Fiscal Policy

Fiscal Policy is the Federal

Government spending and taxing
authority and is used in our context to
influence the performance of the
economy
1
 AD review basic point

Price move along the Price shift the curve

level curve when the Level when a relevant
price level factor changes
changes

RGDP RGDP

2
 Types of Fiscal Policy
There are two types of fiscal policy: discretionary and non-
discretionary (automatic).
The discretionary policy is the government (federal) changing
spending (G), changing taxes (on households) T, or some
combination of the two. The logic of the change is to
influence the performance of the economy. Back in 1946 the
federal government pledged to have economic growth, price
stability and full employment.
Non-discretionary policy is really the overall framework and
design of the government spending and taxing authority. As
an example, having a progressive tax system, once set up,
works automatically in the economy. 3
 Recession
We saw a recession could happen if C, I, G, or X fell. The
short term effect was falling RGDP and raising
unemployment. The ratchet effect kept the price level from
falling
The short term rising unemployment is painful for many folks
and the focus of Fiscal Policy is to try to counterbalance the
fall in C, I, G, or X so that the unemployment does not
result.
The tools the government would use are 1) Increasing G, or
2) lowering taxes (on households) and thus increasing C, or
3) some combination of the two.
4
 Discretion – expansionary fiscal
policy
If the AD curve is shifting to the left, then the way to counter this is
to increase G and/or cut taxes. This would make the AD curve shift
back to the right. This is the discretionary expansionary fiscal
policy.
The short run unemployment would not happen.
Let’s see this in a graph on the next slide. Note we start with AD1, ,
SRAS1, RGDP1, and P1. Let’s assume RGDP1 is the full
employment level of output.
Then we have AD fall to AD2 for reasons you should recall from
previous notes (this would be a good time to find those notes and
think about the ideas). RGDP falls to RGDP2 by the full multiplier
5
of the change in C, I, G, or X.
 Recession – expansionary FP
P The expansionary
The arrows fiscal policy would
pointing left AD1 SRAS1 just reverse the
signify the fall arrows and have the
in AD and AD curve end up
resulting fall in P1 back where it started.
RGDP and rise
in
unemployment. AD2
RGDP
RGDP2 RGDP1
Recall that with the multiplier, fiscal policy makes up only a fraction of
the change in AD. Additional rounds of spending kick in. 6
 Inflation
Similarly, if the economy was moving into a booming phase, when
RGDP rises above the potential or full employment RGDP, a rising
price level (inflation) is the end result.
The discretionary fiscal policy moves to counter a boom and the
resulting inflation is to cut government spending and/or increase
taxes and thus lower consumption, or some combination of the two.
On the next slide we start with an economy at its potential. Then
we will see the economy grow in the short term from its potential
and we will have demand pull inflation.

7
 Discretion – contractionary fiscal
policy
P
Note as AD
rises we move
up the SRAS SRAS1
and we get a
higher price P2
level – P1
inflation! We AD2
are assuming
here this AD1
inflation is RGDP
higher than we RGDP1 RGDP2
care to have. 8
 Discretion – Contractionary fiscal policy

With the price P

level ratcheted
up to P2, to SRAS1
stop further
increase in P2
inflation the P1
fiscal policy is AD2
to shift AD
back. But AD AD1
doesn’t have to
fall as far to RGDP1 RGDP2 RGDP
get back to 9
RGDP1.
 Inflation – contractionary fiscal
policy
Note the cure for inflation is to lower AD. But the decrease in
AD doesn’t have to be a large as the AD increase that created
the problem. The logic here is that on the way up the price
level adjusted and influenced the size of the rise in the RGDP.
On the way down if we didn’t have a ratchet effect on the price
the AD would shift back and a falling price level would then
encourage some additional spending. But since we won’t get
the lower price level and the stimulus it would create, the AD
just has to be lowered along the P2 line in the graph to above
the RGDP1 level.

10
 Government Budget
In the course of a year the government budget is kept track of and
there are three large parts observed. We have
Government purchases (what we have called G) + transfer payments
(like social security payments to beneficiaries) – tax revenue from all
sources (which includes FICA, or social security taxes collected).
Let’s rewrite this as
Government budget = G – tax + transfers = G – (tax -transfers) = G –
T, where T is net taxes, or taxes net of transfers.
Remember with fiscal policy changes in G shifts AD and changes in
T shift C and thus AD.

