FED 19

Fiscal Policy Overview

• Expansionary Fiscal Policy:

  • Aimed at stimulating the economy during recessions.

  • Involves either increasing government spending, cutting taxes, or both.

  • Denoted as:

    • Up arrow for government spending (G)

    • Down arrow for taxes (T)

  • Important note: Government can combine these actions and doesn't have to raise taxes to increase spending as borrowing is an option.

• Contractionary Fiscal Policy:

  • Designed to decrease aggregate demand during economic upswings.

  • Involves less government spending and/or higher taxes.

Goals of Fiscal Policy

• Stabilization:

  • Aim to push the economy toward long run aggregate supply (LRAS) wherever there are deviations.

  • When the economy shifts away from LRAS (either to the right or left), stabilization policies are employed to bring it back.

Phases of Fiscal Policy

• 1. Expansionary Fiscal Policy in response to a Recession:

  • Starts from long run equilibrium.

  • When aggregate demand shifts left, it causes a recession.

  • Commonly experienced during periods of low inflation or deflation.

  • Key issue: High unemployment creates economic hardships for people.

• 2. Automatic Mechanism:

  • Free market adjusts back to long run equilibrium without intervention.

  • Characterized by downward pressure on wages due to high unemployment, influencing short-run aggregate supply to shift inward.

  • However, this natural adjustment process can take a prolonged time (e.g., 5-8 years) which poses challenges for unemployed individuals.

Need for Government Intervention

• Why impose fiscal policy if the market self-corrects?

  • The time taken for the free market to return to equilibrium can be excessively long, leaving individuals without jobs for years.

  • Expansionary fiscal policy is introduced to facilitate a quicker recovery to potential GDP by supporting aggregate demand more rapidly.

Real-World Implications

• Expected Outcomes:

  • Expansionary fiscal policy may not always return the economy to potential GDP completely, but it can certainly help in easing the recessionary gap.

  • The government’s actions likely improve economic conditions incrementally, enabling the free market to finalize the adjustment back to equilibrium eventually.