CHAPTER
8
THE FISCAL POLICIY
1
Learning Outlines:
•
•
•
Introduction
Automatic fiscal policy
Discretionary fiscal policy
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INTRODUCTION
• Besides monetary policy as discussed in Chapter 7, there is another common type of
economic policy that government uses to control the economy – the FISCAL POLICY.
• Fiscal policy is
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________.
• Like Monetary policy, Fiscal policy also aims at influencing the aggregate demand (AD) in
an economy.
• To achieve the goals, the government must manipulate the followings - hence the tools
to fiscal policy are:
1. Government expenditure (G)
2. Level of taxation (T)
3
Government Budget Concept
• To understand the effect changes in government spending (G) and taxes (T) may have
on a nation’s economy, we need to grasp the concept of the government’s budget.
• A nation’s government must, in principle, finance its expenditure through the
collection of taxes from households and firms, through borrowing from the public, or
though the sale of state-owned enterprises to the private sector. These make up a
government’s expenditure.
• An increase in expenditures or a decrease in taxes would lead to an increase in AD – ____________________.
• A decrease in expenditures or an increase in taxes would lead to a decrease in AD –
____________________.
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Deficits, Surpluses and Debt
• _____________________is when a government’s total expenditure exceeds its total
tax revenue in a particular year.
• In order to pay for this deficit, the government must borrow from the public.
Whenever a government borrows to finance a budget deficit, the government
increases its national debt, which is the accumulation of the deficits from the past
years.
• _____________________is when a government’s tax revenue exceeds its
expenditure.
• A budget surplus reduces the national debt, since surplus tax revenue can be used to
pay down what the government owes the public from past deficits.
• If a government’s expenditure exactly equals its tax revenue, the government has a
balanced budget.
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Q: Examine the table below and
answer the questions:
Year
2004
2005
2006
2007
2008
2009
2010
US national
debt/billion of $
7,379
7,933
7,933
9,008
10,025
11,910
13,562
a. In how many years did the US
federal government run a budget
surplus? Justify your answer.
b. In which year was the US budget
deficit the largest? Justify your
answer.
c. What must be true of the level of
government spending relative to
the total tax revenues collected in
the US during the period
represented by this table?
d. Discuss one possible explanation
for the continuous growth in the
US national debt.
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Fiscal policy may be either (1) non-discretionary (automatic) or (2) discretionary.
Fiscal Policy
1. Discretionary
2. Nondiscretionary/Automatic
i. Expansionary
ii. contractionary
i. Automatic expansion
ii. Automatic contraction
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AUTOMATIC FISCAL POLICY
See figure 8.1
AUTOMATIC FISCAL POLICY refers to changes in G and T which occur automatically without
the government’s action.
Period of economic growth
During period of economic growth where output is high, unemployment is low and income
level is high, there will be an automatic decrease in the government’s expenditure on
certain items especially on transfer payments (healthcare, subsidies, welfare,
unemployment benefits)  G is therefore automatically reduced.
On the other hand, a growth in a nation’s GDP automatically leads to increases in tax
revenues, which are based primarily on incomes and expenditures of households and firms.
Thus the decrease in G with increase in tax revenue that occur during periods of expansion
have the effect of automatically reducing AD and offsetting the inflationary pressure that
comes with an expansion.
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AUTOMATIC FISCAL POLICY
Figure 8.1
Price level
AS
AD2
Pe
ADST
AD1
0
Ye
Output (Y)
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AUTOMATIC FISCAL POLICY
See figure 8.2
Period of recession
At the period of recession, where output is low, unemployment is high and income level
is low, there will an automatic increase in the government’s expenditure on certain
items especially on transfer payments  G is therefore automatically increased.
On the other hand, tax revenues automatically decrease as incomes and expenditures
by the nation’s households and firms decline.
Thus the automatic increase in G and the decrease in taxes have the effect of
automatically increasing AD and hence keeping recession at bay.
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AUTOMATIC FISCAL POLICY
Price level
Figure 8.2
AS
Pe
AD1
ADST
AD2
0
Ye
Output (Y)
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In theory, there is a level of GDP
at which a government could
achieve a balanced budget
where T=G – likely to be around
full-employment level
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Automatic fiscal policy refers to the notion that in
most nations, tax and government spending systems
have an element of ________________through
which an increase in GDP is automatically
accompanied by a _________ in G and an ________
in T. A fall in total output and income, on the other
hand, automatically results in an _________ in G
and a __________ in T.
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DISCRETIONARY FISCAL POLICY
• The effect of the automatic adjustments in G and T that occurs as a nation’s GDP
increases or decreases may be enhanced through a government’s discretionary fiscal
policies.
• DISCRETIONARY FISCAL POLICY refers to changes in G and T on purpose by the
government’s decision.
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DISCRETIONARY FISCAL POLICY
Figure 8.3
Price level
AS
AD2
ADST
AD1
0
Output (Y)
Inflationary gap
Period of economic growth – closing
inflationary gap
During this period, a discretionary
fiscal policy is adopted to overcome
inflationary pressure.
Here government would increase tax
and reduce government expenditure
to reduce the rising AD.
When the AD rises during a growth, a
decrease in G and an increase in T
can offset the rise in other spending
and move AD back towards what is
desired by the government, hence
putting downward pressure on the
rate of inflation.
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DISCRETIONARY FISCAL POLICY
Figure 8.4
Price level
AS
AD1
AD3
AD2
0
Output (Y)
Recessionary gap
Period of recession – closing
recessionary gap
During this period, an expansionary
fiscal policy is adopted to overcome
recessionary pressure.
Here government would reduce tax
and increase government
expenditure to stimulate and raises
the AD
When the AD falls during a recession,
an increase in G and decrease in T
can offset the fall in other spending
and move AD back towards what is
desired by the government.
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Tutorial
Q1. Study the table below and answer the questions that follow:
YEAR
UNEMEPLOYMENT
RATE (%)
YEAR
UNEMPLOYMENT
RATE (%)
1990
5.6
1978
7.6
1991
6.8
1979
11.3
1992
7.5
1980
13.5
1. Describe the macroeconomic conditions in the US during the two time periods
represented above.
2. Determine a fiscal policy which you think appropriate to be carried out to curb the
conditions during the two time periods. Using a AD/AS diagram, illustrate the
conditions before the enactment of the fiscal policy and after.
3. For each policy used in part 2, identify the possible risk(s).
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