Macro Exam 2: Ch. 10

Fiscal Policy and Debt

Fiscal Policy

The use f gov’t revenue (mainly tax receipts) and spending to influence the economy

• each year since 2001, the federal gov’t has spent far more than it collected in revenues, producing a deficit

Federal Spending: Discretionary Spending

• Spending that works through the appropriations process in congress

• Includes: national defense, transportation, science, education, and environmental protection

Federal Spending: Mandatory Spending

Spending that is required by law to adjust spending, congress must change the law

• includes: social security, medicare, and interest on the national debt

The multiplier and spending

When an economy is below full employment, fiscal policy spending is magnified by the multiplier, shifting AD towards long-run equilibrium

Spending Injections

Include investment (I), gov’t spending (G), and exports (X)

Spending withdrawals

Include savings (S), taxes (T), and imports (M)

Tax changes vs. Spending Changes

An increase in taxes is paid in part by a reduction is saving, already a withdrawal from the economy

• ex. a $100 increase in taxes (with mpc = 0.75) results in:

  • $75 reduction in consumption

  • $25 reduction in savings

  • A $100 reduction in gov’t spending would have a larger impact on aggregate output

Types of Fiscal Policy: Expansionary Fiscal Policy

Increasing gov’t spending or decreasing taxes to increase aggregate demand and output

• Is effective when an economy is below long-run equilibrium, but once long-run output is achieved, expansionary fiscal policy leads to demand-pull inflation

Contractionary Fiscal Policy

Decreasing gov’t spending or increasing taxes to reduce inflationary pressures

• When an economy is above its full employment output level, contractionary fiscal policy can be used to shift AD back to its long-run output level, reducing inflaitonary pressures

Fiscal Policy and Aggregate Supply

• The goal of supply-side fiscal policy is to expand the economy without increasing inflationary pressures

• Fiscal policy is designed to shift the long-run aggregate supply curve to the right

• These policies do not always require a trade-off between price level and output

• They require more time to work than demand-side policies

• If successful, fiscal policy directed at increasing aggregate supply can lead to more employment and lower prices

Supply-side Fiscal Policy

1. Spending on infrastructure, education, and technology

2. Reducing tax rates

3. Expanding investment and reducing regulations

These factors helped to keep interest rates and inflation low for several decades

The Laffer Curve

Arthur Laffer suggested that reducing tax rates could lead to increasing tax revenues

• Lower taxes encourage people to work and encourage businesses to invest

• As investment grows, incomes rise, which leads to higher tax revenues

Laffer Curve

• Tax revenues rise as tax rates increase from 0% to point B, then fall as tax rates increase further

• Different tax rates can lead to the same amount of tax revenue, such as point A and point C

Encouraging Investment

Investments can be increased by:

• Investment tax credits

• More rapid depreciation schedules for plant and equipment

  • Allowing firms to expense capital in a shorter period reduces the tax burden

• Repealing unnecessary regulation

• Government grants for research

Automatic Stabilizers

Tax revenues and transfer payments automatically adjust to economic fluctuations without action by congress

• When the economy is growing, tax revenues increase (from higher taxable income) and transfer payments fall (because fewer people require income assisstance)

• These effects temper the increase in ecnomic output

Fiscal Policy Timing Lags: Informational Lags

Most data that policymakers need are not available until at least one quarter after the fact

Fiscal Policy Timing Lags: Recognition Lag

It takes time to recognize trends in the data

Fiscal Policy Timing Lags: Decision Lag

Policies must be debated and passed in congress and signed by the president

Fiscal Policy Timing Lags: Implementation Lag

Once a policy becomes law, it takes time to plan, budget, and implement the new program

Deficit

Amount by which annual government spending exceeds tax revenues

Surplus

Amount by which annual tax revenues exceed government spending

National Debt

The total accumulation of past deficits less surplus

Approaches to Balancing the Budget: Annually Balanced Budget

Revenues and spending must be equal each year, this generally makes recessions worse by forcing spending cuts during economic downturns, when tax revenues drop

Approaches to Balancing the Budget: Cyclically Balanced Budget

The budget must be balances over the business cycle by increases in taxes or reductions in spending during periods of growth to offset deficits that result from recessions

Approaches to Balancing the Budget: Functional Finance

Balancing the budget is not the primary concern of policymakers; the focus is on promoting economic growth and stable prices, and keeping the economy as close as possible to full employment

Financing Debt and Deficits

The government budget constraint: G -T = △M + △B + △A

where:

G: Government spending

T: Tax revenues (G-T is the deficit)

△M: changes in money supply (selling bonds to the federal reserve)

△B: change in bonds held by the public

△A: The sale of government assets

Equity Aspects of the National Debt

• A concern regarding the national debt is the effect on wealth distribution

• People who own part of the national debt tend to be wealthier than those who do not

• Interest payments on the debt therefore redistribute wealth to the rich, leading to greater income inequality

Crowding-out Effect

Another concern is that government finances its debt by selling bonds, pushing the interest rate higher

• Higher interest rates make consumers and businesses less likely to borrow for purchases and investments

• Therefore, gov’t debt crowds out consumption and investment, leading to a less productive future economy

Fiscal Sustainability

Occurs when the present value of all projected future revenues equals the present value of projected future spending