Fiscal Policy Macroeconomics Fiscal Policy Fiscal policy is

Fiscal Policy Macroeconomics

Fiscal Policy • Fiscal policy is the use of changes in taxes and government expenditure to influence aggregate demand thus the level of economic activity • Since most states in the U. S. are statutorily required to run balanced budgets, fiscal policy usually refers to spending and tax changes by the federal government

Government and Aggregate Demand • Government expenditures and tax revenues are the two sides of the government budget • Government expenditure, that is, government spending on goods and services, is a component of aggregate demand • Tax rates affect either consumption or investment expenditure, which are components of aggregate demand

Strategies in Fiscal Policy • Expansionary policy attempts to increase aggregate demand • Contractionary policy attempts to decrease aggregate demand

Federal Budgets • When the federal government spends more money than it receives in taxes in a given year, it runs a budget deficit • Conversely, when the government receives more money in taxes than it spends in a year, it runs a budget surplus • If government spending and taxes are equal, it is said to have a balanced budget

Federal Spending, 1960– 2010 as a Percentage of GDP

What does the Federal Government Spend Money on?

What about the other 29%? • international affairs • science and technology • natural resources and the environment • Transportation • Housing • Education • income support for the poor • community and regional development • law enforcement and the judicial system • the administrative costs of running the government

Federal Taxes

Local and State Spending

What do States Spend Money on? • Education accounts for about one-third of the total • Highways • Libraries • hospitals and healthcare • parks • police and fire protection

Revenue Sources for State and Local Government: • sales taxes • property taxes • revenue passed along from the federal government • personal and corporate income taxes • fees and charges

A Healthy, Growing Economy In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E 0 to E 1 to E 2. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level. But if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop

Expansionary Fiscal Policy to Fight Unemployment Expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending shifts the aggregate demand curve to the right

Contractionary Fiscal Policy to Fight Inflation Contractionary fiscal policy uses tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment

Automatic Stabilizer • A government program that tends to reduce fluctuations in GDP automatically is called an automatic stabilizer • It increases GDP when it is falling and reduce GDP when it is rising • Changes in expenditures and taxes that occur through automatic stabilizers do not shift the aggregate demand curve

Discretionary Spending • Discretionary government spending and tax policies can be used to shift aggregate demand • Expansionary fiscal policy might consist of an increase in government purchases or transfer payments, a reduction in taxes, or a combination of these tools to shift the aggregate demand curve to the right • A contractionary fiscal policy might involve a reduction in government purchases or transfer payments, an increase in taxes, or a mix of all three to shift the aggregate demand curve to the left

Expansionary and Contractionary Fiscal Policies to Shift Aggregate Demand

An Increase in Government Purchases

Policy Response to Inflationary Gap Year Situation 1968 Inflationary gap 1969 Inflationary gap Policy response A temporary tax increase, first recommended by President Johnson’s Council of Economic Advisers in 1965, goes into effect. This one-time surcharge of 10% is added to individual income tax liabilities President Nixon, facing a continued inflationary gap, orders cuts in government purchases

Policy Responses to Recessionary Gaps 1975 President Ford, facing a recession induced by an OPEC oil-price increase, proposes a temporary 10% tax cut. It is passed almost immediately and goes into effect within two months. 1981 President Reagan had campaigned on a platform of increased defense spending and a sharp cut in income taxes. The tax cuts are approved in 1981 and are implemented over a period of three years. The increased defense spending begins in 1981. While the Reagan administration rejects the use of fiscal policy as a stabilization tool, its policies tend to increase aggregate demand early in the 1980 s. 1992 1993 2001 2008 2009 President Bush had rejected the use of expansionary fiscal policy during the recession of 1990– 1991. Indeed, he agreed late in 1990 to a cut in government purchases and a tax increase. In a campaign year, however, he orders a cut in withholding rates designed to increase disposable personal income in 1992 and to boost consumption. President Clinton calls for a $16 -billion jobs package consisting of increased government purchases and tax cuts aimed at stimulating investment. The president says the plan will create 500, 000 new jobs. The measure is rejected by Congress. President Bush campaigned to reduce taxes in order to reduce the size of government and encourage long-term growth. When he took office in 2001, the economy was weak and the $1. 35 billion tax cut was aimed at both long-term tax relief and at stimulating the economy in the short term. It included, for example, a personal income tax rebate of $300 to $600 per household. With unemployment still high a couple of years into the expansion, another tax cut was passed in 2003. Fiscal stimulus package of $150 billion to spur economy. It included $100 billion in tax rebates and $50 in tax cuts for businesses. Fiscal stimulus package of $787 billion included tax cuts and increased government spending passed in early days of President Obama’s administration.

Practice Question What are some examples of automatic stabilizers that have contractionary and expansionary impacts?

Quick Review • What are the major spending categories and major revenue sources in the U. S. Federal budget? • What are the major spending categories and major revenue sources in U. S. state and local budgets? • What is fiscal policy? What are the roles of tax rates and government spending? • What is the difference between discretionary and automatic fiscal policy? • Compare and contrast expansionary/contractionary fiscal policies? • How do tax changes and government spending changes work?