Principles of Macroeconomics
Lecture 3b
FISCAL POLICY
What fiscal policy is and what it is used for
What discretionary fiscal policy is and its function
About the economy’s built-in stabilizers What a cyclically adjusted budget is The problems, criticisms, and
complications of fiscal policy
In this chapter you will learn
Legislative Mandates Fiscal Policy & the AD-AS Model Built-In Stabilization Evaluating Fiscal Policy Problems, Criticisms & Complications
Topics
Great Depression need for stabilization role
Unemployment Insurance introduced during World War II
Governments regularly use fiscal policy to stabilize the economy
Legislative Mandates
Definition: Deliberate changes of
government expenditures taxes
Dependent upon deliberate decisions in Parliament
Discretionary Fiscal Policy
Expansionary Fiscal Policy Recessionary GapOptions: Increase Government Spending Decrease Taxes Some Combination of the Two
Discretionary Fiscal PolicyDiscretionary Fiscal Policy
AS
AD0
Pric
e le
vel
Real GDP (billions)
PL0
GDPfGDP0recessionaryrecessionarygapgap
Expansionary Fiscal Policy
Figure 10-1Figure 10-1
AS
AD0
Pric
e le
vel
Real GDP (billions)
PL0
GDPfGDP0
PL1
AD1
Figure 10-1Figure 10-1
Expansionary Fiscal Policy
Contractionary Fiscal Policy Inflationary GapOptions: Decrease Government Spending Increase Taxes Some Combination of the Two
Discretionary Fiscal PolicyDiscretionary Fiscal Policy
Real GDP (billions)
AS
GDPf
AD3
PL3
Pric
e le
vel
GDP3
inflationaryinflationarygapgap
Figure 10-2Figure 10-2
Contractionary Fiscal Policy
Real GDP (billions)
AS
GDPf
AD3
PL2
AD2
Pric
e le
vel
Figure 10-2Figure 10-2
Contractionary Fiscal Policy
PL3
depends on political views about size of government
Policy Options: G or T?
A tax or government expenditure which automatically: increases the deficit during recession phase decreases the surplus during inflation
phase
Automatic or Built-In Stabilizers
Government establishes tax rates, but Government establishes tax rates, but does not set total taxesdoes not set total taxes
Government establishes tax rates, but Government establishes tax rates, but does not set total taxesdoes not set total taxes
G,T T = Net Taxes
G (assumed constant)
GDP0GDP1
T1
Automatic or Built-In StabilizersAutomatic or Built-In Stabilizers
Figure 10-3Figure 10-3
Deficit {
G,T T
G
GDP0 GDP2
Surplus
T2
Automatic or Built-In StabilizersAutomatic or Built-In Stabilizers
Figure 10-3Figure 10-3
the stabilizers will automatically generate an expansionary budget deficit when GDP is low
and a contractionary surplus when GDP is high
Automatic or Built-In Stabilizers
The built-in stability depends on: Tax Progressivity
Progressive Proportional Regressive
The more progressive the tax system, the greater the automatic stabilization
Automatic or Built-In Stabilizers
automatic stabilizers can mask the direction of discretionary fiscal policy
the cyclically adjusted budget shows what the budget balance would be if the economy were operating at full employment
Cyclically Adjusted Budget
500500
real GDPreal GDP
G, TG, T TT
GG
GDPGDP11
(year 1)(year 1)
450450
GDPGDP22
(year 2)(year 2)
Figure 10-4Figure 10-4
full-employment GDPfull-employment GDPfull-employment GDPfull-employment GDP
the cyclically adjusted the cyclically adjusted deficit is zero in year 1 deficit is zero in year 1
at GDPat GDP11
the cyclically adjusted the cyclically adjusted deficit is zero in year 1 deficit is zero in year 1
at GDPat GDP11
it is also zero in year 2 it is also zero in year 2 at GDPat GDP22
it is also zero in year 2 it is also zero in year 2 at GDPat GDP22
