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Chapter 12: Fiscal Policy (G). Role of Government Spending One major function of the government is to stabilize the economy (prevent unemployment or inflation).

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Presentation on theme: "Chapter 12: Fiscal Policy (G). Role of Government Spending One major function of the government is to stabilize the economy (prevent unemployment or inflation)."— Presentation transcript:

1 Chapter 12: Fiscal Policy (G)

2 Role of Government Spending One major function of the government is to stabilize the economy (prevent unemployment or inflation). Stabilization can be achieved in part by manipulating the public budget government spending and tax collectionsto increase output and employment or to reduce inflation. Discretionary fiscal policy refers to the deliberate manipulation of taxes and government spending by Congress to alter real domestic output and employment, control inflation, and stimulate economic growth. Discretionary means the changes are at the option of the Federal government. Legislative mandatesThe Employment Act of 1946 A.Congress proclaimed governments role in promoting maximum employment, production, and purchasing power.

3 Budget Deficits and Surpluses Budget deficit: -- Present when total government spending exceeds total revenue. n When the money supply is constant, deficits must be covered with borrowing. n The U.S. Treasury borrows funds by issuing bonds. Budget surplus: -- Present when total government spending exceeds total revenue. n Surpluses reduce the size of the governments outstanding debt.

4 Financing Deficits Two ways: a.Borrowing: the government competes with private borrowers for funds and could drive up interest rates; the government may crowd out private borrowing, and this offsets the government expansion. b. Money Creation : when the Federal Reserve loans money directly to the government by buying bonds (no crowding out since private investors are not buying bonds).

5 Budget Deficits and Surpluses Changes in the size of the federal deficit or surplus are often used to gauge whether fiscal policy is adding additional demand stimulus or imposing additional demand restraint. Changes in the size of the budget deficit or surplus may arise from either: n A change in the state of the economy, or n A change in discretionary fiscal policy -- that is, through either government spending and/or changes in taxation.

6 The Keynesian View of Fiscal Policy n Keynesian theory highlights the potential of fiscal policy as a tool capable of reducing fluctuations in demand. n When an economy is operating below its potential output, the Keynesian model suggests that the government should institute expansionary fiscal policy: n increase the governments purchases of goods & services, and/or n cut taxes.

7 G oods & S ervices (real GDP) P rice level LRAS AD 1 Y F P 1 Y 1 SRAS 1 Y F e1e1 P 3 We begin in the short run at Y 1, below the economys potential capacity (Y F ). There are 2 routes to long-run full-employment equilibrium: Wait for both lower wages and resource prices to reduce costs (increasing supply to SRAS 2 ). P 2 Expansionary Fiscal Policy to Promote Full-Employment Alternatively, expansionary fiscal policy could stimulate aggregate demand (shift AD 1 to AD 2 ) and guide the economy back to E 2, at Y F. SRAS 2 Expansionary fiscal policy stimulates demand and directs the economy to full-employment AD 2 Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process. E1E1 E2E2 Y F Y F

8 The Keynesian View of Fiscal Policy n When inflation is a potential problem, the Keynesian analysis suggests a shift toward a more restrictive (contractionary) fiscal policy: n reduce government spending or raise taxes Keynesians challenged the view that the government should always balance its budget.

9 G oods & S ervices (real GDP) P rice level LRAS Y F P 1 Y 1 SRAS 1 AD 1 E1E1 P 2 Strong demand such as AD 1 will temporarily lead to an output rate beyond the economys long-run potential (Y F ). If maintained, the high level of demand will lead to the long-run equilibrium E 3 at a higher price level (as SRAS shifts back to SRAS 2 ). P 3 Contractionary Fiscal Policy to Combat Inflation However, contractionary fiscal policy could restrain demand to AD 2 and guide the economy to a non-inflationary equilibrium (E 2 ). SRAS 2 Y F Restrictive fiscal policy restrains demand and helps control inflation. AD 2 E3E3 E2E2 Y F

10 Fiscal Policy Choices 1.What type of fiscal policy is used to combat a recession? Expansionary fiscal policy (increase government spending and/or decrease taxes) 2. To combat demand pull inflation? Contractionary fiscal policy (increase taxes and/or decrease government spending) 3.What could happen with both a spending decrease and tax increase?


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