ECON 2 PRINCIPLES OF ECONOMICS 2

FISCAL POLICY, DEFICITS AND DEBT

Lesson 12

Economic Policy Instruments

 governments use these instruments to help achieve
macroeconomic goals

1. Fiscal policy
 involves changing the total level of taxation or
government spending in an economy to
influence the level of demand for goods and
services

2. Monetary policy
 uses the interest rate of the central bank to
influence demand

3. Supply-side policy Contractionary Fiscal Policy

 instruments used to encourage higher levels
of output and employment
 includes tax incentives, subsidies and
regulations
Fiscal Policy and the AD-AS Model
 used to reduce price inflation (demand-pull inflation)
 possible fiscal policy solutions: (1) decrease in
government spending, (2) increase in taxes, (3) a
combination of both
 may create budget surplus

Discretionary Fiscal Policy

 refers to the deliberate manipulation of taxes and
government spending to alter real domestic output
and employment, control inflation, and stimulate
economic growth
 “discretionary” means the changes are at the option
of the national government

Nondiscretionary Fiscal Policy

 changes not directly resulting from congressional
action, or changes that occur automatically
 also known as passive fiscal policy

Fiscal Policy Choices Policy Options: G or T?

Expansionary Fiscal Policy
 used to combat recession
 possible fiscal policy solutions:
1. an increase in government spending (shifts
AD to right by more than change in G due to
multiplier)
2. a decrease in taxes (raises income, and
consumption rises by MPC x the change in
income; AD shifts to right by a multiple of the
change in consumption)
3. a combination of increased spending and
reduced taxes
 if the budget was initially balanced, expansionary
fiscal policy creates a budget deficit
 economists tend to favor higher G during recessions
and higher taxes during inflationary times if they are
concerned about unmet social needs or
infrastructure
 others tend to favor lower T for recessions and
lower G during inflationary periods when they think
government is too large and inefficient
Built-In Stability
 a built-in stabilizer is anything that increases the
government’s budget deficit (or reduce its budget
surplus) during a recession and increase its budget
surplus (or reduce its budget deficit) during an
expansion without requiring explicit action by
policymakers

INSTRUCTOR: NIÑA MAE BIANCA J. MARTIN LESSON 12

PAGE 1
 ECON 2 PRINCIPLES OF ECONOMICS 2
 built-in stability arises because net taxes (taxes
minus transfers and subsidies) change with GDP
 taxes automatically rise with GDP because incomes
rise and tax revenues fall when GDP falls
 transfers and subsidies rise when GDP falls; when
these government payments (welfare,
unemployment, etc.) rise, net tax revenues fall along
with GDP
Evaluating Fiscal Policy
 in evaluating the status of fiscal policy, we must
adjust deficits and surpluses to eliminate automatic
changes in tax revenues and compare the sizes of
the adjusted budget deficits (or budget surpluses) to
the level of potential GDP
 the standardized budget (or full-employment
budget) is used for this purpose; it is a measure of
what the Federal budget deficit or surplus would be
with existing tax rates and government spending
programs if the economy had achieved its full-
employment GDP in the year; The standardized
budget deficit is zero at the full-employment output
level
 if the economy slides into a recession, the
standardized budget deficit is still zero since
government expenditure equals the tax revenue that
would be forthcoming at the full-employment GDP
 the deficit that arises in a recession is a cyclical
deficit and is not caused by government
discretionary fiscal policy
 if a standardized deficit of zero in one year is
followed by a standardized budget deficit in the next
year, then fiscal policy is expansionary
 conversely, if a standardized deficit of zero in one
year is followed by a standardized budget surplus in
the next year, then fiscal policy is contractionary
Problems, Criticisms, and Complications
a) Problems of timing
INSTRUCTOR: NIÑA MAE BIANCA J. MARTIN
PAGE 2
o timing issues include recognition lag,
administrative lag and operational lag
b) Political considerations
o include political business cycles: the alleged
tendency of presidential administration and
Congress to create macroeconomic instability
by reducing taxes and increasing government
spending before elections and to raise taxes
and reduce expenditures after elections
c) Future policy reversals
o consumption smoothing arises when
taxpayers believe policy is only temporary and
is likely to be reversed in the future
d) Offsetting state and local finance
o the fiscal policies of state and local
governments are frequently pro-cyclical; they
worsen rather than correct recession or
inflation
e) Crowding-out effect
o a decrease in private investment caused by
higher interest rates that result from the
Federal government’s increased borrowing to
finance deficits (or debt)
Current Thinking on Fiscal Policy
1. Despite the many complications of fiscal policy, the
current popular view is that fiscal policy can help
“push the economy” in an intended direction but
cannot “fine-tune it” to a specific outcome.
2. Monetary policy is considered by many to be the
best month-to-month stabilization tool for the U.S.
economy.
The Public Debt
 the national or public debt is essentially the total
accumulation of the deficits (minus the surpluses)
the Federal government has incurred through time
 deficits have emerged because of war financing,
recessions, fiscal policy, and lack of political will
by Congress
 the total public debt represents the total amount of
money owed by the Federal government to the
owners of government securities (Treasury bills,
Treasury notes, Treasury bonds, savings bonds,
issued by the Federal government to finance
expenditures that exceed tax revenues)
 As of December 2012, the debt of the Philippines
is ₱5.347 trillion according to the Bureau of
LESSON 12
 ECON 2 PRINCIPLES OF ECONOMICS 2

Treasury ( ₱1.969 trillion or 36% was owed to

external creditors and ₱3.468 trillion, or 64%, to
domestic creditors)

INSTRUCTOR: NIÑA MAE BIANCA J. MARTIN LESSON 12

PAGE 3