Fiscal Policy

Expansionary Fiscal Policy

  • Fiscal Policy: the government’s use of taxation and government spending to influence the level of AD and GDP

  • Expansionary Fiscal Policy

    • in order to increase AD, govt can decrease taxes or increase govt spending

      • decrease in tax → increase in disposable incomes → increase C and I → increase in AD → increase in GDP & PL

      • increase in govt spending → increase in AD → increase in GDP & PL

  • Change in Taxes vs Changes in Govt Spending

    • changes in taxes are primarily aimed at boosting consumer spending

      • households have more money to spend → rapidly stimulate economic activity.

    • changes in govt spending directly injects money into the economy → more immediate impacts on infrastructure and public services → create jobs and further enhance AD

    • a tax cut will always need to be larger than an increase in govt spending to achieve a particular change in GDP

Contractionary Fiscal Policy in the AD-AS Model

  • Contractionary Fiscal Policy: When govt decreases in govt spending or increases taxes w/ the goal of reducing AD, rGDP, and inflation

    • Inc. in taxes → dec. in disposable incomes → dec. in C & I → inc. in AD → dec. in PL & GDP

    • dec. in govt spending → dec. in AD → dec. in PL & GDP

    • effects: lower inflation, full employment (if economy was overheating), stable growth

Automatic Stabilizers

  • lags in discretionary fiscal policy = delays happen, making it slow to respond to recessions/booms

  • automatic stabilizers = built-in systems that help the economy immediately without new laws

  • examples = progressive income taxes + transfer payments (like unemployment or welfare)

key ideas:

  • automatic stabilizers reduce the size of business cycle swings

  • they don’t stop recessions or booms but make them less extreme

  • when economy slows:

    • income taxes fall

    • transfer payments rise

    • people have more money to spend → softens the slowdown

  • when economy booms:

    • income taxes rise

    • transfer payments fall

    • less extra money → cools the boom

how taxes work as stabilizers:

  • progressive taxes = higher income = higher tax rate

  • during recession:

    • income drops → lower tax rate → disposable income doesn’t fall as much

  • during boom:

    • income rises → higher tax rate → disposable income doesn’t rise as much

transfer payments as stabilizers:

  • unemployment benefits and welfare increase when people lose jobs

  • helps keep consumer spending from crashing

  • transfer payments aren’t counted in gdp directly but affect consumption

impact on government budgets:

  • during recession = lower tax revenue + higher spending → budget deficit

  • during boom = higher tax revenue + lower spending → budget surplus

  • example:

    • salvania = recession → tax revenue drops → spending rises → deficit

    • nadyaland = boom → tax revenue rises → spending drops → surplus

  • real world u.s. examples:

    • 1982 recession = deficit bigger because of automatic stabilizers

    • 1999 boom = surplus bigger because of automatic stabilizers

Fiscal Policy’s Effects on LR Economic Growth

  • sometimes fiscal policy can be used to promote LR economic growth

  • taxes:

    • tax dec. in household → save/spend more → no inc. in LR economic growth

    • tax dec. in businesses → inc. in I → inc. in capital stocks → inc. in LR

  • govt spending:

    • inc. govt spending on national defense → mostly for protection → does not make businesses or workers more productive → LR economic growth

    • inc in govt spending on education, research and development, or infrastructure → helps people work productively → inc. in LR economic growth