Chapter 13
Fiscal Policy
“Democracy will defeat the economist at every turn at its own
game” – Harold Innis, Canadian Economist and Historian
Governments can do plenty to stabilize the
economy – not only during downturns when
unemployment is high, but also during
inflationary upswings. Governments can use
certain policies to achieve economic stability; for
example, they can spend more money or
reduce taxes to cause changes in total
spending and aggregate demand. This chapter
examines the theory behind such policies and
their outcomes.
Stabilization Policy
Government policy designed to lessen the effects of
the business cycle, particularly unemployment and
inflation
Goal
Keep the economy as close as possible to its
potential output
To smooth out business cycle
- the closer the economy stays to the long-run trend
of potential output, the lower will be the social costs
of unemployment and inflation to the country’s
citizens
Business Cycle
2 Types of Stabilization Policy
Expansionary policies: government policies designed
to reduce unemployment and stimulate output
 when output is below its potential
 Injections > withdrawal
Contractionary policies: government policies
designed to stabilize prices and reduce output
 when the economy is booming
 Withdrawal > injections
2 Categories of Stabilization
Policy
Fiscal policy – government stabilization policy that
uses taxes and government purchases as its tools
 also known as budgetary policy
 Usually applied to a fiscal year: the 12 month period
to which a budget applies
Monetary Policy – government stabilization policy that
uses interest rates and the money supply as its tools
Types of Stabilization Policy
Two methods used on Fiscal
Policy
The government makes changes on 2 factors to
influence aggregate demand, thus the equilibrium
price and quantity
 Government Spending

Immediate effect on aggregate demand (direct
injection/withdrawal)
 Tax Rate

Less immediate effect on aggregate demand
(Indirect injection/withdrawal)
Expansionary Fiscal Policy
 Government
Spending
 Increases
 Tax Rate

Decreases
 Encourage households and business spending
 Consumption & investment increase
Contractionary Fiscal Policy
 Government
spending
 Decreases
 Tax rate



Increases
Reduce household’s disposable income and
businesses’ profits
Consumption & investment decrease
Discretionary Policy vs.
Automatic Stabilizers
 Discretionary policy: intentional government
intervention in the economy
 i.e.budgeted changes in spending/ taxation
 Automatic stabilizers: built-in measures that lessen
the effect of the business cycle
 i.e. Taxation & transfer programs  progressive
income taxes, unemployment insurance, welfare
payments
Net Tax Revenues
= taxes collected – transfers & subsidies
 During a period of expansion…


Net tax revenues increase (leakage)
Spending and aggregate demand decrease
 During a period of contraction…


Net tax revenues decrease
Spending and aggregate demand increase
How Does Automatic
Stabilizer work?
Contracting Economy
1. Household incomes & business profits fall
2. Taxes collected by government fall
3. Government transfer payments & subsidies increase
(job lost & business suffers)
4. Decline in net tax revenues  spending & aggregate
demand increase
5. Economy pushed towards its potential output
How Does Automatic
Stabilizer work?
Expanding Economy
1. Personal incomes & business profits increase
2. Governments collect more taxes
3. Government transfer payments & subsidies reduced
(high employment, businesses prosper)
4. Spending & aggregate demand decrease
5. Economy pushed back down to its potential output
The Spending Multiplier
Used to estimate the impact of government policies on
the economy in terms of dollar values
The Multiplier Effect: the magnified impact of a
spending change on AD
• Assumes price level stays constant
The Spending Effect: value by which an initial
spending change is multiplied to give the total change
in outputs shift in the AD curve
Multiplier Effect
- 1. Marginal propensity to consume (MPC) – effect
on domestic consumption of a change in income
- Explains “if income increase x amount, how much
extra will be spent on domestic goods and services?”
- Applies to individual households and the economy as
a whole
Multiplier Effect
- 2. Marginal propensity to withdraw (MPW)
-
Effect of withdrawing – saving, imports and taxes –
of a change in income
MPC + MPW =1
Always!! Because income is either spent on domestic
consumption or withdrawn from the circular flow
Spending Multiplier formulas
How does the
Multiplier Effect work?
Multiplier Effect
Effect of a Tax Cut
 Tax adjustment has a smaller initial effect on
spending compared to government purchases
 i.e. assume MPC = 0.5
 Tax cut increases Spender A’s income by $1000
(after tax)  initial change in spending on domestic
items = $500
 Government purchases  initial change in spending
on domestic items = $1000
What if Price Levels Vary?
 Recall: slope of the aggregate supply curve is
steeper as it reaches or surpasses the potential
output level
 If AD curve shifts from AD0 to AD1 the price level
rises proportionally more than the output does
 Expansionary fiscal policy is less effective when
the economy is close to its potential
 If AD curve shifts to the left, the price level falls
proportionally more than the output does
What if Price Levels Vary?
!! Multiplier Effect is just a theory, it is not
definite because of possible changes in price
level, However, it is still useful to indicate the
Maximum change in equilibrium output
following a certain fiscal policy !!
Benefits of Fiscal Policy
#1. Regional Focus
 Discretionary fiscal policy can be targeted on
particular regions to balance out regional differences
in economy situations

During a recession, new government purchases or
tax cuts can be targeted to regions where
unemployment rates are highest

In a boom, spending cuts and tax hikes can be
concentrated on the regions where inflation is at
its worst
Benefits of Fiscal Policy
#2. Impact on Spending
 Fiscal policy has a more straightforward impact than
monetary policy
 The first spending adjustment is assured since the
government itself initiates the change
Drawbacks of Fiscal Policy
#1. Delays through 3 time lags
 Recognition lag: the amount of time it takes policy-
makers to realize that a policy is needed
 Decision lag: the amount of time needed to formulate
and implement an appropriate policy
 Impact lag: the amount of time between a policy’s
implementation and its having an effect on the
economy
Drawbacks of Fiscal Policy
#2. Political Visibility
 Highly visible and therefore often affected by political
as well as economic considerations
 Voters and political parties are likely to respond more
favourably to expansionary policies regardless of the
appropriateness of these policies for the economy
Drawbacks of Fiscal Policy
#3. Public Debt
 The total amount owed by the federal government as
a result of its past borrowing
 The government has to pay public debt charges each
year and has not been able to reduce the public debt
just by paying only the interest
Impact of Fiscal Policy
Budget Surpluses and Deficits

Balanced Budget
 Expenditures = revenues

Budget Surplus
 Revenues > expenditures
 Surplus amount = revenue – expenditures

Budget Deficit
 Expenditures > Revenues
 Deficit amount = expenditures – revenue
Impact of Fiscal Policy
Budget Surplus and Deficit's impact on
Public Debt
 Amount of deficit = amount increase in
public debt
 Amount of surplus = amount reduced in
public debt
Fiscal Policy Guidelines
 Annually Balanced Budget
Revenues and expenditures should balance each
year
 Cyclically Balanced Budget
Government revenues and expenditures should
balance over the course of one business cycle
 Functional Finance
Government budgets should be geared to the yearly
needs of the economy
Discussion