11
 Government Budget
If G – T > 0 we have a budget deficit in the year,
If G – T < 0 we have a budget surplus in the year, and
If G – T = 0 we have a balanced budget in the year.
On the next screen we place G and T in a graph with RGDP.
We have seen G before in the context of the AE model. But
we have not put taxes in the graph like we will see on the next
screen.

12
 Government budget
G, T
Note that G is set
by government, as
T
we have said
before. T is also
set by government G
in terms of the tax
structure. This is
the non- RGDP
discretionary part I
mentioned before. Budget Budget
13
deficit surplus
 Government Budget
On the previous slide you can see if the level of RGDP grows
for reasons other than government policy the budget can move
from deficit to surplus. Basically as RGDP grows tax revenues
will grow and with a fixed amount of spending the budget
moves toward surplus. Moreover, as RGDP grows more people
work and so less is paid out in transfers like unemployment
insurance.
Conundrum: Fiscal policy can change course by itself as RGDP
moves or it can change by discretionary fiscal policy. Let’s
look at this next.

14
 Conundrum
Let’s say the economy falls into a recession. Policy makers
can use discretion and increase G, or lower T, or some
combination of the two. This expansionary fiscal policy
moves the government budget into more of a deficit. But even
without the expansionary move the budget will move more
into deficit. With lower RGDP less taxes will be paid and
more transfers like unemployment insurance will be paid out.
This cyclical deficit could fool people into thinking that we
have done something to cure the problem, when in fact
nothing has been done.
Solution: Look at the standardized budget!
15
 Standardized budget
G, T

RGDP
Full
employment
RGDP 16
 Standardized budget
The graph on the previous screen shows what the state of the
budget would be if the economy was at full employment. Plus,
if we move away from the full employment level we can see
how the budget would change automatically.
Here the state of the budget at full employment is called the
standardized budget – here we see it is a deficit. We look here
to see about discretionary policy. When the economy moves
away from full employment the budget status will change, but
for automatic reasons.
Say we have expansionary fiscal policy due to a recession.
The G line would shift up and our standardized budget will be
in even larger deficit at full employment. 17
 Problems of Fiscal Policy
We have a simple theory of the economy here and policy
makers also have models of the economy (perhaps more
sophisticated than what you see here). The size of the
economy is so large we as people may not be able to fully
understand all the details of the workings of the economy. For
this and other reasons fiscal policy may be difficult to
implement. Let’s explore these ideas next.

18
 Problems of timing
The recognition, administration and operational lags all have
to do with the idea that things in the economy can not be
changed in an instant.
It takes time to recognize a recession or inflation has started to
occur. Then it takes time to put into action the appropriate
discretionary course of action.
A real bummer would be we recognize too late that a recession
has occurred. Then while the economy is “healing” itself we
implement expansionary policy and thus throw the economy
into an inflationary spiral.

19
 Other problems
Other problems you can read about are political
considerations, future policy reversals and offsetting state and
local finance. I do want to mention more about crowding out.
Some folks think expansionary policy in the form of higher G
might mean I and C will fall and we thus really we do not get
any change in RGDP, but just a reshuffling of its mix from I
and C to G. Here is the logic. If G is raised without getting
more taxes the government will have to borrow more. This
increased borrowing will raise the interest arte and thus I and
C will be “crowded out” by the new G.

20
 Deficit The debt
or
surplus

The year
timeline

Each of these vertical parts of the line signify both the end
of one year and the beginning of the next year. During any
year we may have a government budget deficit or surplus
(or balanced budget).
When we pick a particular date – like then end of a year –
and add up all the past deficits and surplus the net amount
21
that has not been paid is called the debt.
 The debt
In the US the only way the federal government can go into
deficit in a year is to borrow. It does this by issuing US
government securities called bills, notes and bonds, depending
on their maturity (when the government says they will pay back
– you should check what is difference between bills, notes and
bonds). So, the debt is all past borrowing not paid off.
Note in 2005 the debt was around 8 trillion dollars, is largely
held by Americans, and has a component called interest that
grows if the debt is not paid off.
What has happened often lately is that some debt will come due,
the government pays off the person who held the debt, and then
the government re-issues more debt to cover what it just paid 22
off? Can the federal government do this for ever?