Principles of Macroeconomics
Lecture 3b
FISCAL POLICY
In this chapter you will learn
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What fiscal policy is and what it is used for
What discretionary fiscal policy is and its function
About the economy’s built-in stabilizers
What a cyclically adjusted budget is
The problems, criticisms, and complications of
fiscal policy
Topics
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Legislative Mandates
Fiscal Policy & the AD-AS Model
Built-In Stabilization
Evaluating Fiscal Policy
Problems, Criticisms & Complications
Legislative Mandates
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Great Depression  need for stabilization role
Unemployment Insurance introduced during World
War II
Governments regularly use fiscal policy to stabilize
the economy
Discretionary Fiscal Policy
Definition:
 Deliberate changes of



government expenditures
taxes
Dependent upon deliberate decisions in
Parliament
Discretionary Fiscal Policy
Expansionary Fiscal Policy
 Recessionary Gap
Options:
 Increase Government Spending
 Decrease Taxes
 Some Combination of the Two
Expansionary Fiscal Policy
Figure 10-1
Price level
AS
PL0
AD0
recessionary
gap
GDP0
GDPf
Real GDP (billions)
Expansionary Fiscal Policy
Figure 10-1
Price level
AS
PL1
PL0
AD1
AD0
GDP0
GDPf
Real GDP (billions)
Discretionary Fiscal Policy
Contractionary Fiscal Policy
 Inflationary Gap
Options:
 Decrease Government Spending
 Increase Taxes
 Some Combination of the Two
Contractionary Fiscal Policy
Price level
Figure 10-2
AS
PL3
AD3
inflationary
gap
GDPf GDP3
Real GDP (billions)
Contractionary Fiscal Policy
Price level
Figure 10-2
AS
PL3
PL2
AD3
AD2
GDPf
Real GDP (billions)
Policy Options: G or T?

depends on political views about size of
government
Automatic or Built-In Stabilizers

A tax or government expenditure which
automatically:
 increases
the deficit during recession phase
 decreases the surplus during inflation phase
Government establishes tax rates, but
does not set total taxes
Automatic or Built-In Stabilizers
Figure 10-3
G,T
T1
T = Net Taxes
Deficit
G (assumed
constant)
{
GDP1
GDP0
Automatic or Built-In Stabilizers
Figure 10-3
G,T
T
T2
Surplus
G
GDP0 GDP2
Automatic or Built-In Stabilizers


the stabilizers will automatically generate an
expansionary budget deficit when GDP is low
and a contractionary surplus when GDP is high
Automatic or Built-In Stabilizers
The built-in stability depends on:
 Tax Progressivity

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Progressive
Proportional
Regressive
The more progressive the tax system, the greater
the automatic stabilization
Cyclically Adjusted Budget


automatic stabilizers can mask the direction of
discretionary fiscal policy
the cyclically adjusted budget shows what the
budget balance would be if the economy were
operating at full employment
Cyclically Adjusted Budget
Figure 10-4
T
G, T
500
the deficit is a byG the
product of
recession
the cyclically adjusted
deficit is zero in year 1
at GDP1
450
it is also zero in year 2
at GDP2
GDP2 GDP1 real GDP
(year 2)(year 1)
full-employment GDP
Cyclically Adjusted Budget
G, T
$25 billion deficit Figure
due to 10-4
expansionary fiscal policy
T
1
T2
500
475
450
425
the cyclically adjusted deficit is
zero in year 3
G
$50 billion deficit due
to recession
taxes are reduced
economy enters a recession in
year 4
GDP4 GDP3 real GDP
(year 4)(year 3)
full-employment GDP
Problems, Criticisms, & Complications
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Problems of Timing
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Recognition Lag
Administration Lag
Operational Lag
A Political Business Cycle?
Offsetting Provincial & Municipal Finance
Problems, Criticisms, and Complications
•
Crowding-Out Effect
expansionary fiscal policy
 higher interest rates
 reduction in interest-sensitive spending
•
•
may not be significant in a recession
fiscal policy can be accommodated by increases
in money supply
Problems, Criticisms, and Complications

some portion of the potential effect of
expansionary fiscal policy may be dissipated in
the form of inflation
illustrated…
Fiscal Policy, AS & Inflation
Figure 10-5
AD1
Price level
AD0
AS
PL2
PL1
GDP0 GDP1 GDPf
Real GDP (billions)
Fiscal Policy, AS & Inflation
Figure 10-5
AD1
Price level
AD0
AS


PL2
PL1
GDP0 GDP1 GDPf
Real GDP (billions)
price level rises
GDP increases only to
GDP1
Fiscal Policy in the Open Economy
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
Shocks Originating from Abroad
Net Export Effect…
Table 10-1
recession
expansionary fiscal policy
higher domestic interest rates
increased foreign demand for C$
C$ appreciates
net exports fall
partial offset to expansionary fiscal policy
27
Table 10-1
inflation
contractionary fiscal policy
lower domestic interest rates
decreased foreign demand for C$
C$ depreciates
net exports rise
partial offset to contractionary fiscal policy
28
Supply-Side Fiscal Policy

tax changes may alter aggregate supply & affect
the results of fiscal policy
 saving
& investment
 work incentives
 risk-taking

examine the effects of a tax cut…
Supply-Side Fiscal Policy
Figure 10-6
Price level
AS1
AS2
PL2
PL3
PL1
AD2
AD1
GDP1 GDP2 GDP3
Real GDP (billions)
Supply-Side Fiscal Policy

most economists are skeptical about the supply-side
effects of tax cuts
 weak
 timing
effects