Chapter 12: Fiscal Policy

1. Chapter 12: Fiscal Policy • Major function of government is to stabilize the economy • Prevent unemployment & Inflation • Stabilization can be achieved by manipulating public budget to increase output, employment or reduce inflation • Government Spending • Tax Collections

2. Fiscal Policy & the AD – AS Model • Discretionary Fiscal Policy: Deliberate manipulation of Taxes & Gov’t Spending by Congress to alter real domestic output & employment, control inflation, & stimulate economic growth • Discretionary means the changes are optional for Federal gov’t

3. Simplifying Assumptions • Assume Initial Gov’t Purchases DO NOT depress or stimulate Private Spending • Assume Fiscal Policy affect ONLY demand, not supply side of the economy

4. Fiscal Policy Choices • Expansionary Fiscal Policy • Contractionary Fiscal Policy

5. Expansionary Fiscal Policy • Used to combat Recession • Eg, Decline in Investment decreased AD  Real GDP & Employment fell • Possible Solutions: • Increase Government Spending • Decrease Taxes • Combination of Increased Gov’t Spending & Reduced Taxes

6. Contractionary Fiscal Policy • Used to combat Inflation • Eg, Increase in Investment or Net Exports increased AD  Prices rose • Possible Solutions: • Decrease Government Spending • Increase Taxes • Combination of Decreased Gov’t Spending & Higher Taxes

7. Financing Deficits • Borrowing: Gov’t competes w/ private borrowers for funds & drive up interest rates, “crowding out” private borrowing, offsets the gov’t expansion • Money creation: When the Federal Reserve loans directly to the Gov’t by buying bonds, expansionary effect is greater since private investors are not buying bonds

8. Disposing of Surpluses • Debt Reduction is good but may cause interest rates to fall and stimulate spending  inflationary • Impounding or letting the surplus funds remain idle would have greater anti-inflationary impact. Gov’t holds these tax revenues, keeps funds from being spent

9. Policy Options: G or T? • Economists favor higher G during recessions & higher taxes during inflationary times if they are concerned with unmet social needs or infrastructure • Other economists favor lowering T for recessions & lower G during inflationary periods when they think government is too large & inefficient

10. Problems, Criticisms, & Complications • Timing • Recognition Lag: Time between beginning of recession / inflation & awareness • Administrative Lag: Reflects difficulties in changing policies • Operational Lag: Time between policy change & impact on the economy

11. Political Considerations • Political Business Cycle: Election years have been characterized by more expansionary policies regardless of economic conditions • State & Local Finance policies may offset federal stabilization efforts • “Crowding – out” may occur w/ gov’t deficit spending: increased interest rate, reduces private spending, weakening/canceling the stimulus of fiscal policy

12. Last Word: The Leading Indicators • Index comprises 10 variables that have indicated changes in Real GDP: • Average Workweek • Initial Claims for Unemployment • New Orders for Consumer Goods • Vendor Performance • New Orders for Capital Goods • Building Permits for Houses • Stock Market Prices • Money Supply • Interest Rate Spread • Index of Consumer Expectations