Understanding Fiscal Policy

Revenues - Expenses

• Federal Budget is a written document indicating the amount of money the government expects to receive for a certain year and authorizing the amount the government can spend that year.

• Fiscal Year – a twelve-month period that can begin on any date

• The federal budget takes about 18 months to prepare

• Budgets are tools used by consumers and the government to better manage their resources

Government Spending DecisionsForces Affecting Government Spending Decisions

Economic Forces

• Changes in the economy, including changes in growth rates, interest rates, employment rates, income distribution, and other indicators

• Differing opinions about how changes in taxation would affect the economy

Political Forces• Desire of members of Congress to please constituents

• Different views of the political parties

Cultural Forces• American belief in limited government

• American belief in economic freedom

Psychological Forces

• Individual beliefs about the role of government

• Individual attitudes toward paying taxes

Budget Terms

• Balanced Budget = revenues are the same as expenditures

• Budget Surplus = annual revenues are higher than spending

• Budget Deficit = government expenditures exceed government revenues

Deficit

• Must find a way to pay for the extra expenditures

• Two possible solutions– Create money

• Can lead to inflation or hyperinflation

– Borrow money• Treasury bill, notes and bonds• Other countries own our national debt

Treasury Securities

• Treasury bill – a government bond that is repaid within three

months to one year

• Treasury note – a government bond that is repaid within two to

ten years

• Treasury bond – a government bond that can be issued for as

long as 30 years

National Debt• The sum of all the yearly deficits• As of April 8, 2009 the national debt clock

was $11.156 trillion• The estimated population of the United

States is 305,964,539• So, each citizen's share of this debt is

$36,462.67 • The National Debt has continued to

increase an average of $3.85 billion per day since September 28, 2007!

U.S. Federal Debt

• April 6, 2009 $11,149,346,771,082.81

• JAN 21, 2005 $7,614,468,360,651.30

• JAN 19 2001  $5,727,776,738,304.64

• JAN 21,1997 $5,310,267,076,516.85

• Jan 20 1993 $4,188,092,107,183.60

Factoids about the Debt• GDP = 13.13 trillion – do you see a

problem if we produce less than our debt?• Daily increase of debt = $1.52 billion • Hourly increase of debt = $75 million• Second increase of debt = $13,000• Interest on the debt is the third single

largest budget item (Social Security and defense)

• Paying interest means we cannot spend money elsewhere in the U.S.

What can be done?

• Balance the Budget

• Increase Taxes

• Decrease Spending

• No Pork Barreling

• Term Limits on Congress

• Reduce Foreign Aid, Grants, Etc.

Stabilization of Economy

• The government’s economic priorities are seen by analyzing the budget.

• Also can be seen by the way they use Fiscal Policy

• Fiscal means “basket” or “bag” , or “pool of money” (Latin, not Greek)

• Specifically, money held by the government

Definition• Fiscal policy is a

way of managing the nation’s financial affairs through a program of expenditures and taxation.

• Purpose is to achieve particular economic goals

• Stabilization

Two Types of Fiscal Policy

1. Expansionary Fiscal Policy• Increase Government spending and/or• Decrease Government taxes

– Objective of this type of policy is to increase total spending in the economy to reduce the unemployment rate.

– Encourage growth in the economy• Multiplier Effect – the idea that every

one dollar of government spending creates more than one dollar in economic activity

Unemployment – Increase Spending

• If the unemployment rate is high it is a result of people not spending enough money in the economy.

• If people spend more money, firms will sell more goods, and they will have to hire people to produce more goods.

• Government chooses to spend more on health care, education, national defense, or any other program, that results in firms selling more goods.

• When firms sell more goods, they hire more workers to produce additional goods and unemployment goes down.

Unemployment – Decrease Taxes

• Consumers have after tax income to purchase all their needs and wants

• If the government lowers the taxes, consumers have more income to spend.

• The total spending in the economy rises as a result of a tax cut.

• Increased spending means firms sell more goods, and firms hire additional workers.

• Unemployment rate goes down as a result of more people working.

2. Contractionary Fiscal Policy• Decrease Government spending and/or• Increase Government taxes

– Objective is to reduce total spending in the economy in order to reduce inflation

– Cool the economy down

Inflation – Decrease Spending

• Remember – Inflation is demand growing faster than the supply – “too much money chasing too few goods”

• Decrease in government spending is a decrease in overall spending in the economy, so firms sell less goods.

• When they sell less, they end up with a surplus and a decrease in the prices.

Inflation – Increase Taxes

• Economists believe the opposite will happen if taxes are raised

• After tax income will be lower, so people will buy less, lowering total spending in the economy.

• Firms keep less profit so they decrease buying land, labor and capital, cut production and lowers the GDP

Limits of Fiscal Policy

• Clumsy and difficult to put into practice.

• Hard to know real status of the economy.

• Lag time can be up to 18 months

• Political pressure from constituents

• Hard for branches to work together

• Temporary fix, could slide into recession

Classical Economists

• Looked at supply and demand of individual products, not the aggregate (whole) economy

• Believed it would move to equilibrium on its own, no government interference

• Adam Smith

• David Ricardo

• Thomas Malthus

Keynesian Economists

• Looked at the economy as a whole

• Looked at productive capacity (maximum output that an economy can produce without big increases in inflation)

• John Maynard Keynes– “In the long run we are all dead.”– Could not wait for the economy to recover on

its own, challenged Classical view

Terms to Know

• Demand-side economics - idea that government spending and tax cuts help an economy by raising demand

• Keynesian economics - a form of demand-side economics that encourages government action to increase or decrease demand and output

• Supply-side economics – a school of economics that believes tax cuts can help an economy by raising supply (Reaganomics)

Fiscal Policy History• Hoover and previous – Classical• FDR – Keynesian – war spending• 1945 – 1960 – let the good times role• Kennedy – 6.7% unemployment – cut income

taxes from 90% to 35% • Vietnam War increased spending and had the

look of Keynesian success• Late 1970’s – unemployment and inflation• 1981 – Reaganomics – cut taxes by 15% over

three years – huge deficits because of spending

How successful do you think Fiscal Policy Is?