Fiscal Policy

12

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Fiscal Policy

• Deliberate changes in:

• Government spending

• Taxes

• 2009 Stimulus Package included roughly $550 billion in new spending and $275 billion in tax reductions.

• Designed to:

• Achieve full-employment

• Control inflation

• Encourage economic growthLO1 30-2

Expansionary Fiscal Policy

• Used during a recession

• Increase government spending

• Decrease taxes

• Combination of both

• Creates a deficit

LO1 30-3

Expansionary Fiscal Policy

Real GDP (billions)

Pri

ce l

evel

AD2

AD1

$5 billion increase inspending

Full $20 billion increase inaggregate demand

AS

$490 $510

P1

LO1

RecessionsDecrease AD

30-4

What is the MPC?

Contractionary Fiscal Policy

• Used during demand-pull inflation

• Decrease government spending

• Increase taxes

• Combination of both

• Create a surplus

LO1 30-5

Contractionary Fiscal Policy

Real GDP (billions)

Pri

ce l

evel

AD1

AD2

$3 billion initialdecrease inspending

Full $12 billion decrease inaggregate demand

AS

$522

P2

AD3

$510

b

aP1

c

LO1 30-6

Policy Options: G or T?

• To expand the size of government

• If recession, then increase government spending

• If inflation, then increase taxes• To reduce the size of government

• If recession, then decrease taxes

• If inflation, then decrease government spending

LO1 30-7

Built-In Stability• Automatic stabilizers

• Taxes vary directly with GDP

• Transfer payments vary inversely with GDP

• Reduces severity of business fluctuations• Progressive tax system

LO2 30-8

Built-In Stabilizers

G

T

Deficit

Surplus

GDP1 GDP2 GDP3Real domestic output, GDP

Go

vern

men

t ex

pen

dit

ure

s, G

,an

d t

ax r

even

ues

, T

LO2 30-9

Note: The red line, indicating govt. expenditures, should actually slope downward. Why?

Recent U.S. Fiscal PolicyFederal Deficits (-) and Surpluses (+) as Percentages of GDP, 2000-2009

(1)Year

(2)Actual

Deficit – orSurplus +

(3)CyclicallyAdjusted

Deficit – orSurplus +*

2000 +2.4 +1.1

2001 +1.3 +0.5

2002 -1.5 -1.3

2003 -3.4 -2.7

2004 -3.5 -3.2

2005 -2.6 -2.5

2006 -1.9 -2.0

2007 -1.2 -1.2

2008 -3.2 -2.8

2009 -9.9 -7.3

• As a percentage of potential GDPSource: Congressional Budget Office, http://www.cbo.gov.

LO3 30-13

Budget Deficits and Projections

Source: Congressional Budget Office, http://www.cbo.gov.

$200

0

-200

-400

-600

-800

-1000

-1200

-1400

-1600

Bu

dg

et D

efic

it (

-) o

r S

urp

lus,

Bill

ion

s

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

ActualProjected

LO4 30-15

Global Perspective

LO4 30-16

The U.S. Public Debt

LO4

Debt held outsidethe Federal government and theFederal Reserve:57%

Debt held bythe Federal government and the Federal Reserve:43%

30-20

Crowding-Out Effect

5 10 15 20 25 30 35 400

2

4

6

8

10

12

14

16R

eal

inte

rest

rat

e (p

erce

nt)

Investment (billions of dollars)

ID1

ID2

a

b c

Increase ininvestmentdemand

Crowding-out effect

LO4 30-25

This diagram demonstrates the “crowding out” effect.

However, most economists believe that increased AD will spur businesses to new investment (increase investment demand) if the economy is not at full employment.