Chapter 12: Fiscal Policy

This chapter describes the government mandates (discretionary fiscal policy) to stabilize national output, employment, economic growth and inflation. It examines the use of fiscal policy during contractionary and expansionary gaps through aggregate demand and aggregate supply model.

The chapter also examines Non-discretionary fiscal policy (built-in or automatic stabilizer) that measures government expenditures and tax revenues to adjust the economy in the case of business cycle.

• In the early 1980s, U.S. government introduced a 25% reduction in personal income tax without changing government spending. This policy led to the expansion of aggregate demand to get the economy out of the recession of the early 1980s, and to increase output and employment.
• U.S. government raised taxes on both corporate and personal income taxes during Vietnam war.

The purpose of the government intervention through government spending or taxing is to make the economy more stable. For example, Employment Act of 1946 was a Congressional mandate to promote economic stability. This legislative mandates was government’s role to achieve full employment and output level.

• The council of economic advisors (CEA) to advise the president for economic issues.
• The Joint Economic Committee of Congress to investigate economic problems of national interest.

Discretionary fiscal policy: the deliberate changes of taxes and government spending by Congress to stabilize the economy through aggregate demand by achieving full employment, control inflation, and economic growth.

A- Expansionary fiscal policy:

1. By increasing government spending, the aggregate demand will shift to the right (spending on highways, satellite communications). For example if the MPC =0.75, then the multiplier will be 4 and the aggregate demand will shift back to the right by 4 times the amount of government spending (say 5 billion dollars).
2. By reducing taxes the aggregate demand curve will shift to the right. For example, government cuts personal income taxes by $6.67 billion, which will increase disposable income by the same amount. MPC(.75) times $6.67 billion dollars equals $5 billion and saving will increase by 1.67 billion( MPS times 6.67 billion ). The initial increase in consumption spending is $5 billion because of the multiplier effect, the real GDP will increase by $20 billion. If the MPC is smaller then it is needed a higher tax cut.
3. The combination of both policies (decreasing taxes and increasing government spending)

2. Contractionary fiscal policy: by fighting against demand-pull inflation.

There are 3 cases involved here.

1. By reducing government spending, the aggregate demand will shift to the left and prices will fall down assuming that there is downward price flexibility (see figure). But real GDP will be the same because of that aggregate supply is vertical.
2. By raising taxes, aggregate demand will shift to the left If marginal propensity (MPP) is 0.75, government has to increase taxes by $6.67 billion to reduce consumption by $ 5 billion (.75 * 6.67= 5 billion) and 0.25 * 6.67 billion = $1.67 billion reduction in saving (see figure 12.2).
3. Combined government spending cuts and tax increases. For example, a $2 billion decrease in government accompanied with a $4 billion increase in taxes, aggregate demand would shift by how much? Government spending will increase by $2*4 = $8 billion after multiplier effect; tax cut will be .75*4 billion = $3 billion, and $1 billion of saving (.25*4 billion. After multiplier effect, the effect will be $3 billion times the multiplier (4) = $12 billion. Therefore the combined effect, which is $8 billion + $12 billion = $20 billion, that aggregate demand will decline.

Financing of deficits and disposing of surpluses:

Borrowing versus new money.

Government can finance a deficit by two ways.

1. Borrowing : if the government borrows money this will lead to interest rate increase and crowd out some private investment spending. For example, decreases in private spending reduce the expansionary impact of the deficit spending.
2. Money creation: If the government finances its deficit spending by creating new money, then there is no crowding out of private spending. That is this spending will increase without reducing consumption or investment. This kind of financing is a more expansionary way but more inflationary.

Debt retirement versus idle surplus

1- debt reduction: The government should use the surplus by paying of f the debt. This means that the government buys back some of its bonds, and this will cause to interest rate decrease and private borrowing and spending will increase.

Therefore, the increase in private spending offsets the contractionary fiscal policy.

3. Impounding: if the surplus tax revenue are not spent in the economy (idle surplus), then this will lead to more anti-inflationary impact of the contractionary policy.

Liberals recommend government spending increase during demand-pull inflation because there are many social needs to be supported.

Conservatives advocate that public sector is too large and inefficient therefore they recommend tax cuts during recessions and reductions in government spending during demand inflation.

Non-discretionary fiscal policy (automatic stabilizers or built-in): Automatic stabilizers are types of automatic fiscal policies, which do not require new legislation Act from Congress. They are as a result of net taxes, which changes as GDP changes. Net taxes are taxes minus subsidies and transfers.

• The progressive income tax: Taxes increase automatically as income increase and fall as income declines.
• Unemployment compensation: Transfers and subsidies increase as GDP decreases. That means unemployment compensation payments rise as the economy slums into a recession and vice verse as the economy expands.
• The magnitude of automatic stability depends on responsiveness of changes in taxes to changes in GDP.

Possible offsets of fiscal policy: Crowding-out effect:

- Indirect crowding out: the tendency of expansionary fiscal policy through deficit spending increases interest rate which in turn reduces investment and consumption. The interest rate declines because government finances budget deficit by government borrowing and this will compete with the private sector in terms of borrowing money. Because of this, aggregate demand increases by less than the amount of the increase in government spending.

• Direct Crowding out: that is when expenditures offsets directly. Actions taken by the private sector will offset government spending actions. That is the way private sector will spend their money cancel out government actions.

The open economy effect: when interest rate increases as a result of government deficit spending through borrowing, then foreigners will demand more dollars. As a result dollar appreciates which means that the value of dollar will increase relative to other currencies. Therefore, U.S. exports will decrease and imports will increase and aggregate demand will decrease by the amount of export decrease.

Fiscal policy and time lags:

• recognition time lag: the time lag required to get information about the economy( recession or inflation)
• Administrative time lag or action time lag: the time required between recognizing the economic problem and applying fiscal policy into effective. It is to short for both monetary and fiscal policy.
• Operational lag or effect time lag: the time that elapses between the onset of the policy and the results of that policy.