Chapter 30: Fiscal Policy
1. Discretionary Fiscal Policy is the deliberate manipulation of taxes and government spend to alter
GDP and employment, control inflation, and stimulate growth.
2. Stabilization Policies in the short run involve the following two options:
a) Expansionary fiscal policy is used to eliminate a recessionary gap and stimulate AD in
order to return the economy to full employment.
b) Contractionary fiscal policy is used to counteract an inflationary gap and reduce AD in
order to return the economy to full employment.
3. Fiscal Policy Options
Effect on Budget
Gov’t Spending
a) expansionary increase
toward deficit
b) contractionary decrease
surplus

Taxes Effect on GDP Effect
lower increase
increase
raise
lower
decrease
on
Prices
toward
effect on prices assumes in intermediate or vertical region of AS (horizontal, region, no change)
4. The crowding out effect is an argument that an expansionary fiscal policy (deficit spending) will
increase the interest rate and reduce private investment, reducing the stimulus of the fiscal policy.
Specifically, here are the linkages:
a)
b)
c)
d)
government spending and/or tax reduction increases the budget deficit
the budget deficit is finance through government borrowing of funds in the money market
the increase in the demand for money raises the interest rate
the higher interest rate discourages or “crowds out” private investment
e) economic growth in long run (LRAS) will be reduced due to smaller private capital stock
5. The net export effect further reduces the impact of expansionary fiscal policy as higher domestic
interest rates:
a)
b)
c)
d)
increase foreign demand for dollars
the increased demand for dollars results in an appreciated dollar
the appreciated dollar makes exports more expensive and imports cheaper
net exports decline partially offsetting the expansionary fiscal policy
6. Non discretionary fiscal policy or built-in stabilizers are counter cyclical government programs
(e.g. progressive income tax and transfer payments such as unemployment compensation) that
automatically counteract both recessions and high inflation.
a) For example, as GDP rises during prosperity, tax revenues under a progressive income tax
system automatically increase and transfer payments such as unemployment insurance
automatically decrease, both reducing consumer spending and restraining economic
expansion. The budget will automatically move toward a surplus.
b) Conversely, as GDP falls during a recession, tax revenues automatically decline and
transfer payments automatically increase, stimulating consumer spending and preventing a
prolonged recession. The budget will automatically move toward a deficit.