Fiscal PolicyFiscal Policy

Fiscal PolicyFiscal Policy Fiscal policy refers to Fiscal policy refers to

government policies, like taxes, government policies, like taxes, government purchases, and government purchases, and laws. laws.

– Taxation policiesTaxation policies– Government purchasing (buying Government purchasing (buying

nuclear weapons) nuclear weapons) – Government investment (buying Government investment (buying

capital, like roads, schools, capital, like roads, schools, hydroelectric dams)hydroelectric dams)

Fiscal policies also have indirect Fiscal policies also have indirect influences: interest rates, influences: interest rates, foreign exchange, private foreign exchange, private investment, consumer investment, consumer expenditureexpenditure

(“Monetary” policy refers to use of (“Monetary” policy refers to use of Fed’s tools to affect money supply.) Fed’s tools to affect money supply.)

Overview of Fiscal PolicyOverview of Fiscal Policy Government income Government income

derives from taxes derives from taxes (personal income tax, (personal income tax, business taxes, etc.)business taxes, etc.)

Government spends Government spends according to budget: according to budget: surplus, deficit, or surplus, deficit, or balanced budgetbalanced budget

Government Government purchasespurchases

Transfer paymentsTransfer payments National debt is sum National debt is sum

of all past federal of all past federal deficits and surpluses deficits and surpluses (measure outright, (measure outright, and as % of GDP)and as % of GDP)

Types of Fiscal PoliciesTypes of Fiscal Policies DiscretionaryDiscretionary

– Polices that are chosen Polices that are chosen specifically to influence specifically to influence the economythe economy

– Change government Change government purchases: shift ADpurchases: shift AD

– Change in business Change in business taxes: lower factor taxes: lower factor costs and shift SRAScosts and shift SRAS

– Change income taxes: Change income taxes: encourage or encourage or discourage discourage consumptionconsumption

– Change in transfer Change in transfer payments: encourage payments: encourage or discourage or discourage consumptionconsumption

Automatic StabilizersAutomatic Stabilizers– Unemployment Unemployment

benefitsbenefits– WelfareWelfare

Issues with Fiscal PolicyIssues with Fiscal Policy LagsLags

– Recognition LagRecognition Lag– Implementation LagImplementation Lag– Impact LagImpact Lag

““Crowding Out”: fiscal policies Crowding Out”: fiscal policies inherently limit their inherently limit their effectivenesseffectiveness

– Increasing government Increasing government spending increases deficitspending increases deficit

– Which requires government to Which requires government to borrow, and thereby increase borrow, and thereby increase interest ratesinterest rates

– Higher rates discourage Higher rates discourage investmentinvestment

– Net effect is that G increases, Net effect is that G increases, but I decreases, leaving AD but I decreases, leaving AD little changedlittle changed

Policy choices: governments Policy choices: governments are run by politicians, with are run by politicians, with differing agendas and differing agendas and philosophiesphilosophies

Issues with Fiscal PolicyIssues with Fiscal Policy ““Supply-side Economics:” Supply-side Economics:”

fiscal policy to shift LRASfiscal policy to shift LRAS– lower taxes to encourage lower taxes to encourage

people to work, businesses people to work, businesses to invest to create capitalto invest to create capital

– Wealth will “trickle down” Wealth will “trickle down” to poorer classesto poorer classes

– Controversial: appears to Controversial: appears to favor the wealthy and big favor the wealthy and big business, but may actually business, but may actually workwork

– Remember: Lowering taxes Remember: Lowering taxes will require lower spending will require lower spending or increased debtor increased debt

National DebtNational Debt– Huge or small? Measure Huge or small? Measure

outright, or measure as % outright, or measure as % of GDP?of GDP?

Expansionary Fiscal PoliciesExpansionary Fiscal Policies Examples:Examples:

– Personal income tax cutsPersonal income tax cuts– Increased spendingIncreased spending

What are the effects onWhat are the effects on– Price levelPrice level– rGDP? rGDP? – Interest rates?Interest rates?– Foreign exchange?Foreign exchange?

Are some expansionary Are some expansionary programs better than others?programs better than others?

Which would work faster and Which would work faster and more reliably to increase AD: tax more reliably to increase AD: tax cuts or increased spending?cuts or increased spending?

– Consumers may not spend all Consumers may not spend all income generated by tax cutsincome generated by tax cuts

– Spending directly goes to Spending directly goes to economy, especially if programs economy, especially if programs are chosen wellare chosen well

– Both cause crowding out, as both Both cause crowding out, as both increase the deficitincrease the deficit

Real GDP

Price Level

AD1

SRAS

AD2

LRAS

Contractionary Fiscal PoliciesContractionary Fiscal Policies Examples:Examples:

– Raise personal income Raise personal income tax cutstax cuts

– Cut spendingCut spending What are the effects What are the effects

onon– Price levelPrice level– rGDP? rGDP? – Interest rates?Interest rates?– Foreign exchange?Foreign exchange?

Are some Are some contractionary contractionary decisions better than decisions better than others?others?

Real GDP

Price Level

AD2

SRAS

AD1

LRAS