FISCAL POLICY Government efforts to promote full employment and price stability by changing government spending (G) and/or taxes (T). Government efforts to promote full employment and price stability by changing government spending (G) and/or taxes (T). Congress only… Congress only…

TWO KINDS OF FISCAL POLICY Expansionary policy; counters recession Expansionary policy; counters recession Increase government spending ( G ) Increase government spending ( G ) Decrease taxes ( T ) Decrease taxes ( T ) Contractionary policy; counters inflation Contractionary policy; counters inflation Decrease government spending ( G ) Decrease government spending ( G ) Increase Taxes ( T ) Increase Taxes ( T ) Time for some graphing!

TWO OTHER WAYS OF CATEGORIZING FISCAL POLICY Discretionary Discretionary Changing the level of Government Spending and/or Taxes in order to return the economy to full employment. Changing the level of Government Spending and/or Taxes in order to return the economy to full employment. Policy makers doing fiscal policy in response to an economic problem Policy makers doing fiscal policy in response to an economic problem Automatic Automatic Takes place without policy makers having to respond to current economic problems. Takes place without policy makers having to respond to current economic problems. Unemployment compensation & marginal tax rates are examples of automatic policies. Unemployment compensation & marginal tax rates are examples of automatic policies.

WHAT ARE THE WEAKNESSES OF FISCAL POLICY Lags Lags Inside lag – The time it takes to recognize economic problems, promote solutions, and implement policy change. Inside lag – The time it takes to recognize economic problems, promote solutions, and implement policy change. Outside lag – The time it takes for newly implemented policy to have a noticeable effect in the economy. Outside lag – The time it takes for newly implemented policy to have a noticeable effect in the economy. Political Motivation Political Motivation Politicians are more likely to support expansionary rather than contractionary fiscal policy. Politicians are more likely to support expansionary rather than contractionary fiscal policy.

CROWDING OUT Fiscal Policy may lead to deficits (1 st we must understand this) Fiscal Policy may lead to deficits (1 st we must understand this) Crowding out is a possible side effect of expansionary Fiscal Policy. This effect may be caused by the government engaging in deficit spending. In order to fund deficit spending, the government must barrow money. This increases the demand for loanable funds. Increased demand for loanable funds raises the cost of loanable funds (borrowing). The cost of borrowing is the real interest rate ( r ). The result then is that r increases. Crowding out is a possible side effect of expansionary Fiscal Policy. This effect may be caused by the government engaging in deficit spending. In order to fund deficit spending, the government must barrow money. This increases the demand for loanable funds. Increased demand for loanable funds raises the cost of loanable funds (borrowing). The cost of borrowing is the real interest rate ( r ). The result then is that r increases. We already know that… r  Ig  AD We already know that… r  Ig  AD Don’t forget that … r  D$  $  X and M  Xn  AD Don’t forget that … r  D$  $  X and M  Xn  AD Finally, the loanable funds graph Finally, the loanable funds graph          