Fiscal PolicyFiscal Policy

Chapter 12Chapter 12

StabilizationStabilization

The United States government has 4 basic The United States government has 4 basic goals in terms of economic policygoals in terms of economic policy

Full employmentFull employment

Price StabilityPrice Stability

High but sustainable growthHigh but sustainable growth

Balanced BudgetBalanced Budget

Legislative MandatesLegislative Mandates

Employment Act of 1946Employment Act of 1946Congress proclaims government’s role in Congress proclaims government’s role in promoting maximum employment, promoting maximum employment, production, & purchasing powerproduction, & purchasing powerCreates Council of Economic AdvisersCreates Council of Economic AdvisersReport to the PresidentReport to the PresidentJoint Economic Committee of Congress to Joint Economic Committee of Congress to investigate economic problem of national investigate economic problem of national interestinterest

Fiscal Policy & the AD/AS ModelFiscal Policy & the AD/AS Model

Discretionary fiscal policyDiscretionary fiscal policy – Deliberate – Deliberate manipulation of taxes and spending by manipulation of taxes and spending by Congress – the economic options of the Congress – the economic options of the Federal governmentFederal government

Expansionary fiscal policyExpansionary fiscal policy is needed to is needed to or used to combat recessionor used to combat recession

Ways to fight recessionWays to fight recession

Increase government spending (shifts AD Increase government spending (shifts AD to the right)to the right)

Decrease taxes (shifts right)Decrease taxes (shifts right)

Increased spending and reduced taxesIncreased spending and reduced taxes

This will create a budget deficit assuming This will create a budget deficit assuming it was balanced to startit was balanced to start

Contractionary Fiscal PolicyContractionary Fiscal Policy

What is Demand-Pull Inflation?What is Demand-Pull Inflation?

Fights by decreasing government Fights by decreasing government spending. The goal is to reduce price spending. The goal is to reduce price levels but maintain GDP (output)levels but maintain GDP (output)

Increase taxes Increase taxes

Financing DeficitsFinancing Deficits

BorrowingBorrowing – Government competes with – Government competes with private lending institutions for money. This private lending institutions for money. This however could drive up interest rateshowever could drive up interest rates

Print MoneyPrint Money – Federal Reserve loans – Federal Reserve loans directly to the US Government by directly to the US Government by purchasing bonds purchasing bonds

Disposing of SurplusesDisposing of Surpluses

Debt Reduction is good however it may Debt Reduction is good however it may cause interest rates to fall and spark cause interest rates to fall and spark inflationinflation

Saving the surplus (Not bloody likely)Saving the surplus (Not bloody likely)

Built In StabilityBuilt In Stability

Arises because net taxes (minus transfer Arises because net taxes (minus transfer & subsidies) change with GDP. Spending & subsidies) change with GDP. Spending needs to increase in a recession, needs to increase in a recession, decrease in an inflationary perioddecrease in an inflationary periodTaxes will automatically rise w/ GDP Taxes will automatically rise w/ GDP because incomes rise. In turn, they because incomes rise. In turn, they decrease when GDP fallsdecrease when GDP fallsTransfers and subsidies rise when GDP Transfers and subsidies rise when GDP fallsfalls

Automatic StabilizersAutomatic Stabilizers

Depends on how progressive the Depends on how progressive the corresponding tax system is. corresponding tax system is.

Automatic stability reduces instability but Automatic stability reduces instability but does not correct economic instabilitydoes not correct economic instability

In other words, it will not prevent the In other words, it will not prevent the problem from happening, but it will soften problem from happening, but it will soften the blow when it doesthe blow when it does

Problems of TimingProblems of Timing

Recognition LagRecognition Lag – Elapsed time between – Elapsed time between beginning of a recession or inflation and beginning of a recession or inflation and awareness of the occurrenceawareness of the occurrenceAdministrative LagAdministrative Lag – Difficulty in – Difficulty in changing policy once the problem has changing policy once the problem has been recognizedbeen recognizedOperational LagOperational Lag – Difference in time – Difference in time between change in policy and its between change in policy and its economic impact economic impact

Political ConsiderationsPolitical Considerations

Government has other goals other than Government has other goals other than economic stability and may conflict with economic stability and may conflict with stabilization. Examples?stabilization. Examples?

How do election cycles affect economic How do election cycles affect economic policy?policy?

State & Local finance policies may offset State & Local finance policies may offset Federal efforts – Think Texas and its Federal efforts – Think Texas and its refusal of Federal stimulus fundsrefusal of Federal stimulus funds

Deficit Spending ProblemsDeficit Spending Problems

““Crowding Out” may occur w/ government Crowding Out” may occur w/ government deficit spending. deficit spending.

Deficit spending will lead to higher interest Deficit spending will lead to higher interest rates which weakens spending which rates which weakens spending which could cancel out benefits of fiscal policycould cancel out benefits of fiscal policy

Most economists argue that this will not Most economists argue that this will not occur during a recessionoccur during a recession

Leading IndicatorsLeading Indicators

Average workweekAverage workweekUnemployment claimsUnemployment claimsOrders for consumer goodsOrders for consumer goodsVendor performanceVendor performanceNew orders for capital goodsNew orders for capital goodsBuilding permits for housesBuilding permits for housesStock market pricesStock market pricesMoney SupplyMoney SupplyInterest RatesInterest RatesConsumer ExpectationsConsumer Expectations