# Lesson 9 - Fiscal Policy

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2 2 Lesson 9 - ECO 151- Master.nb fiscal policies would be recommended during a recession? There are two policies that would be expansionary (think of shifting the Aggregate Demand curve to the right): the first would be a decrease in taxes and the second would be an increase in government spending. Let s look at the impact of each. A decrease in taxes raises consumption by the MPC times the decrease in taxes and then will shift the AD to the right by a multiple of the change in consumption. It will be helpful to walk through this process. Let s say that the government decides to reduce taxes by one million dollars. When consumers are informed that their taxes are going down by one million dollars, they will find that they now have one million dollars that they thought they were going to have to pay in taxes that they are actually going to be allowed to keep. In many ways, this will seem to them like a one million dollar increase in income. How much of the one million dollars will they actually spend? This depends on the MPC. For example, if the MPC is equal to 0.8, consumers will spend \$800,000 when their taxes are reduced by one million dollars. What will they do with the other \$200,000? They will save it, because if their MPC is equal to 0.8, their MPS is equal to 0.2. The increase in consumption of \$800,000 is going to shift the AD to the right, but by how much? With an MPC of 0.8, the expenditures multiplier is equal to 5 and the AD curve will be shifted by \$4,000,000. In this case, the AD curve will shift to the right leading to higher real GDP, a higher price level, and lower unemployment. The one-period model below illustrates the impact of expansionary fiscal policy on the economy. Click on the GDP<LRAS button to show an economy that is below its potential GDP. If you shift the first slider for fiscal policy to the right, the AD curve shifts right. Notice, that if all else is held constant then real GDP increases, price level increase and the unemployment rate decreases. This expansionary fiscal policy can be used to stimulate economic growth. This policy is enacted by Congress and the President by decreasing taxes and/or increasing government spending. A two-period (dynamic) model of expansionary fiscal policy is presented at the end of this section.

3 Lesson 9 - ECO 151- Master.nb 3 One-Period Model Static - AD AS The graph below illustrates a one-time period model where maroeconomic equilibrium is at potential GDP GDP=LRAS, where macroeconomic equilibrium is above potential GDP GDP>LRAS, and where macroeconomic equilibrium is less than potential GDP GDP<LRAS. One of the purposes of macroeconomics policy is to get macroeconomic equilibrium to potential GDP LRAS. Fiscal policy works through the aggregate demand curve AD. Expansionary fiscal policy includes decreasing taxes and or increasing government spending, which shifts the aggregate demand curve to the right. Contractionary fiscal policy includes increasing taxes and or decreasing government spending, which shifts the aggregate demand curve to the left. If the economy is overheated GDP>LRAS then contractionary fiscal policy is usually undertaken to cool down the economy. If the economy is struggling GDP<LRAS then expansionary fiscal policy is usually undertaken to try and heat up the economy. Watch what happens to equilibrium price level and real GDP when expansionary and contractionary policies are implemented. The arrows in the table indicate if the equilibrium price level and real GDP has increased Æ, decreased, or stayed at the same value õ. LRAS GDP=LRAS GDP>LRAS GDP<LRAS Fiscal Policy Shifts in AD Contr...Expans. Shifts in SRAS Left...Right Æ,,õ Eq. Price Level = Eq. Real GDP = Unemployment Rate = õ õ õ Contractionary Fiscal Policy Fiscal policy can be used to combat excessive demand-pull inflation as well. Contractionary fiscal policy is most often used during periods of high inflation when policy makers believe contracting the economy (and thereby reducing inflation) is possible with either no impact on or minimal reductions in real output, causing small increases in unemployment that would be considered acceptable. Which fiscal policies would be recommended during a period of high inflation? There are two policies that would be contractionary (think of shifting the Aggregate Demand curve to the left): the first would be a decrease in government spending and the second would be an increase in taxes. The one-period model above illustrates the impact of contractionary fiscal policy on the economy. Click on the GDP>LRAS button to show an economy that is above its potential GDP and struggling with demand-pull inflation. If you shift the first slider for fiscal policy to the left, the AD curve shifts left. Notice, that if all else is held constant then real GDP decreases, price level decrease and the unemployment rate increases. This contractionary fiscal policy can be used to slow the economic growth of the economy down. This policy is enacted by Congress and the President by increasing taxes and/or decreasing government spending. A two-period (dynamic) model of contractionary fiscal policy is presented at the end of this section. Countercyclical Fiscal Policy Countercyclical fiscal policy is a government policy designed to offsets shocks that would create a business cycle. For example, the terrorist attacks on 9/11 spawned a number of government spending programs in order to offset the

