FISCAL POLICY 11 C H A P T E R

Fiscal Policy One major function of the government is to stabilize the economy (prevent unemployment or inflation). Stabilization can be achieved in part by manipulating the public budget—government spending and tax collections—to increase output and employment or to reduce inflation. Discretionary Fiscal Policy (active). Non-Discretionary Fiscal Policy (passive).

Fiscal Policy and the AD/AS Model Discretionary fiscal policy (active): Refers to the deliberate manipulation of taxes and government spending by the government to alter real domestic output and employment, control inflation, and stimulate economic growth (Fiscal policy goals). Simplifying assumptions: 1.Assume initial government purchases don’t depress or stimulate private spending. 2.Assume fiscal policy affects only the demand, not the supply side of the economy.

Fiscal policy choices: Expansionary fiscal Policy: Expansionary fiscal policy is used to fight a recession, e.g., if there is a decline in Ig which has decreased AD from AD1 to AD2 so real GDP has fallen and employment has declined. Possible fiscal policy solutions: a.An increase in government spending (shifts AD to right by more than change in G due to the multiplier effect),

b. A decrease in taxes: Raises income, and consumption rises by MPC × change in income. AD shifts rightward by a multiple of the change in consumption. C. A combination of increased spending and reduced taxes: If the budget was initially balanced, expansionary fiscal policy creates a budget deficit.

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

Contractionary fiscal policy When demand ‑ pull inflation occurs (as illustrated by a shift from AD3 to AD4), then contractionary policy is the remedy: Possible fiscal policy solutions: a. A decrease government spending: Shifts AD to the LHS, once the multiplier process is complete. Here price level returns to its pre-inflationary level but GDP remains at its full-employment level.

b. An increase in taxes: Will reduce income and then consumption at first by MPC × fall in income, and then multiplier process leads AD to shift leftward still further. c. A combined spending decrease and tax increase: Could have the same effect with the right combination.

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

Budget Deficit Budget deficit The situation in which the government’s expenditures are greater than its tax revenue. Budget surplus The situation in which the government’s expenditures are less than its tax revenue.

Fiscal Policy government Budget is composed of the annual government expenditures and revenue. If Government Revenue > Government Expenditure, then we have a Budget Surplus If Government Revenue < Government Expenditure, then we have a Budget Deficit If Government Revenue = Government Expenditure, then we have a Balanced Budget Government Budget : the government budget is the annual statement of the government’s expenditures and tax revenues. Fiscal policy is the use of the government budget to achieve macroeconomic objectives, such as full employment, sustained long-term economic growth, and price level stability.

Debt can be a problem for a government for the same reasons that debt can be a problem for a household or a business. Deficits, Surpluses, and Federal Government Debt Is Government Debt a Problem?

Fiscal Policy: Government Debt Government debt is the total amount that the government has borrowed, that the government currently owes. It is the accumulation of all past budget deficits. The government debt can be observed as a bathtub Bathtub The level of the bathtub is the government debt Water entering the bathtub is the current government borrowing or government deficit Water leaving the bathtub is the government surplus used to pay off debt When the government has a budget deficit (Revenues < Expenditures), It has to borrow money to cover the deficit.