Fiscal Policy Lecture Notes

Fiscal Policy

  • Fiscal policy involves government policymakers setting the level of government spending and taxation.
  • This is done through the Federal Budget.
  • Recall the equation: Y = C + I + G + NX, where:
    • Y = GDP (Gross Domestic Product)
    • C = Consumption
    • I = Investment
    • G = Government Spending
    • NX = Net Exports

Expansionary Fiscal Policy

  • Aims to increase Aggregate Demand (AD).
  • Achieved through:
    • Increase in government spending (G ↑)
    • Decrease in taxes, leading to increased consumption (C ↑)

Impact of Expansionary Fiscal Policy

  • An increase in aggregate demand shifts the aggregate-demand curve to the right (e.g., from AD1 to AD2).
  • In the short run:
    • The economy moves from point A to point B on the graph.
    • Output increases from Y1 to Y2.
    • The price level increases from P1 to P2.

Contractionary Fiscal Policy

  • Aims to decrease Aggregate Demand (AD).
  • Achieved through:
    • Decrease in government spending (G ↓)
    • Increase in taxes, leading to decreased consumption (C ↓)

Impact of Contractionary Fiscal Policy

  • A fall in aggregate demand shifts the aggregate-demand curve to the left (e.g., from AD1 to AD2).
  • In the short run:
    • The economy moves from point A to point B.
    • Output falls from Y1 to Y2.
    • The price level falls from P1 to P2.

Discretionary Fiscal Policy

  • Involves deliberate, new legislation passed to impact the macroeconomy.

Automatic Stabilizers

  • Automatic changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession.
  • These occur without policymakers having to take any deliberate action.
  • Examples:
    • The income tax system
    • Government spending on welfare and unemployment insurance

Keynesians in the White House

  • President John F. Kennedy advocated fiscal policy based on the ideas of John Maynard Keynes.
  • Investment Tax Credit:
    • A tax break provided to firms that invest in new capital.
    • Aims to stimulate aggregate demand immediately.
    • Aims to increase the economy’s productive capacity over time.
    • Enacted in 1964, leading to a period of robust economic growth.