FISCALPOLICY

LEGISLATIVE MANDATES

Employment Act of 1946

Council of Economic

Advisors (CEA)

Joint Economic

Committee (JEC)

FISCAL POLICY AND THE AD-AS MODEL

Two Options• Discretionary Fiscal Policy • Non-Discretionary Fiscal

PolicyExpansionary Fiscal PolicyTo Reduce Unemployment…• Increase Government

Spending• Tax Reductions• Combinations of the Two

Pri

ce le

vel

Real GDP (billions)

EXPANSIONARY FISCAL POLICY

Full $20 billionincrease in aggregatedemand

AD2 AD1

$5 billion initialincrease in spending

the multiplier at work...

P1

$490 $510

AS

To Reduce Inflation…• Decrease Government

Spending• Tax Increases• Combinations of the

Two

FISCAL POLICY AND THE AD-AS MODEL

Contractionary Fiscal Policy

Pri

ce le

vel

Real GDP (billions)

CONTRACTIONARY FISCAL POLICY

Full $20 billiondecrease in aggregatedemand

AD3 AD4

$5 billion initialdecrease in spending

the multiplier at work...

P2

$510 $522

AS

P1

FINANCING OF DEFICITS ANDDISPOSING OF SURPLUSES

•Borrowing vs. New Money•Borrowing From The Public•Money Creation

•Debt Retirement vs. Idle Surplus•Debt Reduction•Impounding

Which Policy Option? G or T?

BUILT-IN STABILITYNet tax revenues vary

directly with GDPTransfer payments behave

the opposite way as tax collections

Automatic or Built-In Stabilizers

Economic Importance

BUILT-IN STABILITY

GDP1 GDP2 GDP3

Real Domestic Output, GDP

Gov

ern

men

t E

xpen

dit

ure

s,G

, an

d T

ax R

even

ues

, T

Deficit

Surplus

T

G

BUILT-IN STABILITY

Tax Progressivity• Progressive Tax System• Proportional Tax System• Regressive Tax System

The more progressive the tax system, the greater the economy’s built-in stability.

FULL-EMPLOYMENT DEFICITS

GDP2 GDP1

Real Domestic Output, GDP

Gov

ernm

ent

Exp

endi

ture

s,G

, and

Tax

Rev

enue

s, T

(bi

llio

ns)

G

T1

(Year 1)(Year 2)

ab

c$500 475 450 425

No Change inFiscal Policy

FULL-EMPLOYMENT DEFICITS

GDP4 GDP3

Real Domestic Output, GDP

Gov

ernm

ent

Exp

endi

ture

s,G

, and

Tax

Rev

enue

s, T

(bi

llio

ns) T2

G

T1

Year 3Year 4

de

f$500 475 450 425

DiscretionaryFiscal PolicyTax Decrease

h

g

EVALUATING FISCAL POLICYFull-Employment BudgetCyclical DeficitRecent U.S. Deficits & Surpluses

Year

ActualDeficit orSurplus

Full-EmploymentDeficit orSurplus

1990199119921993199419951996199719981999200020012002

-3.9%-4.5%-4.7%-3.9%-2.9%-2.2%-1.4%-0.3%+0.8%+1.4%+2.4%+1.3%-1.5%

-2.1%-2.4%-2.9%-2.8%-2.1%-2.0%-1.3%-0.9%-0.4%+0.3%+1.1%+0.8%-1.5%

-6 -4 -2 0 2 4

Italy

Sweden

Canada

United Kingdom

France

United States

Ireland

Norway

Japan

GLOBAL PERSPECTIVEBUDGET DEFICITS OR SURPLUSESAS A PERCENTAGE OF GDP, 2002

Source: Organization for Economic Development and Cooperation

PROBLEMS, CRITICISMS,AND COMPLICATIONS

•Problems of Timing•Recognition Lag•Administrative Lag•Operational Lag

•Political Considerations•Political Business Cycles

•Offsetting State & Local Finance•Crowding-Out Effect

FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION

Fiscal Policy:No Complications

Pri

ce le

vel

Real GDP (billions)

AD1 AD2

P1

$490 $510

AS

FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION

Fiscal Policy:ShowingCrowding-out Effector Net ExportEffectP

rice

leve

l

Real GDP (billions)

AD1 AD2

P1

$490 $510

AS

AD’2

$504

FISCAL POLICY IN THEOPEN ECONOMY

Shocks Originating from Abroad

Net Export Effect