1. The
President
Congress
BUDGET
Taxes
Spending
Fiscal
Policy

2. Fiscal Policy
A tool of macroeconomic policy that seeks to influence the level of economic activity through control of government expenditure and taxation.
There are two types of fiscal policy:
Automatic Stabilizers
Discretionary Policy

3. Fiscal Policy: Automatic Stabilizers
Built in, non-discretionary elements in fiscal policy that serve to reduce the impact of economic events automatically. For example,
A fall in output and national income reduces tax burdens as income falls and increases unemployment and welfare payments.
Lower tax payments and higher transfer payments increase the government’s budget deficit and restore some of the income lost by people.

4. Fiscal Policy: Discretionary Policy
Discretionary Fiscal Policy
Expansionary Fiscal Policy
Decreases in taxes and/or increases in spending which tend to increase economic activity.
Contractionary Fiscal Policy
Increases in taxes and/or decreases in spending which tend to dampen economic activity.

5. Fiscal Policy: Demand Side Transmission Mechanism
Investment
Spending is
Crowded Out
Interest Rates
Rise
Export
Spending is
Crowded Out
Government
Spending
Rises
Aggregate
Spending
Increases
Deficit
Increases
Imports Rise
Exports Fall
Taxes
Decrease
Price Level
Rises
Spending
Decreases
Expansionary Fiscal Policy

6. Aggregate demand shifts from AD1 to AD2.AE AS
AE2(P1)
We begin at Y1, where AD< AS*. The economy is in a recessionary gap.
To close the gap, the government engages in expansionary fiscal policy.
The increase in government spending and/or decrease in taxes causes aggregate expenditures to increase from AE1 to AE2.
Aggregate demand shifts from AD1 to AD2.
At point 2, AD > AS*. As the price level rises, AD decreases along the aggregate demand curve.
The rising price level causes AE2 to shift down to AE3. Equilibrium is established at Y2 and P2. 2
AE3(P2)
AE1(P1) 3 1
Y Y Y3 Y P
AS* AS 3 P2 2 P1 1
AD2
AD1
Y Y Y3 Y

7. Fiscal Policy: Demand Side Transmission Mechanism
Investment
Spending Rises
Interest Rates
Fall
Export
Spending
Rises
Government
Spending
Falls
Aggregate
Spending
Decreases
Deficit
Decreases
Imports Fall
Exports Rise
Taxes
Increase
Price Level
Falls
Spending
Increases
Contractionary Fiscal Policy

8. Aggregate expenditures decrease from AE1(P1) to AE2 (P1).
We begin at Y3, where AD> AS*. The economy is in an inflationary gap.
To close the gap, the government engages in contractionary fiscal policy.
The decrease in government spending and/or increase in taxes causes aggregate demand to shift from AD1 to AD2.
Aggregate expenditures decrease from AE1(P1) to AE2 (P1).
At point 2, AS* > AD. As the price level falls, AD increases along the aggregate demand curve.
The falling price level causes AE2(P1) to shift up to AE3(P2). Equilibrium is established at Y2 and P2. 1
AE3(P2)
AE2(P1) 3 2
Y Y Y3 Y P
AS*r AS 2 1 P1 3
AD1 P2
AD2
Y Y Y3 Y

9. Demand-Side Fiscal Policy Problems
Expansionary fiscal policy can be used to push the economy to a higher level of output, but it also results in a higher price level.
Fiscal policy actions often miss the target.
We have only estimates of the size of the multiplier.
Fiscal policy actions often are timed poorly.
Fiscal policy affects GDP with a lag.
Fiscal policy can get mired down in politics.

