Download 15.1 The Evolution of Fiscal Policy Objectives

15.1 The Evolution of Fiscal Policy
Objectives
 Identify the economy’s potential output
level.
 Distinguish between fiscal policy before
and after the Great Depression.
CONTEMPORARY ECONOMICS
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15.1 The Evolution of Fiscal Policy
Key Terms
 potential output
 natural rate of unemployment
 classical economists
 annually balanced budget
 multiplier effect
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15.1 The Evolution of Fiscal Policy
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Fiscal Policy and Potential Output
Fiscal policy aims to use government
taxing and spending to move the economy
toward full employment with price stability.
The focus is mainly on shifts of the
aggregate demand curve.
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15.1 The Evolution of Fiscal Policy
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Potential Output
Potential output is the economy’s
maximum sustainable output in the long
run.
Potential output also is referred to as the
full-employment output.
The natural rate of unemployment is the
unemployment rate when the economy is
producing its potential level of output.
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15.1 The Evolution of Fiscal Policy
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Fiscal Policy and Potential Output
 The pink-shaded
area indicates real
GDP below the
economy’s potential.
 The blue-shaded
area indicates real
GDP exceeding the
economy’s potential.
Figure 15.1
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15.1 The Evolution of Fiscal Policy
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Output Below Potential
The economy is not producing as much as
it can.
Unemployment exceeds its natural rate.
The amount by which short-run output falls
short of the economy’s potential output is
called a contractionary gap.
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15.1 The Evolution of Fiscal Policy
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Output Exceeding Potential
Unemployment is below its natural rate.
The amount by which actual output in the
short run exceeds the economy’s potential
output is called the expansionary gap.
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15.1 The Evolution of Fiscal Policy
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How Can Output Exceed the
Economy’s Potential?
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Potential output means not zero
unemployment, but the natural rate of
unemployment.
Even in an economy producing its
potential output, there is still some
unemployed labor and some unused
production capacity.
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15.1 The Evolution of Fiscal Policy
SLIDE
Discretionary Fiscal Policy
to Close a Contractionary Gap
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 The aggregate demand
curve AD and the aggregate
supply curve AS intersect at
point e.
 Output of $11.5 trillion falls
short of the economy’s
potential of $12.0 trillion.
 The result is a contractionary
gap of $0.5 trillion.
Figure 15.2
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15.1 The Evolution of Fiscal Policy
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Discretionary Fiscal Policy
to Close a Contractionary Gap (continued)
 This gap could be closed by
discretionary fiscal policy that
increases aggregate demand
by just the right amount.
 An increase in government
spending, a decrease in
taxes, or some combination
of the two could shift
aggregate demand to AD*,
moving the economy to its
potential level of output at e*.
Figure 15.2
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15.1 The Evolution of Fiscal Policy
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The Rise of Fiscal Policy
Before the Great Depression, most policy
makers believed that an economy
producing less than its potential in the
short run would move to its potential in the
long run without help from the federal
government.
They thought the government should just
balance its budget and forget about trying
to stabilize the economy in the short run.
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15.1 The Evolution of Fiscal Policy
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The Rise of Fiscal Policy
(continued)
Before the Great Depression, the federal
government played a relatively minor role
in the economy.
Federal spending as a percent of GDP
3 percent at the onset of the Great
Depression
20 percent today
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15.1 The Evolution of Fiscal Policy
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View of Classical Economists
 Classical economists—A group of laissez-faire
economists, who believed that economic
downturns corrected themselves in the long run
through natural market forces
 Annually balanced budget—Matching annual
spending with annual revenue, except during
war years; approach to the federal budget prior
to the Great Depression
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15.1 The Evolution of Fiscal Policy
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The Great Depression and Keynes
Keynesian theory and policy were
developed to address the problem of
unemployment during the Great
Depression.
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15.1 The Evolution of Fiscal Policy
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The Multiplier Effect
 Keynes also argued that any change in taxing or
government spending had a magnified effect on
aggregate demand.
 Each round of income and spending increases
aggregate spending a little more.
 The multiplier effect of fiscal policy says that
any change in fiscal policy affects aggregate
demand by more than the original change in
spending or taxing.
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15.1 The Evolution of Fiscal Policy
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The Rise of Fiscal Policy
Three developments in the years following
the Great Depression supported the use of
fiscal policy in the United States.
The influence of Keynes’s General Theory
The powerful impact World War II had on
output and employment
The passage of the Employment Act of 1946
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15.2 Fiscal Policy Reconsidered
Objectives
 Identify the two tools of fiscal policy.
 Evaluate discretionary fiscal policy in light
of the time lags involved.
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15.2 Fiscal Policy Reconsidered
Key Terms
 discretionary fiscal policy
 automatic stabilizers
 recognition lag
 decision-making lag
 implementation lag
 effectiveness lag
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15.2 Fiscal Policy Reconsidered
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Fiscal Policy Tools
The tools of fiscal policy sort into two
broad categories:
Discretionary fiscal policy
Automatic stabilizers
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15.2 Fiscal Policy Reconsidered
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Discretionary Fiscal Policy
Discretionary fiscal policy—legislative
changes in government spending or taxing
to promote macroeconomic goals
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15.2 Fiscal Policy Reconsidered
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Automatic Stabilizers
Automatic stabilizers—government
spending and taxing programs that year
after year automatically reduce
fluctuations in disposable income, and
thus in consumption, over the business
cycle
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15.2 Fiscal Policy Reconsidered
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Problems with
Discretionary Fiscal Policy
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Stagflation
Calculating the natural rate of
unemployment
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15.2 Fiscal Policy Reconsidered
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The Problem of Lags
 Recognition lag—the time it takes to identify a
problem and determine how serious it is
 Decision-making lag—the time needed to
decide what to do once the problem has been
identified
 Implementation lag—the time needed to
execute a change in policy
 Effectiveness lag—the time needed for
changes in policy to affect the economy
CONTEMPORARY ECONOMICS
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15.2 Fiscal Policy Reconsidered
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Fiscal Policy and Aggregate Supply
Fiscal policy can affect aggregate supply,
although often that effect is unintentional.
Both automatic stabilizers and
discretionary fiscal policies may affect
individual incentives to work, spend, save,
and invest.
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