?  Are some expansionary programs better than others?  Which would work faster and more reliably to increase AD: tax cuts or increased spending? –Consumers may not spend all income generated by tax cuts –Spending directly goes to economy, especially if programs are chosen well –Both cause crowding out, as both increase the deficit

Contractionary Fiscal Policies  Examples: –Raise personal income tax cuts –Cut spending  What are the effects on –Price level –rGDP? –Interest rates? –Foreign exchange?  Are some contractionary decisions better than others?