Policy
20
chapter
Gerald COREECONOMICS
20
Fiscal Stone
Chapter Outline
20 chapter
Demand-Side Fiscal Policy Supply-Side Fiscal Policy Implementing Fiscal policy
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Learning Objectives
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At the end of this chapter, the student will be able to:
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Explain the expansionary effect of government spending Diagram the impact of demand-side fiscal policy Illustrate the role of the multiplier in discretionary fiscal policy Compare the effects of demand-side and supply-side policies Discuss drawbacks of discretionary fiscal policy
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Fiscal Policy
20 chapter
Fiscal policy is one way the government tries to manage the economy and to tame the business cycle. Fiscal policy involves adjusting government spending on goods and services, transfer payments, and taxes, with the express purpose of sustaining a healthy rate of economic growth.
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Discretionary Spending
20 chapter
The federal budget can be split into two distinct types of spending: discretionary and mandatory. Discretionary spending is that part of the budget that works its way through the appropriations process of Congress each year. It includes such programs as national defense, transportation, science, environment, income security (some welfare programs like Medicaid), education, and veterans benefits and services.
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Mandatory Spending
20 chapter
Mandatory spending is authorized by permanent laws and does not go through the same appropriation process as discretionary spending. To change these entitlements, Congress must change the law. Mandatory spending includes such programs as Social Security, Medicare, interest on the national debt, and some means tested income security programs including Medicaid, food stamps and family support assistance.
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Demand-Side Fiscal Policy
20 chapter
Government can influence aggregate demand through spending and taxes. When an economy faces a horizontal aggregate supply curve, increases in aggregate demand can move the economy toward full employment without affecting the price level. When the economy is in equilibrium below full employment but faces a positive-sloping short run aggregate supply curve, output can be increased at the expense of raising price levels. When the economy is in an inflationary equilibrium above full employment and faces a positive-sloping short run aggregate supply curve, contracting aggregate demand brings about tradeoffs: decreasing output dampens inflation but leads to unemployment.
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Discretionary Fiscal Policy
20 chapter
The exercise of discretionary fiscal policy involves adjusting government spending and tax policies with the express short-run goal of moving the economy toward full employment, encouraging economic growth, or controlling inflation. Some examples of the use of discretionary fiscal policy include tax cuts enacted during the Kennedy, Reagan, and George W. Bush administrations. These tax cuts were designed to expand the economy, both in the near term and in the long run. They were meant to influence both aggregate demand and aggregate supply.
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The Multiplier Effect
20 chapter
When government spending is injected into the economy, the total level of economic activity will expand by an amount equal to the amount of the new expenditure times the multiplier. When the economy reaches the positively sloped portion of the aggregate supply curve, the value of the multiplier declines as some of the stimulus is absorbed into price increases.
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Taxes
20 chapter
When taxes are increased, money is withdrawn from the economys spending stream. When taxes are reduced, consumers and business have more to spend. A tax increase (or decrease, for that matter) will have less of a direct impact on income, employment, and output than will an equivalent change in government spending.
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Expansionary Fiscal Policy
20 chapter
Expansionary fiscal policy involves increasing government spending or decreasing taxes so as to increase aggregate demand. These policies put more money into the hands of consumers and business. In theory, these additional funds should lead to higher spending. The precise effect expansionary fiscal policies will have depends, however, on whether the economy is at or below full employment.
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Expansionary Fiscal Policy
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Aggregate Price Level (P) P 1 P 0
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If the economy begins at point e below full employment, expansionary fiscal policy can be implemented so as to boost aggregate demand to AD1. AD 1
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Q Q 0 f Aggregate Output (Q)
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Contractionary Fiscal Policy
20 chapter
If the economy is beyond the point of full employment, contractionary fiscal policy can be used to dampen inflationary pressures. This requires an increase in taxes or a decrease in government spending.
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Contractionary Fiscal Policy
20 chapter LRAS
Aggregate Price Level (P)
AS 0 A contractionary fiscal policy that would shift aggregate demand from AD0 to AD1 will lower the price level as it reduces aggregate output. AD 1 AD 0
P 0 P 1
e a
Q Q f 0 Aggregate Output (Q)
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2008 Worth Publishers CoreEconomics Stone
Checkpoint
20 chapter
Demand-Side Fiscal Policy
Demand-side fiscal policy involves using government spending, transfer payments, and taxes to change aggregate demand and equilibrium income, output, and the price level in the economy. Government spending raises income and output by the amount of spending times the multiplier. Tax reductions have a smaller impact on the economy than government spending because some of the reduction in taxes is added to saving and is therefore withdrawn from the economy.
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Checkpoint
20 chapter
Demand-Side Fiscal Policy
Expansionary fiscal policy involves increasing government spending, increasing transfer payments, or decreasing taxes. Contractionary fiscal policy involves decreasing government spending, decreasing transfer payments, or increasing taxes. When an economy is at full employment, expansionary fiscal policy may lead to greater output in the short term, but will ultimately just lead to higher prices in the longer term.
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Supply-Side Fiscal Policies
20 chapter
Supply-side fiscal policies are different from policies to influence aggregate demand in that they do not always require such tradeoffs between price levels and output. Supply-side policies require more time to work than do demand-side policies.
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They aim to shift the long-run aggregate supply curve to the right.
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Supply-Side Outcomes
20 chapter
The current economic landscape illustrates the outcome of a rightward shift in long-run aggregate supply. Improvements in technology and communications have increased productivity. These changes have helped to keep interest rates and inflation low for several decades.