Cyclically Adjusted BudgetCyclically Adjusted BudgetCyclically Adjusted BudgetCyclically Adjusted Budget
the deficit is a by-the deficit is a by-product of the product of the
recessionrecession
the deficit is a by-the deficit is a by-product of the product of the
recessionrecession
500500475475450450425425
G, TG, T
real GDPreal GDP
GG
TT11
TT22
GDPGDP33
(year 3)(year 3)GDPGDP44
(year 4)(year 4)
the cyclically adjusted deficit is the cyclically adjusted deficit is zero in year 3zero in year 3
the cyclically adjusted deficit is the cyclically adjusted deficit is zero in year 3zero in year 3
taxes are reducedtaxes are reducedtaxes are reducedtaxes are reduced
full-employment GDPfull-employment GDPfull-employment GDPfull-employment GDP
Figure 10-4Figure 10-4
Cyclically Adjusted BudgetCyclically Adjusted BudgetCyclically Adjusted BudgetCyclically Adjusted Budget
$50 billion deficit due $50 billion deficit due to recessionto recession
$50 billion deficit due $50 billion deficit due to recessionto recession
$25 billion deficit due to $25 billion deficit due to expansionary fiscal policyexpansionary fiscal policy $25 billion deficit due to $25 billion deficit due to
expansionary fiscal policyexpansionary fiscal policy
economy enters a recession in economy enters a recession in year 4year 4
economy enters a recession in economy enters a recession in year 4year 4
Problems of Timing Recognition Lag Administration Lag Operational Lag
A Political Business Cycle? Offsetting Provincial & Municipal Finance
Problems, Criticisms, & Complications
• Crowding-Out Effectexpansionary fiscal policy higher interest rates reduction in interest-sensitive spending
• may not be significant in a recession• fiscal policy can be accommodated by
increases in money supply
Problems, Criticisms, and Complications
some portion of the potential effect of expansionary fiscal policy may be dissipated in the form of inflation
illustrated…
Problems, Criticisms, and Complications
AD0
AS
PL1
Pric
e le
vel
Figure 10-5Figure 10-5
Fiscal Policy, AS & Inflation
Real GDP (billions)
AD1
GDP0 GDPf
PL2
GDP1
AD0
AS
PL1
Pric
e le
vel
Figure 10-5Figure 10-5
Fiscal Policy, AS & Inflation
Real GDP (billions)
AD1
GDP0 GDPf
PL2
GDP1
price level risesprice level rises GDP increases only to GDP increases only to
GDPGDP11
Shocks Originating from Abroad Net Export Effect…
Fiscal Policy in the Open Economy
recessionrecession
expansionary fiscal policyexpansionary fiscal policy
higher domestic interest rateshigher domestic interest rates
increased foreign demand for C$increased foreign demand for C$
C$ appreciatesC$ appreciates
net exports fallnet exports fall
partial offset to expansionary fiscal policypartial offset to expansionary fiscal policy
2727
Table 10-1Table 10-1
2828
inflationinflation
contractionary fiscal policycontractionary fiscal policy
lower domestic interest rateslower domestic interest rates
decreased foreign demand for C$decreased foreign demand for C$
C$ depreciatesC$ depreciates
net exports risenet exports rise
partial offset to contractionary fiscal policypartial offset to contractionary fiscal policy
Table 10-1Table 10-1
tax changes may alter aggregate supply & affect the results of fiscal policy saving & investment work incentives risk-taking
examine the effects of a tax cut…
Supply-Side Fiscal Policy
Supply-Side Fiscal Policy
AS1
AD1
Pric
e le
vel
Real GDP (billions)
PL1
GDP1
Figure 10-6Figure 10-6
PL2
AD2
GDP2
AS2
PL3
GDP3
most economists are skeptical about the supply-side effects of tax cuts weak effects timing
Supply-Side Fiscal Policy
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