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Using Fiscal Policy
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Chapter 15: Using Fiscal Policy
KEY CONCEPT
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Fiscal policy uses taxes and government spending in an effort to
smooth out the peaks and troughs of the business cycle.
WHY THE CONCEPT MATTERS
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During the 20th century, periods of rampant inflation and economic
depression caused great hardship for millions of people in different
parts of the world. The federal government uses a combination of
spending and taxation to reduce the impact of economic extremes.
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What Is Fiscal Policy?
Fiscal Policy Tools
KEY CONCEPTS
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Fiscal—refers to government revenue, spending, and debt
Fiscal policy—government’s use of taxes, spending to affect
economy
Expansionary fiscal policy—raises aggregate demand, stimulates
economy
Contractionary fiscal policy—reduces aggregate demand, slows
economy
Federal government’s tools to influence economy: taxation, spending
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Fiscal Policy Tools
Discretionary Fiscal Policy
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Discretionary fiscal policy—actions government takes to stabilize the
economy
– involve choices government makes about taxes or spending
– Congress must enact legislation for policies to be implemented
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Fiscal Policy Tools
Automatic Stabilizers
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Automatic stabilizers—fiscal policy features that work automatically
– control aggregate demand in expansionary or contractionary
manner
Public transfer payment programs and progressive income taxes
– increase incomes and reduce impact of a recession
– reduce extra income entering economy, slow growth, check
inflation
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The Purpose of Fiscal Policy
KEY CONCEPTS
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Expansionary fiscal policy designed to help a weak economy grow
Contractionary fiscal policy used to slow down a growing economy
– purpose is to control inflation
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The Purpose of Fiscal Policy
Policy 1: Expansionary Fiscal Policy
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Expansionary policy increases aggregate demand so economy can
grow
Increased spending on public projects done by hiring private firms
– jobs created; workers spend on goods and services
Lower personal, corporate income taxes leaves more money
available
– increase in demand for products, saving, capital and labor
investment
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The Purpose of Fiscal Policy
Policy 2: Contractionary Fiscal Policy
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Too rapid economic growth leads to demand-pull inflation
Spending cuts mean less income for private firms working for
government
– aggregate demand drops; production drops; inflation is controlled
Higher taxes reduce disposable income
– decreases consumer spending, production; workers laid off; prices
drop
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Limitations of Fiscal Policy
KEY CONCEPTS
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Fiscal policy intended to
– reduce economic slowdowns that result in unemployment
– curb inflation
Has significant limitations
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Limitations of Fiscal Policy
Limitation 1: Policy Lags
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Fiscal policy lags behind conditions it is meant to address
May take time to identify problem and to get Congress to act
Implementing policy change takes time
– tax changes can take effect faster than new spending programs
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Limitations of Fiscal Policy
Limitation 2: Timing Issues
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Fiscal policy meant to smooth out peaks and troughs of business
cycle
If timing is good, fluctuations in the business cycle are less severe
If timing is bad, policy can make matters worse. Example:
– if moving out of recession, expansionary policy can bring on
inflation
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Limitations of Fiscal Policy
Limitation 3: Rational Expectations Theory
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Rational expectations theory—people anticipate that changes in
fiscal policy will have certain outcomes
– take actions to protect themselves against outcomes
May expect expansionary policy to increase demand and raise prices
– so buy more to stay ahead of inflation, thus causing more inflation
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Limitations of Fiscal Policy
Limitation 4: Political Issues
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Political considerations, especially chance for reelection, influence
policy
Council of Economic Advisers—group of advisors to president
– President or Congress may not follow their advice
– particular issue for House where all tax bills originate
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Limitations of Fiscal Policy
Limitation 5: Regional Issues
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Not all parts of the country may have same economic conditions
– One state or region may have recession while another has inflation
One broad policy for entire nation may not be appropriate
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Reviewing Key Concepts
Use each of the terms below in a sentence that illustrates
the meaning of the term:
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expansionary fiscal policy
discretionary fiscal policy
rational expectations theory
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Demand-Side and
Supply-Side Policies
Demand-Side Economics
KEY CONCEPTS
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Until Great Depression, government did little to influence economy
– persistent unemployment, low production changed many
economists’ minds
John Maynard Keynes proposed Keynesian economics:
– idea that during recession government should stimulate aggregate
demand
– basis of demand-side fiscal policy—policy to stimulate aggregate
demand
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Demand-Side Economics
Keynesian Theory
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Changes in aggregate demand affect business cycle: GDP =
C+I+G+F
– GDP = consumer (C), investment (I), government goods (G), net
exports (F)
– exports small role in the economy; consumer, government
spending stable
Keynes believed investment caused fluctuations in the economy
– spending multiplier effect—a spending change results in larger
GDP change
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John Maynard Keynes: Architect of Demand-Side
Policy
Using Government Action to Stimulate Demand
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Keynes: lower aggregate demand meant layoffs, less aggregate
demand
Began field of macroeconomics and revolutionized economic thinking:
– aggregate demand is sum of investment, consumer and
government spending
– only active government action can break the patterns in business
cycle
– government spending to stabilize economy better than balanced
budget
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Government and Demand-Side Policies
KEY CONCEPTS
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Discretionary fiscal policy involves making choices about taxation and
