Chapter 10 - Fiscal Policy, Economic Growth, and Productivity

Fiscal policy

Deliberate changes in government spending and net tax collection to affect economic output, unemployment, and the price level. Typically designed to manipulate AD to “fix” the economy.

Expansionary fiscal policy

Real GDP is low and unemployement is high when the economy suffers a recession

When the economy operates beyond full employement, inflation becomes a problem, so the government might need to contract the economy

Contractionary fiscal policy

Sticky prices

If price levels do not change, especially downward, with changes in AD, then prices are thought of as sticky or inflexible

Budget deficit

Exists when government spending exceeds the revenue collected from taxes

Budget surplus

Exists when the revenue collected from taxes exceeds government spending

Annual budget deficit

Occurs when, in a year, the government spends more than what is collected in tax revenue. To pay for this, the goverment borrows funds.

National debt

When budget deficits are an annual occurence in a country. It’s an accumulation of the borrowing needed to cover annual deficits.

Ways to finance the deficit in expansionary policy

Borrowing

Creating money

Borrowing

When the government borrows in the form of Treasury bonds, it increases the demand for loanable funds. This increases the real rate of interest and reduces the quantity of funds available for private investment opportunities. If the goal is to expand the macroeconomy, the expansion is slowed down by increasing interest rates.

Creating money

This can avoid getting higher interest rates, but it increases the risk of inflation which can decrease the effectiveness of expansionary fiscal policy

Ways to finance the deficit in contractionary policy

Pay down debt

Do nothing

Pay down debt

If the government pays down debt and retires bonds ahead schedule, the demand for loanable funds increases lowering interest rates. These stimulate investment and consumption countering the contractionary policy and decreasing the downward effects on the price level.

Do nothing

Not allowing the borrowed funds to be recirculated through the economy causes the anti-inflationary policy to be more effective

Automatic stabilizers

Mechanisms built into the tax system that automatically regulate, or stabilize, the macroeconomy as it moves through the business cycle by changing net taxes collected by the government.

They increase a deficit during a recession and increase a budget surplus during inflation.

Relationship betwee net taxes and GDP

Net taxes increase and decrease with GDP

Crowding-out effect

When the government borrows funds to cover a deficit, the interest rate increases and households and firms are crowded out of the market for loanable funds

"Crowding in"

When a budget surplus is the result of the contractionary policy and government debt is retired, the demand for loanable fund decreases, interest rates fall and private investment increases

Net export effect

A rising interest rate increases foreign demand for U.S. dollars. The dollar then appreciates in value, causing net exports from the United States to fall. Falling net exports decreases AD, which lessens the impact of the expansionary fiscal policy. This is a variation of crowding out.

Expansionary fiscal policy is less effective if

* Government borrowing crowds out private investment with higher interest rates
* Net exports fall because of an appreciating dollar

Productivity

The quantity of output that can be produced per worker in a given amount of time

Determinants of productivity

* Stock of physical capital
* Human capital
* Natural resources
* Nonrenewable resources
* Renewable resources
* Technology

Stock of physical capital

When the quantity of physical capital in an economy is increased, in many cases, the capital helps increase the quantity of more capital

Human capital

The amount of knowledge and skills that labor can apply to the work that they do and the general level of health that the labor force enjoys

Natural resources

Productive resources provided by nature

Nonrenewable resources

Natural resources that cannot replenish themselves

Renewable resources

Natural resources that can replenish themselves if they are not overharvested

Technology

A nations knowledge of how to produce goods in the best possible way

Supply-side fiscal policy

Fiscal policy centered on tax reductions targeted to AS so that real GDP increases with very little inflation

Investment tax credit

A reduction in taxes for firms that invest in new capital like a factory or piece of equipment

What does lower income taxes create

They create disposable income for households, increasing the consumption and savings of these which allows for an increase in the productivity capacity of the country because of the capital stock accumulated. This increases the long-run AS curve.

Tax incentives to increase savings can also increase AD.

How lower taxes can increase AS and AD

By productivity incentives and risk-taking

Productivity incentives

Lower taxes mean workers take more of their pay home, which might prompt wage earners to work harder, take less time off, and be more productive

Risk-taking

Lowering the tax rate on profits increases the expected rate of return and encourages more investment