Using Fiscal Policy

Chapter 15: Using Fiscal Policy KEY CONCEPT Fiscal policy uses taxes and government spending in an effort to smooth out the peaks and troughs of the business cycle. WHY THE CONCEPT MATTERS During the 20th century, periods of rampant inflation and economic depression caused great hardship for millions of people in different parts of the world. The federal government uses a combination of spending and taxation to reduce the impact of economic extremes.

What Is Fiscal Policy? Fiscal Policy Tools KEY CONCEPTS Fiscal—refers to government revenue, spending, and debt Fiscal policy—government’s use of taxes, spending to affect economy Expansionary fiscal policy—raises aggregate demand, stimulates economy Contractionary fiscal policy—reduces aggregate demand, slows economy Federal government’s tools to influence economy: taxation, spending

Fiscal Policy Tools Discretionary Fiscal Policy Discretionary fiscal policy—actions government takes to stabilize the economy involve choices government makes about taxes or spending Congress must enact legislation for policies to be implemented

Fiscal Policy Tools Automatic Stabilizers Automatic stabilizers—fiscal policy features that work automatically control aggregate demand in expansionary or contractionary manner Public transfer payment programs and progressive income taxes increase incomes and reduce impact of a recession reduce extra income entering economy, slow growth, check inflation

The Purpose of Fiscal Policy KEY CONCEPTS Expansionary fiscal policy designed to help a weak economy grow Contractionary fiscal policy used to slow down a growing economy purpose is to control inflation

The Purpose of Fiscal Policy Policy 1: Expansionary Fiscal Policy Expansionary policy increases aggregate demand so economy can grow Increased spending on public projects done by hiring private firms jobs created; workers spend on goods and services Lower personal, corporate income taxes leaves more money available increase in demand for products, saving, capital and labor investment

The Purpose of Fiscal Policy Policy 2: Contractionary Fiscal Policy Too rapid economic growth leads to demand-pull inflation Spending cuts mean less income for private firms working for government aggregate demand drops; production drops; inflation is controlled Higher taxes reduce disposable income decreases consumer spending, production; workers laid off; prices drop

Limitations of Fiscal Policy KEY CONCEPTS Fiscal policy intended to reduce economic slowdowns that result in unemployment curb inflation Has significant limitations

Limitations of Fiscal Policy Limitation 1: Policy Lags Fiscal policy lags behind conditions it is meant to address May take time to identify problem and to get Congress to act Implementing policy change takes time tax changes can take effect faster than new spending programs

Limitations of Fiscal Policy Limitation 2: Timing Issues Fiscal policy meant to smooth out peaks and troughs of business cycle If timing is good, fluctuations in the business cycle are less severe If timing is bad, policy can make matters worse. Example: if moving out of recession, expansionary policy can bring on inflation

Limitations of Fiscal Policy Limitation 3: Rational Expectations Theory Rational expectations theory—people anticipate that changes in fiscal policy will have certain outcomes take actions to protect themselves against outcomes May expect expansionary policy to increase demand and raise prices so buy more to stay ahead of inflation, thus causing more inflation

Limitations of Fiscal Policy Limitation 4: Political Issues Political considerations, especially chance for reelection, influence policy Council of Economic Advisers—group of advisors to president President or Congress may not follow their advice particular issue for House where all tax bills originate

Limitations of Fiscal Policy Limitation 5: Regional Issues Not all parts of the country may have same economic conditions One state or region may have recession while another has inflation One broad policy for entire nation may not be appropriate

Reviewing Key Concepts Use each of the terms below in a sentence that illustrates the meaning of the term: expansionary fiscal policy discretionary fiscal policy rational expectations theory

Demand-Side Economics Demand-Side and Supply-Side Policies Demand-Side Economics KEY CONCEPTS Until Great Depression, government did little to influence economy persistent unemployment, low production changed many economists’ minds John Maynard Keynes proposed Keynesian economics: idea that during recession government should stimulate aggregate demand basis of demand-side fiscal policy—policy to stimulate aggregate demand

Demand-Side Economics Keynesian Theory Changes in aggregate demand affect business cycle: GDP = C+I+G+F GDP = consumer (C), investment (I), government goods (G), net exports (F) exports small role in the economy; consumer, government spending stable Keynes believed investment caused fluctuations in the economy spending multiplier effect—a spending change results in larger GDP change

John Maynard Keynes: Architect of Demand-Side Policy Using Government Action to Stimulate Demand Keynes: lower aggregate demand meant layoffs, less aggregate demand Began field of macroeconomics and revolutionized economic thinking: aggregate demand is sum of investment, consumer and government spending only active government action can break the patterns in business cycle government spending to stabilize economy better than balanced budget

