Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth.

Fiscal Policy

Automatic stabilizers Government spending and taxes that automatically increase or decrease along with the business cycle.

Automatic Stabilizers versus Discretionary Fiscal Policy

Economists use the term fiscal policy to refer to changes in taxing and spending polices by:a. Only state and local governments.b. Only the federal government.c. All levels of government, federal, state,

and local.d. None of the above.

The Federal Government’s Share of Total Government Expenditures, 1929–2010

Federal Purchases and Federal Expenditures as a Percentage of GDP, 1950–2010

Federal Government Expenditures, 2010

What is the relationship between government purchases and government expenditures?a. Government purchases include government

expenditures.b. Government expenditures include government

purchases.c. Government purchases and government

expenditures are the same thing.d. Government purchases include the totality of

government spending, while government expenditures do not.

Federal Government Revenue, 2010

In 2010, which of the following two were the largest sources of federal government revenues?a. Corporate income taxes and sales taxes.b. Revenue from tariffs on imports and other fees.c. Individual income taxes and social insurance taxes.d. Excise and other taxes.

Deficits, Surpluses, and Federal Government Debt

The Federal Budget Deficit, 1901–2009

Should the government’s budget always be balanced? Should it be balanced at full employment?

Deficits, Surpluses, and Federal Government DebtThe Federal Government Debt, 1901–2006

Is Government Debt a Problem?• The federal government won’t default on its debt.

• It can raise the funds it needs through taxes or spending cuts to make the interest payments on the debt (now ~10 % of expend).

• If an increasing debt drives up interest rates• crowding out of investment spending lower capital stock in the

long run reduced capacity of the economy to produce things

• This is somewhat offset if some of the government debt was incurred to finance improvements in infrastructure (bridges, highways, ports); to finance education; or to finance R&D

• But beware a debt death spiral!• Debt rises because of interest cost• Interest rate rises because debt rises• Interest cost rises because of greater debt and higher interest

rate

The Effects of Fiscal Policyon Real GDP and the Price Level

Fiscal Policy

Looks a lot like expansionary and contractionary monetary policy

…except for impacts on interest rates and investment spending

A Summary of How Fiscal Policy Affects Aggregate Demand

Countercyclical Fiscal Policy

PROBLEM TYPE OF POLICYACTIONS BY CONGRESS AND THE PRESIDENT RESULT

Recession Expansionary Increase government spending or cut taxes

Real GDP and the price level rises.

Rising Inflation

Contractionary Decrease government spending or raise taxes

Real GDP and the price level falls.

The Effects of Fiscal Policyon Real GDP and the Price Level

Don’t Let This Happen to YOU!Don’t Confuse Fiscal Policy and Monetary Policy

The appropriate fiscal policy for the Fed to follow in a recession is to increase the money supply and lower interest rates.

A) True B) False

The Government Purchases and Tax Multipliers

The Multiplier Effect and Aggregate Demand

The Government Purchases and Tax Multipliers

The Multiplier Effect of an Increase in Government Purchases

This spending multiplier is analogous but not the same as the deposit multiplier

The Government Purchases and Tax MultipliersA cut in tax rates affects equilibrium real GDP through two channels:

(1)A cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending, and

(2)a cut in tax rates increases the size of the multiplier effect … it reduces the rate at which purchasing power leaks from the spending stream

The less the marginal propensity to leak, the greater the spending multiplier.

The Limits of Using Fiscal Policyto Stabilize the Economy

An Expansionary Fiscal Policy Increases Interest Rates

Crowding out A decline in private expenditures as a result of an increase in government purchases.Money market

The Limits of Using Fiscal Policyto Stabilize the Economy

Crowding Out in the Short Run: G up Y up Md up i up I down Y doesn’t increase as much as otherwise

The Effect of Crowding Out in the Short Run

Taking into Account the Effects of Aggregate Supply

The Government Purchases and Tax Multipliers

The Multiplier Effect and Aggregate Supply

Was Fiscal Policy Expansionary during the New Deal?Did Fiscal Policy Fail during the Great Depression?

Although government spending increased during the Great Depression, the cyclically adjusted budget was in surplus most years.

FEDERAL GOVERNMENT

EXPENDITURES (BILLIONS OF

DOLLARS

ACTUALFEDERAL BUDGET DEFICIT

OR SURPLUS (BILLIONS OF

DOLLARS)

CYCLICALLY ADJUSTED

BUDGET DEFICIT OR SURPLUS (BILLIONS OF

DOLLARS)

CYCLICALLY ADJUSTED

BUDGET DEFICIT OR SURPLUS AS A PERCENTAGE

OF GDP

1929 $2.6 $1.0 $1.24 1.20%

1930 2.7 0.2 0.81 0.89

1931 4.0 -2.1 -0.41 -0.54

1932 3.0 -1.3 0.50 0.85

1933 3.4 -0.9 1.06 1.88

1934 5.5 -2.2 0.09 0.14

1935 5.6 -1.9 0.54 0.74

1936 7.8 -3.2 0.47 0.56

1937 6.4 0.2 2.55 2.77

1938 7.3 -1.3 2.47 2.87

1939 8.4 -2.1 2.00 2.17

The mistake of 1937!

The Fed’s mistake in 1937 was to increase taxes and reduce government spending when unemployment was still high.

A) True B) False

K e y T e r m s

Automatic stabilizersBudget deficitBudget surplusCrowding outCyclically adjusted budget

deficit or surplusFiscal policyMultiplier effectTax wedge