“ECONOMICS for Christian Schools”
By Alan J. Carper
Bob Jones University Press. 1998
Unit V: Economics of the Government
“Fiscal Policy”
A.P. Macroeconomics Chapter 12
Economics/Honor Econ Chapter 14
Biblical Integration
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We need to remember God is the power
behind a nation, state, county, township, or
individual who makes them wealthy or
poor. (I Sam. 2:7)
Objectives:
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Define fiscal policy
Explain Keynes' solution to the business cycle
Describe the marginal propensity to consume and its effect on the
money supply
List and explain the problems of using government spending as a
tool of fiscal policy
List the major source of the government's tax revenue
Contrast proportional taxes.
Progressive taxes and regressive taxes
List and explain the problems with using taxation
as a tool of fiscal policy
Explain the Keynesian concept of "pump priming"
List and explain the problems with using government borrowing as
a tool of fiscal policy
A.P. Objectives:
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What fiscal policy is and why it is an important tool in
managing economic fluctuations.
Which policies constitute expansionary fiscal policy and
which constitute a contractionary fiscal policy.
Why fiscal policy has a multiplier effect and how this
effect is influenced by automatic stabilizers.
Why tax and transfer multipliers are less than the
government purchases multiplier.
Why government calculate the cyclically adjusted budget
balance.
Why a large public debt may be a cause for concern.
Why implicit liabilities of the government are also a
cause for concern.
Sources of Tax Revenue in the
United States, 2004
Personal income
taxes, taxes on
corporate profits,
and social insurance
taxes account for
most government
tax revenue. The
rest is a mix of
property taxes, sales
taxes, and other
sources of revenue.
Source: Bureau of
Economic Analysis.
(Erbil)
Government Spending in the
United States, 2004
Social insurance
programs are government
programs intended to
protect families against
economic hardship.
The two types of
government spending are
purchases of goods and
services and government
transfers. The big items
in government purchases
are national defense and
education. The big items
in government transfers
are Social Security and
health care programs.
(Erbil)
Expansionary and Contractionary Fiscal
Policy
Expansionary Fiscal Policy Can Close a Recessionary Gap
Expansionary fiscal policy
increases aggregate demand.
At E1 the economy is in short-run
equilibrium where the aggregate
demand curve AD1 intersects the
SRAS curve. At E1, there is a
recessionary gap of YE − Y1.
An expansionary fiscal policy—an
increase in government purchases, a
reduction in taxes, or an increase in
government transfers—shifts the
aggregate demand curve rightward.
It can close the recessionary gap by
shifting AD1 to AD2, moving the
economy to a new short-run
equilibrium, E2, which is also a
long-run equilibrium.
Recessionary gap
(Erbil)
Expansionary and Contractionary Fiscal
Policy
Contractionary Fiscal Policy Can Eliminate an Inflationary Gap
At E1 the economy is in short-run
equilibrium where the aggregate
demand curve AD1 intersects the
SRAS curve.
At E1, there is an inflationary gap of
Y1 − YE .
A contractionary fiscal policy—
reduced government purchases,
an increase in taxes, or a
reduction in government
transfers—shifts the aggregate
demand curve leftward.
It can close the inflationary gap
by shifting AD1 to AD2, moving
the economy to a new short-run
equilibrium, E2, which is also a
long-run equilibrium.
(Erbil)
Contractionary fiscal
policy decreases
aggregate demand.
Inflationary gap
Lags in Fiscal Policy
In the case of fiscal policy, there is an important reason for
caution: there are significant lags in its use.
 Realize the recessionary/inflationary gap by collecting and
analyzing economic data  takes time
 Government develops an action plan takes time
 Implementation of the action plan  takes time
(Erbil)
Fiscal Policy and the Multiplier
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Fiscal policy has a multiplier effect on the economy.
Expansionary fiscal policy leads to an increase in real GDP
larger than the initial rise in aggregate spending caused
by the policy.
Conversely, contractionary fiscal policy leads to a fall in real
GDP larger than the initial reduction in aggregate
spending caused by the policy.
(Erbil)
The Multiplier Effect of an Increase in Government
Purchases of Goods and Services A $50 billion increase in government
purchases of goods and services has the
direct effect of shifting the aggregate
demand curve to the right by $50
billion.
However, this is not the end of the
story. The rise in GDP causes a rise in
disposable income, which leads to an
increase in consumer spending, which
leads to a further rise in GDP, which
leads to a further rise in consumer
spending, and so on.
The eventual shift, from AD1 to AD2,
is a multiple of the rise in GDP.
