Module 30(66) Fiscal Policy Basics. Module Objectives. Module Outline. I. What is Fiscal Policy?

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1 Module 30(66) Fiscal Policy Basics Module Objectives What students will learn: What fiscal policy is Why fiscal policy is an important tool for managing economic fluctuations Which policies constitute expansionary fiscal policy and which constitute contractionary fiscal policy Module Outline Opening Example: The opening story discusses the controversy surrounding the American Recovery and Reinvestment Act of The controversy concerns whether the amount of stimulus was too big, too small, or just right. I. What is Fiscal Policy? 148 A. Sources of government tax revenue in the United States in 2007 included: 1. personal income taxes: 37%. 2. social insurance taxes: 25%. 3. corporate profit taxes: 11%. 4. other taxes mainly collected at the state and local level: 27%. B. Total government spending in the United States in 2007 included: 1. education: 17%. 2. Medicare and Medicaid: 20%. 3. national defense: 15%. 4. Social Security: 16%. 5. other goods and services: 25%. 6. other government transfers: 8%. C. Definition: Social insurance programs are government programs intended to protect families against economic hardship. 1. Social Security provides income to older Americans. 2. Medicare covers much of the cost of health care for Americans over age Medicaid covers much of the cost of health care for Americans with low incomes. 4. Unemployment insurance provides payments to unemployed workers. 5. Food stamps provide food to low-income families

2 Module 30(66) fiscal policy basics 149 D. The government directly controls government spending (G), indirectly influences consumer spending (C) with transfer payments and and sometimes influences investment spending (I) through its tax policies. E. Expansionary fiscal policy 1. Expansionary fiscal policies include: a. increases in government purchases of goods and services. b. decreases in taxes. c. increases in government transfer payments. 2. Expansionary fiscal policies increase aggregate demand and thus shift the aggregate demand curve to the right. F. Contractionary fiscal policy 1. Contractionary fiscal policies include: a. decreases in government purchase of goods and services. b. increases in taxes. c. decreases in government transfer payments. 2. Contractionary fiscal policies decrease aggregate demand and thus shift the aggregate demand curve to the left. II. Can Expansionary Fiscal Policy Actually Work? A. Claim 1: Government spending always crowds out private spending. 1. This is true only if resources in the economy are always fully employed. B. Claim 2: Government borrowing always crowds out private investment spending. 1. This is true only if the increase in borrowing drives up interest rates. C. Claim 3: Government budget deficits lead to reduced private spending 1. This is true only if consumers anticipate that they will have to pay higher taxes in the future to pay off the government debt and as a result reduce spending today in order to save money. D. Because of the long period needed to implement fiscal policy and the sometimes long period before the effects are felt, it is often difficult to accurately implement fiscal policy at the right time. Teaching Tips Fiscal Policy: The Basics Creating Student Interest Ask students what stage of the business cycle the economy is in. Take a poll of students (show of hands, voice vote, or written response) and form a class consensus. Explain that hindsight is required to know for certain where the economy is and present information from the NBER Business Cycle Dating Committee (see the Web Resources section). Once you have established the class consensus on the state of the economy, ask students what they think should be done to address the state of the economy. Use this discussion to introduce fiscal policy as the topic of this chapter. Presenting the Material It is important to point out the sources of tax revenue as well as the major spending areas for governments. These data are displayed in Figures 30-2 and 30-3 in the text.

3 150 Module 30(66) fiscal policy basics Other 29% Personal income 37% Social insurance 27% Corporate profit 7% Other government transfers, 9% Medicare and Medicaid, 20% Social Security, 15% National defense, 13% Other goods and services, 27% Education, 16% In addition, demonstrate the effect of contractionary and expansionary fiscal policies using the AD AS model from both the long-run and short-run perspectives. Emphasize the manner in which fiscal policy can be used to close a recessionary gap or an inflationary gap as shown in Figures 30-4 and 30-5 in the text. Aggregate price level LRAS SRAS P 2 E 2 P 1 E 1 AD 2 Y 1 Y P Potential Real GDP output Recessionary gap

4 Module 30(66) fiscal policy basics 151 Aggregate price level LRAS SRAS P 1 P 2 E 2 E 1 AD 1 AD 2 Potential output Y P Y 1 Real GDP Inflationary gap The text discusses three claims that are often used to explain why expansionary fiscal policy does not work. Now that you have explained how expansionary fiscal policy works in theory, you can explain these three claims. You might first start a discussion about the fiscal stimulus of 2009 to see what your students know and what their opinions are. Then you can discuss each claim. If you want more information about the American Recovery and Reinvestment Act of 2009, here is a good place to start: Pages/default.aspx. Common Student Pitfalls Transfer Payments. Students sometimes don t understand why transfer payments are discussed separately from government spending on goods and services. Explain that transfer payments are different from other forms of government spending in that transfer payments made by the government are not in direct exchange for any goods or services received by the government. Case Studies in the Text Economics in Action What Was in the Recovery Act? This EIA discusses the American Recovery and Reinvestment Act of 2009 in terms of whether the money was used for government spending, tax cuts, or transfer payments. Ask students the following questions: 1. What percentage of Recovery Act spending went for tax cuts? (Answer: 34%) 2. What percentage of Recovery Act spending went to state and local governments? (Answer: 33%)

5 152 Module 30(66) fiscal policy basics Activities Filling in the Gaps (10 minutes) Ask students to work in pairs on the following exercises. 1. Describe a policy measure the government can use to close a recessionary gap. 2. Illustrate your response to question 1 in a graph. 3. Describe a policy measure the government can use to close an inflationary gap. 4. Illustrate your response to question 3 in a graph. Answers: 1. To close a recessionary gap the government can use expansionary fiscal policies, such as decreasing taxes paid by businesses or households, or increasing government spending on, say, public schools or roads. 2. Aggregate price level LRAS SRAS P 2 E 2 P 1 E 1 AD 2 0 Y 1 Y P Recessionary gap Potential output AD 1 Real GDP 3. To close an inflationary gap, the government can use contractionary fiscal policies, such as increasing taxes paid by businesses or households, or decreasing government spending on, say, public hospitals and the military. Web Resources The following websites provide information on the state of the economy and the size of the federal deficit and national debt: The NBER Business Cycle Dating Committee:

6 Module 30(66) fiscal policy basics 153 U.S. national debt clocks: com/optimist/2006/04/the_best_debt_c.html Federal budget data from the Congressional Budget Office: Treasury Direct: Global Policy Forum: Bureau of the Public Debt: