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CHAPTER 29 Fiscal Policy. Fiscal policy basics. In economics, fiscal policy refers to corrective actions taken by Congress and the executive branch. Some fiscal policy corrections are automatic, some are specifically initiated by government.
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CHAPTER 29 Fiscal Policy
Fiscal policy basics • In economics, fiscal policy refers to corrective actions taken by Congress and the executive branch. • Some fiscal policy corrections are automatic, some are specifically initiated by government. • Does NOT involve the Federal Reserve – Fed controls monetary policy and changes to the money supply.
Government Spending in theUnited States, 2016 Social insurance programs are government programs intended to protect families against economic hardship.
The Government Budget and Total Spending C + G + I + (X-M) = GDP Fiscal policy is the use of tax policy, government transfers, or government purchases of goods and services to shift the aggregate demand curve.
Expansionary and Contractionary Fiscal Policy Expansionary Fiscal Policy Can Close a Recessionary Gap Expansionary fiscal policy increases aggregate demand. Recessionary gap
Expansionary and Contractionary Fiscal Policy Contractionary Fiscal Policy Can Eliminate an Inflationary Gap Contractionary fiscal policy decreases aggregate demand. Inflationary gap
Lags in Fiscal Policy In the case of fiscal policy, there is an important reason for caution: there are significant lag timesin its use. • Realize the recessionary/inflationary gap by collecting and analyzing economic data takes time • Government develops an action plan takes time • Implementation of the action plan takes time
Fiscal Policy and the Multiplier • Fiscal policy has a multiplier effect on the economy. • Expansionary fiscal policy leads to an increase in real GDP larger than the initial rise in aggregate spending. • Conversely, contractionary fiscal policy reduces real GDP larger than the initial reduction in aggregate spending.
Fiscal Policy and the Multiplier • The size of the shift of the aggregate demand curve depends on the type of fiscal policy. • The multiplier on changes in government purchases = 1/MPS. • The multiplier on changes in taxes or transfers = MPC/MPS This is because part of any initial change in taxes or transfers is absorbed by savings. • Changes in government purchases have a more powerful effect on the economy than equal-sized changes in taxes or transfers.
How Taxes Affect the Multiplier Rules governing taxes and some transfers act as automatic stabilizers, and automatically reduce the size of fluctuations in the business cycle. Example: Unemployment compensation Discretionary fiscal policy arises from deliberate actions by Congress and the Executive branch rather than from the business cycle. Example: Tax stimulus rebates
The Budget Balance • How do surpluses and deficits fit into the analysis of fiscal policy? • Are deficits ever a good thing and surpluses a bad thing?
The Budget Balance as a Measure of Fiscal Policy:How to calculate government surplus or deficit Gov. surplus = tax revenue - gov. spending – transfer payments
The Budget Balance as a Measure of Fiscal Policy • Expansionary fiscal policies make a budget surplus smaller or a budget deficit bigger. • Conversely, contractionary fiscalpolicies—smaller government purchases of goods and services, smaller government transfers, or higher taxes—increase the budget balance for that year, making a budget surplus bigger or a budget deficit smaller.
The Business Cycle and the Cyclically Adjusted Budget Balance • Some of the fluctuations in the budget balance are due to fluctuations the business cycle. • Governments estimate the cyclically adjusted budget balance, an estimate of the budget balance if the economy were at potential output (LRAS). • Translation: Government budget assumes approx. 3% growth in RGDP.
The U.S. Federal Budget Deficit and the Business Cycle The budget deficit as a percentage of GDP tends to rise during recessions (indicated by shaded areas) and fall during expansions.
The U.S. Federal Budget Deficit and the Unemployment Rate There is a close relationship between the budget balance and the business cycle: A recession moves the budget balance toward deficit, but an expansion moves it toward surplus.
The Actual Budget Deficit Versus the Cyclically Adjusted Budget Deficit
Should the Budget Be Balanced? • Most economists don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers. • Example: during a serious recession, government would have to raise taxes to maintain a balanced budget. • Yet continued, excessive deficits make many people believe some deficit limits are necessary.
Long-Run Implications of Fiscal Policy • U.S. government budget accounting is calculated on the basis of fiscal years. (Oct. 1 – Sept. 30) (Named for the calendar year in which they end) • Persistent budget deficits have long-run consequences because they lead to an increase in public debt. • Deficit = yearly imbalance • Debt = total imbalance
Problems Posed by Rising Government Debt This can be a problem for two reasons: • Public debt may crowd out investment spending, which reduces long-run economic growth. • And in extreme cases, rising debt may lead to government default, resulting in economic and financial turmoil. • Ex. Argentina in 2001 – defaults on $81 billion
Deficits and Debt in Practice A widely used measure of fiscal health is the debt–GDP ratio. This number can remain stable or fall even in the face of moderate budget deficits if GDP rises over time.
Implicit Liabilities Implicit liabilities are spending promises made by governments that are effectively a debt, but they are not included in the usual debt statistics.
