Fiscal Policy
The use of government spending
and/or taxing to alter Aggregate
Demand.
Fiscal Policy
• The Employment Act of 1946 committed
the federal government to maintaining
economic stability.
• The federal government must constantly
monitor and analyze economic activity and
act to maintain a non-inflationary growing
economy through spending or taxing
legislation.
Expansionary Fiscal Policy
• The Problem – the economy is below fullemployment; in a recession
• The Solution - Expansionary fiscal policy
– increase government spending (G )
– reduce taxes (C )
– enact both spending increases and tax cuts
• The Result
– G or C or both increase causing AD to increase,
which causes output and employment to rise.
– Creates a budget deficit
To Tax or Spend?
• Changing government spending is always
more expansionary or contractionary
than changing taxes. Why?
– Part of any change in taxes comes from or
goes into savings.
Contractionary Fiscal Policy
• The Problem - the economy is past fullemployment; it is experiencing inflation
• The Solution - Contractionary fiscal policy
– reduce government spending (G )
– increase taxes (C )
– enact both spending cuts and tax increases
• The Result
– G or C or both decrease causing AD to decrease,
which lowers price levels.
– Creates a budget surplus
Discretionary versus Automatic
Fiscal Policy
• If government has to pass a law or take
some other specific action to change its
tax and/or spending policies then
government is stabilizing the economy
through discretionary policy.
Discretionary versus Automatic
Fiscal Policy
• If the policy change happens by itself as
the economic situation changes, then it is
known as an automatic stabilizer or a
built-in stabilizer.
• Examples of automatic stabilizers are
unemployment compensation during
recessions and higher taxes during
inflationary/expansionary periods.
Discretionary versus Automatic
Fiscal Policy
• There is a direct relationship between
GDP and net taxes.
– Net taxes are taxes less transfer payments
(unemployment compensation, food stamps,
TANF)
• As GDP rises our progressive tax system collects
a greater percentage of income in taxes and vice
versa.
• As GDP rises the need for transfer payments
decreases and vice versa.
Problems and Complications of
Fiscal Policy
• Problems of timing
– recognition lag – time it takes to gather data
on economic activity
– administrative lag – time it takes for
government (Congress) to pass legislation
– operational lag – time it takes for money to
enter economy and take effect
Problems and Complications of
Fiscal Policy
• Complications
– Crowding Out
• Expansionary fiscal policy (deficit
spending) will increase the interest
rate and reduce consumer and
business spending, thereby
weakening or canceling the stimulus
of expansionary policy.
Crowding Out Effect
• Interest rates (i) :. Investment (I)
and Consumption (C) :. AD :.
output and employment
The Crowding Out Effect
AD/AS
Price
Level
AS
Real
Interest
Loanable
Funds Mkt
Real
Interest
s
i2
i2
i1
i1
PL2
PL3
PL1
Investment
Demand
D2
AD1 AD3
AD2
Q1 Q3 Q2
RGDP
Id
D1
Q1 Q2
Q of Loans
Q2
Q1
Q of Investment
Graph 1: At AD1 we are in a recession. Government cuts Taxes and increases Spending to move the economy to AD2.
Graph 2: Because the government is now deficit spending the demand for loanable funds increases causing interest rates to
rise.
Graph 3: This increase in interest rates decreases Investment spending which causes AD to fall back to AD3 (Graph1 again).
Problems and Complications of
Fiscal Policy
– Modifications of crowding out
• If increased government spending raises
business profits expectations, the
investment demand curve shifts right and
there is little overall impact on investment
spending.
• Also if the Federal Reserve accommodates
fiscal policy by increasing the money
supply, interest rates will not change.
Problems and Complications of
Fiscal Policy
• Net Export Effect
– As interest rates increase the
consequential change in the value of
the dollar leads to a decrease in Net
Exports
– NX :. AD :. output and
employment
The Net Export Effect
AD/AS
Price
Level
AS
Real
Interest
FEX Market
Loanable
Funds Mkt
s
i2
e2
i1
e1
PL2
PL3
PL1
s
Price of
USD
D2
AD1 AD3
AD2
Q1 Q3 Q2
RGDP
D2
D
D1
Q1 Q2
Q of Loans
Q1 Q2
Q of USD
Graph 1: At AD1 we are in a recession. Government cuts Taxes and increases Spending to move the economy to AD2.
Graph 2: Because the government is now deficit spending the demand for loanable funds increases causing interest rates to
rise.
Graph 3: This increase in interest rates Increases demand for the USD in the currency exchange markets causing the dollar
to appreciate. The price of our goods in the international markets rise leading to a decrease in Exports and an
increase in Imports. Net exports decrease causing AD to decrease (AD3) on graph 1.
Problems and Complications of
Fiscal Policy
• Political problems
– State and local policy restraints
• Fiscal policy at lower levels tends to be
pro-cyclical.
• In times of recessions because of
constitutional or legislative restraints they
may have to increase taxes and reduce
spending.
Problems and Complications of
Fiscal Policy
• Political problems
– Other goals of Congress and
President
• The need to provide public goods,
redistribute income, the elimination of
budget deficits or war may make fiscal
policy use untenable.
Problems and Complications of
Fiscal Policy
• Political problems
– Political business cycles
• Fiscal policy may be corrupted for political
purposes and may cause economic
fluctuations
To Tax or Spend
• Choosing between increasing spending or
decreasing taxes; decreasing spending or
increasing taxes is a political philosophy
question.
– Republicans prefer smaller government so
they would choose options that achieve that –
tax cuts and reduced spending
– Democrats believe government has a vital
role in the economy, so they would choose to
increase taxes and increase spending
Financing Deficits
• Borrowing vs Creating New Money
– Borrowing may drive up equilibrium interest
rates decreasing investment spending
(Crowding Out Effect)
– Creating new money is the more
expansionary
Disposing of Surpluses
• Debt Retirement vs Idle Surplus
• Debt retirement means paying back loans
made to the government; money is put
back into the economy causing more
inflation
• Letting a surplus sit idle is more
contractionary
Government Debt and
Deficits
If government spending exceeds
government revenue (taxes) within
one year it is called deficit spending
If government revenue exceeds
government spending within one year
it is called a budget surplus
The Total Deficit or Surplus 1969 to 2016
2009 Projected deficit is $1.67 trillion.
The Federal Debt is the total of all budget deficits
and budget surpluses in our history.
http://www.usdebtclock.org/