Chapter 13: Fiscal policy
Recall from Chapter 4 that one of the important economic functions of government is to "promote economic stability." This refers to the government's role in stabilizing the macroeconomy over the business cycle. In other words, helping to deal with the problems of unemployment and inflation. This is accomplished through what are referred to as macroeconomic stabilization policies. The purpose of such policies is to try to maintain the economy as close as possible to the full-employment, non-inflationary level of national output (Real GDP). Chapter 13 introduces us to the first of these policies, fiscal policy. Chapter 16 deals with the other, monetary policy, which involves the use of control of the money supply and interest rates.
Fiscal policy refers to the government's use of its taxing and spending powers (budgetary) to affect the level of total spending (AD). Recall the Keynesian logic: If the economic problem is unemployment, it must result from too little spending. Conversely, the problem of inflation (demand-pull) results from too much spending. Therefore, government should act to expand total spending (AD) during recessions and contract spending during inflationary periods.
Discretionary Fiscal Policy
When we think about fiscal policy, we are usually referring to discretionary fiscal policy. Discretionary means the federal government must do something affirmative or overt. Congress and the Administration must do something intentionally. If the economic problem is recession, it calls for an expansionary fiscal policy. This might include increasing government spending or cutting taxes, or some combination of the two. If the problem is inflation (demand pull), it calls for a contractionary fiscal policy. This might include decreasing government spending or raising taxes or some combination of the two.
Pay close attention to Figures 13.1 and 13.2.
The preference or choice of fiscal policy measures depends largely on one's view as to whether government is too large or too small. If you believe that there are many unmet social and infrastructure needs that government needs to address, then you probably will advocate increased government spending during recession and tax increases in times of demand-pull inflation. On the other hand, if you believe that government is already too big and inefficient, you will probably choose a tax cut during recession and a cut in government spending during inflationary periods. (See, page 258)
It is important to recognize that an expansionary fiscal policy requires deficit spending by the federal government. The government must borrow the funds necessary to undertake the policy, regardless of which tool it chooses.
Automatic stabilizers (passive fiscal policy)
Even if the government takes no intentional action, the inaction is a form of fiscal policy usually referred to as passive fiscal policy or the automatic stabilizers.
During periods of recession, government tax revenues fall. Higher unemployment means less income to tax, and the lower levels of income are taxed at a lower rate. So, tax revenues fall. At the same time, government spending in the form of transfer payments increases. This results in an automatic budget deficit which is expansionary. So, doing nothing really ends up doing something. During periods of demand-pull inflation, it works just the opposite. The increase in tax revenues and decrease in government transfer payments creates an automatic budget surplus which is contractionary.
Do not worry about Evaluating Fiscal Policy on pages 260-263 with the exception of Social Security considerations on page 263.
Problems, Criticisms, and Complications - We will focus on three of these.
Timing Problems (the lags)
* Recognition lag -
* Administrative lag -
* Operational lag -
Crowding-out effect refers to the idea that when the government engages in expansionary fiscal policy it necessarily entails a budget deficit. The government borrowing causes higher interest rates which "crowds out" private spending, especially business investment. Some economists such as Milton Friedman argue that the crowding-out is dollar-for-dollar and so government deficit spending during recessions simply substitutes government spending for private spending and therefore the expansionary effect is negligible. Many economists argue that deficit spending during significant recessions will have little crowing-out effect.
Exercises:
I. Suppose the price level is fixed and there is a -$320B GDP Gap. If the MPC = .8, what combination of expansionary fiscal policy measures might be undertaken to move this economy back to full employment?
II. If the MPC = .75, the government could shift AD to the left by $60B by:
$G = _____ ?
$T = _____ ?
III. If the MPC = .6, the government could shift AD to the right by $100B by
$G = _____ ?
$T = _____ ?
IV. Which of the following is most contractionary?
a. $20B tax cut c. $20 increase in government spending
b. $20B tax increase d. $20 decrease in government spending
V. Suppose MPC = .8 and the government wanted to shift AD to the right by $80B at each price level to remedy a bad recession. It could:
$G = _____ ?
$T = _____ ?
VI. Suppose MPC = .9 and government wanted to shift AD to the left by $100B at each price level to remedy demand-pull inflation. It could:
$G = _____ ?
$T = _____ ?