Fiscal Policy

I.           Legislative Mandates:  Before the Great Depression, government may have affected the economy – maybe sometimes without knowledge it was doing so, but it certainly did not take it as it’s purpose to fiddle with the economy.  But the Great Depression and the rise of Keysian MacroEconomics changed that.  Once government knew what it could do – and how…it was just a matter of time before it decided it should.

A.      Employment Act of 1946 – required government to act to improve economic conditions where it could – including dealing with unemployment, inflation and using fiscal tools to attack these problems.

B.      CEA and JEC – economic advisory groups for the President (Committee of Economic Advisors) and Congress (Joint Economic Committee)

II.                  Fiscal Policy and the Aggregate Demand-Aggregate Supply Model

A.      Expansionary Fiscal Policy: expansionary is a $.50 word for growing.  The purpose of expansionary policy is to make the economy grow.  Fiscal means that it has to do with tax and spending policy – i.e. the government budgetary process.  Therefore, expansionary fiscal policy concerns making the economy grow by using tax and spending policy.

–          budget deficits – expansionary fiscal policy is designed to spend more than the government takes in through taxes – so budget deficits are expected (and in fact by definition are required) to do expansionary fiscal policy.

money photo1)       Increased Government Spending

The first method or tool that government has at its disposal is government spending.  This is the same government spending that we used to find AE and AgD.  If we increase government spending, (G), we expect that AE will rise, and AgD will shift to the right.

The graph below shows how when G increases (from G to G’), the AE curve rises (from AE to AE’) giving us a greater level of GDP (from GDP to GDP’).  At the same time, that means that the level of GDP must be rising in the AgD-AS graph too (there can be only one level of GDP at any one time).  Inthe lower graph, AgD (which also depends on G) shifts in response to the increase in G.

2)       Tax Reductions

Tax deductions work differently, but the graph looks almost identical.  When a tax cut is given (ceteris peribus – i.e. no matching decrease in G), the effect is felt through changes in the disposable income of individual consumers and businesses.

Here the tax cut gives people more disposable income (YD), which can be spent or saved (a portion of which is spent if MPC > 0), that shifts AE up and increases GDP

Here the tax cut, increases the profit margin of businesses, making more investments profitable – leading to more investment, which shifts AE up and increases GDP

Another possibility that goes hand-in-hand with the first equation is that tax decreases mean people can save more too – lowering interest rates, making more investments profitable, increasing investment, which increases AE and GDP

currency photo3)       Combined Tax Reductions and Increased Government Spending

Doing both types of expansionary fiscal policy simultaneously increases GDP even faster – and creates deficits faster.

B.      Contractionary Fiscal Policy:  Contractionary means to shrink.  So Contractionary Fiscal policy is designed to shrink the economy (¯ GDP).  Why would you ever want to shrink GDP?  We can see why in the AgD-AS graph.  Look what happens to the level of PL as we shift from AgD’ to AgD’’.  The PL falls as GDP shrinks.  That means that one way to defeat inflation is to create a recession (falling GDP).  Have we ever done this?  Yes, we have.

1)       Decreased Government Spending

A decrease in government spending causes the AE curve to shift down, leading to lower GDP and PL (decreases inflation)

2)       Tax Increases

Increases in taxes leave less money in the hands of individuals (YD), so they spend less (↓C), and that causes AE to fall, creating less GDP.  But the PL also falls.

Increases in corporate taxes causes profits to fall, decreasing the return on investment.  Firms make fewer investments and AE falls, causing GDP to fall as well.  But the PL also falls.

Increases in personal taxes also effects businesses, because people have less money in their hands (YD), so they save less, causing interest rates to rise, making it more expensive to invest, so firms invest less.  AE falls, GDP decreases and so does the PL.

3)       Combined Tax Increases and Decreased Government Spending: Obviously, combining both contractionary tools causes GDP to fall faster, and PL to decrease faster.  It also creates surpluses by government raising taxes and cutting spending.

C.      Financing of Deficits and Disposing of Surpluses

What do we do with the surpluses?  Can we use them to pay off the debt?  Generally, the answer is “no”.  If we simply take that money and pay off debts by calling in government bonds, then money is injected into the system (Incomes rise).  That would cause GDP to rise again – and PL with it.

currency photo1)       Borrowing vs New Money

–          Borrowing from the Public: The government borrows from the public by issuing government bonds.  When you buy a government bond, you’ve lent the government your money – which they promise to pay back with interest.  You are acting as a bank.  The more they borrow from you, the less you have in cash, on hand.

It also does the same to businesses through consumers having less left to save:

–          Money Creation: printing money seems like a painless way to pay debt – but when you print money to pay off government’s bills, more money is in the hands of the public (which they can then spend).  This causes C to rise – increasing AE and GDP.

2)       Debt Retirement vs Idle Surplus

–          Debt Reduction

–          Idle Surplus

D.      Policy Options: G or T?

III.                    Built in Stability

A.      Automatic Stabilizers

B.      Economic Importance

C.      Tax Progressivity

–          Progressive Tax system

–          Regressive Tax System

–          Proportional Tax System

IV.                  Evaluating Fiscal Policy

A.      Full-Employment Budget

B.      Recent U.S. Fiscal Policy

V.               Problems, Criticisms and Complications

A.      Problems of Timing

1)       Recognition Lag

2)       Administrative Lag

3)       Operational Lag

B.      Political Considerations

– Political Business Cycles

C.      Future Policy Reversals

D.      Offsetting State and Local Finance

E.       Crowding Out Effect

F.       Graphical Presentation

G.      Criticisms of the Crowding Out Effect

H.      Fiscal Policy in the Open Economy

1)       Shocks Originating from Abroad

2)       Net Export Effect

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