4 4 Lesson 9 - ECO 151- Master.nb financial anxiety gripping the country at the time. You might also remember the Cash for Clunkers program that President Obama initiated in 2009, where the Federal government rebated about \$2.9 billion to U.S. residents in order to incentivize them to trade in their used cars and purchase newer, more fuel efficient cars. All such programs are designed to counteract current economic conditions, and push the economy toward full-employment RGDP. Automatic Fiscal Stabilizers There is another type of fiscal policy that does not require Congressional or Presidential approval for implementation. These are known as automatic fiscal stabilizers. They have been established by Federal legislation prior to any particular economic event and do not require Congress to take new action hence the terms built-in or automatic stabilizers. Examples of automatic stabilizers include the unemployment and welfare compensation for people who lose their jobs during an economic recession. The laws surrounding these programs have long since been passed, and money is automatically made available to such individuals when they simply initiate an unemployment or welfare claim. Note this process is countercyclical. When people lose their jobs, incomes are reduced and spending levels begin to decline. The issuance of the unemployment checks, welfare payments, and/or food stamps at least partially offsets both the income and spending reductions, helping to stabilize the economy. Further, when the claimant gets a new job, such payments automatically cease as the individual gets back to his/her pre-laid-off situation. Another automatic stabilizer is the current federal tax system. For example, when income is high, spending in the economy increases, driving up real output levels and raising prices. However, as incomes go up, more families find themselves in higher tax brackets, paying higher levels of taxes. This reduces the disposable incomes of families and limits the amount of spending and upward price pressure. The tax system works in the opposite manner when the economy enters a recession. As more and more people find themselves without jobs and incomes, they will fall into lower tax brackets, which helps stabilize their disposable incomes, and partially offsets the other reductions in the economy. Two-period Expansionary and Contractionary Fiscal Policy (Optional) The affects of expansionary and contractionary fiscal policy are discussed in a one-period setting. Below are graphs that represent fiscal policy in a two-period (dynamic) model. The first graph represents expansionary fiscal policy. There are two circumstances that Congress and the President would undertake expansionary fiscal policy: slow economic growth and recession.

5 Lesson 9 - ECO 151- Master.nb 5 Two-Period Model Dynamic - Expansionary Fiscal Policy The graph below illustrates a two-period model. We use it to help us understand how expansionary fiscal policy will impact unemployment, GDP, and inflation. We are currently in period 1. Each scenario forecasts what the economy will be like in period 2. In scenarios 1 slow economic growth and 2 recession, Congress can enact expansionary fiscal policy decreasing taxes and or increasing government spending to combat the problem. After clicking on 'AD Period 2' and 'SRAS Period 2' under scenarios 1 and 2, select 'Increasing Taxes' or 'Decrease Spending' to see how the forecast for period 2 changes. The purpose of expansionary fiscal policy is to increase the growth rate of GDP and decrease unemployment rates. The cost of expansionary fiscal policy is higher inflation rates. Scenario 1: Slow Growth Forecast AD Period 2 SRAS Period 2 Policy Response Decrease Taxes No D T. Increase Spending No D S. Scenario 2: Recession Forecast AD Period 2 SRAS Period 2 Policy Response Decrease Taxes No D T. Increase Spending No D S. The second graph represents contractionary fiscal policy. There are two circumstances that Congress and the President would undertake contractionary fiscal policy: demand-pull inflation and cost-push inflation. Cost-pull inflation provides problems for the enacting fiscal policy. The problem with cost-pull inflation is high inflation rates. It can be accompanied by a recession (see graph below). We call this situation of high inflation and negative GDP growth stagflation. If contractionary fiscal policy is enacted by increases taxes and/or decreasing government spending it will, in theory, slow the rate of inflation but cause a deeper recession.

