1. ECON 521 Special Topics in Economic Policy CHAPTER FOUR Fiscal Policy and the Budget

2. I. Overview The government is to stable the economy. Stabilization is through Government intervention role by manipulating the public budget to increase output and employment or reduce inflation. Fiscal Policy – the government changing its budget position (G - T) in order to stabilize the economy. Fiscal Policy, by its nature, alters the Budget

3. Example; The US Federal Budget: 2003 (Billions of Dollars) Tax Revenues$1974.8 Gov. Expenditure$2381.3 Federal Budget -$406.5 Note: Source: Economic Indicators, October 2005.

4. II. The Budget and The Budget Position Budget = T - G Budget Position (or size of deficit) = G – T Budget < 0 -- Budget Deficit Budget > 0 -- Budget Surplus Budget = 0 -- Balanced Budget Realistic Goal -- Balanced Budget when Y = Y N

5. The National Debt – - The total accumulated stock of debt owed by the government to its lenders (holders of government bonds). - Expanded by budget deficits, reduced by budget surpluses. - Debt-Income Ratio = (National Debt)/(GDP) Example; For the US in 2004 = ( $4295.5)/($11734.3) = 0.366 For the US in 2010 =

6. The Income Tax and the Budget Y*   Tax Revenues   T   (T - G)  A strong and growing economy improves the budget. Y*   Tax Revenues   T   (T - G)  A weak economy generates a lower budget.

7. The Income Tax and Automatic Stabilization Automatic Stabilization -- due to the income tax system, tax revenues change in directions that help to stabilize the economy, without any change in the tax structure (i.e. fiscal policy).

8. III. Fiscal Policy Implications (1)Strategy of Fiscal Policy Expansionary policies seek to induce more purchasing of goods and services by increasing (G - T) -- i.e. G  or T . Contractionary policies seek to induce less purchasing of goods and services by decreasing (G - T) -- i.e. G  or T .

9. (2) Fiscal Policy in the AD-AS Model Expansionary Fiscal Policy shifts the AD curve rightward, increases Y* and P*. Contractionary Fiscal Policy shifts the AD curve leftward, decreases Y* and P*.

10. (3) Fiscal Policy Options Policy options: G or T? -Economists tend to favor higher G during recessions and higher taxes during inflationary times if they are concerned about unmet social needs or infrastructure. -Others tend to favor lower T for recessions and lower G during inflationary periods when they think government is too large and inefficient.

11. IV. Automatic Stabilization Y*  (maybe > Y N )  Tax Revenues  helps to cool the economy Y*  (maybe < Y N )  Tax Revenues  helps to stimulate the economy Note -- all this takes place without any change in the tax structure, as prescribed by fiscal policy.

12. As a result; The size of automatic stability depends on responsiveness of changes in taxes to changes in GDP: The more progressive the tax system, the greater the economy’s built ‑ in stability. In Figure 1 line T is steepest with a progressive tax system. The U.S. tax system reduces business fluctuations by as much as 8 to 10 percent of the change in GDP that would otherwise occur. Automatic stability reduces instability, but does not eliminate economic instability.

13. Figure 1; Built-In Stability G T Deficit Surplus GDP 1 GDP 2 GDP 3 Real Domestic Output, GDP Government Expenses, G and Tax Revenues, T

14. V. Obstacles to Fiscal Policy Effectiveness Difficulties in getting the proper policy passed through General Assembly. A tax cut that isn’t used for spending. AD curve does not shift rightward, no change in Y*. Worries about the Budget within a sluggish economy. Time lag between changing the policy and its impact on the economy

15. VI. Other Complication to Fiscal Policy Effectiveness (1)The Crowding Out Effect -- An Adverse “Side Effect” The Crowding Out Effect -- Expansionary fiscal policy creates an increased need for more borrowing by the government. This financing increases the demand for financial capital. As a result, long-term interest rates (r*) rise and Investment (I*) decreases.

16. (2)The Crowding Out Effect -- Fiscal Policy Effectiveness Crowding Out Effect -- makes fiscal policy less effective than would be otherwise. Decrease in investment to some extent offsets rise in (G - T). Smaller shift in AD curve than would be without the crowding out effect.

17. (3)The Crowding Out Effect – Impeding Economic Growth Crowding Out Effect  loss of Investment (I). Decrease in Investment retards the buildup of the capital stock and possible implementation of new technology (i.e. Labor Productivity growth). Smaller shifts in LAS curve, smaller increases in Y N.

18. NOTE; Ways to Avoid the Crowding Out Effect Bottom line -- get the supply of financial capital to shift rightward at the same time as when expansionary fiscal policy occurs.