FISCAL POLICY

Definition of Fiscal Policy a government policy for dealing with the budget (especially with taxation and borrowing)

FISCAL POLICY AND THE AD-AS MODEL Two Options Discretionary Fiscal Policy Non-Discretionary Fiscal Policy Expansionary Fiscal Policy To Reduce Unemployment… Increase Government Spending Tax Reductions Combinations of the Two

Price level Real GDP (billions) EXPANSIONARY FISCAL POLICY Full $20 billion increase in aggregate demand AD 2 AD 1 $5 billion initial increase in spending the multiplier at work... P1P1 $490 $510 AS

To Reduce Inflation… Decrease Government Spending Tax Increases Combinations of the Two FISCAL POLICY AND THE AD-AS MODEL Contractionary Fiscal Policy

Price level Real GDP (billions) CONTRACTIONARY FISCAL POLICY Full $20 billion decrease in aggregate demand AD 3 AD 4 $5 billion initial decrease in spending the multiplier at work... P2P2 $510 $522 AS P1P1

FINANCING OF DEFICITS AND DISPOSING OF SURPLUSES Borrowing vs. New Money Borrowing From The Public Money Creation Debt Retirement vs. Idle Surplus Debt Reduction Impounding Which Policy Option? G or T?

BUILT-IN STABILITY Net tax revenues vary directly with GDP Transfer payments behave the opposite way as tax collections Automatic or Built-In Stabilizers Economic Importance

BUILT-IN STABILITY GDP 1 GDP 2 GDP 3 Real Domestic Output, GDP Government Expenditures, G, and Tax Revenues, T Deficit Surplus T G

BUILT-IN STABILITY Tax Progressivity Progressive Tax System Proportional Tax System Regressive Tax System The more progressive the tax system, the greater the economy’s built-in stability.

FULL-EMPLOYMENT DEFICITS GDP 2 GDP 1 Real Domestic Output, GDP Government Expenditures, G, and Tax Revenues, T (billions) G T1T1 (Year 1)(Year 2) a b c $ No Change in Fiscal Policy

FULL-EMPLOYMENT DEFICITS GDP 4 GDP 3 Real Domestic Output, GDP Government Expenditures, G, and Tax Revenues, T (billions) T2T2 G T1T1 Year 3Year 4 d e f $ Discretionary Fiscal Policy Tax Decrease h g

EVALUATING FISCAL POLICY Full-Employment Budget Cyclical Deficit Recent U.S. Deficits & Surpluses Year Actual Deficit or Surplus Full-Employment Deficit or Surplus % -4.5% -4.7% -3.9% -2.9% -2.2% -1.4% -0.3% +0.8% +1.4% +2.4% +1.3% -1.5% -2.1% -2.4% -2.9% -2.8% -2.1% -2.0% -1.3% -0.9% -0.4% +0.3% +1.1% +0.8% -1.5%

Italy Sweden Canada United Kingdom France United States Ireland Norway Japan GLOBAL PERSPECTIVE BUDGET DEFICITS OR SURPLUSES AS A PERCENTAGE OF GDP, 2002 Source: Organization for Economic Development and Cooperation

PROBLEMS, CRITICISMS, AND COMPLICATIONS Problems of Timing Recognition Lag Administrative Lag Operational Lag Political Considerations Political Business Cycles Offsetting State & Local Finance Crowding-Out Effect

FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION Fiscal Policy: No Complications Price level Real GDP (billions) AD 1 AD 2 P1P1 $490 $510 AS

FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION Fiscal Policy: Showing Crowding-out Effect or Net Export Effect Price level Real GDP (billions) AD 1 AD 2 P1P1 $490 $510 AS AD’ 2 $504

FISCAL POLICY IN THE OPEN ECONOMY Shocks Originating from Abroad Net Export Effect

Forecasting the Future The Leading Indicators Average Workweek Initial Claims for Unemployment Insurance New Orders for Consumer Goods Vendor Performance New Orders for Capital Goods Building Permits for Houses Stock Prices Money Supply Interest-Rate Spread Consumer Expectations