spending
– increase aggregate demand or control inflation
Demand-side policies advocate use of these fiscal policy tools
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Government and Demand-Side Policies
The Role of Government
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Depression economy stable, but high unemployment, little aggregate
demand
Keynes argued for government spending to create jobs, increase
income
– also lower taxes to encourage consumer spending, business
investment
During inflation Keynes favored decreased spending, raised taxes
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Government and Demand-Side Policies
Demand-Side Policies—Analysis
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Sometimes demand-side policies work; example, World War II
production
Difficult to discontinue popular programs after recession
Difficult for politicians to raise taxes during inflationary periods
Demand-side policies ineffective for stagflation
– slow economic growth with unemployment and inflation
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Supply-Side Economics
KEY CONCEPTS
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Some economists prefer influencing the economy through supply side
Supply-side fiscal policy—provides incentives to producers
– focuses on cutting the cost of production to increase aggregate
supply
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Supply-Side Economics
The Role of Government
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Supply-side economists favor cutting individual, corporate taxes
– to encourage people to work, save, invest more
– reducing highest tax brackets frees income to most likely investors
Favor lower government spending: if need less revenue, can lower
taxes
Favor less regulation: cuts production costs, ups aggregate supply
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Supply-Side Economics
The Laffer Curve
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Laffer Curve—shows how tax cuts affect tax revenues, economic
growth
Laffer said tax revenues increase as tax rates increase up to a point
Higher taxes discourage working, saving, investing
– people find alternatives to income-producing activities
– taxable income, revenue drops; aggregate supply falls; economy
slows
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Supply-Side Economics
Supply-Side Policies—Analysis
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In 1980s, taxes were reduced but revenue increased
– inflation, unemployment fell; economy grew steadily
Some chose to work fewer hours for same income; savings declined
Some economists: success depends on where economy is on Laffer
Curve
Others say economy grew from tax cuts plus increased defense
spending
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Reviewing Key Concepts
Explain the relationship between the terms in each of
these pairs:
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Keynesian economics and demand-side fiscal policy
supply-side fiscal policy and Laffer Curve
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Deficits and the National Debt
The Federal Deficit and Debt
KEY CONCEPTS
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All levels of government struggle to achieve balanced budget
Budget surplus occurs when government takes in more than it
spends
Budget deficit occurs when government spends more than it takes in
Deficit spending—spending more than revenues for specific budget
year
National debt—the total amount of money the government owes
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The Federal Deficit and Debt
Causes of the Deficit
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Four main reasons for deficit spending
— national emergencies usually require massive spending beyond
normal budget
— building public goods and services is expensive, work takes years
— public projects to stimulate, stabilize weak economy need large
sums
— entitlement programs that people depend on are expensive
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The Federal Deficit and Debt
Raising Money for Deficit Spending
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To borrow money, federal government issues bonds through Treasury
Department
Savings bonds mature in 20 years; denominations from $25 to
$10,000
Treasury bills (T bills) mature in less than one year
Treasury notes mature between 2 and 10 years
Treasury bonds mature in 30 years
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The National Debt
KEY CONCEPTS
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Government owes bond holders the amount of the bond plus interest
Also borrows from government trust funds—money held for specific
future purpose
– trust fund surpluses invested in bonds until programs need the
funds
– some economists do not think moving funds within government is
debt
– no burden to current economy because current budget does not
pay for it
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The National Debt
The Current Debt
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In August 2006, national debt about $8.4 trillion
– federal deficits and debt increased during 1980s, 1990s
– since 1980s debt has grown faster than inflation—grown in real
terms
In 1981, debt was 33 percent of GDP; in 2006 was nearly 68%
in 1981, about 80 percent privately owned; in 2006 less than 60%
private
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The National Debt
The Effect of the Debt on the Economy
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If government spending stimulates economy, jobs and public goods
created
If government outbids private sector, pays higher bond interest rates
– crowding-out effect—money leaves private sector, interest rates
rise
Constant borrowing increases total interest and taxes to service debt
– higher taxes decrease consumer spending and business
investment
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The National Debt
Attempts to Control Deficits and Debt
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Sharp rise in deficits, debt in 1980s
Officials tried various measures to control deficit spending
Various bills had mixed success; government continues to struggle
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Reviewing Key Concepts
Explain the differences between the terms in each of
these pairs:
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budget surplus and budget deficit
national debt and deficit spending
Treasury bills and Treasury bonds
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Is the Federal Deficit Too Large
Background
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Taxpayers ultimately pay the interest on the national debt, which is created by
deficit spending by the federal government.
The government uses deficit spending for several reasons, including paying
for national emergencies and implementing expansionary fiscal policies
during periods of recession.
What’s the Issue
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Is the federal deficit too large?
Thinking Economically
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Identify the economic cause-and-effect relationships described in Documents
A and C.
How does Document B illustrate the challenge facing the Bush administration
in its efforts to carry out the plan discussed in Document C?
Do you think the Bush administration shares the concerns about the deficit
expressed in Document A? Use information from the documents to explain
your answer.
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