6 6 Lesson 9 - ECO 151- Master.nb Two-Period Model Dynamic - Contractionary Fiscal Policy The graph below illustrates a two-period model. We use it to help us understand how contractionary fiscal policy will impact unemployment, GDP, and inflation. We are currently in period 1. Each scenario forecasts what the economy will be like in period 2. In scenarios 1 demand-pull inflation and 2 cost-push inflation, Congress can enact contractionary fiscal policy raising taxes and or decreasing government spending to combat the problem. After clicking on 'AD Period 2' and 'SRAS Period 2' under scenarios 1 and 2, select 'Increasing Taxes' or 'Decrease Spending' to see how the forecast for period 2 changes. The purpose of contractionary fiscal policy is to slow the growth rate of prices inflation. The cost of contractionary policy is lower GDP and higher unemployment. If demand-pull inflation exists then we would just expect lower economic growth than forecast. For cost-push inflation it could potentially make the economy grow even slower. This makes fixing cost-push inflation tricky. Scenario 1: Demand-Pull Inflation Forecast AD Period 2 SRAS Period 2 Policy Increase Taxes No D T. Decrease Spending No D S. Scenario 2: Cost-Push Inflation Forecast AD Period 2 SRAS Period 2 Policy Increase Taxes No D T. Decrease Spending No D S. Section 2: Fiscal Policy Issues Fiscal Policy Issues There are a number of important issues associated with fiscal policies, and their overall effectiveness. Many of these issues revolve around positive versus normative economics, and the associated political implications. That is, policy makers tend to be rewarded for making policy, but that doesn t necessarily mean it is good policy. Sometimes fiscal policy is more expedient for short-term purposes, but not necessarily good for long-term economic strength. For example, significant amounts of government deficit spending might help reduce the unemployment level over the next 18 months, but leaves a large national debt that must be paid off by some future generation. Issue 1: The effectiveness of fiscal policy depends, in part, on three types of lags: a) Recognition Lag: The recognition lag is the time it takes between the occurrence of the economic condition and the policymakers' recognition of the situation. For example, suppose a recession begins in May, but policy

