Fiscal Policy

Chapter 9 1
 Fiscal Policy
• Fiscal Policy is the purposeful movement in government
spending or tax policy designed to direct an economy
• Discretionary Fiscal Policy: government spending and
tax changes enacted at the time of the problem to alter
the economy
• Nondiscretionary Fiscal Policy: that set of policies that
are built into the system to stabilize the economy
(sometimes called automatic stabilizers)

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 Smoothing GDP
• People would prefer to have smoother consumption than lumpier
(obviously would rather have 3 meals every day then 6 meals per day
in November and no food in December)
• For that reasons we don’t like recessions very much-even if
temporary they hurt at the time
• Fiscal policy is one way of smoothing things-we try to provide some
insurance during recessions so that things are better during a
recession (and then presumably a bit worse during booms)

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 How Nondiscretionary
Fiscal Policy Works
• Nondiscretionary fiscal policy consists of policies that are built into
the system so that an expansionary or contractionary stimulus can be
given automatically.
• Unemployment insurance, the progressive income tax, and welfare
serve as the built-in policies.
• If the economy is in recession, those who lose their jobs are granted
unemployment and/or welfare benefits and they owe less in taxes.
• If the economy is growing at an unsustainable rate, people are
making a lot of money and are faced with higher tax rates and there
are fewer people eligible for government benefits.

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 How Discretionary Fiscal Policy Works

• If we are in a recession the fiscal policy to

stimulate the economy would consist of
• Government buying Stuff
• Government paying people to do stuff
• Decrease in taxes
• Giving money directly to people

• If we are in an inflationary period the fiscal policy

to contract the economy would consist of just the
opposite (I will focus on the first one since it is
more relevant)
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 Expansionary Fiscal Policy i

Price
Index

Real GDP
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 Shocks

• A Shock is any unanticipated economic event.

– Aggregate Demand Shock: an unexpected event which
causes aggregate demand to increase or decrease, e.g.
the Sept 11, 2001 terrorist attacks.
– Aggregate Supply Shock: an unexpected event which
causes aggregate supply to increase or decrease, e.g.
Iraq’s 1990 invasion of Kuwait and threat to Saudi
Arabia.

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Expansionary Fiscal Policy In response to a
Demand Shock

We start out here

Then get hit by an aggregate
Price demand shock
Index
The Nondiscretionary
fiscal policy undoes some
of it
The Discretionary
policy takes it up
further

Real GDP
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Expansionary Fiscal Policy In response to a
Supply Shock

We start out here

Then get hit by an aggregate
Price supply shock
Index
The Nondiscretionary
fiscal policy undoes some
of it
The Discretionary
policy takes it up
further

Real GDP
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 The Multiplier
• This isn’t in the book, but is a very important issue when thinking
about fiscal policy
• If I get $100 richer, I take my family out to a $100 dinner and leave nice $20 tip
• The server takes her $20 tip and uses it to buy a $12 umbrella
• The umbrella store guy buys a burrito
• etc.
• The bottom line is a $100,000,000 stimulus might boost GDP by
more than $100,000,000
• This is the main argument for a stimulus or a job creation package
• It depends on the marginal propensity to consume
• There are major fights about this in the popular press between various
economists about this
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 Limitations
• More than anything: there is no free lunch. If you lower taxes or
spend money today you need to raise taxes tomorrow.
• Even if there is a large positive effect today there should be a large
negative effect tomorrow
• Plus there is deadweight loss of taxation so overall effects might be
negative

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 Ricardian Equivalence
• Some people argue it should be zero (Ricardian Equivalence)
• Suppose interest rate is 10% and you give me $1000 today but will raise my
taxes by $1100 tomorrow.
• It shouldn’t have any actual effect on my spending, I am not any richer
• I should just undo it by saving that money to pay my taxes tomorrow
• However, most economist don’t believe this works perfectly
• People are not completely aware of what is going on
• Some of it will be distribution from some people to others
• Even more, could be redistribution from future generations to current generations

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 Further issues

•Even if this doesn’t happen perfectly, there is reason to

believe that it might partly happen
•Further interest rates will automatically do some of this
•Government borrows
•This causes interest rate to go up
•People choose to save more
•Hiring workers might also lead to multiplier less than 1
•Government hires someone to build a highway
•That person might have gotten a job doing something else
•In this case you didn’t necessarily “create a job” for every worker you hire

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 Evaluating
Nondiscretionary Fiscal Policy
• Most economists believe that the built-in stabilizers have had a
modestly positive effect on diminishing the severity of modern
recessions.

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 The Mistiming of
Discretionary Fiscal Policy
• Recognition Lag: the time it takes to measure the
state of the economy
• Administrative Lag: the time it takes for
Congress to agree on a course of action with the
president
• Operational Lag: the time it takes for the full
impact of a government program or tax change to
have its effect on the economy

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 Political Problems
with Fiscal Policy
• Expansionary bias is the problem where
politicians are more willing to deal with
recessions with tax cuts and spending increases
than they are to deal with inflationary pressures
with tax increases and spending cuts.
• The Political Business Cycle suggests that
politically motivated fiscal policy is used for
short term gain just prior to elections

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 The Rise, Fall and Rebirth of
Discretionary Fiscal Policy
• Between 1975 and 2001 fiscal policy was pretty
much abandoned as a mechanism for controlling
the economy.
• Monetary policy was used to expand or contract
prices and GDP.
• In 2001, the impending recession motivated tax
rebates and the Sept. 11 attacks motivated a variety
of tax cut and spending increase ideas in Congress.
• In 2003, the continuing slow growth motivated a
renewal of the tax credit rebate idea.
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The 2003 Rebate

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 Obama Stimulus Plan

Stimulus Plan Element Amount in Millions

Non-Discretionary Fiscal Policy: Unemployment, Welfare, Medicaid $135,832

Aid to States $53,600

Discretionary Fiscal Policy: Tax Cuts $301,135

Discretionary Fiscal Policy: Spending Increases $300,047

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 Current Jobs Package Proposed by
President Obama
• Total amount is around $450 billion
• Payroll tax cut for businesses and workers
• Tax breaks to businesses that hire
• Tax credit to hire long-term unemployed
• Extend unemployment insurance
• Tax credit for veterans
• Help refinance mortgages
• Tax changes to pay for it(mostly raising taxes on rich)
• Money for schools
• Infrastructure projects
• Prevent teacher, police and firefighter layoffs
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