Fiscal PolicyFiscal PolicyGovernment actions and Government actions and decisions to influence the decisions to influence the

economyeconomy

Reference 15.1

Fiscal Policy

Government Action (Executive, Legislative)(not monetary policy conducted by FRB)

• Expansionary: Increase total spending to reduce unemployment

• Contractionary: Reduce total spending to reduce inflation

When might the government employ Expansionary Fiscal Expansionary Fiscal

Policy Policy ??• During recessions

• During periods of high unemployment

• Maybe just before the next election“It’s the economy, Stupid”

Expansionary Fiscal PolicyExpansionary Fiscal Policy

• The government can decide to:

1. Increase government spending (jobs)

2. Lower taxes (increase aggregate demand)

3. Do both

Will this policy achieve its goal????Will this policy achieve its goal????

maybe…maybe…• Many variables

• Will additional government spending “crowd out”“crowd out” private spending?

• Crowding-outCrowding-out• Example: An additional $2,000,000 dollars spent on

education by government may result in consumers spending $2,000,000 less on private school tuition.

John Maynard KeynesThe General Theory of Employment, Interest, and MoneyThe General Theory of Employment, Interest, and Money

• 1883-1946• Revolutionizes thinking about

the government’s role in the economy.– Influential to the “New Deal”

• Argued for expansionary fiscal policy in times of recession or depression

• Increasing government spending will spur the economy to create more jobs

Contractionary Fiscal PolicyContractionary Fiscal Policy

• The government can decide to:

1. Reduce government spending

2. Increase taxes

3. Do both

NOT VERY POPULAR…But will it work?NOT VERY POPULAR…But will it work?

maybe…maybe…• Will private spending “crowd in”? Will

consumers spend more when faced with less government spending?

• Crowding-inCrowding-in• Example: The schools are so under-funded

that parents spend money to put their kids in private schools.

How Taxes Can Affect Spending

• After-tax incomeAfter-tax income: what you have left to spend after you’ve paid income taxes.

• Higher after-tax income increases demand (expansionary) low tax rate

• Lower after-tax income decreases demand (contractionary) high tax rate

Marginal Tax Rates

• Current Issue: How will the repeal of the Bush tax cuts affect the economy?

How Taxes Can Affect Supply

• If you were taxed at 100%, would you work?

• High tax rates can reduce productivityHigh tax rates can reduce productivity

Tax Rates ….Tax Tax Rates ….Tax RevenuesRevenues

• Will higher tax rates give the government greater tax revenues?

• Will lower tax rates give the government smaller tax revenues?

Only if INCOME is constant.Only if INCOME is constant.

Laffer CurveLaffer Curve

• controversial theory

• created by economist Arthur Laffer

• represents the relationship between tax rates and tax revenues.

• What is the ideal tax rate?What is the ideal tax rate?

Review

• What is expansionary fiscal policy, and for what purpose is it likely to be implemented?

• What is contractionary fiscal policy, and for what purpose is it likely to be implemented?

Review

• Is expansionary fiscal policy always effective at increasing total spending and decreasing unemployment?

• Explain your answer.

Review

• Someone says, “If the federal government cut income tax rates, tax revenues will fall.” Might this person be wrong?

Explain your answer.

Class/Homework:

• 16.2 Budget: Deficits and Surpluses– Read and note– Complete Section Review #1-5