Government and Fiscal Policy

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Government and Fiscal Policy

“When a business or an individual spends more than it makes, it goes bankrupt. When government does it, it sends you the bill.”

-Ronald Reagan

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Fiscal Policy: A second tool to manage the economy

We’ve already studied Monetary Policy.

We’ve learned that it is a tool that the Federal Government (the Fed) has to

manage the macroeconomy.

We now turn our attention to a second (and final) tool: Fiscal Policy.

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What is fiscal policy?

Fiscal policy is the use of federal government spending and/or taxes to

influence the level of economic activity.

Think of it this way: In times of recession, a government may choose to increase its spending (or cut taxes) to

counterbalance cutbacks in Consumption or some other component of GDP.

Put another way…if C falls, then G can be increased to offset it!

Changes in government spending or taxation can be used to influence

economic activity…and that is a Key Learning Outcome!

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Remember that Aggregate Demand (AD) comes from four sources

• C = Consumption• I = Investment• G = Government• Xn = Net Exports

For fiscal policy, we’ll be

exploring this component!

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The four pistons in the U.S. economic engine

Government Spending isn’t the

biggest “piston” in the U.S. economic

engine.

But it does comprise about 20% of

economic activity in this country.

Let’s look at that with some perspective…that is 20% of the

world’s largest economy!

That makes it a powerful force in

determining what the overall economy

does.

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Government Expenditures

Given the size of government spending, it is easy to imagine that it could be

used to manipulate an economy.

As an example, a government might be able to accelerate economic

growth by spending more money.

That is one application of fiscal policy!

Let’s explore that in more detail on the next few slides.

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LRAS

$200b

P2

AD1

SRAS1

Imagine a hypothetical economy operating in an ideal macroeconomic scenario

…And Real GDP is at full employment and potential

GDP.

Perhaps prices are at an acceptable level… Unfortunately this

does not always happen.

Note: Potential GDP is the GDP an economy can

obtain when it employs all its resources

That means unemployment is at the natural rate…what we

assume to be 5%.

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If AD falls, then a recession could occur

This economy is underperforming. AD has shifted to the left and Real

GDP has fallen. We presume that unemployment has risen.

That is a recession!

LRAS

$2

00b

AD2

SRAS1

P1

$1

50b

“Recessionary Gap”

AD1

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If AD increases, then inflation could occur

What about the other direction…

what if an economy is “overheating”?

In this economy, AD is moving too quickly. That

causes prices to rise…which is

inflation!

LRAS

$2

50b

AD1

SRAS1

P3

$2

00b

“inflationary Gap”

AD2

How can fiscal policy be used to

mitigate these impacts?

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So what can be done undesirable movements in AD?

Fiscal policy can be used to manipulate movements in the AD curve.

If AD is increasing too quickly, contractionary fiscal policy can be used to cool it

down!

If AD is increasing too slowly, expansionary fiscal

policy can be used to heat it up!

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Expansionary versus contractionary fiscal policy

Here we see the AD moving to the right… That is inflationary.

Perhaps a government could increase taxes or reduce spending.

Here we see the AD curve moving to the left. That is a recession.

Perhaps a government could reduce taxes or increase spending.

This might alarm a government as it can lead to hyperinflation.

In this case, expansionary fiscal policy can be used to combat recession.

In this case, contractionary fiscal policy can be used to combat inflation.

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LRAS

$2

00b

AD2

SRAS1

P1

$1

50b

“Recessionary Gap”

AD1

Let’s see how fiscal policy works. Here we have a recession

With this leftward movement of AD,

RGDP falls. That is a recession.*

*Officially recession are measured using numerous indicators. But loosely defined they involve two or more quarters of declines in

RGDP.

At this level of Real GDP.

Unemployment is above the natural rate. Perhaps it is

8%.

A government may use fiscal policy to

“stimulate” this economy.

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How does a government encourage AD to shift to the right?

By either increasing government spending or reducing taxes (or both), AD will increase.

Did you get one of those checks? If so, what did you do with it? I bet you spent some of it thereby

increasing AD.

George W. Bush did this in 2001 and in 2008 by reducing taxes and sending each household a check.

A government could also choose to increase spending…building bridges dams and other things.

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The Economy Recovery and Reinvestment Act is a more recent example

Signed by President Obama in 2009 and designed to: • Providing $288 billion in tax cuts• Increasing federal funds for education

and health care and unemployment benefits ($224 billion)

• Making $275 billion available for federal contracts, grants and loans

• Learn more at here.

Have you seen any of these signs? If so, you have seen fiscal policy

in action.

http://www.recovery.gov/About/Pages/The_Act.aspx

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The question is, which is better: Increased government spending or reduced taxes?

Which you think is better may be largely dependent on your opinion of the size of government. There is no “right answer”.

