Macro 3.8 & 3.9 Fiscal Policy and Automatic Stabilizers

Fiscal Policy Overview

• Definition: Fiscal policy is the use of government tools to influence economic performance, specifically targeting unemployment and inflation.

• Main Objectives: Achieve full employment and stable prices.

• Primary Actors: The President and Congress can implement fiscal policy through tax and spending changes.

Economic Models

AS-AD Model

• Equilibrium: Fiscal policy aims to adjust output toward long-run equilibrium if not at equilibrium.

• Gaps:

  • Recessionary Gap: Output < Full employment output

  • Inflationary Gap: Output > Full employment output

• Long-Run Adjustment: Wages and resource prices are flexible, leading to eventual adjustment to full employment.

• Keynesian Perspective: Fiscal policy can accelerate the return to long-run equilibrium.

Fiscal Policy Tools

Taxes

• Impact of Taxes:

  • Increasing taxes reduces disposable income, thus decreasing consumer spending.

  • Decreasing taxes increases disposable income and consumer spending.

Government Spending

• Types of Spending:

  1. Government Purchases:

     • Examples: Military tanks, teachers, infrastructure.

     • Enhances long-term economic growth.

  2. Transfer Payments:

     • Examples: Food stamps, unemployment compensation.

     • Increase consumer spending when raised and decrease when lowered.

Expansionary vs. Contractionary Policy

Expansionary Fiscal Policy

• Goal: Combat unemployment in a recessionary gap by increasing spending or cutting taxes.

• Effect: Shifts aggregate demand curve to the right, increasing output and price levels.

Contractionary Fiscal Policy

• Goal: Combat inflation in an inflationary gap by decreasing spending or raising taxes.

• Effect: Shifts aggregate demand curve to the left, lowering price levels but potentially increasing unemployment.

• Political Implications: Contractionary policy is unpopular due to its association with higher unemployment rates.

Policy Effectiveness

Pro-Cyclical Actions

• Actions that may exacerbate existing economic conditions, making recessionary or inflationary gaps larger.

Multipliers

1. Spending Multiplier: The increase in GDP resulting from an increase in government spending.

2. Tax Multiplier: The decrease in GDP resulting from an increase in taxes.

3. Balanced Budget Multiplier: Ensures that equal increases in taxes and spending can lead to GDP growth without affecting the budget deficit.

Automatic Stabilizers

• Definition: Mechanisms that automatically adjust government spending and taxes without new legislation.

Types of Automatic Stabilizers

1. Taxes: Rise during expansions as incomes increase, fall during recessions as incomes decrease.

2. Transfer Payments: Decrease during expansions as unemployment falls, increase during recessions as unemployment rises.

• Overall Impact: Mild business cycle fluctuations through automatic adjustments in deficits.

Challenges of Fiscal Policy

National Debt Concerns

• Government debt has exceeded $31 trillion, with expansionary policies leading to higher deficits.

• Crowding Out: Increased government borrowing raises interest rates, potentially reducing private investment and economic growth.

Operational Lag

• Delays in recognizing economic issues, formulating responses, and implementing policies can lead to inefficient or counterproductive fiscal actions.

Conclusion

• Understanding fiscal policy and its tools is essential to navigate macroeconomic environments. While fiscal policies can stabilize or stimulate the economy, they also face limitations and political challenges. For further study, refer to ReviewEcon.com and the Total Review booklet.