1. 12
C H A P T E R
FISCAL POLICY

2. INSTRUCTIONAL OBJECTIVES
Distinguish between discretionary and nondiscretionary fiscal policy.
Differentiate between expansionary and contractionary fiscal policy.
Recognize the conditions for recommending an expansionary or contractionary fiscal policy.
Describe the two ways to finance a government budget deficit and how each affects the economy.
Describe the two ways to handle a government budget surplus and how each affects the economy.
Give two examples of how built‑in stabilizers help eliminate recession or inflation.

3. Explain the differential impacts of progressive, proportional, and regressive taxes in terms of stabilization policy.
Explain the significance of the “full-employment budget” concept.
List three timing problems encountered with fiscal policy.
State political problems that limit effective fiscal policy.
Identify actions by households, and by state and local governments that can frustrate fiscal policy.
Explain and recognize graphically how crowding out can reduce the effectiveness of fiscal policy.
Give two examples of complications that may arise when fiscal policy interacts with international trade.
Explain the purpose and structure of the Leading Economic Indicators (Last Word).

4. Fiscal Policy
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 collections—to increase output and employment or to reduce inflation
Discretionary Fiscal Policy (active).
Non-Discretionary Fiscal Policy (passive or automatic).

5. Fiscal Policy and the AD/AS Model
Discretionary fiscal policy (active). refers to the deliberate manipulation of taxes and government spending by the government to alter real domestic output and employment, control inflation, and stimulate economic growth (Fiscal policy goals).
Simplifying assumptions.
Assume initial government purchases don’t depress or stimulate private spending.
2. Assume fiscal policy affects only the demand, not the supply, side of the economy.

6. Fiscal policy choices:
Expansionary fiscal Policy:
Expansionary fiscal policy is used to combat a recession, e.g., if there is a decline in Ig which has decreased AD from AD1 to AD2 so real GDP has fallen and employment has declined.
Possible fiscal policy solutions:
a. An increase in government spending (shifts AD to right by more than change in G due to multiplier),

7. b. A decrease in taxes (raises income, and consumption rises by MPC × change in income; AD shifts to right by a multiple of the change in consumption).
C. A combination of increased spending and reduced taxes.
If the budget was initially balanced, expansionary fiscal policy creates a budget deficit.

8. EXPANSIONARY FISCAL POLICY
the multiplier at work...
$5 billion initial
increase in spending AS
Full $20 billion
increase in
aggregate
demand P1
Price level
AD2
AD1
$ $510
Real GDP (billions)

9. Contractionary fiscal policy:
When demand‑pull inflation occurs (as illustrated by a shift from AD3 to AD4), then contractionary policy is the remedy:
Possible fiscal policy solutions:
A decrease government spending shifts AD to the LHS, once the multiplier process is complete. Here price level returns to its pre-inflationary level but GDP remains at its full-employment level.

10. An increase in taxes will reduce income and then consumption at first by MPC × fall in income, and then multiplier process leads AD to shift leftward still further.
A combined spending decrease and tax increase could have the same effect with the right combination.

11. CONTRACTIONARY FISCAL POLICY
the multiplier at work...
$5 billion initial
decrease in spending AS P2
Full $20 billion
decrease in
aggregate
demand
Price level P1
AD3
AD4
$510 $522
Real GDP (billions)

12. Financing deficits or disposing of surpluses
Deficit Finance:
The method used influences fiscal policy effect. Financing deficits can be done in 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 (investments), and this offsets the government expansion.

13. Money creation: When the Central Bank loans go directly to the government by buying government bonds, the expansionary effect is greater since private investors are not buying bonds (no crowding out). Creating new money is more expansionary but it is inflationary
Note: Monetarists argue that it is the monetary, not fiscal, policy that is having the expansionary effect in such a situation.
How the Government of Kuwait finance its deficit?

14. Disposing of surpluses:
Disposing of surpluses can be handled two ways.
a. Debt reduction is good but may cause interest rates to fall and stimulate spending. This could be inflationary (stimulates interest sensitive spending).
b. Impounding or letting the surplus funds remain idle would have greater anti‑inflationary impact. The government holds surplus tax revenues, which keeps these funds from being spent.

15. What Kuwait is doing with the surplus
What Kuwait is doing with the surplus?, what is the potential impact on AD and equilibrium GDP?
Policy options: G or T?
1. Economists tend to favor higher G during recessions and higher T during inflationary times if they are concerned about unmet social needs or infrastructure.
2. Others tend to favor lower T for recessions and lower G during inflationary periods when they think government is too large and inefficient.

16. Task Government Budget in Kuwait
Go to
Download budget figures
Analyze Revenues and expenditures in Kuwait

17. Built-In Stability
Built‑in stability arises because net taxes (taxes minus transfers and subsidies) change with GDP (recall that taxes reduce incomes and therefore, spending). It is desirable for spending to rise when the economy is slumping and fall when the economy is becoming inflationary.
Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP falls.