What happens if government purchases
of goods and services are instead
reduced?
The math is exactly the same,
except that there’s a minus sign in
front: if government purchases fall by
$50 billion and the marginal propensity
to consume is 0.6, the AD curve shifts
leftward by $125 billion.
(Erbil)
How Taxes Affect the Multiplier
Rules governing taxes and some transfers act as automatic
stabilizers, reducing the size of the multiplier and automatically
reducing the size of fluctuations in the business cycle.
In contrast, discretionary fiscal policy arises from deliberate
actions by policy makers rather than from the business cycle.
(Erbil)
Differences in the Effect of Expansionary Fiscal Policies
(Source: economy.com)
(Erbil)
The Budget Balance as a Measure of
Fiscal Policy
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Other things equal, discretionary expansionary fiscal policies— increased
government purchases of goods and services, higher government
transfers, or lower taxes—reduce the budget balance for that year.
That is, expansionary fiscal policies make a budget surplus smaller or a
budget deficit bigger.
Conversely, contractionary fiscal policies—smaller government
purchases of goods and services, smaller government transfers, or
higher taxes—increase the budget balance for that year, making a
budget surplus bigger or a budget deficit smaller.
(Erbil)
The Business Cycle and the
Cyclically Adjusted Budget Balance
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Some of the fluctuations in the budget balance are due to the
effects of the business cycle.
In order to separate the effects of the business cycle from the
effects of discretionary fiscal policy, governments estimate
the cyclically adjusted budget balance, an estimate of
the budget balance if the economy were at potential
output.
(Erbil)
The U.S. Federal Budget Deficit and the Business
Cycle
The budget deficit as a percentage of GDP tends
to rise during recessions (indicated by shaded
areas) and fall during expansions.
The U.S. Federal Budget Deficit and the Unemployment
Rate
Here, the
unemployment rate
serves as an indicator of
the budget cycle, and
we should expect to see
a higher unemployment
rate associated with a
higher budget deficit.
This is confirmed by the
figure: The budget
deficit as a percentage
of GDP moves closely
in tandem with the
unemployment rate.
There is a close relationship between the budget balance
and the business cycle: A recession moves the budget
balance toward deficit, but an expansion moves it toward
surplus.
(Erbil)
Source: Congressional Budget Office, Bureau of Labor Statistics
Long-Run Implications of Fiscal
Policy
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U.S. government budget accounting is calculated on the basis of
fiscal years.
Persistent budget deficits have long-run consequences because
they lead to an increase in public debt.
(Erbil)
Government Debt as a Percentage of GDP
“Public debt as a percentage of GDP is a widely used measure of how deeply in debt a
government is. The United States lies in the middle range among wealthy countries.
Governments of countries with high public debt–GDP ratios, like Italy and Belgium, pay
large sums in interest each year to service their debt. “
(Source: OECD.)
(Erbil)
Problems Posed by Rising
Government Debt
This can be a problem for two reasons:
 Public debt may crowd out investment spending, which
reduces long-run economic growth.
 And in extreme cases, rising debt may lead to government
default, resulting in economic and financial turmoil.
(Erbil)
Deficits and Debt in Practice
A widely used measure of fiscal health is the debt–GDP ratio.
This number can remain stable or fall even in the face of
moderate budget deficits if GDP rises over time.
(Erbil)
U.S. Federal Deficit since 1939
The debt–GDP ratio is government
debt as a percentage of GDP.
The federal
budget deficit
as a percentage
of GDP since
1939.
The federal
government
ran huge
deficits during
World War II
and has usually
run smaller
deficits ever
since.
(Erbil)
The Federal Debt–GDP Ratio Since 1939
Comparing with the
previous slide, one can
see that many years the
debt-GDP ratio has
declined in spite of
government deficits.
This seeming paradox
reflects the fact that the
debt–GDP ratio can
fall, even when debt is
rising, as long as GDP
grows faster than debt.
Source: Economic Report of the President (2005).
(Erbil)
Implicit Liabilities
Implicit liabilities are spending promises made by governments
that are effectively a debt despite the fact that they are not
included in the usual debt statistics.
(Erbil)
The Implicit Liabilities of the U.S. Government
This figure shows current
spending on Social Security,
Medicare, and Medicaid as
percentages of GDP, together
with Congressional Budget
Office projections of
spending in 2010, 2030, and
2050.
Source: Congressional Budget Office.
Due to the combined effects
of the aging of the population
and rising health care
spending, these programs
represent large implicit
liabilities of the federal
government.
(Erbil)