2. FISCAL POLICY

3. LEGISLATIVE MANDATES Employment Act of 1946 Council of Economic Advisors (CEA) Joint Economic Committee (JEC)

4. FISCAL POLICY AND THE AD-AS MODEL Two Options Discretionary Fiscal Policy Non-Discretionary Fiscal Policy Expansionary Fiscal Policy To Reduce Unemployment… Increase Government Spending Tax Reductions Combinations of the Two

5. Price level Real GDP (billions) EXPANSIONARY FISCAL POLICY Full $20 billion increase in aggregate demand AD 2 AD 1 $5 billion initial increase in spending the multiplier at work... P1P1 $490 $510 AS

6. To Reduce Inflation… Decrease Government Spending Tax Increases Combinations of the Two FISCAL POLICY AND THE AD-AS MODEL Contractionary Fiscal Policy

7. Price level Real GDP (billions) CONTRACTIONARY FISCAL POLICY Full $20 billion decrease in aggregate demand AD 3 AD 4 $5 billion initial decrease in spending the multiplier at work... P2P2 $510 $522 AS P1P1

8. FINANCING OF DEFICITS AND DISPOSING OF SURPLUSES Borrowing vs. New Money Borrowing From The Public Money Creation Debt Retirement vs. Idle Surplus Debt Reduction Impounding Which Policy Option? G or T?

9. BUILT-IN STABILITY Net tax revenues vary directly with GDP Transfer payments behave the opposite way as tax collections Automatic or Built-In Stabilizers Economic Importance

10. BUILT-IN STABILITY GDP 1 GDP 2 GDP 3 Real Domestic Output, GDP Government Expenditures, G, and Tax Revenues, T Deficit Surplus T G

11. BUILT-IN STABILITY Tax Progressivity Progressive Tax System Proportional Tax System Regressive Tax System The more progressive the tax system, the greater the economy’s built-in stability.

12. FULL-EMPLOYMENT DEFICITS GDP 2 GDP 1 Real Domestic Output, GDP Government Expenditures, G, and Tax Revenues, T (billions) G T1T1 (Year 1)(Year 2) a b c $500 475 450 425 No Change in Fiscal Policy

13. FULL-EMPLOYMENT DEFICITS GDP 4 GDP 3 Real Domestic Output, GDP Government Expenditures, G, and Tax Revenues, T (billions) T2T2 G T1T1 Year 3Year 4 d e f $500 475 450 425 Discretionary Fiscal Policy Tax Decrease h g

14. EVALUATING FISCAL POLICY Full-Employment Budget Cyclical Deficit Recent U.S. Deficits & Surpluses Year Actual Deficit or Surplus Full-Employment Deficit or Surplus 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 -3.9% -4.5% -4.7% -3.9% -2.9% -2.2% -1.4% -0.3% +0.8% +1.4% +2.4% +1.3% -1.5% -2.1% -2.4% -2.9% -2.8% -2.1% -2.0% -1.3% -0.9% -0.4% +0.3% +1.1% +0.8% -1.5%

15. -6 -4 -2 0 2 4 Italy Sweden Canada United Kingdom France United States Ireland Norway Japan GLOBAL PERSPECTIVE BUDGET DEFICITS OR SURPLUSES AS A PERCENTAGE OF GDP, 2002 Source: Organization for Economic Development and Cooperation

16. PROBLEMS, CRITICISMS, AND COMPLICATIONS Problems of Timing Recognition Lag Administrative Lag Operational Lag Political Considerations Political Business Cycles Offsetting State & Local Finance Crowding-Out Effect

17. FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION Fiscal Policy: No Complications Price level Real GDP (billions) AD 1 AD 2 P1P1 $490 $510 AS

18. FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION Fiscal Policy: Showing Crowding-out Effect or Net Export Effect Price level Real GDP (billions) AD 1 AD 2 P1P1 $490 $510 AS AD’ 2 $504

19. FISCAL POLICY IN THE OPEN ECONOMY Shocks Originating from Abroad Net Export Effect