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