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The Laffer Curve
20 chapter
One recommendation of supply-side economics is to lower tax rates so as to increase productivity. The Laffer shows Curve that tax revenues can sometimes be increased by lowering tax rates. Reducing tax rates should encourage risktaking by entrepreneurs since lower taxes mean higher after-tax returns on investments. Similarly, cutting taxes should encourage private saving and business investment.
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Encouraging Investment
20 chapter
Investment can be encouraged by such policies as investment tax credits and more rapid depreciation schedules for plant and equipment.
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When a firm can expense its capital equipment over a shorter period of time, it cuts taxes now rather than later, and so earns a higher net return.
Similarly, government grants for basic research help firms increase their budgets for research and development, which results in new products brought to market.
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Curbing Regulation
20 chapter
Another way of increasing supply without raising prices involves repealing unnecessarily onerous regulations that simply hamper business and add to costs. Examples of excessively regulated industries have included trucking and the airlines.
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When these industries were deregulated in the 1980s, prices fell and productivity improved .
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CheckpointSupply-Side Fiscal Policy
20 chapter
The goal of supply-side fiscal policies is to shift the long-run aggregate supply curve to the right. The Laffer curve suggested that reducing tax rates could lead to higher revenues. Other supply-side policies include providing incentives for business investment and reducing burdensome regulation. The major limitation of supply-side policies is that they take a long time to have an impact on long run aggregate supply.
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Automatic Stabilizers
20 chapter
Tax revenues and transfer payments are the two principal automatic stabilizers. Without any overt action by Congress or other policy makers, these components of the federal budget will expand or contract in ways that help counter movements of the business cycle.
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When the economy is growing at a solid rate, tax receipts will rise, since individuals and firms are increasing their taxable incomes. At the same time, transfer payments will decline, because fewer people require welfare or unemployment assistance.
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Automatic Stabilizers
20 chapter
The income tax is a powerful stabilizer because of its progressivity.
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When incomes fall, tax revenues fall faster since people do not just pay taxes on smaller incomes, but they also pay at lower rates as their incomes fall. Disposable income, in other words, falls more slowly than aggregate income.
The key point to remember here is that automatic stabilizers reduce the intensity of business fluctuations. Automatic stabilizers do not eliminate fluctuations in the business cycle, but they render business cycles smoother and less chaotic.
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Fiscal Policy Timing Lags
20 chapter
Data lag
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Most of the macroeconomic data that policy makers need to enact the proper fiscal policies are not available until at least one quarter after the fact. Even if the most recent data suggest the economy is trending into a recession, it may take several quarters to confirm the record. Fiscal policy requires a long and often contentious legislative and implementation process.
Recognition lag
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Implementation lag
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The Crowding-Out Effect
20 chapter
The crowding-out effect of fiscal policy arises from deficit spending, which requires the government to borrow. This borrowing can drive up interest rates. A higher cost of borrowing will dampen consumer spending on durable goods such as cars or refrigerators. It will also discourage business investment. While deficit spending is usually expansionary, its impact can be partially offset by reductions in private spending.
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Economic Growth
20 chapter
Often, fiscal policy debates have little to do with the state of the business cycle. Underlying the rhetoric about the economic benefits or dangers of tax cuts, budget deficits, and spending priorities lies a longstanding philosophical debate about the proper size of government. Rising budget deficits over recent decades have constrained the possibilities for tax cuts.
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CheckpointImplementing Fiscal Policy
20 chapter
Automatic stabilizers reduce the intensity of business fluctuations. When the economy is booming, tax revenues are rising, and unemployment compensation and welfare payments are falling.
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When the economy enters a recession, tax revenues fall, and transfer payments rise, cushioning the decline. This happens automatically.
Policy makers face lags in collecting data, interpreting trends, and implementing policy when business cycle conditions change.
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CheckpointImplementing Fiscal Policy
20 chapter
Lags often result in government policy being mistimed. For example, expansionary policy taking effect when the economy is well into a recovery or failing to take effect when a recession is underway can destabilize the economy. Crowding-out occurs when the government runs a deficit and then sells bonds to finance the deficit. This drives interest rates up and reduces private investment. Lower investment now means reduced income and output in the future.
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Chapter Summary
20 chapter
Governments try to influence aggregate demand by using fiscal policy. The governments main fiscal policy tools are spending on goods and services, transfer payments, and taxes. Fiscal policy is powerful because of the multiplier effect, which tells us that added government spending will raise equilibrium income and output by the multiplier times the added expenditure. Expansionary fiscal policies include increasing government spending; increasing transfer payments such as social security, unemployment compensation, and welfare payments; and decreasing taxes. These policies put more money into the hands of consumers and businesses.
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Chapter Summary
20 chapter
The multiplier will have its full effect when an economy is in depression.
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When the same economy begins to recover, its short run aggregate supply curve will be positively sloped, and thus higher prices will absorb some of the effects of increased spending. When the economy reaches full employment, its long run aggregate supply curve will be vertical.
Supply-side policies do not require such tradeoffs; they can expand output without raising prices.
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The goal of supply-side economics is to shift the long-run aggregate supply curve to the right.
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Chapter Summary
20 chapter
Automatic stabilizers such as transfer payments and the progressive income tax counteract the movements of the business cycle . Using fiscal policy to smooth out the short-term business cycle is difficult because of several lags associated with implementing it. The crowding-out effect arises when the government engages in deficit spending, thereby driving up interest rates. This action can reduce spending on durable goods and business investment. Deficit spending has an expansionary effect on the economy, but this effect can be diminished by offsetting reductions in private spending.
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