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Chapter 12: Fiscal Policy
Major function of government is to
stabilize the economy

Prevent unemployment & Inflation
Stabilization can be achieved by
manipulating public budget to increase
output, employment or reduce inflation
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Government Spending
Tax Collections
Fiscal Policy & the AD – AS
Model
Discretionary Fiscal Policy: Deliberate
manipulation of Taxes & Gov’t Spending
by Congress to alter real domestic
output & employment, control inflation,
& stimulate economic growth

Discretionary means the changes are
optional for Federal gov’t
Simplifying Assumptions
Assume Initial Gov’t Purchases DO NOT
depress or stimulate Private Spending
Assume Fiscal Policy affect ONLY
demand, not supply side of the
economy
Fiscal Policy Choices
1. Expansionary Fiscal Policy
2. Contractionary Fiscal Policy
Expansionary Fiscal Policy
Used to combat Recession
Eg, Decline in Investment decreased AD
 Real GDP & Employment fell
Possible Solutions:
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Increase Government Spending
Decrease Taxes
Combination of Increased Gov’t Spending
& Reduced Taxes
Contractionary Fiscal Policy
Used to combat Inflation
Eg, Increase in Investment or Net
Exports increased AD  Prices rose
Possible Solutions:

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Decrease Government Spending
Increase Taxes
Combination of Decreased Gov’t Spending
& Higher Taxes
Financing Deficits
1.Borrowing: Gov’t competes w/ private
borrowers for funds & drive up interest rates,
“crowding out” private borrowing, offsets the
gov’t expansion
2.Money creation: When the Federal Reserve
loans directly to the Gov’t by buying bonds,
expansionary effect is greater since private
investors are not buying bonds
Disposing of Surpluses
Debt Reduction is good but may cause
interest rates to fall and stimulate
spending  inflationary
Impounding or letting the surplus funds
remain idle would have greater antiinflationary impact. Gov’t holds these
tax revenues, keeps funds from being
spent
Policy Options: G or T?
Economists favor higher G during recessions
& higher taxes during inflationary times if
they are concerned with unmet social needs
or infrastructure
Other economists favor lowering T for
recessions & lower G during inflationary
periods when they think government is too
large & inefficient
Problems, Criticisms, &
Complications
Timing

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Recognition Lag: Time between beginning
of recession / inflation & awareness
Administrative Lag: Reflects difficulties in
changing policies
Operational Lag: Time between policy
change & impact on the economy
Political Considerations
Political Business Cycle: Election years have
been characterized by more expansionary
policies regardless of economic conditions
State & Local Finance policies may offset
federal stabilization efforts
“Crowding – out” may occur w/ gov’t deficit
spending: increased interest rate, reduces
private spending, weakening/canceling the
stimulus of fiscal policy
Last Word:
The Leading Indicators
Index comprises 10 variables that have
indicated changes in Real GDP:
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Average Workweek
Initial Claims for Unemployment
New Orders for Consumer Goods
Vendor Performance
New Orders for Capital Goods
Building Permits for Houses
Stock Market Prices
Money Supply
Interest Rate Spread
Index of Consumer Expectations