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Fiscal Policy

After studying this chapter, you should be able to:

Define fiscal policy.

Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilize the economy.

Explain how the multiplier process works with respect to fiscal policy.

Discuss the difficulties that can arise in implementing fiscal policy.

Explain how the federal budget can serve as an automatic stabilizer.

Discuss the long-run effects of fiscal policy.

A Boon for H&R Block

5In this chapter, we will explore how the government uses fiscal policy, which involves changes in taxes and changes in government purchases…

Fiscal Policy

LEARNING OBJECTIVE1

Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth.

What Fiscal Policy Is and What It Isn’t

Automatic Stabilizers versus Discretionary Fiscal Policy

Automatic stabilizers Government spending and taxes that automatically increase or decrease along with the business cycle.

Fiscal Policy

17 - 1The Federal Government’s Share of Total Government Expenditures, 1929-2004

An Overview of Government Spending and Taxes

Fiscal Policy

17 - 2Federal Purchases and Federal Expenditures as a Percentage of GDP, 1929-2004

Fiscal Policy

17 - 3Federal Government Expenditures, 2004

The Federal Budget

Fiscal policy operates within the framework of the Employment Act of 1946, which committed the government to work toward “maximum employment, production, and purchasing power.”

The President’s Council of Economic Advisers monitors the economy and advises the President on economic policy.

Employment Act of 1946

The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means consistent with its needs and obligations and other essential considerations of national policy, with the assistance and cooperation of industry, agriculture, labor, and State and local governments, ... for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self-employment, for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power.

The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means consistent with its needs and obligations and other essential considerations of national policy, with the assistance and cooperation of industry, agriculture, labor, and State and local governments, ... for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self-employment,

for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power.

The Federal Budget

The federal budget is the annual statement of the federal government’s expenditures and tax revenues.Fiscal policy is the use of the federal budget to achieve macroeconomic objectives, such as full employment, sustained long-

term economic growth, and price level stability.

The Federal Budget

Fiscal policy operates within the framework of the Employment Act of 1946, which committed the government to work toward “maximum employment, production, and purchasing power.”

The President’s Council of Economic Advisers monitors the economy and advises the President on economic policy.

The Federal Budget

The federal government’s budget balance equals tax revenue minus expenditure.If tax revenues exceed expenditures, the government has a budget surplus.If expenditures exceed tax revenues, the government has a budget deficit.If tax revenues equal expenditures, the government has a balanced budget.

The Federal Budget

Government debt is the total amount that the government has borrowed—that the government owes. It is the accumulation of all past deficits.

The Federal Budget

Figure below shows the evolution of the debt as a percentage of GDP since 1942.

The Federal Budget

State and Local BudgetsIn 2002, when the federal government spent $2,000 billion, state and local governments spent almost $1,900 billion, mostly on education, protective services, and roads. State and local budgets are not used for stabilization purposes, and occasionally are destabilizing in recessions.

National Debt/GDP

Who Is Debt Owed To?

National Debt

National Debt – Some Simple Calculations

National Debt January 2007 per capita ($000)

(Pop = 300m)

Publicly-held USA 2674 8.9

Publicly-held-foreign 2240 7.5

US Government held 3794 12.6

Total 8708 29.0

Net Debt

Foreign-held 2240 7.5

Total 4914 16.4

Foreign debt as % of net debt 45.6%

The Future of Social Security and Medicare

17 - 1

Will the federal government be able to keep the promises made by the Social Security and Medicare programs?

Fiscal Policy

17 - 4Federal Government Revenue, 2004

Using Fiscal Policy to Influence Aggregate Demand

LEARNING OBJECTIVE2

17 - 5An Expansionary Fiscal Policy

Expansionary Fiscal Policy

17 - 6A Contractionary Fiscal Policy

Contractionary Fiscal Policy

A Summary of How Fiscal Policy Affects Aggregate Demand

PROBLEM TYPE OF POLICYACTIONS BY CONGRESS AND THE PRESIDENT RESULT

Recession Expansionary Increase government spending or cut taxes

Real GDP and the price level rise

Rising Inflation

Contractionary Decrease government spending or raise taxes

Real GDP and the price level fall

Countercyclical Fiscal Policy

17 – 1

Don’t Confuse Fiscal Policy and Monetary Policy

The Government Purchases and Tax Multipliers

LEARNING OBJECTIVE3

17 - 7The Multiplier Effect and Aggregate Demand

Multiplier effect The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures.