Government and Demand-Side Policies KEY CONCEPTS Discretionary fiscal policy involves making choices about taxation and spending increase aggregate demand or control inflation Demand-side policies advocate use of these fiscal policy tools

Government and Demand-Side Policies The Role of Government Depression economy stable, but high unemployment, little aggregate demand Keynes argued for government spending to create jobs, increase income also lower taxes to encourage consumer spending, business investment During inflation Keynes favored decreased spending, raised taxes

Government and Demand-Side Policies Demand-Side Policies—Analysis Sometimes demand-side policies work; example, World War II production Difficult to discontinue popular programs after recession Difficult for politicians to raise taxes during inflationary periods Demand-side policies ineffective for stagflation slow economic growth with unemployment and inflation

Supply-Side Economics KEY CONCEPTS Some economists prefer influencing the economy through supply side Supply-side fiscal policy—provides incentives to producers focuses on cutting the cost of production to increase aggregate supply

Supply-Side Economics The Role of Government Supply-side economists favor cutting individual, corporate taxes to encourage people to work, save, invest more reducing highest tax brackets frees income to most likely investors Favor lower government spending: if need less revenue, can lower taxes Favor less regulation: cuts production costs, ups aggregate supply

Supply-Side Economics The Laffer Curve Laffer Curve—shows how tax cuts affect tax revenues, economic growth Laffer said tax revenues increase as tax rates increase up to a point Higher taxes discourage working, saving, investing people find alternatives to income-producing activities taxable income, revenue drops; aggregate supply falls; economy slows

Supply-Side Economics Supply-Side Policies—Analysis In 1980s, taxes were reduced but revenue increased inflation, unemployment fell; economy grew steadily Some chose to work fewer hours for same income; savings declined Some economists: success depends on where economy is on Laffer Curve Others say economy grew from tax cuts plus increased defense spending

Reviewing Key Concepts Explain the relationship between the terms in each of these pairs: Keynesian economics and demand-side fiscal policy supply-side fiscal policy and Laffer Curve

The Federal Deficit and Debt Deficits and the National Debt The Federal Deficit and Debt KEY CONCEPTS All levels of government struggle to achieve balanced budget Budget surplus occurs when government takes in more than it spends Budget deficit occurs when government spends more than it takes in Deficit spending—spending more than revenues for specific budget year National debt—the total amount of money the government owes

The Federal Deficit and Debt Causes of the Deficit Four main reasons for deficit spending — national emergencies usually require massive spending beyond normal budget — building public goods and services is expensive, work takes years — public projects to stimulate, stabilize weak economy need large sums — entitlement programs that people depend on are expensive

The Federal Deficit and Debt Raising Money for Deficit Spending To borrow money, federal government issues bonds through Treasury Department Savings bonds mature in 20 years; denominations from $25 to $10,000 Treasury bills (T bills) mature in less than one year Treasury notes mature between 2 and 10 years Treasury bonds mature in 30 years

The National Debt KEY CONCEPTS Government owes bond holders the amount of the bond plus interest Also borrows from government trust funds—money held for specific future purpose trust fund surpluses invested in bonds until programs need the funds some economists do not think moving funds within government is debt no burden to current economy because current budget does not pay for it

The National Debt The Current Debt In August 2006, national debt about $8.4 trillion federal deficits and debt increased during 1980s, 1990s since 1980s debt has grown faster than inflation—grown in real terms In 1981, debt was 33 percent of GDP; in 2006 was nearly 68% in 1981, about 80 percent privately owned; in 2006 less than 60% private

The National Debt The Effect of the Debt on the Economy If government spending stimulates economy, jobs and public goods created If government outbids private sector, pays higher bond interest rates crowding-out effect—money leaves private sector, interest rates rise Constant borrowing increases total interest and taxes to service debt higher taxes decrease consumer spending and business investment

The National Debt Attempts to Control Deficits and Debt Sharp rise in deficits, debt in 1980s Officials tried various measures to control deficit spending Various bills had mixed success; government continues to struggle

Reviewing Key Concepts Explain the differences between the terms in each of these pairs: budget surplus and budget deficit national debt and deficit spending Treasury bills and Treasury bonds

Is the Federal Deficit Too Large Background Taxpayers ultimately pay the interest on the national debt, which is created by deficit spending by the federal government. The government uses deficit spending for several reasons, including paying for national emergencies and implementing expansionary fiscal policies during periods of recession. What’s the Issue Is the federal deficit too large? Thinking Economically Identify the economic cause-and-effect relationships described in Documents A and C. How does Document B illustrate the challenge facing the Bush administration in its efforts to carry out the plan discussed in Document C? Do you think the Bush administration shares the concerns about the deficit expressed in Document A? Use information from the documents to explain your answer.