Chapter 11: Fiscal Policy - Notes

Fiscal Policy: The use of government's budget tools, including government spending and taxes, to influence the macroeconomy.
Fiscal policy is legislated and approved by both Congress and the president.

During the Great Recession, the economy experienced lower output and high unemployment.
The Great Depression was much worse and lasted longer.
Classical Economists Perspective: The market is self-correcting.
Keynesian Economists Perspective: Market corrections take time due to sticky wages and focus on policy aimed at aggregate demand (AD).

Definition: Government increases spending or decreases taxes to stimulate or expand the economy.
Leads to government deficits.
Implementation:
1. Increasing Government Spending: Increases AD (since G is a component of AD), which increases GDP.
2. Decreasing Taxes: Raises disposable income and consumption, increasing AD and GDP.

Definition: Government decreases spending or increases taxes to slow the economy.
Goals:
- Pay off government debt.
- Keep the economy from expanding beyond long-run capabilities.
- Reduce upward pressure on price level.
Still aims to smooth out cycles.

Economic Stimulus Act 2008:
- Signed by President Bush.
- Tax rebate for Americans.
- Totaled $168$ billion.
- Typical family of four received $1,800$ .
- Goal: Increase consumption, stimulate the economy.
American Recovery and Reinvestment Act 2009:
- Signed by President Obama.
- Focused on government spending.
- $787$ billion stimulus.
- Goal: Increase aggregate demand.

Expansionary fiscal policy became necessary in March 2020.
CARES Act: Signed by President Trump; allocated funds to fight the virus and help households and firms, and provided economic stimulus checks.
American Rescue Plan Act of 2021: Signed by President Biden; similar goals to the CARES Act.

When government spending increases and taxes decrease, budget deficits increase.
Government finances this gap by borrowing.
Example:
- During a recession, incomes fall and unemployment rises.
- Government spending increases by $500$ billion.
- Tax revenues decrease.
- Deficit and debt rise by more than $500$ billion.

Expansionary fiscal policy leads to increases in budget deficits and the national debt during economic downturns.

Decrease AD by decreasing government spending or increasing taxes.
Objectives:
- Pay off debt accrued during expansionary fiscal policy.
- Slow down an overheated economy to prevent inflation.
Not sustainable in the long run.
Try to reduce the upward pressure on price level.
Interested in smoothing out cycles.

An economy with consistent growth is preferable to erratic growth.
Definition: Fiscal policy that seeks to counteract business cycle fluctuations.
- Expansionary policy during recessions.
- Contractionary policy during expansions.
The government tries to shift AD back to a long-run equilibrium faster than without government intervention.
The goal is to reduce fluctuations in a business cycle.

Fiscal Policy Action	Timing	Objective: How it Affects Aggregate Demand (AD)	By-Product: How it Affects the Budget Deficit
Expansionary ↑ Government Spending (G)	When the economy is contracting	G is one component of AD, so increases in G directly increase AD.	Increases budget deficit
Expansionary ↓ Taxes (T)	When the economy is contracting	Decreasing T leaves more funds to consumers, increasing consumption (C), which raises AD.	Increases budget deficit
Contractionary ↓ Government Spending (G)	When the economy is expanding	Decreases in G directly decrease AD.	Decreases budget deficit
Contractionary ↑ Taxes (T)	When the economy is expanding	Increasing T leaves fewer funds to consumers, decreasing consumption (C), which lowers AD.	Decreases budget deficit

Recognition Lag: Difficulty in determining when the economy is turning.
- GDP data is released quarterly and revised later.
- Unemployment rate data lags further.
- Growth is not constant.
Implementation Lag: Time to implement fiscal policy.
- Fiscal policy must pass as legislation.
Impact Lag: Time for effects of policy to materialize.
- Multiplier effects occur over time.

Definition: Government programs that naturally implement countercyclical fiscal policy in response to economic conditions.
Can eliminate recognition and implementation lags.
Examples:
- Progressive income tax rates
- Corporate profit taxes
- Unemployment compensation
- Welfare programs

Definition: When private spending falls in response to increases in government spending.
Reduces the ability of government spending to stimulate aggregate demand.
Implications:
- Overall spending may not increase.
- The government now has a higher deficit and debt.
Example:
- Government spending increases by $100$ billion.
- This money is borrowed, so someone had to save it.
- Demand increase for loans increases the interest rate.
- This discourages private spending and encourages private saving.
- Crowding-out is the decrease in private spending as a result of the increase in government spending.

New Classical Critique: Increases in government spending and decreases in taxes are largely offset by increases in savings.
When there is an increase in government spending or decrease in taxes:
- People recognize that the government has borrowed funds.
- Individuals save to pay for higher future taxes, which reduces consumption.
- It mitigates the initial purpose of the increase in government spending or decrease in taxes.

Shortcoming	Summary	Result
Time Lags	The effects of fiscal policy are delayed by recognition, implementation, and impact lags.	If lags are significant, fiscal policy can be mistimed and destabilize business cycles.
Crowding-out	Government spending can substitute for private spending.	Crowding-out weakens the impact of fiscal stimulus.
Savings Shifts	In response to increases in G or lower taxes, people increase their current savings to help pay for higher future taxes.	If savings increase by the amount of the federal stimulus, the effects of the stimulus are offset.

Definition: The use of government spending and taxes to affect the production (supply) side of the economy.
Target the LRAS and SRAS curves.
Factors that shift aggregate supply: changes in resources, technology, and institutions.
They increase incentives for productive activities.
Policies often take time, so supply proposals are emphasized as long-run solutions for growth.

Fiscal policy involves the use of government spending and taxes to influence the economy.
Countercyclical fiscal policy aims to smooth out cycles.
Increases in G and tax cuts are financed by borrowing.
Fiscal policy is imperfect due to lags, crowding-out, and savings adjustments.