10. Fiscal Policy: Supply Side Transmission Mechanism
Inflation Falls
Unemployment Falls
After-tax Wage
Higher
Increase in
Labor Supply
Aggregate Supply
Rises
Lower Personal
Tax Rates
Interest Rates
Fall
Productivity
Rises
Savings Rise
Lower Business
Tax Rates
After-tax ROR
Rises
Investment Rises

11. Fiscal Policy: Supply Side
Expansionary Fiscal Policy
The federal government decreases taxes.
People work more: People save more: Firms invest more.
Aggregate supply increases, unemployment falls, inflation falls.

12. Tax Cuts: Labor Supply
The decrease in marginal income tax rates encourages people to work more.
People are willing to work more because they now keep more of their wages.
More specifically, they get to keep more of the last dollar earned.
Therefore, the increased labor supply increases output without putting upward pressure on wages.

13. Tax Cuts: Saving and Investment
Business tax cuts increase business profits.
Higher profits encourage investment in new capital.
Individual tax cuts stimulate household savings.
Increased savings contribute to lower interest rates and increased investment in new capital.
New capital increases productivity, thus, lowering costs and inflationary pressures.

14. Fiscal Policy: Supply Side
Contractionary Fiscal Policy
The federal government increases taxes.
People work less: People save less: Firms invest less.
Aggregate supply decreases, unemployment rises, inflation rises.

15. Supply Side Fiscal Policy
AS2
AS1 P P
AS1
AS2 2 P2 1 1 P1 P1 2 P2
AD1
AD1
Y1 Y2 Y
Y2 Y1 Y
Expansionary
Contractionary

16. Supply-Side Fiscal Policy Problems
Small Magnitude of the Supply-side Effects.
Savings do not appear to respond to tax incentives.
Demand Side Effects.
People respond to tax cuts by spending more. They may or may not respond by working more.
Timing Problems
The impact of increases in investment spending occur much later as industrial capacity increases

17. Supply-Side Fiscal Policy Problems
Effect on Income Distribution
Supply-side tax cuts favor the wealthy
Tax Cuts Increase the Budget Deficit
But, so do demand-side tax cuts.

18. Are Deficits Bad? When the government runs a deficit, it must borrow.
The borrowing tends to cause interest rates to be higher than they otherwise would be.
Interest sensitive spending that occurs in the private sector declines while government spending increases.

19. Are Deficits Bad? Government budget deficits are said to..
Reduce national saving
Create a flow of assets overseas
Slow rate of capital accumulation
Redistribute income and wealth

20. Output Effects of Deficits
An economy’s output is determined by its productive capacity.
Productive capacity is determined in part by the stock of capital.
If deficits crowd out investment, the capital stock grows more slowly.
Over a decade or more, the economy’s capacity to produce can be reduced.
National income rises more slowly.

21. Wealth Effects of Deficits
When foreigners increase their ownership of domestic assets, more income from production flows overseas in the form of rent, interest and profits.
National income may continue to rise, but the amount that the citizens of the country actually keep falls.

22. Wages and Profits and Deficits
If deficits crowd out investment and result in a smaller amount of available capital, labor productivity and real wages will fall.
The productivity of capital and its return, however, will rise.

23. Economists and the Balanced Budget Amendment
Most economists do not support a balanced budget amendment because:
Forecasting deficits requires an impossible degree of accuracy.
It is bad public policy to balance the budget in every year. The budget should be balanced over the business cycle.
Deficits in recession cushion the economy
Surplus in inflation cool off the economy

24. Economists and the Balanced Budget Amendment
Annual balancing would increase economic instability and investor uncertainty adding to the problem rather than fixing it.
Distort budget policy causing a permanent preference for spending cuts over tax increases.
Preclude the development of capital budgeting procedures.
Give rise to inappropriate uses of government mandates, regulations, tax breaks, and new forms of “off-budget” spending designed to evade restrictions on taxing and spending.

25. Economists and the Balanced Budget Amendment
Make international coordination of economic policies more difficult.
Postpone the day of reckoning until after ratification of the amendment.
Decrease the flexibility of economic policy because the amendment would involve the courts, whose function it is to interpret the Constitution.