1. Fiscal Policy
Chapter 30

2. Fiscal policy is the idea that the government can influence the economy through taxation and/or government spending
Employment Act of 1946—requires the government to use all reasonable measures to keep unemployment under control
Act established the Council of Economic Advisors (CEA)—assists the President on economic issues
Established the Joint Economic Committee (JEC) to investigate national economic problems
Legislative Mandates

3. Fiscal Policy and the AD-AS Model
There are two types of fiscal policy
Discretionary—optional, government chooses to do it
Indiscretionary—occurs automatically or independent of government choice
During the first part of the chapter we are only talking about discretionary
Expansionary fiscal policy uses increased government spending or a decrease in taxes to push the economy out of recession
There are 3 tools the government can use under fiscal policy:
Increase spending
Cut taxes
Some combinations of the two
Fiscal Policy and the AD-AS Model

4. Fiscal Policy and the AD-AS Model
If the budget is balanced, using fiscal policy will lead to a budget deficit—why?
Because an increase in spending and/or a decrease in taxes with nothing else changing means you go negative
If the government increases spending, AD will shift to the right
Be aware that the multiplier effect applies
For example if RGDP was at $490B and the government increased spending by $5B—RGDP would only increase to $495B temporarily
After the multiplier effect it would increase even more
Fiscal Policy and the AD-AS Model

5. Fiscal Policy and the AD-AS Model
For example—say our marginal propensity to consume (MPC) = 0.75
Remember the multiplier effect = 1/MPS(.25)
So…1/MPS = 4
If our original increase in government spending was $5B and our multiplier effect is 4, what will our final increase in the economy look like
$5B ×4 = $20B
Fiscal Policy and the AD-AS Model

6. Fiscal Policy and the AD-AS ModelG
$5B PL
This model shows an overall increase of $20B in the economy after the multiplier effect AS
multiplier P1
AD2
AD1
RGDP
$490
$510
Fiscal Policy and the AD-AS Model

7. Fiscal Policy and the AD-AS Model
The increase to $510B would result in the economy pulling out of a recession and a decrease in unemployment that occurred during the recession because there is now money to help hire people
You can also use tax cuts to accomplish the same goals
You will have to cut taxes by more ($6.67B) to accomplish the same result because people will save (MPS) so much
The larger the MPS/smaller the MPC the more taxes you have to cut to get the same affect as raising government spending
The government could also combine these two policies to achieve results
Fiscal Policy and the AD-AS Model

8. Fiscal Policy and the AD-AS Model
When demand-pull inflation occurs the government will implement contractionary fiscal policy
In this case the government cuts spending, increases taxes, or a combo of both to control inflation
IF INFLATION, THEN:
G↓ .: AD  .: RGDP↓ & PL↓ .: u%↑ OR
T↑ .: DI↓ .: C↓ .: AD  .: RGDP↓ & PL↓ .: u%↑
IF UNEMPLOYMENT, THEN:
G↑ or T↓, then AD shifts causing PL and RGDP which causes u%
Fiscal Policy and the AD-AS Model

9. Fiscal Policy and the AD-AS ModelPL P1
$500
$520 T
$5B
multiplier
RGDP
This model shows an overall decrease of $20B in the economy after the multiplier effect
Fiscal Policy and the AD-AS Model

10. Fiscal Policy and the AD-AS Model
There are two ways the government can get money to expand
They can borrow money (sell interest bearing bonds) but then they are competing with private companies which creates new demand and will raise interest rates—when interest raises, consumer spending will drop which will weaken the expansionary effect
They can create new money—new money will allow them to spend without immediately affecting consumption; however, it will likely cause an increase in inflation
Fiscal Policy and the AD-AS Model

11. Fiscal Policy and the AD-AS Model
Demand-pull inflation calls for contractionary fiscal policy which is achieved by either:
Debt reduction—if the government has a surplus of money then inflation will occur. To offset that, they can use the surplus to pay their debts (buy back bonds). In doing so, it will drive down interest rates, drive up consumption and cause more money to circulate which minimizes the effect they were going for.
Impounding—means they let the surplus sit idle, if they aren’t put back into the economy via spending, then it will bring inflation back down
Fiscal Policy and the AD-AS Model

12. Fiscal Policy and the AD-AS Model
So, which is better? Government spending increases or tax cuts…
It depends on your point of view
Democrats tend to believe that government spending should be used to deal with unmet social needs—this results in an increase in the size of the government
Republicans tend to believe that the government is too large and thus tax cuts should be used—this results in a decrease in the size of the government
Fiscal Policy and the AD-AS Model

13. Government taxes may also be nondiscretionary—meaning that some tax increases occur naturally within the business cycle
If the GDP goes up so will the revenue made from taxes (a.k.a. sales taxes bring in more money because people buy more, or income tax revenue increases because people make more money)
Consequently, if GDP goes down “negative taxes” (transfer payments), such as welfare, unemployment, and subsidies go up
The US Tax System is a built-in stabilizer—Congress doesn’t have to change anything to react to recessions or inflations
Built-In Stability

14. A regressive tax is one that puts more of the burden on people from lower incomes
Sin tax because people from the lower class purchase those products more than upper class
A progressive tax is one that puts more of the burden on people from higher incomes
The income tax system (higher wages are taxed at a higher percentage, while lower wages are taxes at a lower percentage)
A proportional tax is neutral
Fair tax or flat tax
Built-in stabilizers cannot do all the work, fiscal or monetary policy is required to stabilize when the economy slips
Built-In Stability

15. A progressive tax will increase with GDP where as a regressive tax will decrease when GDP rises
The more progressive taxes are the greater the built-in stability is G T
Government Spending and Taxation
Surplus
Deficit
RGDP
Built-In Stability

16. Problems, Criticisms, and Complications
There are many problems when trying to enact fiscal policy
Recognition lag—how long it takes to become aware of a problem existing
Administration lag—Congress and the President are slow to act
Meanwhile, the Fed acts quickly
Operational lag—government planning (regarding spending) take a long time—building roads, etc.
You also have to include political consideration—politicians want to get reelected
They will spend more in election time to look productive, spend less after the election
Problems, Criticisms, and Complications

17. Problems, Criticisms, and Complications
Other problems with fiscal policy:
Future policy reversals—if the people think the tax cuts will go away, they will save more making the policy less effective
Offsetting state and local finance—when the federal government moves one direction and the state moves the other way
Crowding-Out effect
A possible side-effect of increased government spending and reduced taxes is a budget deficit which may lead to the ‘crowding-out’ of Gross Private Investment (IG) and Net Exports (XN)
Problems, Criticisms, and Complications

18. Problems, Criticisms, and Complications
The Crowding Out effect results in the following linkage:
G (or T ): G borrows $: Dm : i : Ig
When investments go down, instead of expanded the economy (as was hoped for in increasing spending) the overall GDP will go down
NOTE: interest sensitive consumption could go down as well
Crowding-Out results in businesses being stifled by government spending
Problems, Criticisms, and Complications

19. Problems, Criticisms, and Complications
Crowding out
Problems, Criticisms, and Complications

20. Crowding Out