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FISCAL POLICY, DEFICITS, AND DEBT

EXPANSIONARY FISCAL POLICY

Fiscal policy is the use of discretionary government spending or taxes in order to stabilize the economy.

There are two kinds of government spending; mandatory spending, which is automatic spending written into the law or discretionary spending which must be revisited every year.

Social Security is an example of mandatory spending. About 63% of the federal budget is mandatory spending.

Transportation, education and science spending are examples of discretionary spending.

If aggregate demand falls, output falls and cyclical unemployment rises.

Government can use expansionary fiscal policy to correct a recessionary gap,

shifting aggregate demand to the right by increasing government spending, reducing taxes, or both.

Exactly how much taxes or Kspending must change depends on the marginal propensity to consume and the related multiplier.

Let's say government officials decide to close the recessionary gap by increasing government spending

In the graph, aggregate demand decreased from AD1 one to AD2, reducing real GDP from $510 billion to $490 billion and creating a $20 billion recessionary gap.

Let's say government officials decide to close the recessionary gap by increasing government spending

•If the MPC is 0.75. the MPS is 0.25 and the multiplier i 4(1/0.25)

Policymakers could choose instead to correct a recessionary gap by lowering taxes

However, we know that a tax cut is not as effective as an increase in government spending, because consumers will save some of the tax cut.

In this case, with an MPC of 0.75, consumers would only spend 75% of a tax cut.

So, taxes would have to be reduced by $6.67 billion (0.75 times $6.67 billion = $5 billion) to achieve the same $20 billion increase in aggregate demand that was achieved by a $5 billion increase in government spending

The smaller the MPC, the larger the tax cut necessary to achieve the same result.

Expansionary fiscal policy also has consequences for the federal budget.

Assume the United States begins with a balanced budget which means that spending equals tax revenue.

If the government lowers taxes or increases spending as part of expansionary fiscal policy, it will create a budget deficit in which it is spending more than its revenues in a year.

Government must borrow through the sale of government securities which are bonds T-bills and notes, to finance that deficit.

• A deficit also adds to the national debt, the total amount the government has borrowed over the years

CONTRACTIONARY FISCAL POLICY

•Contractionary fiscal policy and policy options

If aggregate demand rises, part of the inflationary gap increases output, while the other part increases prices with demand pull inflation

•Contractionary fiscal policy is the use of a tax increase, a reduction in government spending, or both to reduce an inflationary gap.

A reduction in spending directly affects aggregate demand.

•But in determining how far to lower spending, it is important to keep the ratchet effect in mind

Once the price level ratchets up, it tends not to come back down, due to the sticky wages and prices we discussed in previous units

So, when the government decides how much to reduce spending, it must take this ratchet effect into account

Best