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FISCAL POLICY
Fiscal Policy
• We will not be using the section starting on
pg. 220 on evaluating fiscal policy.
• Nor will I be using graphs.
Fiscal Policy
• Government policies on taxation and
spending.
• All governments have a fiscal policy.
Fiscal Policy: Paying the Bills
• There are a number of ways governments
can obtain the funds to pay for their
spending.
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Conquer another country
Print money
Borrow money (issue bonds)
Raise taxes
Fiscal Policy: Paying the Bills
• It is no longer acceptable to conquer other
countries to raise money from them.
• Printing money leads to inflation, which is not
acceptable either.
• When governments borrow money, they have to
repay it, with tax revenues.
• Ultimately taxes are the only source of funds.
FISCAL POLICY:
CHANGES IN SPENDING
AND TAXATION
Fiscal Policy: Changes in
Taxation
• Key concept:
Disposable income.
• Defined as: your after tax income.
Fiscal Policy: Increase in Taxes
1. Increased taxation leads to decreased disposable
income.
2. Decreased disposable income leads to decreased
consumption.
3. Decreased consumption is visible as decreased
sales.
4. Decreased sales leads to increased inventory.
Fiscal Policy: Increase in Taxes
5. Increased inventory leads to decreased
production.
6. Decreased production leads to rising
unemployment.
7. Rising unemployment leads to decreased
incomes and decreased disposable income.
Fiscal Policy: Increase in Taxes
•
Increased taxation, CETERIS PARIBUS,
can lead to a fall in the economy.
•
But notice the ceteris paribus assumption!
Fiscal Policy: Decrease in Taxes
1. Decreased taxation leads to increased disposable
income.
2. Increased disposable income leads to increased
consumption.
3. Increased consumption is visible as increased
sales.
4. Increased sales leads to decreased inventory.
Fiscal Policy: Decrease in Taxes
5. Decreased inventory leads to increased
production.
6. Increased production leads to falling
unemployment.
7. Falling unemployment leads to increased
incomes and increased disposable income.
Fiscal Policy: Decrease in Taxes
•
Decreased taxation, CETERIS PARIBUS,
can lead to growth in the economy.
•
But notice the ceteris paribus assumption!
Fiscal Policy: Increased
Government Spending
1. Increased government spending leads to
increased employment as both government and
business hire more people.
2. This leads to increased disposable income.
3. Increased disposable income leads to increased
consumption.
Fiscal Policy: Increased
Government Spending
5. Increased consumption is visible as increased
sales.
5. Increased sales leads to decreased inventory.
6. Decreased inventory leads to increased
production.
7. Increased production leads to falling
unemployment.
Fiscal Policy: Increased
Government Spending
•
Increased federal government spending,
CETERIS PARIBUS, can lead to growth
in the economy.
•
But notice the ceteris paribus assumption!
Fiscal Policy: Decreased
Government Spending
1. Decreased government spending leads to
decreased disposable income.
2. Decreased disposable income leads to decreased
consumption.
3. Decreased consumption is visible as decreased
sales.
4. Decreased sales leads to increased inventory.
Fiscal Policy: Decreased
Government Spending
5. Increased inventory leads to decreased
production.
6. Decreased production leads to rising
unemployment.
7. Rising unemployment leads to decreased
incomes and decreased disposable income.
Fiscal Policy: Decreased
Government Spending
•
Decreased government spending,
CETERIS PARIBUS, can lead to a fall in
the economy.
•
But notice the ceteris paribus assumption!
How to Boost the Economy?
•
Increase federal government spending.
•
Decrease federal government taxation.
Which technique is better?
•
Increases in federal government spending
immediately lead to a rise in the number
of jobs and consumption.
•
Cutting taxation takes many months to
impact the economy.
Automatic Stabilizers
•
Certain government programs run automatically.
•
They aren’t voted on by Congress every year.
•
They function to help stabilize the economy.
Full Automatic Stabilizers
1. Transfer payments
- welfare
- unemployment compensation
2. Progressive income taxes
How Stabilizers Work
1. Recession leads to a rising number of
unemployed people.
2. Rising unemployment leads to falling
incomes.
3. Falling incomes leads to falling sales and
then falling profits.
How Stabilizers Work
1. With unemployment compensation,
when people are laid off, their income
doesn’t fall to zero.
2. With at least some income, they can
spend.
How Stabilizers Work
1. This slows down the collapse in sales
2. The slowdown in the fall of sales also
slows down the process of rising layoffs.
3. Altogether this acts to slow down the fall
of the economy.
How Stabilizers Work
• Automatic stabilizers increase during
recessions, which helps reduce the
severity of the downturn.
• Automatic stabilizers decrease during
periods of economic growth.
Government Borrowing
•
All governments normally borrow money,
because:
1. Revenues don’t come in at the same time that
they need to spend.
2. Big projects require a large sum at once, and
we want the costs spread out.
Government Borrowing
•
Government borrowing, by itself, is not bad.
•
It is part of normal government functioning.
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Further, federal government borrowing to reduce
or end a recession isn’t necessarily bad, either.
Federal Government
Borrowing
•
What is a problem is continuous, very
large scale borrowing by the Federal
government.
Problems with Federal
Government Borrowing
•
Federal Budget Deficit
–
•
Federal government spending is greater than
federal government revenues.
Federal Budget Surplus
–
Federal government spending is less than
federal government revenues.
Problems with Federal
Government Borrowing
•
There are three main problems with large
federal budget deficits, and the large
amount of borrowing necessary to pay for
it.
1. CROWDING OUT
2. WEALTH REDISTRIBUTION
3. SQUEEZING OUT OTHER SPENDING
Crowding Out
1. To borrow, the Unites States government issues
United States Treasury bonds.
2. Treasury bonds are promises to repay the face
value of a bond, plus interest, by a certain time.
IOU’s basically.
3. People who buy bonds are lending money to the
government.
Crowding Out
4. The more people lend to the US government, the
less they have to lend to others.
5. Money follows the law of demand: if money
becomes scarce, its price goes up.
6. The price of money is the interest that you pay
for borrowing money.
Crowding Out
7. If money becomes scarce, interest rates
rise.
8. What happens to consumption when
interest rates rise?
9. What happens to investment when interest
rates rise?
Crowding Out
10. People would prefer to lend to the US
government, which is risk-free money.
11. Thus when the government borrows, it
crowds out other borrowers, and interest
rates rise.
Wealth Redistribution
1. Ninety (90%) of all bonds are owned by the
richest 10% of all households.
2. The United States government repays the
principle, plus interest.
3. To obtain money for the repayment of these
loans, the US government raises taxes.
Wealth Redistribution
4. Taxes on the wealthy have been falling,
especially since 1980.
5. Taxes on large corporations have been
falling, especially since 1980.
6. So on whom is the tax burden falling?
Squeezing Other Programs
1. Rising federal government deficits leads
to rising borrowing by the federal
government.
2. In turn, this means that more federal
revenues will be spent repaying the
borrowed money, in future years.
Squeezing Other Programs
1. Rising interest and repayment of past
borrowing reduces the amount of federal
money for any other use.
2. This means less money available for other
government programs: health, education,
road repair or the environment.
Squeezing Other Programs
1. We have the statements of former
members of the Reagan administration
that that is exactly why they liked the huge
government deficits of the 1980’s.
2. There is reason to believe that the Bush
administration is thinking the same way.