The President Congress BUDGET Taxes Spending Fiscal Policy

Fiscal Policy A tool of macroeconomic policy that seeks to influence the level of economic activity through control of government expenditure and taxation. There are two types of fiscal policy: Automatic Stabilizers Discretionary Policy

Fiscal Policy: Automatic Stabilizers Built in, non-discretionary elements in fiscal policy that serve to reduce the impact of economic events automatically. For example, A fall in output and national income reduces tax burdens as income falls and increases unemployment and welfare payments. Lower tax payments and higher transfer payments increase the government’s budget deficit and restore some of the income lost by people.

Fiscal Policy: Discretionary Policy Discretionary Fiscal Policy Expansionary Fiscal Policy Decreases in taxes and/or increases in spending which tend to increase economic activity. Contractionary Fiscal Policy Increases in taxes and/or decreases in spending which tend to dampen economic activity.

Fiscal Policy: Demand Side Transmission Mechanism Investment Spending is Crowded Out Interest Rates Rise Export Spending is Crowded Out Government Spending Rises Aggregate Spending Increases Deficit Increases Imports Rise Exports Fall Taxes Decrease Price Level Rises Spending Decreases Expansionary Fiscal Policy

Aggregate demand shifts from AD1 to AD2. AE AS AE2(P1) We begin at Y1, where AD< AS*. The economy is in a recessionary gap. To close the gap, the government engages in expansionary fiscal policy. The increase in government spending and/or decrease in taxes causes aggregate expenditures to increase from AE1 to AE2. Aggregate demand shifts from AD1 to AD2. At point 2, AD > AS*. As the price level rises, AD decreases along the aggregate demand curve. The rising price level causes AE2 to shift down to AE3. Equilibrium is established at Y2 and P2. 2 AE3(P2) AE1(P1) 3 1 Y1 Y2 Y3 Y P AS* AS 3 P2 2 P1 1 AD2 AD1 Y1 Y2 Y3 Y

Fiscal Policy: Demand Side Transmission Mechanism Investment Spending Rises Interest Rates Fall Export Spending Rises Government Spending Falls Aggregate Spending Decreases Deficit Decreases Imports Fall Exports Rise Taxes Increase Price Level Falls Spending Increases Contractionary Fiscal Policy

Aggregate expenditures decrease from AE1(P1) to AE2 (P1). We begin at Y3, where AD> AS*. The economy is in an inflationary gap. To close the gap, the government engages in contractionary fiscal policy. The decrease in government spending and/or increase in taxes causes aggregate demand to shift from AD1 to AD2. Aggregate expenditures decrease from AE1(P1) to AE2 (P1). At point 2, AS* > AD. As the price level falls, AD increases along the aggregate demand curve. The falling price level causes AE2(P1) to shift up to AE3(P2). Equilibrium is established at Y2 and P2. 1 AE3(P2) AE2(P1) 3 2 Y1 Y2 Y3 Y P AS*r AS 2 1 P1 3 AD1 P2 AD2 Y1 Y2 Y3 Y

Demand-Side Fiscal Policy Problems Expansionary fiscal policy can be used to push the economy to a higher level of output, but it also results in a higher price level. Fiscal policy actions often miss the target. We have only estimates of the size of the multiplier. Fiscal policy actions often are timed poorly. Fiscal policy affects GDP with a lag. Fiscal policy can get mired down in politics.

Fiscal Policy: Supply Side Transmission Mechanism Inflation Falls Unemployment Falls After-tax Wage Higher Increase in Labor Supply Aggregate Supply Rises Lower Personal Tax Rates Interest Rates Fall Productivity Rises Savings Rise Lower Business Tax Rates After-tax ROR Rises Investment Rises

Fiscal Policy: Supply Side Expansionary Fiscal Policy The federal government decreases taxes. People work more: People save more: Firms invest more. Aggregate supply increases, unemployment falls, inflation falls.

Tax Cuts: Labor Supply The decrease in marginal income tax rates encourages people to work more. People are willing to work more because they now keep more of their wages. More specifically, they get to keep more of the last dollar earned. Therefore, the increased labor supply increases output without putting upward pressure on wages.

Tax Cuts: Saving and Investment Business tax cuts increase business profits. Higher profits encourage investment in new capital. Individual tax cuts stimulate household savings. Increased savings contribute to lower interest rates and increased investment in new capital. New capital increases productivity, thus, lowering costs and inflationary pressures.

Fiscal Policy: Supply Side Contractionary Fiscal Policy The federal government increases taxes. People work less: People save less: Firms invest less. Aggregate supply decreases, unemployment rises, inflation rises.

Supply Side Fiscal Policy AS2 AS1 P P AS1 AS2 2 P2 1 1 P1 P1 2 P2 AD1 AD1 Y1 Y2 Y Y2 Y1 Y Expansionary Contractionary

Supply-Side Fiscal Policy Problems Small Magnitude of the Supply-side Effects. Savings do not appear to respond to tax incentives. Demand Side Effects. People respond to tax cuts by spending more. They may or may not respond by working more. Timing Problems The impact of increases in investment spending occur much later as industrial capacity increases

Supply-Side Fiscal Policy Problems Effect on Income Distribution Supply-side tax cuts favor the wealthy Tax Cuts Increase the Budget Deficit But, so do demand-side tax cuts.

Are Deficits Bad? When the government runs a deficit, it must borrow. The borrowing tends to cause interest rates to be higher than they otherwise would be. Interest sensitive spending that occurs in the private sector declines while government spending increases.

Are Deficits Bad? Government budget deficits are said to.. Reduce national saving Create a flow of assets overseas Slow rate of capital accumulation Redistribute income and wealth

Output Effects of Deficits An economy’s output is determined by its productive capacity. Productive capacity is determined in part by the stock of capital. If deficits crowd out investment, the capital stock grows more slowly. Over a decade or more, the economy’s capacity to produce can be reduced. National income rises more slowly.

Wealth Effects of Deficits When foreigners increase their ownership of domestic assets, more income from production flows overseas in the form of rent, interest and profits. National income may continue to rise, but the amount that the citizens of the country actually keep falls.

Wages and Profits and Deficits If deficits crowd out investment and result in a smaller amount of available capital, labor productivity and real wages will fall. The productivity of capital and its return, however, will rise.

Economists and the Balanced Budget Amendment Most economists do not support a balanced budget amendment because: Forecasting deficits requires an impossible degree of accuracy. It is bad public policy to balance the budget in every year. The budget should be balanced over the business cycle. Deficits in recession cushion the economy Surplus in inflation cool off the economy

Economists and the Balanced Budget Amendment Annual balancing would increase economic instability and investor uncertainty adding to the problem rather than fixing it. Distort budget policy causing a permanent preference for spending cuts over tax increases. Preclude the development of capital budgeting procedures. Give rise to inappropriate uses of government mandates, regulations, tax breaks, and new forms of “off-budget” spending designed to evade restrictions on taxing and spending.

Economists and the Balanced Budget Amendment Make international coordination of economic policies more difficult. Postpone the day of reckoning until after ratification of the amendment. Decrease the flexibility of economic policy because the amendment would involve the courts, whose function it is to interpret the Constitution.