Lecture #16: Fiscal Policy

Fiscal Policy (FP) 2 types of Fiscal Policy Fiscal policy deals w/changes the gov’t makes in spending or taxation to achieve particular economics goals. Expansionary FP is an increase in gov’t spending or a reduction in taxes Contractionary FP is a decrease in gov’t spending or an increase in taxes Remember when taking Cornell Notes you need to come up with at least 3 questions per page!

Change in government spending Types of Fiscal Policy Type of fiscal policy Change in government spending Change in taxes Expansionary And/Or Contractionary

Fiscal Policy (FP) cont Expansionary FP Problem--unemployment Gov’t can use expansionary FP to decrease the unemployment rate A high unemployment rate b/c people aren’t spending enough money in the economy If govt increases spending and/or reduces taxes, consumers have more money to spend An increase in govt spending means more spending in the economy When businesses sell more goods—they need to hire more workers = unemployment goes down!

Fiscal Policy (FP) cont Crowding Out Not all economists agree that it is that easy to lower the unemployment rate Crowding Out = occurs when increases in govt spending lead to reductions in private spending If govt spends more on education, people may decide to spend less on private school

Fiscal Policy (FP) cont Crowding Out cont Complete Crowding Out = when increased spending in the govt exactly equals reduced spending by citizens. Incomplete Crowding Out = when the reduction in consumer spending is less than the increase in govt spending Total spending in the economy increases

Total output in the economy Expansionary Fiscal Policies Increasing Government Spending If the federal govt increases its spending or buys more goods & services, it triggers a chain of events that raise output & creates jobs. Cutting Taxes When the govt cuts taxes, consumers & businesses have more money to spend or invest. This increases demand & output. Effects of Expansionary Fiscal Policy Total output in the economy High output Low output High prices Low prices Price level Aggregate supply Original aggregate demand Lower output, lower prices Higher output, higher prices Aggregate demand with higher government spending

Fiscal Policy (FP) cont Contractionary FP Problem--Inflation Inflation is the result of too much spending in the economy compared w/the quantity of goods & services available for purchase The govt can slow inflation by reducing the amount it spends As a result of the decrease in spending, firms sell fewer goods—to reduce unwanted inventory they lower prices!

Fiscal Policy (FP) cont Crowding IN Crowding in—occurs when decreases in govt spending lead to increases in private spending Crowding in can be complete or incomplete Complete crowding is also called zero crowding in

Total output in the economy Contractionary Fiscal Policies Decreasing Government Spending If the federal govt spends less, or buys fewer goods & services, it triggers a chain of events that may lead to slower GDP growth. Raising Taxes If the federal govt increases taxes, consumers & businesses have fewer dollars to spend or save. This also slows growth of GDP. Effects of Contractionary Fiscal Policy Total output in the economy High output Low output High prices Low prices Price level Aggregate supply Higher output, higher prices Original aggregate demand Lower output, lower prices Aggregate demand with lower government spending

The Effectiveness of Fiscal Policy Objective Policy Condition existing Does the policy affect total spending in the economy? Does the policy meet the objective (as stated in the 1st column)? Reduce unemployment Expansionary fiscal policy (as measured by an increase in govt spending) No crowding out YES Complete crowding out NO Incomplete Crowding out Reduce inflation Contractionary fiscal policy (as measured by an decrease in govt spending) No crowding in Complete crowding in Incomplete Crowding in

Fiscal Policy (FP) cont FP & Taxes After-tax income = part of income that is left over after taxes are paid If govt lowers taxes—more money is available from earnings & total spending increases Leads to increased sales & hiring—reducing the unemployment rate.

Fiscal Policy (FP) cont & Taxes If govt raises taxes— the opposite occurs. After-tax income is reduced—decreasing spending & causing unemployment to increase.

Fiscal Policy (FP) cont & Taxes People are more willing to work when taxes are lower If taxes were 100% of earnings—there would be no incentive to work Lower tax rates do not necessarily result in lower tax revenues for the govt. Lower taxes will likely give incentive to work more = more spending = more tax revenue for the govt!

Fiscal Policy (FP) cont Laffer Curve The Laffer curve, named after economist Arthur Laffer, shows the relationship between tax rates & tax revenues As tax rates rise from zero—tax revenues rise—reach a maximum—and then fall.

Supply-Side Economics Supply-side economics stresses the influence of taxation on the economy. Supply-siders believe that taxes have a strong, negative influence on output. The Laffer curve shows how both high and low tax revenues can produce the same tax revenues. Laffer Curve High revenues Low revenues 100% High taxes 0% Low taxes 50% Tax revenues Tax rate a b c

Review—True or False FALSE TRUE If government spending is increased and taxes are increased, it is expansionary fiscal policy. FALSE Expansionary fiscal policy brings up the issue of crowding out. TRUE If the inflation rate is high, government may implement contractionary fiscal policy. Incomplete crowding in will make contractionary fiscal policy ineffective. Tax cuts always lead to lower tax revenues.

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