Lecture #16: Fiscal Policy

2 types of Fiscal Policy

• Fiscal policy deals w/changes the gov’t makes in spending or taxation to achieve particular economics goals.

1. Expansionary FP is an increase in gov’t spending or a reduction in taxes

2. Contractionary FP is a decrease in gov’t spending or an increase in taxes

Remember when taking

Cornell Notes you need to come up

with at least 3 questions per page!

Fiscal Policy (FP)

Type of fiscal policy

Change in government

spending

Change in taxes

Expansionary And/Or

Contractionary And/Or

Types of Fiscal Policy

Expansionary FP

Problem--unemployment

• Gov’t can use expansionary FP to decrease the unemployment rate

• A high unemployment rate b/c people aren’t spending enough money in the economy

• If govt increases spending and/or reduces taxes, consumers have more money to spend

• An increase in govt spending means more spending in the economy

• When businesses sell more goods—they need to hire more workers = unemployment goes down!

Fiscal Policy (FP) cont

Crowding Out

• Not all economists agree that it is that easy to lower the unemployment rate

• Crowding Out = occurs when increases in govt spending lead to reductions in private spending

• If govt spends more on education, people may decide to spend less on private school

Fiscal Policy (FP) cont

Crowding Out cont

• Complete Crowding Out = when increased spending in the govt exactly equals reduced spending by citizens.

• Incomplete Crowding Out = when the reduction in consumer spending is less than the increase in govt spending

• Total spending in the economy increases

Fiscal Policy (FP) cont

Effects of Expansionary Fiscal Policy

Total output in the economyHigh outputLow output

High prices

Low prices

Pric

e le

vel

Aggregate supply

Original aggregate demand

Lower output, lower prices

Higher output, higher prices

Aggregate demand with higher government spending

Expansionary Fiscal PoliciesIncreasing Government Spending If the federal govt increases its spending or

buys more goods & services, it triggers a chain of events that raise output & creates jobs.

Cutting Taxes When the govt cuts taxes, consumers &

businesses have more money to spend or invest. This increases demand & output.

Contractionary FP

Problem--Inflation

• Inflation is the result of too much spending in the economy compared w/the quantity of goods & services available for purchase

• The govt can slow inflation by reducing the amount it spends

• As a result of the decrease in spending, firms sell fewer goods—to reduce unwanted inventory they lower prices!

Fiscal Policy (FP) cont

Crowding IN

• Crowding in—occurs when decreases in govt spending lead to increases in private spending

• Crowding in can be complete or incomplete

• Complete crowding is also called zero crowding in

Fiscal Policy (FP) cont

Effects of Contractionary Fiscal Policy

Total output in the economyHigh outputLow output

High prices

Low prices

Pric

e le

vel

Aggregate supply

Higher output, higher prices

Original aggregate demandLower output,

lower prices

Aggregate demand with lower government spending

Contractionary Fiscal PoliciesDecreasing Government Spending If the federal govt spends less, or buys fewer

goods & services, it triggers a chain of events that may lead to slower GDP growth.

Raising Taxes If the federal govt increases taxes, consumers &

businesses have fewer dollars to spend or save. This also slows growth of GDP.

The Effectiveness of Fiscal Policy

Objective Policy Condition existing

Does the policy affect

total spending in the

economy?

Does the policy meet the objective (as stated in the 1st

column)?

Reduce unemploymen

t

Expansionary fiscal policy

(as measured by an

increase in govt

spending)

No crowding out YES YES

Complete crowding out NO NO

Incomplete Crowding

outYES YES

Reduce inflation

Contractionary fiscal policy (as measured

by an decrease in

govt spending)

No crowding in YES YES

Complete crowding in NO NO

Incomplete Crowding in YES YES

FP & Taxes • After-tax income = part of income that is left over after taxes are paid

• If govt lowers taxes—more money is available from earnings & total spending increases

• Leads to increased sales & hiring—reducing the unemployment rate.

Fiscal Policy (FP) cont

FP &

Taxes

• If govt raises taxes— the opposite occurs.

• After-tax income is reduced—decreasing spending & causing unemployment to increase.

Fiscal Policy (FP) cont

FP &

Taxes

• People are more willing to work when taxes are lower

• If taxes were 100% of earnings—there would be no incentive to work

• Lower tax rates do not necessarily result in lower tax revenues for the govt.

• Lower taxes will likely give incentive to work more = more spending = more tax revenue for the govt!

Fiscal Policy (FP) cont

Laffer Curve

• The Laffer curve, named after economist Arthur Laffer, shows the relationship between tax rates & tax revenues

• As tax rates rise from zero—tax revenues rise—reach a maximum—and then fall.

Fiscal Policy (FP) cont

Laffer Curve

High revenues

Low revenues

100% High taxes

0%Low taxes

50%Ta

x re

venu

es

Tax rate

a

b

c

Supply-Side Economics Supply-side economics stresses the

influence of taxation on the economy. Supply-siders believe that taxes have a strong, negative influence on output.

The Laffer curve shows how both high and low tax revenues can produce the same tax revenues.

Review—True or False1. If government spending is increased and taxes are increased,

it is expansionary fiscal policy. FALSE

2. Expansionary fiscal policy brings up the issue of crowding out. TRUE

3. If the inflation rate is high, government may implement contractionary fiscal policy. TRUE

4. Incomplete crowding in will make contractionary fiscal policy ineffective. FALSE

5. Tax cuts always lead to lower tax revenues. FALSE

Summary

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