Chapter 15: Fiscal Policy

1. Chapter 15: Fiscal Policy

2. Section 1: Understanding Fiscal Policy • Government uses money as tool to stabilize and equilibrate the free market.

3. Circular Flow of the Economy • Businesses and individuals exchange money for goods/services and labor. Goods and Services Money Households Firms Money Labor

4. Adding Government • Government attempts to stabilize the circular flow. Goods and Services Money Taxes/Spending Taxes/Spending Households Government Firms Money Labor

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

6. 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.

7. 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)

8. Expansionary Policy • When the economy is in recession (slow circular flow) the government introduces expansionary policy to increase money in circulation and stimulate spending. Goods and Services Money Taxes/Spending Taxes/Spending Households Government Firms Money Labor

9. Expansionary Policy • Expansionary Policy = tax cuts + increased spending = less money in circular flow Goods and Services Money Taxes/Spending Taxes/Spending Households Government Firms Money Labor

10. Contractionary Policy • When the economy is growing (fast circular flow) the government introduces contractionary policy to limit money in circulation and stabilize growth. Goods and Services Money Taxes/Spending Taxes/Spending Households Government Firms Money Labor

11. Contractionary Policy • Contractionary Policy = tax raises + decreased spending = less money in circulation Goods and Services Money Taxes/Spending Taxes/Spending Households Government Firms Money Labor

12. Section 2: Fiscal Policy Options • Fiscal policy is controversial. Experts have varying theories about how governments should spend.

13. 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.

14. 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”

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

16. Understanding Keynesian Economics • Think about your personal habits… • In an economic recession, will you spend or save money?

17. 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

18. 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.

19. 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.

20. New Deal Spending

21. 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.

22. 2009 American Recovery and Reinvestment Act • www.recovery.gov

23. 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.

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

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

26. 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”

27. 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.

28. Section 3: Budget Deficit and National Debt • Federal budgets rarely balance, leading to deficits and debts.

29. 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.

30. 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)

31. 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

32. 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

33. Deficit vs. Debt • The US Federal Debt is 16 trillion • The deficit is roughly 1.5 trillion

34. How problematic is debt? • Debt appears problematic, but how problematic? • Consider several factors… • Debt vs. Growth • Debt/GDP ratio • Temporary Debt vs. Permanent Debt

35. 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.

36. 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?

37. Temporary vs. Permanent Debt • Is increased debt the result of temporary, elective spending (stimulus package) OR • Permanent, mandatory spending (Medicare/Medicaid/Social Security)