1. Lecture #16: Fiscal Policy

2. 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!

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

4. 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!

5. 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

6. 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

7. 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

8. 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!

9. 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

10. 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

11. 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

12. 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.

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

14. 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!

15. 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.

16. 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

17. 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.

18. Summary
When completing your notes you need to write a 3-5 sentence summary of the lecture. This is a part of your notes grade!