Fiscal Policy is a system of goals, tools and instruments to affect GDP and employment.
U.S.)
The Subject of the fiscal policy is the Ministry of Finance (the Treasury in the
The goals of fiscal policy that we will study in this course are related to the cyclical fluctuations in the economy.
Types of fiscal policy
1. Demand side fiscal policy (Keynesian fiscal policy)
If the economy is depressed and AD < Y, the government might use fiscal policy to encourage an increase in the aggregate demand. The difference between the potential
GDP and the actual GDP is called a recessionary gap.
If the AD is expanding too fast and increases above the potential GDP, it might generate high inflationary pressures. Then, the government can apply fiscal policy to discourage the overheating of the economy.
The difference between actual GDP and the potential GDP is called an inflationary gap.
From this perspective, we distinguish between expansionary and restrictive fiscal
policy. The expansionary fiscal policy would reduce the recessionary gap, while the restrictive fiscal policy will reduce the inflationary gap.
1.1. Tools and instruments of fiscal policy
The Ministry of Finance can affect GDP and employment through government revenues and government spending. These are the major tools of fiscal policy.

They are recorded in the government budget .

Government revenues

Government spending – government purchases and transfer payments
1.1.1.Government budget
The government budget is an assessment of government revenues and expenditures, deficits and surpluses of government finance
expenditures revenues
G
Transfer payments
Taxes
The government can use government spending, or government revenues to affect the economic activity. a) Affecting GDP through G
Expansionary policy:
Government spending is an injection. Therefore, if the government wishes to encourage the economic activity, because AD < Y, it can increase G. Aggregate demand will rise and the multiplier process will be put into action.
Unemployment will fall.
Restrictive policy:

If the government wants to reduce the overspending in the economy, because
AD>Y, it can reduce G. Aggregate demand will fall and again the multiplier process will be put into action.
Unemployment will increase. b) Affecting GDP through taxes
A second way to affect the economic activity is through manipulations with taxation.
Taxes are a leakage.
Expansionary policy:
If the government wants to encourage economic activity, it can reduce taxes.
Aggregate demand will increase and the multiplier process will be put into action.
Restrictive policy:
If the government wants to restrict economic activity, it can raise taxes. Aggregate demand will fall and the multiplier process will be put into action. c) GDP Gaps
The anticyclical fiscal policy aims to reduce aggregate demand fluctuations.
During the recession, when aggregate demand declines, the equilibrium GDP fall below the potential GDP. The difference between the potential GDP and the actual GDP is called the recessionary gap of GDP (fig. 1 on the left).
When aggregate demand rises and goes above the potential GDP, it opens an inflationary gap of GDP (fig. 1 on the right).

Price level
AD
Price level
AS AD
AS
Y* - Y
1
Y
1
Y*
= recessionary gap
GDP
Y
2
Y* Y
– Y* = inflationary gap
GDP
Fig. 1. GDP gaps
The expansionary fiscal policy enforced during the recession aims to reduce the recessionary gap.
The restrictive fiscal policy enforced during the boom aims to reduce the inflationary gap.
1.2. Effectiveness of fiscal policy
The impact of the manipulations with G and T on the economy is not equal. Since
G is a component of aggregate expenditures, the increase in G by €1 million, means and increase in AD by €1 million.
If, however, taxes are reduced by €1 million, the disposable income will increase by
€1 million, but households will not spend all this money. They will save part of it.
Therefore, they will spend less than €1 million. Aggregate demand will increase by less. The impact of the change in taxes on the economic activity, therefore, depends on the marginal propensity to consume and the marginal propensity to save.

1.2.1. Taxation multiplier
The taxation multiplier indicates by how much in will GDP increase as a result of a change in the tax rate.
Taxation multiplier = - MPC/MPS
The taxation multiplier is always negative, because tax reductions lead to GDP increase, and tax increase leads to GDP reduction.
Conclusion : changes in G are more effective as an instrument of fiscal policy than changes in taxes, because the latter have an indirect impact on aggregate demand
(through the disposable income).
1.2.2.Budget deficit (surplus)
If government expenditures are greater than taxes, there is a budget deficit .
If taxes are greater than government spending, there is a surplus.
If there is a budget deficit, the government will borrow money in order to pay for everything that it has to. As opposed to the firms, the government cannot go bankrupt. This is why it’s demand for funds (money) is highly inelastic. Moreover, usually the government needs a lot amount of money. When it goes to the financial markets to borrow money, the demand in these markets increases and the interest rate on loans rises.
The higher interest rate demotivates businesses to invest in investment projects, which would give lower profitability.
Therefore, private investment is crowded out from the economy.
The crowding out effect occurs because the government borrows money in the financial markets and the interest rate increases.
Budget deficit (surplus) :

Primary deficit (surplus) = current revenues-current expenditures


Secondary deficit (surplus) = primary deficit (surplus) + interest payments on domestic debt

Cash deficit (surplus) = secondary deficit (surplus) + flows of external revenues and payments
Government debt is the accumulated deficit.
1.3.Built-in stabilizers
The development and the enforcement of fiscal policy involves time lags. The policy could be enforced much later than when it was needed. However, there are such mechanisms and rules in the government budget and in the economy, which automatically will work anticyclically.
When the economy is slowing down, these rules will automatically lead to an increase in government spending and a reduction in taxes.
When the economy is overheated, they will automatically lead to a reduction in government spending and an increase in taxes.
These are automatic stabilizers.
In the budget these are: income taxes, corporate taxes, social payments. When the economy is depressed and income falls, income taxes fall too, corporate profits and taxes fall too. Unemployment rises and social payments increase. When the economy is in a boom, it is the other way round.
2. Supply-side fiscal policy
This is a system of goals, tools and instruments to affect aggregate supply
2.1. Goals of the supply-side policy:

Increase in productivity

Reduction of the inflationary pressure

Reduction in the need for government spending


Reduction of government debt

Reduction of the crowding-out effect
2.2. Tools of the supply-side policy :

Changes in the tax rates.
Philosophy: The increase in taxes reduces the enthusiasm of people to work and invest. If taxes fall, people will be willing to work more and firms will be willing to invest more. Therefore, tax reductions motivate the supply side of the economy and increase the potential GDP.
.2.3. Effectiveness of the supply side-policy :
It depends on the elasticity of labor supply and capital supply as regard payments for labor and capital. If labor and capital are sensitive to changes in their rewards, they will increase supply with the reduction in income taxes and the increase in disposable income. Such sensitivity was demonstrated by American, British and Irish capital and labor owners. For example, when the American government reduced income taxes,
American workers realized that they will have much more money if they work more, and the government will not get more taxes of the extra income. Thus, they were willing to work more. Tax reductions affected the willingness of capital owners to supply more capital in the same way. As a result, both output and productivity in the US economy increased. When French government reduced taxes, French workers realized that they could have the same income as before, if they were working less. They preferred leisure to higher income. Thus, labor supply in France was not elastic as regard disposable income. As a result, output and productivity in France did not increase.
2.4 The Laffer curve

Т t
0
100%
Fig.1. The Laffer curve
The Laffer Curve shows that from a particular point, the further increase in tax rates starts reducing tax revenues of the government.