27 - 8The Multiplier Effect of an Increase in Government Purchases

17 - 8

Changeinequilibrium real GDPGovernment purchases multiplier

Changein government purchases

Changeinequilibrium real GDPTax multiplier

Changein taxes

The Effect of Changes in Tax Rates

Taking Into Account the Effects of Aggregate Supply

17 - 9The Multiplier Effect and Aggregate Supply

The Multipliers Work in Both Directions

Fiscal Policy Multipliers

LEARNING OBJECTIVE3

The Limits of Using Fiscal Policy to Stabilize the Economy

LEARNING OBJECTIVE4

17 - 10How a Bill Becomes Law

Does Government Spending Reduce Private Spending?

Crowding out A decline in private expenditures as a result of an increase in government purchases.

17 - 11An Expansionary Fiscal Policy Increases Interest Rates

Crowding Out in the Short Run

17 - 12The Effect of Crowding Out in the Short Run

Crowding Out in the Short Run

Crowding Out in the Long Run

Limits to Fiscal Policy: Japan in the Late 1990s

17 - 2

Fiscal policy in Japan has not been effective in expanding real GDP and reducing unemployment.

Deficits, Surpluses, and Federal Government Debt

LEARNING OBJECTIVE5

Budget deficit The situation in which the government’s spending is greater than its tax revenue.

Budget Surplus The situation in which the government’s expenditures are less than its tax revenue.

17 - 13The Federal Budget Deficit, 1901-2004

How the Federal Budget Can Serve as an Automatic Stabilizer

Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

17 – 14How the Level of GDP Affects the Cyclically Adjusted Budget Deficit

How the Federal Budget Can Serve as an Automatic Stabilizer

Did Fiscal Policy Fail During the Great Depression?

17 - 3

Although government spending increased during the Great Depression, the cyclically adjusted budget was in surplus most years.

FEDERAL GOVERNMENT

EXPENDITURES (BILLIONS OF

DOLLARS

ACTUAL FEDERAL BUDGET

DEFICIT OR SURPLUS

(BILLIONS OF DOLLARS)

CYCLICALLY ADJUSTED

BUDGET DEFICIT OR SURPLUS

(BILLIONS OF DOLLARS)

CYCLICALLY ADJUSTED

BUDGET DEFICIT OR

SURPLUS AS A PERCENTAGE

OF GDP

1929 $2.6 $1.0 $1.24 1.20%

1930 2.7 0.2 0.81 0.89

1931 4.0 -2.1 -0.41 -0.54

1932 3.0 -1.3 0.50 0.85

1933 3.4 -0.9 1.06 1.88

1934 5.5 -2.2 0.09 0.14

1935 5.6 -1.9 0.54 0.74

1936 7.8 -3.2 0.47 0.56

1937 6.4 0.2 2.55 2.77

1938 7.3 -1.3 2.47 2.87

1939 8.4 -2.1 2.00 2.17

Should the Federal Budget Always Be Balanced?

The Effect of Economic Fluctuations on the Budget Deficit

LEARNING OBJECTIVE5

The Federal Government Debt

Is the Government Debt a Problem?

17 - 15The Federal Government Debt,1901-2004

The Effects of Fiscal Policy in the Long Run

LEARNING OBJECTIVE6

Tax wedge The difference between the pre-tax and post-tax return to an economic activity.

The Long-Run Effects of Tax Policy

We can briefly look at the effects on aggregate supply of cutting each of the following taxes:

Individual income tax.

Corporate income tax.

Taxes on dividends and capital gains.

Tax Simplification

Should the United States Adopt the “Flat Tax”?

17 - 4

Should the United States simplify the tax code by moving to a flat tax?

COUNTRYFLAT TAX

YEAR FLAT TAX WAS

INTRODUCED

Estonia 26% 1994

Lithuania 33 1994

Latvia 25 1995

Russia 13 2001

Serbia 14 2003

Ukraine 13 2004

Slovakia 19 2004

Georgia 12 2005

Romania 16 2005

The Effects of Fiscal Policy in the Long Run

The Economic Effect of Tax Reform17 - 15

The Supply-Side Effectsof a Tax Change

How Large Are Supply-Side Effects?

The Not-So-Incredible Shrinking Deficit

Automatic stabilizersBudget deficitBudget surplusCrowding outCyclically adjusted budget

deficit or surplusFiscal policyMultiplier effectTax wedge

National Debt/GDP

Who Is Debt Owed To?

National Debt

National Debt – Some Simple Calculations

National Debt January 2007 per capita ($000)

(Pop = 300m)

Publicly-held-foreign 2240 7.5

US Government held 3794 12.6

Total 8708 29.0

Net Debt

Foreign-held 2240 7.5

Total 4914 16.4

Foreign debt as % of net debt 45.6%

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