9 Lesson 9 - ECO 151- Master.nb 9 through issuing savings bonds), the money lent to the government is no longer available to supply the private market, and the supply of loanable funds shifts to the left. This drives up interest rates, which will "crowd out" private investment. As private investment falls, the AD shifts back to the left, thus off-setting the expansionary effects of the increase in government spending. This can be seen on the graphic below. Expansionary Fiscal Polciy through Government Borrowing When the Federal Government borrows money by issuing bonds to the general public to purse expansionary fiscal policy, then there are less funds available in the market for loanable funds. This shifts the supply curve to the left which results in fewer equilibrium funds and higher interest rates. Click on the button 'Govt Borrowing Æ' to see what happens when governments borrow more money to finance expansionary fiscal policy. You can also move the demand curve by using the slider below. The table will show which direction equilibrium interest rates and equilibrium loanable funds are moving. Government Borrowing Start Govt Borrowing Æ Shifts in the Demand for Money Left...Right Æ,,õ Eq. Interest Rate = Eq. Loanable Funds = õ õ In the second case, the Federal Reserve essentially loans directly to the government by buying bonds which does not impact the private loanable funds market, and does not influence interest rates. Since there is no impact on private investment, the expansionary effect is greater than by borrowing because there is no crowding out effect. Since this method of financing the deficit is closely tied to monetary policy, not fiscal policy, we will discuss it in more detail later. The Supply Side of Fiscal Policy Until now, we have focused on the demand side of fiscal policy. There is an important way in which fiscal policies can influence the potential output of the economy through the supply side as well. On the government spending side, fiscal policies geared toward building infrastructure such as roads, bridges, airports, etc., can impact the future productive capacity of the economy and stimulate long-run economic growth. In short, certain types of government spending can influence the ability of the AS curve to shift to the right over time. On the tax side of fiscal policy, we can influence the long-run growth of the economy by the work incentives that our tax codes either stimulate or reduce in families and the productive incentives that our tax codes can either stimulate or reduce in firms. Economist Arthur Laffer was an early proponent of the idea that if tax rates are too high, it can actually give individuals an incentive to work less and thereby lower tax revenues. The graph below has come to be known as the Laffer Curve and illustrates this point. Laffer suggested in the 1970s that we were on the downward sloping (right) side of the Laffer Curve, and that if the United States were to lower tax rates we could actually increase tax revenues. This can be illustrated by clicking on Tax Rate 4 and then on Tax Rate 3. Notice that as the tax rates go down tax

10 10 Lesson 9 - ECO 151- Master.nb revenue actually increase. While there is some debate as to the validity of Laffer's argument, it is interesting to note that when President Ronald Reagan followed Laffer's guidance in this matter and lowered tax rates following his election, tax revenues increased each and every year of his presidency. The Supply Side of Fiscal Policy The Laffer Curve helps us understand what happens to tax revenues when tax rates are changes. For example, look at the left side of the Laffer Curve. Click on 'Tax Rate 1.' Then click on 'Tax Rate 2.' Notice that the dot moves up the curve. So on the left side of the Laffer Curve, if tax rates are raised then tax revenues increase. However, if tax rates are lowered than tax revenues decline. Click '' so the dot disappers. Now, look on the right side of the Laffer Curve. Click on 'Tax Rate 3.' Then click on 'Tax Rate 4.' Notice the movement of the dot. In this case, when tax rates are increased it lowers tax revenue. On the right side of the Laffer Curve, if tax rates are lowered it will increase tax revenue. Left Side of Laffer Curve Tax Rate 1 Tax Rate 2 Right Side of Laffer Curve Tax Rate 3 Tax Rate 4 Which is Better? Government Spending or Taxes "Liberal" economists tend to favor higher government spending during a recession (expansionary policy) and higher taxes during inflationary times (contractionary policy). Both of these policies envision a larger role for the government in the economy. "Conservative" economists tend to favor lower taxes during a recession (expansionary policy) and lower government spending during inflationary times (contractionary policy). Both of these policies envision a smaller role for the government in the economy. As would be the case for most groups in the country, there is no consensus among economists about which policies are preferable. Summary Key Terms Administration Lag Advantages and Disadvantages to Government Debt

11 Lesson 9 - ECO 151- Master.nb 11 Automatic Fiscal Stabilizers Budget Deficit Budget Surplus Contractionary Fiscal Policy Contractionary Fiscal Policy Definition Crowd Out Crowding Out Effect Debt Ratio Debt Service Deficit Discretionary Fiscal Policy Expansionary Fiscal Policy Expansionary Fiscal Policy Definition Fiscal Policy Fiscal Policy Issues Government Budgets Government Spending vs. Taxes Implementation Lag Laffer Curve National Debt Paradox of Thrift Progressive Tax Proportional Tax Recognition Lag Regressive Tax Stagflation Supply Side of Fiscal Policy Surplus Tax Incidence Theory of Bureaucratic Behavior Two-period Contractionary Fiscal Policy Two-period Expansionary Fiscal Policy 2013 by Brigham Young University-Idaho. All rights reserved.

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