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9
FISCAL POLICY
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CHAPTER OUTLINE
Nondiscretionary and Discretionary Fiscal Policy
Using Fiscal Policy to Counteract “Shocks”
Evaluating Fiscal Policy
The Obama Stimulus Plan
Kick It Up a Notch: Aggregate Supply Shocks
Summary
LEARNING OBJECTIVES
LO1: Describe and model discretionary and nondiscretionary fiscal policy using an aggregate supply and
aggregate demand diagram.
LO2: Distinguish between aggregate demand and aggregate supply shocks.
LO3: Acknowledge and enumerate the problems associated with discretionary fiscal policy.
LO4: Describe nondiscretionary fiscal policy as the mainstay of our current macroeconomic system.
KEY TERMS
Fiscal policy- The purposeful movements in government spending or tax policy designed to direct economy.
Discretionary fiscal policy- Government spending and tax changes enacted at the time of the problem to alter the
economy.
Nondiscretionary fiscal policy- A set of policies that are built into the system to stabilize the economy.
Shock- Any unanticipated economic event.
Aggregate demand shock- An unexpected event which causes aggregate demand to increase or decrease.
Aggregate supply shock- An unexpected event which causes aggregate supply to increase or decrease.
Recognition lag- The time it takes to measure the state of the economy.
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Administrative lag- The time it takes for Congress and the president to agree on a course of action.
Operational lag- The time it takes for the full impact of a government program or tax change to have its effect on
the economy.
Political business cycle- Politically motivated fiscal policy used for short-term gain just prior to elections.
DISCUSSION QUESTIONS
1. What are some problems associated with discretionary fiscal policy?
2. What is nondiscretionary fiscal policy and why is it, in general, preferred to discretionary fiscal policy?
3. How does the government finance expansionary fiscal policy? What are some of the problems with each
method?
4. There is considerable debate over whether any fiscal policy will have a real impact on the economy, except
when the economy is in a recession. Under what circumstances would fiscal policy control inflation or
increase real GDP? Use the aggregate demand and supply diagram to illustrate your answer.
5. Why is it said that discretionary fiscal policy may be poorly timed?
6. Should oil prices rise considerably, the economy would experience a negative aggregate supply shock. Use
the aggregate supply and demand model to illustrate the impact of this event on the economy. What kind of
fiscal policy would be appropriate to reduce the negative effects on the economy?
7. Assume that oil prices fall considerably or productivity increases, such that the economy would experience a
positive aggregate supply shock. Use the aggregate supply and demand model to illustrate this impact on the
economy. What kind of fiscal policy would be appropriate?
8. What are some of the political problems with fiscal policy?
9. When will an expansionary fiscal policy be used? When should contractionary fiscal policy be applied?
10. Were the tax rebates in 2001 discretionary or nondiscretionary fiscal policy? How would you classify the
changes in the marginal tax rates? Explain.
11. What are the four basic elements of the Obama stimulus plan?
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THE WEB-BASED QUESTION
Fiscal policy involves government spending or taxation to stimulate or restrain the economy. These changes
involve decisions made by the president, the Senate and Congress. Since different political parties are typically
involved, debates on these issues are usually very politically charged. In addition, there is general agreement that
fiscal policy involves long lags. By the time the legislators discuss and debate what form the policy should take,
the problem may be over. Any enactment of the policy at this point could worsen the situation because of poor
timing.
In the first two websites that follow, you will see various aspects of the 2001 fiscal policy changes that took place
during the first year of President George W. Bush’s administration. The other two articles discuss the
effectiveness of fiscal policy as a tool of stabilization policy, plus the need for fiscal reform.
Part I.
The first website discusses the tax changes enacted by President Bush.
Briefly discuss the highlights of the tax changes. Are these changes discretionary or nondiscretionary fiscal
policy? How does Bush’s policy differ from previous policies of other administrations?
www.fairmark.com/news/egtrra/overview.htm
Part II.
After the terrorist attack on the World Trade Center and the Pentagon on September 11, 2001, Congress
immediately suggested a fiscal stimulus package.
Visit the following website, and then discuss some of the problems with using discretionary fiscal policy as a
means of stimulating the economy.
www.businessweek.com/bwdaily/dnflash/nov2001/nf2001112_0867.htm
Part III.
Is fiscal policy effective as a tool of stabilization policy?
www.econ.berkeley.edu/~auerbach/effective.pdf
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ANSWERS TO STUDY QUESTIONS
SUGGESTED ANSWERS TO THE DISCUSSION QUESTIONS
1. Discretionary fiscal policy is a deliberate government action taken to alter the economy at the time of a
specific problem. Congress and the president have to use their “discretion” and make specific decisions in
order to make it work. They have to agree on a course of action to either stimulate or to dampen the economy
at a specific time.
