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Chapter 12: Fiscal Policy

The Employment Act of 1946

Gave the federal government the right and responsibility to take monetary and fiscal policy action to maintain economic stability.

1. The responsibility of fulfilling the act rests with the executive branch.

a. The President must submit an annual economic report describing the current state of the economy and making policy recommendations to maintain economic stability. (State of the Union Message)

b. The Council of Economic Advisors (1 chairman of the CEA and 2 other members and staff) gathers data and advises the President on economic policy issues.

c. The Joint Economic Committee (one of four such committees in Congress) investigates a wide range of economic problems and advises and educates Congress on these economic issues.

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Discretionary Fiscal Policy is the deliberate changes of taxes and government spending by Congress to alter GDP and employment, control inflation, and stimulate economic growth.

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Expansionary Fiscal Policy

1. Increase G

2. Decrease T

3. Both increase G and decrease T

Expansionary fiscal policy implies a budget deficit.

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Contractionary Fiscal Policy

1. Decrease G

2. Increase T

3. Both decrease G and increase T

Contractionary fiscal policy implies a budget surplus.

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Financing of Deficits and Disposing of Surpluses

1. Financing a deficit by borrowing from US citizens is less expansionary than creating money.

2. Handling a surplus by reducing debt is less contractionary than holding idle balances (impounding).

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Non-Discretionary Fiscal Policy: Built-in Stabilizers

A built-in stabilizer is anything that increases the government’s budget deficit (or reduces its budget surplus) during a recession and increases its budget surplus (or reduces its deficit) during inflation without requiring explicit action by policymakers. (See Figure 12-3.)

1. When the economy goes into a recession and GDP declines, tax revenues decline and have a counter-cyclical effect on the economy.

2. During periods of prosperity when GDP is rising tax revenues increase and have a counter-cyclical effect on the economy.

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Tax Progressivity and the impact on built-in stabilizers:

1. A progressive tax is one for which the average tax rate rises with GDP.

2. A proportional tax is one for which the average tax rate remains constant as GDP rises.

3. A regressive tax has the average tax rate declining as GDP rises.

Note: The more progressive the tax system, the greater the economy’s built-in stability. Built-in stability reduces the severity of business fluctuations, but does not eliminate the need for explicit changes in budget policy to correct recessions and severe inflations.

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Actual vs. Full-Employment Budget

In Figure 12-4 it is possible to determine the extent to which government budget policy is expansionary, neutral or contractionary by examining the full-employment deficit that exists in year 1.

1. The deficit in year 2 is greater than the deficit in year 1 simply because the GDP is lower in year 2.

2. By examining the Full-Employment Budget one can determine the degree to which the budget policy is expansionary, neutral or contractionary.

3. The full-employment budget or the standardized budget measures what the Federal budget deficit or surplus would be with existing tax and government-spending structures if the economy were at full employment throughout the year.

4. Table 12-1 provides a historical comparison between Actual and full-employment deficits and surpluses in the US.

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Problems, Criticisms and Complications

Timing Problems of Fiscal Policy

1. Recognition lag is the time between the occurrence of the problem and its recognition, i.e., recession or inflation.

2. Administrative lag is the time between the recognition of the need for a policy change and the legislated change in policy.

3. Operational lag is the time between when the policy change is enacted and the impact is felt on the output, employment or the price level.

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Political Problems

1. Political Business Cycle: Politicians may not always act to stabilize the economy, but rather to gain voter support. If politicians act to further their popularity with the electorate, the results is likely to create business fluctuations and not to counteract them. Pre-election recession: Increase G and cut T. Post-election inflation: Cut G and increase T. (Politicians stay more popular with the electorate when they cut T and increase G. These deficit tendencies cause expansionary bias.)

2. Offsetting State and Local Finances: State and local governments often take action that is pro-cyclical in nature, e.g., Virginia’s belt-tightening moves during an economic slowdown make the condition worse.

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Crowding-Out Effect:

1. An expansionary fiscal policy that is financed with borrowed money will drive interest rates up and reduce investment spending and some consumer spending. (See Figure 12-5b)

2. Some economists argue that little crowding out effect will occur during a recession. The increased government spending causes increased prosperity in the economy and increase business profit expectations, and increasing investment even with higher interest rates.

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Fiscal Policy, Aggregate Supply and Inflation

With an up sloping aggregate supply curve, some portion of the potential effect of expansionary fiscal policy on real GDP may not happen due to inflation. (See Figure 12-5c)

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Fiscal Policy in the Open Economy

1. Economies are open and unforeseen international aggregate demand shocks can affect domestic GDP and make domestic fiscal policy inappropriate or less effective.

2. Suppose that the US imposes an expansionary fiscal policy that causes interest rates to rise. Higher US interest rates will attract financial capital from abroad, where interest rates have not changed. Foreign investors will purchase US dollars to invest in US securities. The increased demand for dollars causes the value of the dollar to appreciate. Higher dollar value relative to other currencies will reduce net exports. The reduction in net exports will somewhat offset the effect of the expansionary fiscal policy. (Figure 12-5c and Table 12-2)

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Suggestions:

Work problems pp. 229-230: 2., 3., 7., 10.

Work through M-C questions in study guide.

Take two quizzes for chapter from the McConnell website.