Fiscal Policy

Chapter 16

fiscal policy

the use of government tools, spending, and taxes to influence the macroeconomy

• used to stimulate the economy

• Can slow down rapid growth

expansionary policy

when the government increases spending or decrease taxes to stimulate the economy toward expansion

when private spending(C,I,NX) is low

the government can increase demands by directly increasing government(G) spending

• can also focus on consumption by decreasing taxes

How does the government pay for the spending(increase in gov’t taxes) or reduction in taxes

borrowing

example of borrowing(fiscal policy)

the economy slips into recession, and the government decides to increase government spending by $100 billion.

Without a corresponding increase in tax revenue, the government must pay for this spending by borrowing; it must sell $100 billion worth of Treasury bonds. As a result, the federal budget deficit increases.

the budget deficits rise because

tax revenue falls

contradictory fiscal policy

when the government decreases spending or increases taxes to slow economic expansion

why would the government want to increase aggregate demand

• to decrease govt debt

• if the economy is expanding beyond its capabilities

contractionary fiscal policy

when the government decreases spending or increases taxes to slow economic demand

why use contradictory policy

economic expansion can work to reduce the budget deficit and pay off some government debt.

Second, the government might want to reduce aggregate demand if it believes that the economy is expanding beyond its long-run capabilities

countercyclical

fiscal policy that seeks to counteract( move in the opposite direction of) business cycle fluctuations

how does countercyclical fiscal policy work?

using expansionary policy during economic downturns

contractionary policy during economic expansions.

marginal propensity to consume(MPC)

the portion of additional income (e.g.- when you get a bonus or your income rises) that is spent on consumption

MPC equation

change in consumption/ change in income

a fraction between 0 and 1(0<MPC<1)

based on the law of demand, as income increases, consumption spending increases

spending multipler(Ms)

the total impact on spending from a initial change of a given amount

• depends on the marginal propensity to consume

multiplier process in reverse

If the government reduces spending or increases taxes, people have less income to spend, shifting the aggregate demand curve to the left.

three shortcomings of the fiscal policy

time lags, crowding out, saving shifts

time lags have three types that accompany policy decisions

recognition lag, implementation lag , impact lag

reconginition lag

• hard to determine whether an economy is turning up or down

• data is release quarterly, doesn’t always signal expansion or recession

implementation lag

takes time to implement the fiscal policy(job of multiple governing bodies)

impact lag

The multiplier makes fiscal policy powerful, but it takes time to ripple through the economy

automatic stabilizers

government programs that automatically implement countercycial fiscal policy in response to economic conditions

• progressive income tax, taxes on corporate profits, unemployment compensation, welfare programs

crowding out

when private spending falls in response to increases in government spending

example of crowding out

• If the government buys computers for students, students won’t buy as many computers for themselves.

• might take all the money they saved on computers and spend it on other items, instead.

• But if they don’t—if they put some of the money in savings—then private spending is “crowded out” by government spending.

new classical critique

increases in taxes, are offset by increases in savings

people know that they’ll have to pay higher taxes eventually