4/17 - Macro Final Ex. Lecture (ch. 26 & asgn)

Fiscal Policy Definition

• Fiscal Policy: Enacted by Congress and the President to influence the economy through taxation and government spending decisions.

Distinction from Monetary Policy

• Monetary Policy: Conducted by the Federal Reserve, involving money supply and interest rates.
• Fiscal policy differs as it includes specific actions related to government spending and taxation, aimed at manipulating economic conditions.

Goals of Fiscal Policy

• Expansionary Fiscal Policy: Used during recessions to reduce unemployment by increasing government purchases or cutting taxes.

  • Example: Increasing defense spending or infrastructure projects.

• Contractionary Fiscal Policy: Implemented when inflation is high to decrease spending, often through tax hikes or reduced government expenditure.

Automatic Stabilizers vs. Discretionary Fiscal Policy

• Automatic Stabilizers: Elements that automatically adjust based on economic changes without direct government intervention (e.g., tax revenues increase as incomes rise).
• Discretionary Fiscal Policy: Specific policy actions taken by the government to adjust spending and taxes for economic intervention.

Key Components of Government Spending

• Government Expenditures: Total spending by the government, which includes transfer payments (welfare, unemployment benefits) that do not directly purchase goods or services.
• Government Purchases: Expenditures for goods and services that the government buys (e.g., military equipment).

Tax Structures and Government Revenue

• Revenue Sources: Predominantly from income taxes, followed by FICA taxes and corporate taxes.
• Transfer Payments: Significant portion of expenditures, with a large share going to Social Security and public benefits.

Long-term Challenges with Social Security

• Funding Shortage: Projections indicate significant budget shortfall in Social Security due to demographic changes (decreasing birth rates).
• Suggestions for Reform: Potential solutions include increasing taxes, reducing benefits, and adjusting eligibility age. Discussion of allowing personal investment of Social Security funds as a contentious alternative.

Fiscal Policy Tools Available to Congress and President

1. Change in government purchases.
2. Adjustment of business taxes.
3. Modification of income taxes.

Impact of Policies on Economic Graphs

• Graph Analysis: Understanding how fiscal policies (expansionary vs. contractionary) affect the economy's movement in graphs showing real GDP and price levels.
  • Expansionary moves from recession point (A) to full employment (B).
  • Contractionary moves back to equilibrium when inflation is too high.

Multipliers in Fiscal Policy

• Government Purchases Multiplier: Indicates that a change in government spending produces a larger effect on GDP than the initial spending amount due to subsequent economic activity.

  • $1 increase in government spending may lead to a $4 increase in GDP if the marginal propensity to consume (MPC) is 0.75.

• Tax Multiplier: A change in taxes also leads to multiplier effects, but typically less impactful than government spending.

  • A $1 tax cut may lead to a $3 increase in GDP (if MPC is 0.75).

Limitations of Fiscal Policy

• Timing Issues: Delays in approval and implementation of fiscal measures can lessen their effectiveness. Monetary policy adjustments can be made quickly.
• Political Challenges: Politicians are often hesitant to increase taxes or cut popular programs, making necessary fiscal adjustments politically unpopular.
• Crowding Out Effect: Increased government spending can lead to higher interest rates, reducing private sector investment, thus offsetting some of the intended impacts of fiscal policies.

Conclusion

• Fiscal policy is crucial for managing economic activity, particularly during downturns, but faces challenges and limitations compared to monetary policy actions. Understanding these principles is essential for analyzing government economic interventions.