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Fiscal Policy
How can gov’t changes in taxes or expenditure
influence AD?
What is the difference between expansionary and
contractionary fiscal policy?
How does fiscal policy influence both demand- and
supply-side models?
Definition, major points
• Fiscal policy—government changes to its
own expenditures and taxes to influence
the level of aggregate demand
– Purposeful, so it is discretionary policy
• Components of AD: C+I+G+(X-M)
– Fiscal policy can affect the first three:
– G: through making changes in politics
– I: gov’t changes taxes on business profits
– C: gov’t changes income tax, which influences
level of disposable income
Demand-side focus
At any given PL:
• An increase in gov’t spending or in transfer
payments: increases real GDP
• An increase in taxes decreases real GDP
Automatic stabilizers are enhanced by
discretionary fiscal policy
Where did it come from?
• Fiscal policy was the brain child of economist John
Maynard Keynes during the 1930s in an attempt to
understand the Great Depression
• Keynes advocated increased government expenditures
and lower taxes to stimulate demand and pull the global
economy out of the Depression.
– concept that optimal economic performance could be achieved
by influencing aggregate demand through activist stabilization
and economic intervention policies by the government (FISCAL
POLICY)
• Three tools:
– Taxes, gov’t spending, transfer payments
– Keynesian economics is considered to be a “demand-side”
theory that focuses on changes in the economy over the short
run.
Closing a contractionary gap
• When the economy is in contraction or
recession, the government will typically
use expansionary fiscal policy to
“expand” the economy
• The government will increase spending
and/or lower taxes, which has the effect of:
– Increasing GDP (increased AD)
– Lowering unemployment
– Increasing disposable income/consumption
when taxes are adjusted downward
This will push the AD curve to the right by doing the following:
Decreasing taxes (more consumption)
Increasing transfer payments (more money in peoples’ pockets)
Increasing gov’t spending on social programs/military
Closing an inflationary gap
• When the economy is “overheating”, or is an
expansion which results in high prices, the gov’t
will use contractionary fiscal policy to
“contract” the economy
• The government will decrease spending and/or
increase taxes, which has the effect of:
– Decreased AD, fall in real GDP
– Could potentially increase unemployment
– Taxes increased on firms and/or consumers
Remember that fiscal policy is a tool to help stabilize prices and
control unemployment.
Since unemployment is linked to GDP, it’s possible that when the gov’t
enacts contractionary policy to decrease AD, that unemployment
grows. However, this is better than hyperinflation.
The multiplier effect (HL)
• Congress must be careful with the amount of
taxes/spending adjusted, as it could create a
multiplying (“snowball”) effect:
– If the gov’t puts $10 billion into the economy, that
money will affect GDP more than $10 bill. It may
affect by $10.5 or even $12 billion, depending on
responsiveness of economy to fiscal policy
• Difficult to estimate; Effects of fiscal policy
always multiply, which can cause Congress to
stimulate the economy too much, causing high
inflation
What happens when there is too
much economic stimulation?
• Inaccurate estimations of potential output or
natural rate of unemployment can cause an
over-stimulation of the economy
• This can cause AD to extend past potential
output and cause increased GDP with increased
prices
• If this is not corrected, suppliers will not be able
to maintain production with increased price and
AS will decline, causing even higher high prices
and decreased GDP (high unemployment)
• This is also called stagflation
FP’s unintentional affect on
supply of labor
• If gov’t increases transfer payments (unemployment pay)
too much during a contractionary period, expansionary
policy will give the unemployed who benefit from
increased transfer payments, have less incentive to find
work
• If gov’t decreases taxes too much during an
expansionary period, contractionary policy will give
workers, who find their wage reduced by the higher tax
rates, less incentive to work
• Both of these situations would reduce AS, causing high
prices (inflation) and lower the GDP