18. Transfers and subsidies rise when GDP falls; when these government payments (welfare, unemployment, etc.) rise, net tax revenues fall along with GDP.
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.
Automatic stability reduces instability, but does not correct economic instability.

19. Government Expenditures,
BUILT-IN STABILITY T
Surplus
Government Expenditures,
G, and Tax Revenues, T G
Deficit
GDP1
GDP2
GDP3
Real Domestic Output, GDP

20. GLOBAL PERSPECTIVE BUDGET DEFICITS OR SURPLUSES
AS A PERCENTAGE OF GDP, 2002
Italy
Sweden
Canada
United Kingdom
France
United States
Ireland
Norway
Japan
Source: Organization for Economic Development and Cooperation

21. Problems, Criticisms and Complications
Problems of timing.
Recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence.
Administrative lag is the difficulty in changing policy once the problem has been recognized.
Operational lag is the time elapsed between change in policy and its impact on the economy.

22. During elections: tax cuts and G increases.
For these lags, discretionary fiscal policy has increasingly relied on tax changes rather than on changes in spending as its main tool.
A Political Business Cycle?
Political considerations (re-elections) may swap economic considerations in the conduct of fiscal policy, e.g., manipulation of fiscal policy to maximize voter support, even though actions may destabilize the economy.
During elections: tax cuts and G increases.

23. Economic indicators will be in the right direction, i. e
Economic indicators will be in the right direction, i.e., GDP rises, unemployment falls, and price level is relatively stable.
After elections: a demand pull inflation occurs, and politicians trim G and raise T to restrain inflation. (note next election is 2-3 years ahead)

24. The crowding‑out effect may be caused by fiscal policy
“Crowding‑out” may occur with government deficit spending. It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy.
Criticism of the Crowding-Out Effect
Economists agree that government deficits should not occur at full employment. Full employment deficit is inappropriate when the economy has achieved full employment. It will crowd out private expenditures.

25. Little crowding out will occur during a recession
Little crowding out will occur during a recession. When G increases, it will improve expectations about expected returns and may encourage private investment.
Crowding out may also be offset by increasing money supply to offset demand and thus interest will not change.

26. Fiscal Policy in an Open Economy
Shocks or changes from abroad will cause changes in net exports, which can shift aggregate demand leftward or rightward.
Net Export Effect
Net export effect may reduce effectiveness of fiscal policy.

27. Expansionary Fiscal Policy
Recession slows growth 
expansionary fiscal policy 
higher interest rates 
financial capital from abroad will be attracted (e.g., in the form of deposits in domestic banks); increasing foreign demand for domestic currency 
appreciation of currency 
net exports decline and AD decreases, partially offsetting the expansionary fiscal policy.

28. FISCAL POLICY, AGGREGATE SUPPLY AND INFLATIONAS
Fiscal Policy:
No Complications P1
Price level
AD1
AD2
$ $510
Real GDP (billions)

29. FISCAL POLICY, AGGREGATE SUPPLY AND INFLATIONAS
Fiscal Policy:
Showing
Crowding-out Effect
or Net Export
Effect P1
Price level
AD1
AD’2
AD2
$ $510
$504
Real GDP (billions)

30. Contractionary Fiscal Policy
Inflation
contractionary fiscal policy 
lower interest rates 
financial capital to abroad will be attracted (e.g., in the form of deposits in foreign banks) decreasing foreign demand for domestic currency (or increasing demand for foreign currency) 
depreciation of currency 
net exports decline and AD increases, partially offsetting the contractionary fiscal policy

31. LAST WORD: The Leading Indicators
Indices comprises some variables that have indicated forthcoming changes in real GDP in the past.
The variables consist of a weighted average of economic measurements.
A rise in the index predicts a rise in GDP.
A fall predicts declining GDP.
e.g., in USA: The ten components comprise the index:
1. Average workweek: A decrease signals future GDP decline.

32. 2. Initial claims for unemployment insurance: An increase signals future GDP decline.
3. New orders for consumer goods: A decrease signals GDP decline.
4. Vendor performance: Better performance by suppliers in meeting business demand indicates decline in GDP.
5. New orders for capital goods: A decrease signals GDP decline.
6. Building permits for houses: A decrease signals GDP decline.
7. Stock market prices: Declines signal GDP decline.
8. Money supply: A decrease is associated with falling GDP.

33. 9. Interest-rate spread: when short-term rates rise, there is a smaller spread between short-term and long-term rates which are usually higher. This indicates restrictive monetary policy.
10. Index of consumer expectations: Declines in consumer confidence foreshadow declining GDP.
None of these factors alone is sufficient to predict changes in GDP, but the composite index has correctly predicted business fluctuations many times (although not perfectly). The index is a useful signal, but is not totally reliable.

34. Chapter 13
Money
and
Banking
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