Fiscal Policy
Questions:
How can gov’t changes in taxes or expenditure influence AD?
What is the difference between expansionary and contractionary fiscal policy?
How does fiscal policy influence both demand- and supply-side models?
Fiscal policy—government changes to its own expenditures and taxes to influence the level of aggregate
demand
– Purposeful, so it is discretionary policy
Components of AD: C+I+G+(X-M)
 Fiscal policy can affect the first three:
o G: through making changes in politics
o I: gov’t changes taxes on business profits
o C: gov’t changes income tax, which influences level of disposable income
At any given PL:
• An increase in gov’t spending or in transfer payments: increases real GDP
• An increase in taxes decreases real GDP
Automatic stabilizers are enhanced by discretionary fiscal policy
Where did it come from?
Fiscal policy was the brain child of economist __________________________________________ during the
1930s in an attempt to understand the Great Depression
• Keynes advocated ______________________ government expenditures and ______________ taxes to
stimulate demand and pull the global economy out of the Depression.
– concept that optimal economic performance could be achieved by influencing aggregate demand
through activist stabilization and economic intervention policies by the government (FISCAL
POLICY)
– Three tools: Taxes, gov’t spending, transfer payments
Closing a contractionary gap
• When the economy is in contraction or recession, the
government will typically use ____________________ fiscal
policy to “expand” the economy
• The government will increase spending and/or lower taxes,
which has the effect of:
– Increasing _________ (increased AD)
– Lowering unemployment
– Increasing disposable income/consumption when taxes
are adjusted downward
Closing an inflationary gap
• When the economy is “overheating”, or is an expansion which
results in high prices, the gov’t will use
_________________________ fiscal policy to “contract” the
economy
• The government will decrease spending and/or increase taxes,
which has the effect of:
– Decreased AD, fall in real GDP
– Could potentially increase unemployment
– Taxes increased on firms and/or consumers
The multiplier effect (HL)
• Congress must be careful with the amount of taxes/spending adjusted, as it could create a multiplying
(“snowball”) effect:
– If the gov’t puts $10 billion into the economy, that money will affect GDP more than $10 bill. It
may affect by $10.5 or even $12 billion, depending on responsiveness of economy to fiscal
policy
• Difficult to estimate; Effects of fiscal policy always multiply, which can cause Congress to stimulate the
economy too much, causing high inflation
What happens when there is too much economic stimulation?
• Inaccurate estimations of potential output or natural rate
of unemployment can cause an over-stimulation of the
economy
• This can cause AD to extend past potential output and
cause increased GDP with increased prices
• If this is not corrected, suppliers will not be able to
maintain production with increased price and AS will
decline, causing even higher high prices and decreased
GDP (high unemployment)
• This is also called _____________________
FP’s unintentional affect on supply of labor
• If gov’t increases transfer payments (unemployment pay) too much during a contractionary period,
expansionary policy will give the unemployed who benefit from increased transfer payments, have less
incentive to find work
•
If gov’t decreases taxes too much during an expansionary period, contractionary policy will give
workers, who find their wage reduced by the higher tax rates, less incentive to work
•
Both of these situations would reduce AS, causing high prices (inflation) and lower the GDP
SCENARIOS:
What would happen to consumption and aggregate demand if:
1. The government increases income tax?
2. The government lowers expenditure taxes (sales tax or VAT)?
3. The government increases its spending?
Expanding Economy
(Inflationary gap)
Contracting Economy
(Deflationary gap)
Macro objectives
High/stable growth
Stable prices, such as low inflation rate
High growth rate
High or increasing inflation rate
Low level of unemployment
Low unemployment
Falling growth rate or negative growth
Low(-er) inflation rate, possibly
deflation
Increasing/high unemployment
Trade balance (X=M)
M often larger than X; trade deficit
M falling; possible trade surplus
Possible fiscal policies
ΔT, ΔG/transfer payments
ΔT &/or ΔG/ transfer payments
Possible monetary policies
Tight monetary policy; ΔSm, Δr
Loose monetary policy; ΔSm, Δ –r
Positive effects of policies
Lower inflation, relieves pressure on
tight labor market, possible
improvement in trade balance
Decrease in unemployment, increased
output (or slower negative growth),
societal benefits
Negative effects of policies
Growth rate falls back, lower
investment can harm long run potential
growth
Inflationary pressure, increase in
imports might cause trade deficit
Assume the economy of Switzerland is experiencing a slump in aggregate demand, and output in the economy is thought
to be $10 billion less than what would be produced at full employment. On the graph below, illustrate the Swiss economy
at its current level of output.
On the graph you drew, identify the recessionary gap.
Assume that the Swiss government wishes to enact a fiscal policy that would return the economy’s output to its full
employment level. Identify the options available to the Swiss government.