It is often difficult to get an agreement on many politically motivated or charged issues. Often by the time a
consensus is reached, it may be too late to “fix” the economic problem because the problem may no longer
exist or things may have gotten much worse.
2. Nondiscretionary fiscal policy is the set of policies that are built into the system to stabilize the economy
when growth is either too fast or too slow. This type of policy is at work as a result of policies enacted years
ago.
As an example, the country has a progressive tax system in which people with higher incomes pay higher
taxes. Thus, when someone gets a raise or makes a killing in the stock market, the government gets some of
that improved income in the form of increased tax revenue. The reverse happens if one loses a job or
experiences some other drop in income. Because one has less income, the taxes owed automatically falls.
Nondiscretionary fiscal policy is generally preferred to discretionary fiscal policy because it is constantly
working to stabilize the economy. As no action by Congress and the president is required, no one has to use
any discretion or make any decisions to make it work.
3. The government can finance an expansionary fiscal policy through either borrowing or printing the requisite
money.
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Borrowing may cause interest rates to increase because the demand for loanable funds increases.
The price of borrowing funds is the interest rate. As in any supply/demand situation, an increase in
demand leads to an increase in prices, which in this case, increases the interest rates. Increased
interest rates reduce investment and consumer spending that is interest-rate-sensitive (major items
bought “on-time”), which in turn diminishes real GDP, weakening the effect of the expansionary
fiscal policy.
Printing money is not a good option because it nearly always results in inflation.
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4. There is considerable debate over whether any fiscal policy will have a real impact on the economy. We can
see this by looking at the aggregate demand/supply model as in the diagram below:
Price
Level
AS
AD4
AD3
AD1
AD2
RGDP
Fiscal policy shifts the aggregate demand curve. Its effectiveness depends on where on the aggregate supply
curve the aggregate demand curve lies.
An expansionary fiscal policy will only increase real GDP without inflation in the horizontal portion of the
AS curve. If AD1 shifts to the right to AD2, RGDP increases but the price level is unchanged. In any other
range of AS, this policy leads to inflation. It will be completely ineffective in the vertical portion because it
merely creates inflation without bolstering output.
A contractionary fiscal policy will only control inflation in the vertical portion of the AS curve. If AD4 shifts
to the left to AD3, inflation will fall but output will be unaffected. In any other range of AS, this policy will
reduce RGDP.
5. Discretionary fiscal policy is said to be timed incorrectly because of its poor performance in the 1970s. The
reason that it did not work can be attributed to lags in recognizing, administering, and operating this type of
fiscal policy.
This first type of lag is the recognition lag during which it takes time to recognize that there is a recession.
GDP is not easily or immediately measured. After the first set of data on GDP comes in there are further
revisions that come in even much later. Thus, we may not know that there is a recession until months after it
begins.
The second type of lag is the administrative lag. It takes a long time for Congress to agree on a course of
action with the president.
The third type of lag is the operational lag. This is the time it takes for the full impact of a government
program or tax change to have its effect on the economy. Even if the president and Congress can agree on the
time that a policy is needed, and they can agree on the type of policy, it takes months and sometimes years for
the discretionary fiscal policy to have its desired effects.
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6. A negative aggregate supply shock (e.g., an oil price increase) will raise business costs. This will push the
aggregate supply curve to the left from AS1 to AS2 as in the diagram below. Prices will increase significantly
and people will lose their jobs as RGDP falls.
The nondiscretionary fiscal policy (NDFP) that is already in place causes taxes to fall and welfare spending to
rise. This brings about the shift in aggregate demand to the right from AD1 to AD2. The shift in aggregate
demand from NDFP is accompanied by inflation.
Congress and the president may decide that there is a need for discretionary fiscal policy (DFP), which causes
aggregate demand to shift to the right again from AD2 to AD3, and RDGP can increase still further. However,
when RGDP goes up, this will again worsen inflation in the economy.
Price
Level
AS2
AS1
Shock
DFP
NDFP
AD3
P*
AD1
AD2
RGDP*
RGDP
7. When there is a positive aggregate supply shock (e.g., a technological development or a fall in oil prices)
business costs fall. This will push the aggregate supply curve to the right from AS1 to AS2, as in the diagram
below. Nondiscretionary fiscal policy causes taxes to go up and welfare spending to go down. The NDFP
shifts the aggregate demand to the left from AD1 to AD2. There is no need for discretionary fiscal policy
because the shock has a positive effect on the economy. Both the positive shock and the nondiscretionary
fiscal policy serve to keep inflation under control.