Should Government get bigger or

smaller?

?

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Now we know that increased government spending will increase AD. But how much fiscal stimulus is needed?

Fortunately, it is not necessary for the government to inject enough

money to completely

eliminate this gap.

Why not?

The multiplier effect

Assume the policy goal would be to move AD from AD3 to AD4.

LRAS

$2

00b

AD3

SRAS1

P1

$1

50b

AD4

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Recall the circular flow diagram

BusinessBuy ResourcesSell Products

HouseholdsSell ResourcesBuy Products

Resource Market

Product Market

Goods & Services

Lan

d , L

abor

, ca

pita

l, E

ntre

pren

eurs

Goods &

Services

Resources

Wages, Rents, Interest, profitsC

onsumption

Expenditures

Costs

Revenue

When we set this up early in the semester, we ignored an important

player: The government.

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Saved

The multiplier process

BusinessBuy ResourcesSell Products

HouseholdsSell ResourcesBuy Products

Resource Market

Product Market


onsumption

Expenditures

Costs

Revenue

Government

Sp

en

ds $

10

0 m

illion

Saved


onsumption

Expenditures

Costs

Revenue

Saved

Wages, Rents, Interest, profits

Consum

ption E

xpenditures

Costs

Revenue

Saved

Wages, Rents, Interest, profits

Consum

ption E

xpenditures

Costs

Revenue

This is fiscal policy.

New expenditures work their way

through the economy.

Some is saved but most is spent

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Example of the multiplier process

Assume that households spend 90% and save 10% of all new income

These concepts are referred to as the marginal propensity to consume (MPC) and the marginal propensity to save (MPS)

MPC and MPS determine how big the multiplier effect will be

Notice the government’s initial spending increase of $100 million caused $1 billion in economic activity!

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Let’s try an example!

Assume you are presiding over an economy with GDP of $1 trillion.

Your economy is in recession and your advisers estimate the GDP

gap is $500 billion.

Your advisors also estimate the MPC to be 0.80. In other words, consumers spend 80% of all new

income.

That means the multiplier is 5. 1/(1-MPC)=

1/(1-0.8)=

1/(0.2)=

=5

If the GDP gap is $500 billion and the multiplier is 5…..

Then $100 billion in new government spending will “close

the gap”!

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Try one on your own!

You are the Economic Advisor to the president of a hypothetical developed country.

You have watched unemployment begin to rise and RGDP fall below Potential GDP.

You estimate the following:

-The GDP gap is $600 billion

-The country’s MPC is 0.75

The President wants to solve this problem using Fiscal Policy-by increasing Government Spending –to garner votes in the next election.

You recommend that the government increase its spending by $_____ billion150

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Try another one!

You are the Economic Advisor to the president of a hypothetical developed country.

You have watched unemployment begin to rise and RGDP fall below Potential GDP.

You estimate the following:

-The GDP gap is $500 billion

-The country’s MPC is 0.9

The President wants to solve this problem using Fiscal Policy-by increasing Government Spending –to garner votes in the next election.

You recommend that the government increase its spending by $_____ billion50

Understanding how can be used to achieve economic growth,, full employment and stable prices is a Key

Learning Outcome!

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So what is the Current U.S. MPC?

That is a tough number to estimate.

It routinely changes and during the last recession, people got scared and stopped spending

pulling the figure down.

Some economists estimate that the U.S. MPC is between 0.5 and

0.66.

What is yours?If I gave you $100 right now, how much would you spend?I wish I could!

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There are several disadvantages to Fiscal Policy

Perhaps one of the largest problems with fiscal policy is that

we got only half the message.

In bad times, politicians have historically been eager to increase

spending.

It helps the economy and it gives them support back home as they

build new bridges and other items.

In good times, politicians are reluctant to raise taxes or cut

back spending.

It is politically unpalatable and hurts their chances for reelection.

I put it to you – if the economy were doing well and I ran for office saying “WE SHOULD

RAISE TAXES”…

…would you vote for me?

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We got half the message!

That means governments have accrued larger and larger

amounts of debt.

That is easily seen here: The red line is what the U.S. Federal

Government spends.

The blue line is what the U.S. Federal Government receives.

All that over spending has resulted in trillions in debt.

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In Summary

Federal Governments can use changes in spending and taxes to

manipulate an economy.

When growth slows and unemployment increases, taxes

can be lowered or spending increased to stimulate growth.

When growth accelerates and inflation increases, taxes can be increased or spending decreased

to reign in growth.

Governments have routinely done this, taking advantage of the

multiplier effect to close GDP gaps and return an economy to

healthy growth!

In doing so, they have accumulated a large amount of debt…which limits their ability to continue to use this policy tool!

Government and Fiscal Policy

Education

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