12
C HAPTE R
FISCAL
POLICY
INSTRUCTIONAL OBJECTIVES
• Distinguish between discretionary and nondiscretionary
fiscal policy.
• Differentiate between expansionary and contractionary
fiscal policy.
• Recognize the conditions for recommending an
expansionary or contractionary fiscal policy.
• Describe the two ways to finance a government budget
deficit and how each affects the economy.
• Describe the two ways to handle a government budget
surplus and how each affects the economy.
• Give two examples of how built-in stabilizers help
eliminate recession or inflation.
• Explain the differential impacts of progressive,
proportional, and regressive taxes in terms of
stabilization policy.
• Explain the significance of the “full-employment
budget” concept.
• List three timing problems encountered with fiscal
policy.
• State political problems that limit effective fiscal policy.
• Identify actions by households, and by state and local
governments that can frustrate fiscal policy.
• Explain and recognize graphically how crowding out
can reduce the effectiveness of fiscal policy.
• Give two examples of complications that may arise
when fiscal policy interacts with international trade.
• Explain the purpose and structure of the Leading
Economic Indicators (Last Word).
Fiscal Policy
• 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 (active).
• Non-Discretionary Fiscal Policy (passive or
automatic).
Fiscal Policy and the AD/AS Model
•
Discretionary fiscal policy (active). refers to the
deliberate manipulation of taxes and government
spending by the government to alter real domestic
output and employment, control inflation, and
stimulate economic growth (Fiscal policy goals).
Simplifying assumptions.
1.
Assume initial government purchases don’t depress
or stimulate private spending.
2.
Assume fiscal policy affects only the demand, not
the supply, side of the economy.
Fiscal policy choices:
•
Expansionary fiscal Policy:
•
Expansionary fiscal policy is used to combat a
recession, e.g., if there is a decline in Ig which has
decreased AD from AD1 to AD2 so real GDP has
fallen and employment has declined.
•
Possible fiscal policy solutions:
a.
An increase in government spending (shifts AD to
right by more than change in G due to multiplier),
b.
A decrease in taxes (raises income, and
consumption rises by MPC × change in income; AD
shifts to right by a multiple of the change in
consumption).
C.
A combination of increased spending and
reduced taxes.
• If the budget was initially balanced, expansionary fiscal
policy creates a budget deficit.
EXPANSIONARY FISCAL POLICY
the multiplier at work...
$5 billion initial
increase in spending
Price level
AS
Full $20 billion
increase in
aggregate
demand
P1
AD2
$490
AD1
$510
Real GDP (billions)
Contractionary fiscal policy:
•
When demand-pull inflation occurs (as illustrated
by a shift from AD3 to AD4), then contractionary
policy is the remedy:
Possible fiscal policy solutions:
a. A decrease government spending shifts AD to the
LHS, once the multiplier process is complete. Here
price level returns to its pre-inflationary level but
GDP remains at its full-employment level.
b. An increase in taxes will reduce income and
then consumption at first by MPC × fall in
income, and then multiplier process leads AD
to shift leftward still further.
c. A combined spending decrease and tax
increase could have the same effect with the
right combination.
CONTRACTIONARY FISCAL POLICY
the multiplier at work...
$5 billion initial
decrease in spending
Price level
AS
P2
Full $20 billion
decrease in
aggregate
demand
P1
AD3
AD4
$510 $522
Real GDP (billions)
Financing deficits or disposing of surpluses
Deficit Finance:
• The method used influences fiscal policy effect.
Financing deficits can be done in 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
(investments), and this offsets the government
expansion.
b. Money creation: When the Central Bank loans go
directly to the government by buying government
bonds, the expansionary effect is greater since
private investors are not buying bonds (no crowding
out). Creating new money is more expansionary but it
is inflationary
Note: Monetarists argue that it is the monetary, not
fiscal, policy that is having the expansionary effect in
such a situation.
How the Government of Kuwait finance its deficit?
Disposing of surpluses:
•
Disposing of surpluses can be handled two ways.
a.
Debt reduction is good but may cause interest rates
to fall and stimulate spending. This could be
inflationary (stimulates interest sensitive spending).
b. Impounding or letting the surplus funds remain idle
would have greater anti-inflationary impact. The
government holds surplus tax revenues, which keeps
these funds from being spent.
What Kuwait is doing with the surplus?, what is the
potential impact on AD and equilibrium GDP?
Policy options: G or T?
1. Economists tend to favor higher G during recessions
and higher T during inflationary times if they are
concerned about unmet social needs or
infrastructure.
2. Others tend to favor lower T for recessions and lower
G during inflationary periods when they think
government is too large and inefficient.
Task
Government Budget in Kuwait
• Go to
• http://www.mof.gov.kw/in-taw-t6.html
• Download budget figures
• Analyze Revenues and expenditures in Kuwait
Built-In Stability
•
Built-in stability arises because net taxes (taxes
minus transfers and subsidies) change with GDP
(recall that taxes reduce incomes and therefore,
spending). It is desirable for spending to rise when
the economy is slumping and fall when the economy
is becoming inflationary.
a) Taxes automatically rise with GDP because incomes
rise and tax revenues fall when GDP falls.
b) Transfers and subsidies rise when GDP falls; when
these government payments (welfare, unemployment,
etc.) rise, net tax revenues fall along with GDP.
