Untitled Flashcards Set

  1. Expansionary Fiscal Policy
    Definition: Uses discretionary government spending or taxes to stabilize the economy.

    Types of Government Spending:

    • Mandatory Spending

      • Automatic and written into law (e.g., Social Security).

      • Accounts for 63% of federal budget.

    • Discretionary Spending

      • Requires annual review (e.g., Transportation, Education, Science).

    Impact on Aggregate Demand:

    • Increases spending or reduces taxes to correct recessionary gaps.

    • Example: Government spending rises, moving aggregate demand from AD1 to AD2, leading to a $20 billion recessionary gap.

    • If MPC = 0.75, a tax cut of $6.67 billion is needed to match a $5 billion spending increase.

    Budget Deficits and National Debt:

    • Can create budget deficits as spending exceeds tax revenues.

    • Deficits financed through government securities increase national debt.

  2. Contractionary Fiscal Policy
    Purpose: Reduces inflationary gaps when aggregate demand rises.

    Mechanisms:

    • Involves tax increases and reduced government spending.

    Considerations:

    • Must take into account the ratchet effect; prices may not return to previous levels.

    • Example: If MPC is 0.75, to reduce consumption by $3 billion, taxes must increase by $4 billion.

    • The multiplier effect can lead to a total reduction of $12 billion in GDP.

    Budget Surplus:

    • Can create a surplus where tax revenues exceed spending if the government begins with a balanced budget.

    • Surplus can reduce national debt.

  3. Government Perspectives on Policy

    • Conservatives: Prefer smaller government role; favor tax cuts in recessions and spending cuts in inflation.

    • Liberals: Prefer larger government role; support spending increases in recessions and tax increases in inflation.

  4. Automatic Stabilizers
    Definition: Programs that automatically adjust spending/taxes during economic instability.

    Key Examples:

    • Transfer Payments: Increase during recessions as unemployment rises.

    • Progressive Income Taxes: Higher earners pay a larger percentage, benefiting tax revenue during growth.

    Impact on Federal Budget:

    • Balanced budgets tend to go into deficit during recessions and into surplus during growth.

    • Automatic stabilizers are often not sufficient to manage significant demand swings, necessitating active government intervention.

There are a number of problems that face policymakers who try to enact fiscal policy.

A recognition lag refers to the time, often months, between the beginning of a recession or inflation and when it is recognized.

For example, in December 2008, the National Bureau of Economic Research announced that the US economy had already been in recession for a full year before it was recognized.

And administrative lag follows, as Congress takes time, often months, to pass legislation to change taxes or spending to address the identified gap.

operational lag requires time, six months to a year, for the policy to actually take effect, as changes ripple through the system and the multiplier takes effect.

These combined lags illustrate how long a recession or inflation can be under way before a fiscal policy solution can take effect.

They also point out the importance of automatic stabilizers in helping to reduce the impacts of economic instability.

Another problem with fiscal policy is the political considerations involved in making policy.

And in order to gain votes at election time, public officials have an incentive to reduce taxes and increase spending for popular programs, even if such actions are contrary to the fiscal policy appropriate for the economic situation.

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In addition, the government may need to significantly increase spending to deal with the crisis, like a natural disaster or a war, even during a time of inflation, making an inflationary gap even worse.