Chapter 15: Fiscal Policy

Section 1: Understanding Fiscal Policy

• Government uses money as tool to stabilize and equilibrate the free market.

Circular Flow of the Economy• Businesses and individuals exchange money for

goods/services and labor.

FirmsHouseholds

Money

Money

Goods and Services

Labor

Adding Government• Government attempts to stabilize the circular flow.

FirmsHouseholds

Money

Money

Goods and Services

Labor

GovernmentTaxes/SpendingTaxes/Spending

Fiscal Policy

• Fiscal policy is the use of government spending and taxation to influence the economy.

Government

• The government spends $6 billion every day (almost $3 trillion a year)

• This is the single biggest influence in the economy.• Strategic spending (or lack of spending) can have huge

impacts on the economy.

Federal Budget

• Like businesses, the government creates an annual federal budget: a plan for spending through the year

• Fiscal year: a 12-month period (not necessarily from January-December)

Expansionary Policy• When the economy is in recession (slow circular flow) the

government introduces expansionary policy to increase money in circulation and stimulate spending.

FirmsHouseholds

Money

Money

Goods and Services

Labor

GovernmentTaxes/SpendingTaxes/Spending

Expansionary Policy• Expansionary Policy = tax cuts + increased spending =

less money in circular flow

FirmsHouseholds

Money

Money

Goods and Services

Labor

GovernmentTaxes/SpendingTaxes/Spending

Contractionary Policy• When the economy is growing (fast circular flow) the

government introduces contractionary policy to limit money in circulation and stabilize growth.

FirmsHouseholds

Money

Money

Goods and Services

Labor

GovernmentTaxes/SpendingTaxes/Spending

Contractionary Policy• Contractionary Policy = tax raises + decreased

spending = less money in circulation

FirmsHouseholds

Money

Money

Goods and Services

Labor

GovernmentTaxes/SpendingTaxes/Spending

Section 2: Fiscal Policy Options

• Fiscal policy is controversial. Experts have varying theories about how governments should spend.

Classical Economics

• Classical economists believe in laissez faire economics.

• Markets will self correct without government intervention.

• Boom and bust cycles are natural. • Classical economics ruled economic

thought until the 1930s.

Great Depression & John Maynard Keynes

• Great Depression hits in 1929.• John Maynard Keynes agrees with classical economists that in

the long run, markets well self-equilibrate, BUT he says…• “In the long run we are all dead”

John Maynard Keynes

• Keynes said that governments can act to counteract a lack of private demand.

Series10123456789

10

Government DemandConsumer DemandBusiness Demand

Understanding Keynesian Economics

• Think about your personal habits…– In an economic recession, will you spend or save

money?

Understanding Keynesian Economics

• Think about your personal habits…– In an economic recession, will you spend or save

money?– You will naturally save

• What happens if everyone saves money and doesn’t spend it?– The recession deepens

Understanding Keynesian Economics

• Keynes said government needs to take the place of individuals who are not spending.

• Keynesian theory says that temporary increased government spending can increase total demand, reversing the cycle of recession.

• Known as demand-side economics.

Great Depression & FDR’s New Deal

• President FDR followed Keynes’ advice and created the “New Deal” government programs.

• Spent lots of money on work projects to counteract lack of private sector demand.

• It worked.

New Deal Spending

2009 Federal Stimulus Package

• President Bush and President Obama each created “stimulus packages” that were similar attempts.

• Injected over $800 Billion into the economy to create demand.

2009 American Recovery and Reinvestment Act

• www.recovery.gov

Supply Side Economics

• Instead of spending increases, other economists prefer tax cuts to stimulate growth.

• By cutting taxes, government increases the supply of money in circulation.

Question

• Would the government receive more revenue from a 5% tax rate, or a 95% tax rate?

Laffer Curve

• Arthur Laffer suggested that higher taxes hinder economic activity, actually reducing government revenue.

Reaganomics

• Supply-Side economics have been proposed by Ronald Reagan in the 1980s and W. Bush in the 2000s, cutting spending to increase economic output.

• Called “Reaganomics”

Reaganomics: Trickle-Down Effect

• Reagan also coined the “trickle-down effect” – It is most important for the wealthy to receive tax breaks,

because they are the investors and owners.– Money will “trickle-down” to everyone else.

Section 3: Budget Deficit and National Debt

• Federal budgets rarely balance, leading to deficits and debts.

Balanced Budget

• A balanced budget is when revenue = spending.• In your personal life.– You make $50,000/year and spend $50,000/year. – $50,000 - $50,000 = 0. – This is balanced budget.

Budget Surplus• A budget surplus is when the government has more

revenues than spending.• Personally…– You make $50,000/year and spend $40,000– $50,000 – $40,000 = $10,000– You have a surplus (savings)

Budget Deficit

• A budget deficit is when the government has more spending than revenue.

• Personally…– You make $50,000/year and spend $60,000– $50,000 – $60,000 = -$10,000– You have a deficit

Deficit vs. Debt

• Deficit is the governments annual shortfall in the budget. Debt is the total shortfall accumulated over years of deficits.– You earn $50,000/year and spend $60,000/year.– Your annual deficit is $10,000– If you have done this for 8 years, your deficit is

$10,000 but your debt is $80,000

Deficit vs. Debt

• The US Federal Debt is 16 trillion• The deficit is roughly 1.5 trillion

How problematic is debt?

• Debt appears problematic, but how problematic?

• Consider several factors…– Debt vs. Growth– Debt/GDP ratio– Temporary Debt vs. Permanent Debt

Debt vs. Economic Growth

• Debt is problematic, but economic growth is usually prioritized over debt.– In economic recessions, aggressive efforts to

balance the budget could have negative effects on economic growth.

Debt/GDP Ratio

• Is the debt large in comparison to the size of the economy?

• Economists consider the debt to GDP ratio.– 16 trillion is a lot of money, but it is a more

reasonable figure for the US, whose GDP is 16 trillion than for Russia (GDP = 2 trillion)

– 16/16 or 16/2?

Temporary vs. Permanent Debt

• Is increased debt the result of temporary, elective spending (stimulus package) OR

• Permanent, mandatory spending (Medicare/Medicaid/Social Security)