Fiscal Policy Activities 30b by Advanced Placement Economics Teacher Resource Manual. National Council on Economic Education, New York, N.Y.

Objectives: Explain the impact of government spending changes on the economy. Explain the impact of government spending changes on the economy. Explain the effect of changes in taxes on the economy. Explain the effect of changes in taxes on the economy. Describe the embedded fiscal policy tools and explain how the tools adjust the economy. Describe the embedded fiscal policy tools and explain how the tools adjust the economy. Explore the alternative methods of analyzing fiscal policy effects. Explore the alternative methods of analyzing fiscal policy effects.

Fiscal Policy Fiscal policy is one of the two demand management policies available to policy makers. Fiscal policy is one of the two demand management policies available to policy makers. Government expenditures and the level and type of taxes are discretionary fiscal policy tools. Government expenditures and the level and type of taxes are discretionary fiscal policy tools. This lesson will explore the effects of these tools on the economy, the existence of embedded tools and alternative ways to analyze fiscal policy. This lesson will explore the effects of these tools on the economy, the existence of embedded tools and alternative ways to analyze fiscal policy.

Fiscal Policy Aggregate demand is the total amount of spending on goods and services in the economy during a stated period of time. AD consists of: Aggregate demand is the total amount of spending on goods and services in the economy during a stated period of time. AD consists of: Consumer Spending Consumer Spending Government Spending Government Spending Investment Spending Investment Spending Net Exports Net Exports Aggregate supply consists of: Aggregate supply consists of: Total amount of goods and services available in the economy during a stated period of time. Total amount of goods and services available in the economy during a stated period of time.

Fiscal Policy During a recession aggregate demand is usually too low to bring about full employment of resources. During a recession aggregate demand is usually too low to bring about full employment of resources. Government can increase aggregate demand by: Government can increase aggregate demand by: spending more spending more cutting taxes cutting taxes (or) doing both. (or) doing both. These actions often result in budget deficits because the government spends more than it collects in taxes. These actions often result in budget deficits because the government spends more than it collects in taxes. Increasing government spending without increasing taxes or decreasing taxes without decreasing government expenditures should increase AD. Increasing government spending without increasing taxes or decreasing taxes without decreasing government expenditures should increase AD. Such an expansionary fiscal policy should: Such an expansionary fiscal policy should: increase employment increase employment Increase the price level Increase the price level Or both Or both

Fiscal Policy If the level of AD is too high, government can reduce its spending increase taxes or do both. If the level of AD is too high, government can reduce its spending increase taxes or do both. These actions should result in a larger budget surplus or a small budget deficit than existed before. These actions should result in a larger budget surplus or a small budget deficit than existed before. Such a contractionary fiscal policy should lower the level of AD, and the economy will experience: Such a contractionary fiscal policy should lower the level of AD, and the economy will experience: Less employment Less employment Lower price level Lower price level Or both Or both

Fiscal Policy Two primary fiscal policy tools are: Two primary fiscal policy tools are: 1. Government Spending Affects the economy directly by increasing the demand for goods and services. Affects the economy directly by increasing the demand for goods and services. As soon as the government increase its spending, it initiates a multiplier process that results in a greater increase in total spending than the initial increase in government spending. As soon as the government increase its spending, it initiates a multiplier process that results in a greater increase in total spending than the initial increase in government spending. The increase in government spending increase aggregate demand, shifting the AD curve to the right. The increase in government spending increase aggregate demand, shifting the AD curve to the right. In the short run, the usual effects are an increase in real GDP and the price level. In the short run, the usual effects are an increase in real GDP and the price level.

2. Taxes Taxes do not directly change real GDP. Taxes do not directly change real GDP. Changes in taxes affect the disposable income of households or businesses. Changes in taxes affect the disposable income of households or businesses. These changes are felt through consumption spending and investment spending. These changes are felt through consumption spending and investment spending. An increase in taxes decreases disposable income. An increase in taxes decreases disposable income. A decrease in disposable income decreases consumption, but by less than the increase in taxes. A decrease in disposable income decreases consumption, but by less than the increase in taxes. Some of the additional tax bill is paid from savings. Some of the additional tax bill is paid from savings. The multiplier process applies to the increase in taxes, and real GDP decreases by more than the tax increase. The multiplier process applies to the increase in taxes, and real GDP decreases by more than the tax increase.

Fiscal Policy Expansionary fiscal policy leads to an increase in real GDP larger than the initial rise in aggregate spending caused by the policy.   Makes a budget surplus smaller or a budget deficit bigger. Contractionary fiscal policy leads to a fall in real GDP larger than the initial reduction in aggregate spending caused by the policy.   smaller government purchases of goods and services, smaller government transfers, or higher taxes—increase the budget balance for that year, making a budget surplus bigger or a budget deficit smaller.

Part B Test your understanding of fiscal policy by completing the table in Figure Your choices for each situation must be consistent – that is, you should choose either an expansionary or contractionary fiscal policy. (Fiscal policy cannot provide a solution to one of the situations.)

Fill in the spaces as follows: Fill in the spaces as follows: Column A: Objective for Aggregate Demand Column A: Objective for Aggregate Demand Draw an up arrow if you wish to increase aggregate demand. Draw an up arrow if you wish to increase aggregate demand. Draw a down arrow if you wish to decrease aggregate demand. Draw a down arrow if you wish to decrease aggregate demand. Column B: Action on Taxes Column B: Action on Taxes Draw an up arrow if you wish to increase taxes. Draw an up arrow if you wish to increase taxes. Draw a down arrow if you wish to decrease taxes. Draw a down arrow if you wish to decrease taxes. Column C: Action on Government Spending Column C: Action on Government Spending Draw an up arrow if you wish to increase government spending. Draw an up arrow if you wish to increase government spending. Draw a down arrow if you wish to decrease government spending. Draw a down arrow if you wish to decrease government spending. Column D: Effect on Federal Budget Column D: Effect on Federal Budget Write toward deficit if your action will increase the deficit (or reduce the surplus) Write toward deficit if your action will increase the deficit (or reduce the surplus) Write toward surplus if your action will reduce the deficit (or increase the surplus) Write toward surplus if your action will reduce the deficit (or increase the surplus) Column E: Effect on the National Debt Column E: Effect on the National Debt Draw an up arrow if you think the national debt will increase. Draw an up arrow if you think the national debt will increase. Draw a down arrow if you think the national debt will decrease. Draw a down arrow if you think the national debt will decrease.

Figure 30.1: Effects Of Fiscal Policy 1. National unemployment rate rises to 12 percent 2. Inflation is strong at a rate of 14 percent per year. 3. Surveys show consumers are losing confidence in the economy, retail sales are weak and business inventories are increasing rapidly. 4. Business sales and investment are expanding rapidly, and economists think strong inflation lies ahead. 5. Inflation persists while unemployment stays high (A) Objective for Aggregate demand (B) Action on Taxes (C) Actions on Government Spending (D) Effect on Federal Budget (E) Effect on the National Debt Toward deficit Toward surplus Toward deficit Toward surplus Fiscal policy is unable to provide a solution to the situation of high inflation and unemployment: stagflation.