Fiscal Policy

The use of government spending

and/or taxing to alter Aggregate
Demand.
 ***Fiscal Policy
• The Employment Act of 1946 committed
the federal government to maintaining
economic stability.
• The federal government must constantly
monitor and analyze economic activity and
act to maintain a non-inflationary growing
economy through spending or taxing
legislation.
 Expansionary Fiscal Policy
• The Problem – the economy is below full-
employment; in a recession
• The Solution - Expansionary fiscal policy
– increase government spending (G )
– reduce taxes (C )
– enact both spending increases and tax cuts
• The Result
– G or C or both increase causing AD to increase,
which causes output and employment to rise.
– Creates a budget deficit
 Contractionary Fiscal Policy
• The Problem - the economy is past full-
employment; it is experiencing inflation
• The Solution - Contractionary fiscal policy
– reduce government spending (G )
– increase taxes (C )
– enact both spending cuts and tax increases
• The Result
– G or C or both decrease causing AD to decrease,
which lowers price levels.
– Creates a budget surplus
 Government Debt and Deficits

If government spending exceeds

government revenue (taxes) within
one year it is called deficit spending
If government revenue exceeds
government spending within one year
it is called a budget surplus
 ***To Tax or Spend?
• Changing government spending is always
more expansionary or contractionary
than changing taxes. Why?
– Part of any change in taxes comes from or
goes into savings.
 Discretionary versus Automatic
Fiscal Policy
• If government has to pass a law or take
some other specific action to change its
tax and/or spending policies then
government is stabilizing the economy
through discretionary policy.
 Discretionary versus Automatic
Fiscal Policy
• If the policy change happens by itself as
the economic situation changes, then it is
known as an automatic stabilizer or a
built-in stabilizer.
• Examples of automatic stabilizers are
unemployment compensation during
recessions and higher taxes during
inflationary/expansionary periods.
 Discretionary versus Automatic
Fiscal Policy
• There is a direct relationship between
GDP and net taxes.
– Net taxes are taxes less transfer payments
(unemployment compensation, food stamps,
TANF)
• As GDP rises our progressive tax system collects
a greater percentage of income in taxes and vice
versa.
• As GDP rises the need for transfer payments
decreases and vice versa.
 ***Problems and Complications
of Fiscal Policy
• Crowding Out
• Expansionary fiscal policy (deficit spending)
will increase the interest rate and reduce
consumer and business spending, thereby
weakening or canceling the stimulus of
expansionary policy.

• Interest rates (i) :. Investment (I) and

Consumption (C) :. AD :.
output and employment
 The Crowding Out Effect
AD/AS Loanable Investment
Real
Funds Mkt s2 Real
Demand
Interest Interest
Price s
Level
i2 i2
AS
i1 i1

PL2
PL3
PL1 AD2 Id
AD1 AD3 D1

Q1 Q3 Q2 Q2 Q1 Q2 Q1
Q of Loans Q of Investment
RGDP

Graph 1: At AD1 we are in a recession. Government cuts Taxes and increases Spending to move the economy to AD2.
Graph 2: Because the government is now deficit spending the supply of loanable funds decreases causing interest rates to
rise.
Graph 3: This increase in interest rates decreases Investment spending which causes AD to fall back to AD3 (Graph1 again).
 Fiscal Policy and the Crowding Out
Effect Graphs

Graph 1: At AD1 we are in a recession.

Government cuts Taxes and increases Spending to
move the economy to AD2.
Graph 2: Because the government is now deficit
spending the supply of loanable funds decreases
causing interest rates to rise.
Graph 3: This increase in interest rates decreases
Investment spending which causes AD to fall back
to AD3 (Graph1 again).
 ***Problems and Complications
of Fiscal Policy
• Net Export Effect
– As interest rates increase the
consequential change in the value of
the dollar leads to a decrease in Net
Exports
– NX :. AD :. output and
employment
 The Net Export Effect
Loanable FEX Market
AD/AS
Funds Mkt
Real
s2 Price of s
Interest USD
Price s
Level AS
i2 e2

i1 e1
PL2

PL3
D2
PL1 AD2 D
AD1 AD3 D1

Q2 Q1
Q1 Q3 Q2 Q1 Q2 Q of USD
Q of Loans
RGDP

Graph 1: At AD1 we are in a recession. Government cuts Taxes and increases Spending to move the economy to AD2.
Graph 2: Because the government is now deficit spending the supply of loanable funds decreases causing interest rates to
rise.
Graph 3: This increase in interest rates Increases demand for the USD in the currency exchange markets causing the dollar
to appreciate. The price of our goods in the international markets rise leading to a decrease in Exports and an
increase in Imports. Net exports decrease causing AD to decrease (AD3) on graph 1.
Fiscal Policy and the Net Export Effect Graphs
Graph 1: At AD1 we are in a recession. Government cuts
Taxes and increases Spending to move the economy to
AD2.

Graph 2: Because the government is now deficit spending

the supply of loanable funds decreases causing interest
rates to rise.

Graph 3: This increase in interest rates Increases demand

for the USD in the currency exchange markets causing the
dollar to appreciate. The prices of our goods in international
markets rise, leading to a decrease in Exports and an
increase in Imports. Net exports decrease causing AD to
decrease (AD3) on graph 1.
***Problems and Complications
of Fiscal Policy

• Problems of timing
– recognition lag – time it takes to gather data
on economic activity
– administrative lag – time it takes for
government (Congress) to pass legislation
– operational lag – time it takes for money to
enter economy and take effect
 ***Problems and Complications
of Fiscal Policy
• Political problems
– State and local policy restraints
• Fiscal policy at lower levels tends to be
pro-cyclical.
• In times of recessions because of
constitutional or legislative restraints they
may have to increase taxes and reduce
spending.
***Problems and Complications
of Fiscal Policy
• Political problems
– Other goals of Congress and
President
• The need to provide public goods,
redistribute income, the elimination of
budget deficits or war may make fiscal
policy use untenable.
 ***Problems and Complications
of Fiscal Policy
• Political problems
– Political business cycles
• Fiscal policy may be corrupted for political
purposes and may cause economic
fluctuations
 To Tax or Spend
• Choosing between increasing spending or
decreasing taxes; decreasing spending or
increasing taxes is a political philosophy
question.
– Republicans prefer smaller government so
they would choose options that achieve that –
tax cuts and reduced spending
– Democrats believe government has a vital
role in the economy, so they would choose to
increase taxes and increase spending
 Financing Deficits

• Borrowing vs Creating New Money

– Borrowing may drive up equilibrium interest
rates decreasing investment spending
(Crowding Out Effect)
– Creating new money is the more
expansionary
 Disposing of Surpluses

• Debt Retirement vs Idle Surplus

• Debt retirement means paying back loans
made to the government; money is put
back into the economy causing more
inflation
• Letting a surplus sit idle is more
contractionary
The Total Deficit or Surplus 1969 to 2016
2009 Projected deficit is $1.67 trillion.
The Federal Debt is the total of all budget deficits
and budget surpluses in our history.
http://www.usdebtclock.org/
Problems and Complications of
Fiscal Policy
– Modifications of crowding out
• If increased government spending raises
business profits expectations, the
investment demand curve shifts right and
there is little overall impact on investment
spending.
• Also if the Federal Reserve accommodates
fiscal policy by increasing the money
supply, interest rates will not change.