Fiscal Policy Notes

Fiscal Policy

• Fiscal policy refers to government decisions about the level of taxation or government spending.
• It affects the economy by influencing aggregate demand (AD).
  • Changes in government spending (G) directly impact AD.
  • Expenditure multiplier
  • Taxes (T) directly affect consumption, which impacts AD.
  • Tax multiplier

Fiscal Policy and Aggregate Demand (AD)

• Expansionary fiscal policy
  • Example: Suppose MPC = 0.75
    • Change in G? (Increase)
    • Change in T? (Decrease)
• Contractionary fiscal policy
  • Example: Y = 80 billion, Yp = 60 billion, and MPC = 0.8
    • Change in G? (Decrease)
    • Change in T? (Increase)
• Expansionary fiscal policy shifts the AD curve to the right.
  • Output increases.
  • Prices increase.
• Graph:
  • Initial equilibrium: AD1, SRAS, LRAS intersect at Y1 and P1. Y1 > YP.
  • Expansionary policy shifts AD1 to AD2, new equilibrium at YP and P2.
  • Y1 = 80 billion. YP = 60 billion.

Fiscal Policy and AD (continued)

• Why does the government engage in fiscal policy if the economy corrects itself?
  • To smooth fluctuations in the economy.
  • Transition from SR to LR can be a slow (and painful!) process.
• Correcting the economy can be difficult
  • "Crowding out" or "crowding in" is possible. These terms weren't defined in the lecture, but "crowding out" typically refers to when government borrowing increases interest rates and reduces private investment. "Crowding in" refers to when government spending stimulates private sector activity.
  • How large should the policy be? How to implement it?
  • Time lags can make policy ineffective or harmful
    1. Information lag: recognizing the problem.
    2. Formulation lag: deciding on and passing legislation.
    3. Implementation lag: time it takes for the policy to take effect.

Fiscal Policy and AD (continued)

• Automatic stabilizers: Changes in T and G that automatically change with economic conditions (i.e., without specific action from policymakers).
  • Taxes
    • The income tax system is progressive and based on income level.
  • Some government spending
    • Where eligibility criteria are based on income or unemployment status
    • Examples: unemployment insurance benefits, welfare programs

Fiscal Policy and AD (continued)

• Discretionary spending policy: Changes in T and G in response to economic conditions that require specific action from policymakers.
  • Lags reduce its effectiveness.
  • Used when automatic spending is not fixing the economy on its own.
• Limits to the effectiveness of fiscal policy
  • Expansionary policy limitations
  • Contractionary policy limitations

Government Budget

• Tax revenues = government's income
• Government purchases and transfer payments = their expenditures
  • Transfer payments: Government payments to individuals that don't involve a purchase of goods/service (e.g., social security payments).
• Budget deficit: G > T (an annual measure)
• Budget surplus: T > G (an annual measure)
• Federal government budget

Government Debt

• Public debt: Total amount of money that a government owes from all time.
  • Cumulative sum of deficits and surpluses from all years has risen rapidly in the last decade.
  • U.S. government debt: significant, figure 13-6 shows debt in various countries.
  • Figure 13-6 Debt in various countries as % of GDP, 2018

Government Debt (continued)

• How is this debt financed?
  • U.S. government borrows money from people by selling Treasury securities.
    • Treasury bills are short-term government debt (< 1 year).
    • Treasury notes are longer-term government debt (2, 3, 5, 7, and 10-year terms).
    • Treasury bonds are the longest-term debt (20 or 30 years).
• Who owns this debt?
  • Intragovernmental debt (government agencies or Treasury).
  • Debt held by the public
    • U.S. citizens, businesses, smaller government
    • Foreign citizens, businesses, governments
    • Federal Reserve (central bank of the U.S.)
• U.S. government debt is held due to being relatively safe.

Government Budget (continued)

• Benefits of the public debt
  1. Allows the government to be flexible.
  2. Allows the government to pay for investments that lead to growth and prosperity.
• Costs of the public debt
  1. Paying interest on borrowing (direct cost).
  2. Distorting credit markets (indirect cost).
• The government must consider who bears the burden of the debt.
• People today benefit when the government borrows, but future generations will have to repay the loans.