AS1
Price
Level
AS2
Shock
NDFP
AD1
AD2
RGDP
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8. There are two main political problems with fiscal policy: first, politicians may be too concerned with being reelected and second, they may recommend and push for projects for their districts.
Another issue is the political business cycle. It is suggested that politicians, in particular presidents, will add
new spending and tax policies to their pre-election-year budgets to boost the economy in time for their own
party’s re-election.
9. Because an expansionary fiscal policy involves a tax cut or government spending, real GDP is stimulated.
This type of policy is used during a recession to shift aggregate demand to the right. It can work reasonably
well in the horizontal section or the slowly rising intermediate portion of the aggregate supply curve. In the
vertical regions, shifting aggregate demand only leads to inflation. See Figure 9.2 in your text.
Contractionary fiscal policy is the reverse situation. This involves tax increases or decreases in government
spending. AD shifts to the left along the aggregate supply curve. As seen in Figure 9.1 in your text, this
policy only works in the vertical portion of the AS curve where inflation falls, and real output does not fall. In
the other regions, even though prices fall, real output also falls.
10. The tax rebates were essentially discretionary policy actions. They were debated and discussed by the
president and Congress, and they were a one-shot situation.
The change in tax brackets for taxpayers, however, is a nondiscretionary fiscal policy action. These changes
will automatically kick in when RGDP increases or decreases. There will be no need for further policy
decisions. They are now “built-in” to the system.
11. The four basic elements of the Obama Stimulus Plan are (a) non-discretionary spending increases on
unemployment, welfare, and Medicare, (b) direct aid to state governments, (c) discretionary tax cuts, and (d)
discretionary spending increases on “shovel ready” projects.
SUGGESTED ANSWERS TO THE WEB-BASED QUESTIONS
Part I.
The tax debate in 2001 focused on tax cuts as the then new president, George W. Bush, was determined to
keep his campaign promise in 2000 to cut taxes. This is quite a new direction, since during the Clinton
administration taxes were raised.
The centerpiece of the debate was a tax rebate for all people who filed tax returns in 2000. Every taxpayer or
household was given a rebate, ranging from $300 for single taxpayers to $600 for married taxpayers.
The tax plan is for a reduction in tax rates from 2001 to 2006. Tax brackets will be gradually decreased for
those in the 28%, 31%, 36%, and 39.6% tax brackets to 25%, 28%, 33%, and 35% tax brackets, respectively.
The tax rebate and the change in the tax rates are both discretionary policies. They were discussed, debated,
voted on and passed by Congress, and then approved by the president. In subsequent years, however, the
changes in tax brackets have become automatic stabilizers (nondiscretionary fiscal policy), since tax
collections increase when the economy booms, and they fall when the economy goes into a recession.
Sources: www.fairmark.com/news/egtrra/overview.htm
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Part II.
In the aftermath of the terrorist attack of September 11, 2001, it was clear that there was a need for
discretionary fiscal policy to finance the war on terrorism, and offer a fiscal stimulus to the economy.
The following article shows the difficulty of implementing discretionary fiscal policy.
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In an article in BusinessWeek, the author shows the problems of enacting fiscal policy: “Congress
is fiddling while the economy tumbles and layoffs surge. Thanks to the intransigents from both
parties in Washington, the recession could get worse and last longer than the consensus prediction
on Wall Street. It simply takes too long for fractious legislators to agree on a tax-and-spend
package, and, worse, much of what they eventually consent to is of little economic benefit.”
Source: www.businessweek.com/bwdaily/dnflash/nov2001/nf2001112_0867.htm
Part III.
Alan Auerbach in his article “The Effectiveness of Fiscal Policy as Stabilization Policy,” indicates that new
instruments of discretionary and nondiscretionary policy may be required in the future, but at this time we
cannot tell whether such policies will succeed, and whether they should be attempted as frequently as they
have been in the past. He comes to the following conclusions:
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Fiscal policy can be active and responsive to economic conditions even though there are policy
lags, they do not appear to preclude the use of discretionary policy for the purpose of stabilization.
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Governments still use fiscal policy to achieve short-term objectives.
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Fiscal policy does seem to have direct effects on consumption, investment and government
spending and, ultimately, overall effects on output.
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It is hard to judge whether fiscal policy has been successful as a tool of economic stabilization.
Cross-country evidence suggests that activist policy has been counterproductive, but only to a part
of fiscal policy.
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Automatic stabilizers may play a role, but maybe more at lower levels of income distribution. At
these levels, demand effects may be larger and economic distortions less pronounced.
Source: www.econ.berkeley.edu/~auerbach/effective.pdf