fiscalpolicyppt-100129081312-phpapp02

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CHAPTER12


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INTRODUCTION

y One major function of the government is to stabilize

the economy (prevent unemployment or inflation)y Stabilization can be achieved in part by manipulating

the public budget-government spending and taxcollections-to increase output and employment or to

reduce inflation.


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WHAT WILL WE COVER IN THIS

CHAPTER?

1. Legislative mandates given to the government to

pursue stabilization.2. Explore the tools of government fiscal stabilization

policy using theAD-AS model.

3. Discretionary and automatic fiscal adjustments.

4. The problems, criticisms, and complications of fiscalpolicy.


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LEGISLATIVEMANDATESA. In The Employment Act of 1946, Congress

proclaimed the role of government in promoting

maximum employment, production, and purchasingpower.

B. The Act created the CEA (Council of EconomicAdvisers) to advise the President on economic

matters.C. It also created the Joint Economic Committee of

Congress to investigate economic problems ofnational interest.


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FISCAL POLICY AND THEAD/AS

MODELA. Discretionary fiscal policy refers to the deliberate

manipulation of taxes and government spending byCongress to alter real domestic output andemployment, control inflation, and stimulateeconomic growth. Discretionary means thechanges are at the option of the Federal government.

B. Simplifying assumptions:

1. Assume initial government purchases dontdepress or stimulate private spending.

2. Assume fiscal policy affects only the demand, notsupply, side of the economy.


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FISCAL POLICY CHOICES

1. Expansionary fiscal policy: used to combat a

recession.

2. Contractionary fiscal policy: used to combatdemand-pull inflation, due to excess spending.


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EXPANSIONARY FISCAL POLICYExpansionary Policy needed: a decline in investment hasdecreased AD, so real GDP has fallen, and also employment hasdeclined. Apossible fiscal solution may be:

a. An increase in government spending, which shifts AD to theright by more than the change in G, due to the multiplier.

b. Adecrease in taxes (raises income, and consumption rises byMPC times the change in income). AD shifts to the right by amultiple of the change in consumption.

c. Acombination of increased G spending and reduced taxes.d. If the budget was initially balanced, expansionary fiscal policycreates a budget deficit.


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CONTRACTIONARY FISCAL POLICYContractionary Policy needed: When demand-pull inflationoccurs, a shift ofAD to the right in the vertical range ofAS, thencontractionary policy is the remedy.

a. A decrease in G spending shifts AD back left, once themultiplier process is complete. Here price level returns to itspre-inflationary level, but GDP remains at full-employmentlevel.b. An increase in taxes will reduce income, and thenconsumption at first by the MPC times the decrease in income,

and then the multiplier process leads AD to shift leftward stillfurther.c. Acombined G spending decrease and tax increase could havethe same effect with the right combination.d. If the budget was initially balanced, a contractionary fiscalpolicy creates a budget surplus.


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FINANCING DEFICITSThe method used to finance deficits or dispose of surplusesinfluences fiscal policy:

A. Financing deficits can be done 2ways:

1. Borrowing: (crowding out effect) The governmentcompetes with private borrowers for funds, and could drive upinterest rates; the government may crowd out privateborrowing, and this offsets the government expansion.

2. Money Creation: When the Federal Reserve loans

directly to the government by buying bonds, the expansionaryeffect is greater since private investors are not buying bonds.(Monetarists argue that this is monetary, not fiscal, policy thatis having the expansionary effect in this situation).


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DISPOSING OF SURPLUSES

B. Disposing of surpluses can be done in 2ways:

1. Debt reduction is good, but may cause interest ratesto fall and stimulate spending, which could then beinflationary.

2. Impounding or letting the surplus funds remain

idle would have greater anti-inflationary impact. Thegovernment holds surplus tax revenues which keepsthese funds from being spent.


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POLICY OPTIONS: G OR T?y Economists have mixed views about whether to use

government spending or tax changes to promotestability, depending on their view of the government:

1. If economists are concerned about unmet socialneeds or infrastructure, they tend to favor highergovernment spending during recessions and highertaxes during inflationary times.

2. When economists think that government is too largeor inefficient, they tend to favor lower taxes forrecessions and lower government spending duringinflationary periods.


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BUILT-IN STABILITYBuilt-in stability arises because net taxes (taxes minustransfers and subsidies) change with GDP. Remember thattaxes reduce incomes, and therefore, spending. It isdesirable for spending to rise when the economy isslumping and to fall when the economy is becominginflationary.

1. Taxes automatically rise with GDP because incomes rise

and tax revenues fall when GDP falls.2. Transfers and subsidies rise when GDP falls; when these

government payments (welfare, unemployment, etc.)rise, net tax revenues fall along with GDP.


