Chapter 11

1. Chapter 11 Fiscal Policy

2. Chapter Outline • NONDISCRETIONARY AND DISCRETIONARY FISCAL POLICY • USING FISCAL POLICY TO COUNTERACT “SHOCKS” • EVALUATING FISCAL POLICY

3. Fiscal Policy • Fiscal Policy is thepurposeful movement in government spending or tax policy designed to direct an economy • Discretionary Fiscal Policy: government spending and tax changes enacted at the time of the problem to alter the economy • Nondiscretionary Fiscal Policy: that set of policies that are built into the system to stabilize the economy

4. How Nondiscretionary Fiscal Policy Works • Nondiscretionary fiscal policy consists of policies that are built into the system so that an expansionary or contractionary stimulus can be given automatically. • The welfare state and the progressive income tax serve as the built-in policies. • If the economy is in recession, those who lose their jobs are granted unemployment and welfare benefits and they owe less in taxes. • If the economy is growing at an unsustainable rate, people are making a lot of money and are faced with higher tax rates and there are fewer people eligible for government benefits.

5. How Discretionary Fiscal Policy Works • If we are in a recession the fiscal policy to stimulate the economy would consist of • Increases in government spending • Decreases in taxes • If we are in an inflationary period the fiscal policy to contract the economy would consist of • Decreases in government spending • Increases in taxes

6. PI AS PI’ PI* AD’ AD RGDP* RGDP’ RGDP Expansionary Fiscal Policy

7. PI AS PI* PI’ AD AD’ RGDP’ RGDP* RGDP Contractionary Fiscal Policy

8. Shocks • A Shock is any unanticipated economic event. • Aggregate Demand Shock: an unexpected event which causes aggregate demand to increase or decrease, e.g. the Sept 11, 2001 terrorist attacks. • Aggregate Supply Shock: an unexpected event which causes aggregate supply to increase or decrease, e.g. Iraq’s 1990 invasion of Kuwait and threat to Saudi Arabia.

9. PI AS Shock NDFP PI* AD3 AD1 DFP AD2 RGDP RGDP* Nondiscretionary and Discretionary Fiscal Policy Combats a Recession

10. PI AS Shock NDFP AD2 DFP PI* AD3 AD1 RGDP RGDP* Nondiscretionary and Discretionary Fiscal Policy Combats an Overheated Economy

11. AS2 PI Shock AS1 NDFP DFP AD3 PI* AD2 AD1 RGDP RGDP* Nondiscretionary and Discretionary Fiscal in the Wake of a Negative Aggregate Supply Shock

12. PI AS1 Shock AS2 PI* NDFP AD1 AD2 RGDP RGDP* Nondiscretionary and Discretionary Fiscal in the Wake of a Positive Aggregate Supply Shock

13. Evaluating Nondiscretionary Fiscal Policy • Most economists believe that the built-in stabilizers have had a modestly positive effect on diminishing the severity of modern recessions.

14. The Mistiming of Discretionary Fiscal Policy • Recognition Lag: the time it takes to measure the state of the economy • Administrative Lag: the time it takes for Congress to agree on a course of action with the president • Operational Lag: the time it takes for the full impact of a government program or tax change to have its effect on the economy

15. Political Problems with Fiscal Policy • Expansionary bias is the problem where politicians are more willing to deal with recessions with tax cuts and spending increases than they are to deal with inflationary pressures with tax increases and spending cuts. • The Political Business Cycle suggests that politically motivated fiscal policy is used for short term gain just prior to elections

16. The 25-year Abandonment of Discretionary Fiscal Policy • Between 1975 and 2001 fiscal policy was pretty much abandoned as a mechanism for controlling the economy. • Monetary policy was used to expand or contract prices and GDP. • In 2001, the impending recession motivated tax rebates and the Sept. 11 attacks motivated a variety of tax cut and spending increase ideas in Congress.