Chapter 12:
Fiscal Policy (G)
Role of Government Spending
•
One major function of the government is to stabilize the economy (prevent
unemployment or inflation).
•
Stabilization can be achieved in part by manipulating the public budget—
government spending and tax collections—to increase output and
employment or to reduce inflation.
•
Discretionary fiscal policy refers to the deliberate manipulation of taxes
and government spending by Congress to alter real domestic output and
employment, control inflation, and stimulate economic growth.
•
“Discretionary” means the changes are at the option of the Federal
government.
Legislative mandates—The Employment Act of 1946
A. Congress proclaimed government’s role in promoting maximum
employment, production, and purchasing power.
Budget Deficits and
Surpluses
Budget deficit:
-- Present when total government spending
exceeds total revenue .


When the money supply is constant, deficits must be
covered with borrowing.
The U.S. Treasury borrows funds by issuing bonds.
Budget surplus:
-- Present when total government spending exceeds
total revenue.
 Surpluses reduce the size of the government’s
outstanding debt.
Financing Deficits
Two ways:
a. Borrowing: the government competes with private
borrowers for funds and could drive up interest rates;
the government may “crowd out” private borrowing,
and this offsets the government expansion.
b. Money Creation : when the Federal Reserve loans
money directly to the government by buying bonds (no
“crowding out” since private investors are not buying
bonds).
Budget Deficits and
Surpluses
• Changes in the size of the federal deficit or surplus are often
used to gauge whether fiscal policy is adding additional demand
stimulus or imposing additional demand restraint.
Changes in the size of the budget deficit or
surplus may arise from either:


A change in the state of the economy, or
A change in discretionary fiscal policy
-- that is, through either government spending
and/or changes in taxation.
The Keynesian View
of Fiscal Policy

Keynesian theory highlights the potential
of fiscal policy as a tool capable of
reducing fluctuations in demand.

When an economy is operating below its
potential output, the Keynesian model
suggests that the government should institute
expansionary fiscal policy:


increase the government’s purchases
of goods & services, and/or
cut taxes.
Expansionary Fiscal Policy
to Promote Full-Employment
Price
level
SRAS1
LRAS
P2
P1
P3
SRAS2
E2
Expansionary fiscal policy
stimulates demand and
directs the economy to
full-employment
e1
E1
Keynesians believe that allowing
for the market to self-adjust may
be a lengthy and painful process.
AD1
Y1 YF
AD2
Goods & Services
(real GDP)
• We begin in the short run at Y1, below the economy’s potential capacity (YF).
There are 2 routes to long-run full-employment equilibrium:
• Wait for both lower wages and resource prices to reduce costs (increasing
supply to SRAS2).
•
Alternatively, expansionary fiscal policy could stimulate aggregate demand
(shift AD1 to AD2) and guide the economy back to E2, at YF.
The Keynesian View
of Fiscal Policy

When inflation is a potential problem, the Keynesian analysis suggests a
shift toward a more restrictive (contractionary) fiscal policy:

reduce government spending or raise taxes
Keynesians challenged the view that the government should always
balance its budget.
Contractionary Fiscal Policy
to Combat Inflation
Price
level
SRAS2
LRAS
P3
E3
P1
P2
SRAS1
Restrictive fiscal policy
restrains demand and
helps control inflation.
E1
E2
AD2
YF Y1
•
•
•
AD1
Goods & Services
(real GDP)
Strong demand such as AD1 will temporarily lead to an output rate beyond the
economy’s long-run potential (YF).
If maintained, the high level of demand will lead to the long-run equilibrium E3 at
a higher price level (as SRAS shifts back to SRAS2).
However, contractionary fiscal policy could restrain demand to AD2 and guide
the economy to a non-inflationary equilibrium (E2).
Fiscal Policy Choices
1.
What type of fiscal policy is used to combat a recession?
Expansionary fiscal policy (increase government spending and/or
decrease taxes)
2.
To combat demand-pull inflation?
Contractionary fiscal policy (increase taxes and/or decrease
government spending)
3.
What could happen with both a spending decrease and tax increase?