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BUILT-IN STABILITYThe size of automatic stability depends onresponsiveness of changes in taxes to changes in GDP:

The more progressive the tax system, the greater theeconomys built-in stability.

1. Marginal tax rates on personal income can bechanges, such as in 1993, when it was increased from

31% to 39.6% to prevent demand-pull inflation.2. Automatic stability reduces instability, but does not

correct this economic instability.


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EVALUATINGFISCAL POLICYA. To evaluate the direction of discretionary fiscal policy,

adjustments need to be made to the actual budget deficits orsurpluses.

1. The standardized budget is a better index than the actualbudget in the direction of government fiscal policy because itindicates when the Federal budget deficit or surplus would beif the economy were operating at full employment. In the caseof a budget deficit, the standardized budget:

a. Removes the cyclical deficit that is produced by swings in thebusiness cycle, and

b. Reveals the size of the standardized deficit, indicating howexpansionary the fiscal policy was that year.


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EVALUATINGFISCAL POLICYLook at the full-employment budget in Year 1 in Figure12-4(a). Budget revenues equal expenditures when fullemployment exists at GDP.

At GDP there is unemployment and assume nodiscretionary government action, so lines G and T remainas shown.

1. Because of built-in stability, the actual budget deficit will rise with decline of GDP, therefore, actual budgetvaries with GDP.2. The government is not engaging in expansionarypolicy since budget is balanced at full-employmentoutput.


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EVALUATINGFISCAL POLICY

3. The full-employment budget measures what the

Federal budget deficit or surplus would be withexisting taxes and government spending if theeconomy is at full-employment.

4. Actual budget deficit or surplus may differ greatly

from full-employment budget deficit or surplusestimates.


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EVALUATINGFISCAL POLICYIn Figure 12-4(b), the government reduced tax ratesfrom T to T, now that there is a full-employment

deficit.1. Structural deficit occurs when there is a deficit inthe full-employment budget as well as in the actualbudget.

2. There is expansionary policy because trueexpansionary policy occurs when the full-employmentbudget has


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EVALUATINGFISCAL POLICYy If the Full-Employment deficit of zero was followed by

a Full-Employment budget surplus, fiscal policy iscontractionary.

y Look at Table 12-1y Observe that Full-Employment deficits are less than

actual deficits.

y Column 3 indicates expansionary fiscal policy of early

1990s became contractionary in the later years shown.y Actual deficits have dissapeared and the US budget had

actual surpluses after 1999 until the recent recession oflast year.


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PROBLEMS, CRITICISMS, AND

COMPLICATIONSA. Problems of timing

1. Recognition lag is the elapsed time between the

beginning of recession or inflation and awareness ofthe occurrence.

2. Administrative lag is the difficulty in changing policyonce the problem has been recognized.

3. Operational lag is the time elapsed between change inpolicy and its impact on the economy.


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COMPLICATIONSB. Political considerations: Government has other goals

besides economic stability, and these may conflict withstabilization policy.

1. Apolitical business cycle may destabilize the economy:Election years have been characterized by moreexpansionary policies regardless of economic conditions.2. State and local finance policies may offset federalstabilization policies. They are often procyclical, becausebalanced-budget requirements cause states and localgovernments to raise taxes in a recession or cut spending,making the recession possibly worse. In an inflationaryperiod, they may increase spending or cut taxes as theirbudgets head for surplus.


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COMPLICATIONS3. The crowding-out effect may be caused by fiscal policy.

a. crowding-out may occur with government deficit

spending. It may increase the interest rate and reduceprivate spending which weakens or cancels the stimulus offiscal policy.

b. Some economists argue that little crowding out willoccur during a recession.

c. Economists agree that government deficits should notoccur at Full-Employment. It is also argued that monetaryauthorities could counteract the crowding-out byincreasing the money supply to accommodate fiscal policy.


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COMPLICATIONS

C. With an upward sloping AS curve, some portion of

the potential impact of an expansionary fiscal policyon real output may be dissipated in the form ofinflation.


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FISCAL POLICY IN AN OPEN

ECONOMYA. Shocks or changes from abroad will cause changes in

net exports which can shift aggregate demandleftward or rightward.

B. The net export effect reduces the effectiveness offiscal policy by offsetting its effects. For example:

1. Expansionary fiscal policy may increase domesticinterest rates, which can cause the dollar to

appreciate and exports to decline.2. Contractionary fiscal policy may reduce domestic

interest rates, which would cause the dollar todepreciate, and net exports to increase.

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