Ch15 Fiscal Policy

• The U.S. federal government spends roughly 394 million dollars an hour, and 9.5 billion dollars a day.

• Where does this money come from? How will it be spent?

• If you had this much money, what would you do with it?

Understanding Fiscal Policy

• Fiscal Policy is the government’s decisions on collecting and spending money. These decisions have an enormous impact on the economy as a whole, and on specific areas of the economy.

U.S. Budget

• Every person must decide how best to use their own personal money, and as a part of that, you first come up with a budget, or spending plan based on how much money you have, or plan to have. The federal government works in the same way.

• First, requests come from existing agencies for money. Then the Office of Management and Budget puts together a plan with the President. This plan is sent to Congress, and together with the Congressional Budget office, considers the plan as a whole, and individual requests for money. The Congress votes on a plan, which is returned to the president to sign.

Expansionary and Contractionary Fiscal Policies

• Expansionary Fiscal Policies are intended to expand the economy, by reducing taxes, and/or increasing government spending.

• Contractionary Fiscal Policies are intended to contract the economy, by increasing taxes, or reducing government spending.

Limits on Fiscal Policy

• Fiscal policy has several limiting factors, such as mandatory spending, which accounts for about 60% of the budget, and time.

• Much of the federal budget is more or less already fixed, so the portion that the federal government can control directly, discretionary spending, is usually the only place the government can make major changes.

• For policies to take effect on the economy, it can take several months, to years to fully take effect. During this time, the business cycles can change dramatically.

Political Pressure

• Changes in Fiscal Policy are usually very politically charged, and groups that receive money from the government do not want their shares to be reduced, and are usually asking for more.

• Because of this, Fiscal Policy decisions become important campaign issues, as candidates try to get support from special interest groups in exchange for future policy decisions.

Theories of Fiscal Policy

• There are three main fiscal policy theories that provide the basis for most economic thinking.– Classical Economics – Market based economy– Keynesian Economics (Demand Side) – Keynes believed that the

market could not correct large problems like inflation or recession/depression, and argued that the government should intervene. This intervention would be borrowing and buying during recession, and restraint during growth.

– Supply Side Economics (Reagonomics) – Supply side economics came to the fore in the 1980s during the presidency of Ronald Reagan. This theory was that to create growth, the government should help businesses grow by reducing taxes, and with direct payments, so that by increasing supply, output would grow, prices would drop, and employment would increase.

Keynesian Theory

• Classical economic theory prevailed until the great depression showed that market forces alone could not bring the country out of the depression. Keynes argued that government should not only spend, but spend big in order to restore the economy.

• The idea is that because the government has so much more ability to borrow and spend, and is not concerned with profit, that it can engage in big projects like constructing dams, bridges, and roads in order to increase aggregate demand, increasing employment, which encourages businesses to grow.

• Once the economy is restarted, Keynes thought that government should reduce spending, allowing market forces to take over again, and repay the debt incurred by the increased spending.

Supply Side Economics

• Supply side economics argues that by freeing capital through reducing taxes on investments, businesses and entrepreneurs can grow and start new businesses, thus increasing supply and encouraging hiring. Also, the reduction in taxes was believed to actually increase government revenues because of the increased economic activity, as explained by the Laffer Curve.

• This is also called trickle-down economics, and while it does increase economic activity, the benefits rarely reach the lower economic classes.

Budget Deficits and the National Debt

• While federal spending and tax policies (Fiscal Policy) can greatly help the economy by reducing unemployment, controlling inflation, increasing GDP, and stimulating demand, the spending of the federal government can lead to large budget deficits and a larger national debt.

Federal Deficit/Surplus and Debt• Federal Deficit/Surplus describes the difference

between revenues (taxes) and expenditures. When more money is spent than comes in, you have a deficit. When less money is spent, you have a surplus.

• Debt is the total accumulated money owed to other parties by deficit spending.

• In 2000, the national debt was $5.7 trillion.• As of 12 May 2011, the Federal Debt is

$14,388,727,162,852.45 , or $46,171.43 per man, woman and child in the US

• In 2010 the US spent $3,456B, $2,162B came from taxes and fees, that means $1,294B was borrowed and added to the national debt.

• In order to finance the budget, the federal government typically resorts to borrowing money, usually in the form of Treasury Notes, Treasury Bills, and Treasury Bonds.

• These represent the word of the government that the money will be repaid.

• While printing money may be a simple answer to debts and deficits, printing more money to take care of these issues can lead to hyperinflation, rapidly devaluing the U.S. dollar, and making the situation worse

Current Debt Held by

the Public Intragovernmental

Holdings Total

01/02/2009 6,212,922,862,005 4,415,038,433,925 10,627,961,295,930

Problems created by the National Debt

• Monies borrowed by the Federal Government also accrue interest, just as any bank loan or credit card does. A large portion of the Federal Budget goes toward paying off the interest on the loans already made.

• Also, money borrowed by the Federal Government is money that cannot be borrowed by other people, businesses, or organizations, limiting the amount of money available for everyone else. This is called the “crowding out” effect.

• When the government becomes a big borrower, limiting the supply of loans, this acts like any other kind of demand/supply issue, so the “cost” of borrowing money goes up for everyone.

• Is the national debt as bad as people think it is? This is hard to say, because it is also important to note the amount of debt carried as a proportion of Gross Domestic Product. When looked at like this, it is not good, but it may not be as bad as many people think.

• In any event, growing deficits and the national debt prevent spending in other areas that many people think would be of more benefit to the U.S.

Laffer Curve

By lowering taxes, the government can increase either demand,or supply. Also, the government can directly increase demand by doing the buying itself, or supply, by providing direct services. For example, the government lowers taxes to families, which increases domestic spending, which increases demand.

$

Output (GDP)

AggregateDemand 1 Aggregate

Supply

AggregateDemand 2

IncreasingDemand

IncreasingSupply

$

Output (GDP)

AggregateDemand

AggregateSupply 1 Aggregate

Supply 2

Expansionary policies are intended to grow the economy and increase output. This reduces unemployment, but also raises the risk of inflation.

By increasing taxes or reducing spending, the government can decrease demand or supply. For example, if the government raises taxes on businesses, this will make it more costly to produce goods, and they will produce fewer goods, or raise the price of their goods.

$

Output (GDP)

AggregateDemand 1 Aggregate

Supply

AggregateDemand 2

DecreasingDemand

DecreasingSupply

$

Output (GDP)

AggregateDemand Aggregate

Supply 1

AggregateSupply 2

A contractionary policy is intended to slow economic growth, to prevent inflation. The unintended result can be stalling the economy or creating a recession. Contractionary policy also increases unemployment.