•
The size of automatic stability depends on
responsiveness of changes in taxes to changes in
GDP: The more progressive the tax system, the
greater the economy’s built-in stability.
•
Automatic stability reduces instability, but does not
correct economic instability.
Government Expenditures,
G, and Tax Revenues, T
BUILT-IN STABILITY
T
Surplus
G
Deficit
GDP1
GDP2
GDP3
Real Domestic Output, GDP
GLOBAL PERSPECTIVE
BUDGET DEFICITS OR SURPLUSES
AS A PERCENTAGE OF GDP, 2002
-6
-4
-2
0
2
4
Italy
Sweden
Canada
United Kingdom
France
United States
Ireland
Norway
Japan
Source: Organization for Economic Development and Cooperation
Problems, Criticisms and Complications
•
Problems of timing.
1. Recognition lag is the elapsed time between the
beginning of recession or inflation and awareness of
this occurrence.
2. Administrative lag is the difficulty in changing
policy once the problem has been recognized.
3. Operational lag is the time elapsed between change
in policy and its impact on the economy.
For these lags, discretionary fiscal policy has
increasingly relied on tax changes rather than on
changes in spending as its main tool.
• A Political Business Cycle?
• Political considerations (re-elections) may
swap economic considerations in the conduct of
fiscal policy, e.g., manipulation of fiscal policy
to maximize voter support, even though actions
may destabilize the economy.
• During elections: tax cuts and G increases.
• Economic indicators will be in the right direction,
i.e., GDP rises, unemployment falls, and price level is
relatively stable.
• After elections: a demand pull inflation occurs, and
politicians trim G and raise T to restrain inflation.
(note next election is 2-3 years ahead)
The crowding-out effect may be caused by fiscal policy
a.
“Crowding-out” may occur with government deficit
spending. It may increase the interest rate and reduce
private spending which weakens or cancels the
stimulus of fiscal policy.
Criticism of the Crowding-Out Effect
•
Economists agree that government deficits should not
occur at full employment. Full employment deficit is
inappropriate when the economy has achieved full
employment. It will crowd out private expenditures.
• Little crowding out will occur during a recession.
When G increases, it will improve expectations about
expected returns and may encourage private investment.
• Crowding out may also be offset by increasing
money supply to offset demand and thus interest will
not change.
Fiscal Policy in an Open Economy
• Shocks or changes from abroad will cause changes in
net exports, which can shift aggregate demand leftward
or rightward.
• Net Export Effect
• Net export effect may reduce effectiveness of fiscal
policy.
Expansionary Fiscal Policy
Recession slows growth 
expansionary fiscal policy 
higher interest rates 
financial capital from abroad will be attracted (e.g., in
the form of deposits in domestic banks); increasing
foreign demand for domestic currency 
appreciation of currency 
net exports decline and AD decreases, partially
offsetting the expansionary fiscal policy.
FISCAL POLICY, AGGREGATE
SUPPLY AND INFLATION
Price level
AS
Fiscal Policy:
No Complications
P1
AD1
$490
AD2
$510
Real GDP (billions)
FISCAL POLICY, AGGREGATE
SUPPLY AND INFLATION
Price level
AS
Fiscal Policy:
Showing
Crowding-out Effect
or Net Export
Effect
P1
AD1 AD’2 AD2
$490
$510
$504
Real GDP (billions)
Contractionary Fiscal Policy
Inflation
contractionary fiscal policy 
lower interest rates 
financial capital to abroad will be attracted (e.g., in the
form of deposits in foreign banks) decreasing foreign
demand for domestic currency (or increasing demand
for foreign currency) 
depreciation of currency 
net exports decline and AD increases, partially
offsetting the contractionary fiscal policy
• LAST WORD: The Leading Indicators
• Indices comprises some variables that have indicated
forthcoming changes in real GDP in the past.
• The variables consist of a weighted average of
economic measurements.
A rise in the index predicts a rise in GDP.
A fall predicts declining GDP.
e.g., in USA: The ten components comprise the index:
1.
Average workweek: A decrease signals future
GDP decline.
2. Initial claims for unemployment insurance: An
3.
4.
5.
6.
7.
8.
increase signals future GDP decline.
New orders for consumer goods: A decrease signals
GDP decline.
Vendor performance: Better performance by
suppliers in meeting business demand indicates
decline in GDP.
New orders for capital goods: A decrease signals
GDP decline.
Building permits for houses: A decrease signals
GDP decline.
Stock market prices: Declines signal GDP decline.
Money supply: A decrease is associated with falling
GDP.
9.
Interest-rate spread: when short-term rates rise,
there is a smaller spread between short-term and longterm rates which are usually higher. This indicates
restrictive monetary policy.
10. Index of consumer expectations: Declines in
consumer confidence foreshadow declining GDP.
None of these factors alone is sufficient to predict
changes in GDP, but the composite index has correctly
predicted business fluctuations many times (although
not perfectly). The index is a useful signal, but is not
totally reliable.
Chapter 13
Money
and
Banking
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