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LEGISLATIVE MANDATES
Employment Act of 1946
Council of Economic
Advisors (CEA)
Joint Economic
Committee (JEC)
FISCAL POLICY AND THE AD-AS MODEL
Two Options• Discretionary Fiscal Policy • Non-Discretionary Fiscal
PolicyExpansionary Fiscal PolicyTo Reduce Unemployment…• Increase Government
Spending• Tax Reductions• Combinations of the Two
Pri
ce le
vel
Real GDP (billions)
EXPANSIONARY FISCAL POLICY
Full $20 billionincrease in aggregatedemand
AD2 AD1
$5 billion initialincrease in spending
the multiplier at work...
P1
$490 $510
AS
To Reduce Inflation…• Decrease Government
Spending• Tax Increases• Combinations of the
Two
FISCAL POLICY AND THE AD-AS MODEL
Contractionary Fiscal Policy
Pri
ce le
vel
Real GDP (billions)
CONTRACTIONARY FISCAL POLICY
Full $20 billiondecrease in aggregatedemand
AD3 AD4
$5 billion initialdecrease in spending
the multiplier at work...
P2
$510 $522
AS
P1
FINANCING OF DEFICITS ANDDISPOSING OF SURPLUSES
•Borrowing vs. New Money•Borrowing From The Public•Money Creation
•Debt Retirement vs. Idle Surplus•Debt Reduction•Impounding
Which Policy Option? G or T?
BUILT-IN STABILITYNet tax revenues vary
directly with GDPTransfer payments behave
the opposite way as tax collections
Automatic or Built-In Stabilizers
Economic Importance
BUILT-IN STABILITY
GDP1 GDP2 GDP3
Real Domestic Output, GDP
Gov
ern
men
t E
xpen
dit
ure
s,G
, an
d T
ax R
even
ues
, T
Deficit
Surplus
T
G
BUILT-IN STABILITY
Tax Progressivity• Progressive Tax System• Proportional Tax System• Regressive Tax System
The more progressive the tax system, the greater the economy’s built-in stability.
FULL-EMPLOYMENT DEFICITS
GDP2 GDP1
Real Domestic Output, GDP
Gov
ernm
ent
Exp
endi
ture
s,G
, and
Tax
Rev
enue
s, T
(bi
llio
ns)
G
T1
(Year 1)(Year 2)
ab
c$500 475 450 425
No Change inFiscal Policy
FULL-EMPLOYMENT DEFICITS
GDP4 GDP3
Real Domestic Output, GDP
Gov
ernm
ent
Exp
endi
ture
s,G
, and
Tax
Rev
enue
s, T
(bi
llio
ns) T2
G
T1
Year 3Year 4
de
f$500 475 450 425
DiscretionaryFiscal PolicyTax Decrease
h
g
EVALUATING FISCAL POLICYFull-Employment BudgetCyclical DeficitRecent U.S. Deficits & Surpluses
Year
ActualDeficit orSurplus
Full-EmploymentDeficit orSurplus
1990199119921993199419951996199719981999200020012002
-3.9%-4.5%-4.7%-3.9%-2.9%-2.2%-1.4%-0.3%+0.8%+1.4%+2.4%+1.3%-1.5%
-2.1%-2.4%-2.9%-2.8%-2.1%-2.0%-1.3%-0.9%-0.4%+0.3%+1.1%+0.8%-1.5%
-6 -4 -2 0 2 4
Italy
Sweden
Canada
United Kingdom
France
United States
Ireland
Norway
Japan
GLOBAL PERSPECTIVEBUDGET DEFICITS OR SURPLUSESAS A PERCENTAGE OF GDP, 2002
Source: Organization for Economic Development and Cooperation
PROBLEMS, CRITICISMS,AND COMPLICATIONS
•Problems of Timing•Recognition Lag•Administrative Lag•Operational Lag
•Political Considerations•Political Business Cycles
•Offsetting State & Local Finance•Crowding-Out Effect
FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION
Fiscal Policy:No Complications
Pri
ce le
vel
Real GDP (billions)
AD1 AD2
P1
$490 $510
AS
FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION
Fiscal Policy:ShowingCrowding-out Effector Net ExportEffectP
rice
leve
l
Real GDP (billions)
AD1 AD2
P1
$490 $510
AS
AD’2
$504
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