Fiscal Policy Notes – AP Macroeconomics

A. Defined: Manipulation of the federal budget to achieve economic stabilization. This means steady economic growth, price stability (low inflation), and low unemployment. Expansionary Fiscal Policy – Used to fight Recession and rising Unemployment:   Options:   1. Increase Government Spending 2. Decrease Taxes 3. Or a combination of both increasing Government Spending and decreasing Taxes (especially if the recession is severe).

The idea here is to stimulate the economy and increase AD, employment, and GDP.

C. Contractionary Fiscal Policy to fight Inflation:. Options:. 1 C. Contractionary Fiscal Policy to fight Inflation:   Options:   1. Decrease Government Spending 2. Increase Taxes 3. Or a combination of both decreasing Government Spending and increasing Taxes (especially if the inflation is severe). The idea here is to slow down the economy and reduce AD without severely affecting employment and GDP (although that can happen)

D. Discretionary Fiscal Policy:. 1 D. Discretionary Fiscal Policy: 1. Defined: Fiscal policy at the discretion or choice of Congress/President. It requires that a law or governmental regulation be passed. 2. Examples: a. Making the Automatic Stabilizers more effective. b. Public Works spending (roads, bridges, dams, etc.) c. Public Transfer Payments such as unemployment benefits. d. Changes in Tax Rates (reducing rates during recession or increasing them during inflation). e. Changes in Government Spending. E. Automatic or Non-Discretionary Fiscal Policy: 1. Defined: Fiscal policy which automatically kicks in without governmental action. All of these provide help to people or a “safety net” under falling AD. 2. Examples a. Personal Income & Social Security Taxes. Collections of these go down during recession and up during inflation to help economic stabilization. b. Personal Savings. Consumers use these funds during recessions.

as people make more income. a. Recessions: c. Credit Availability. Used during recessions by consumers. d. Unemployment Benefits. Go up during recessions. e. The Corporate Profits Tax. No tax on losses. f. Other Transfer Payments. - The more progressive a country’s tax system, the greater an economy’s built-in stability. A progressive tax system increases personal tax rates as people make more income. a. Recessions: During recessions, people make less income, but get a break by paying lower taxes. b. Inflation: If people make more money during inflationary periods, they will pay more taxes, thus preventing the economy from overheating.

F. Why are large budget deficits so bad. 1 F. Why are large budget deficits so bad? 1. Absorbs savings & raises interest rates – “the Crowding Out” Effect.

The “Crowding Out Effect” involves the federal government using deficit spending to increase government spending and get the economy out of a recession. To do this, the government demands more loanable funds (it sells government securities to the public), causing the real interest rate to increase. When the real interest rate increases, investment demand goes down because it is now more expensive for businesses to borrow money to invest in plant and equipment. However, if Expansionary Fiscal Policy is effective, the overall stimulative effect should not be offset by the Crowding Out Effect. G. How to Pay off the Debt: 1. Raise Taxes. To collect more revenue for the government. But, no one likes more taxes. 2. Decrease Government Spending. Decreases the need for debt to pay for spending. But, no one likes their government programs cut. 3. Maintain high economic growth. People like this option. The economic growth would, all things equal, increase business profits and consumer incomes, providing more tax revenue from these sources. (This is what

Donald Trump is banking on this to avoid seriously increasing the national debt as he reduced taxes and increased military spending. He has also discussed a trillion dollar infrastructure spending plan (Good luck!). H. What about a balanced budget amendment? - Problem is it eliminates deficit spending as a stabilization tool. I. Problems with Fiscal Policy: 1. Inside Lag – Time between the beginning of a recession or inflation and the awareness that it is actually happening and to promote solutions to those problems. 2. Outside Lag – Time it takes to implement solutions to the problems. 3. Political Cycle – Fiscal Policy may be corrupted for political purposes. 4. Offsets State/Local Finance.

5. Crowding-Out Effect – However, some economists, like John Maynard Keynes, say that during severe recessions or depressions, deficit spending does not crowd-out. This is because interest rates won’t go up as deficit spending would only absorb idle funds as companies would not invest during severe economic slack times. In fact, the stimulative effect on AD during this time would “Crowd-In” investment spending.

6. Net Export Effect: A. Expansionary Fiscal Policy Net Export Effect: When the federal government uses deficit spending to increase government spending or reduce taxes and get the economy out of a recession. To do this, the government demands more loanable funds (it sells government securities to the public), causing the real interest rate to increase. When the real interest rate increases, foreign money flows into the U.S. to invest in higher interest rate investments, especially government securities. In order to purchase these government securities, foreigners must demand more U.S. dollars, causing the dollar to appreciate as shown below:

After the dollar appreciates, the following happens: a. U. S After the dollar appreciates, the following happens: a. U.S. Exports decrease as its products become more expensive to foreign nations. b. U.S. Imports increase, however, as Americans have more buying power. c. Therefore, since Net Exports or Xn = Exports minus Imports, Xn goes down. d. Finally, as Xn is part of GDPr, then real GDP decreases. However, the stimulative effect of Expansionary policy will only be partially offset by the Net Export Effect. This is because Xn comprises only 5% of the U.S.’s GDPr

B. Contractionary Fiscal Policy Net Export Effect:   When the federal government uses Contractionary Fiscal Policy to fight inflation and decreases government spending or increases taxes to get the economy out of inflation. When this happens, the government demands fewer loanable funds, causing the real interest rate to decrease. When the real interest rate decreases, foreign money doesn’t flow into the U.S. because interest rates, especially those on government securities, are lower. As such, the demand for the U.S. dollar would decrease, causing the dollar to depreciate as shown below:

After the dollar depreciates, the following happens: U.S. Exports increase as its products become less expensive to foreign nations. U.S. Imports decrease, however, as Americans have less power. Therefore, since Net Exports or Xn = Exports minus Imports, Xn goes up. Finally, as Xn is part of GDPr, then real GDP increases. However, the effect Contractionary policy will only be partially offset by the Net Export Effect. This is because Xn comprises only 5% of the U.S.’s GDPr

Budget Deficits, Budget Surpluses, & National Debt 1. Occurs when the Federal Government spends more than it collects in taxes (G > T). 2. To pay for its overspending, the government sells government securities. They offer lower prices on those securities in order to sell them, get the cash, and increase government spending. 3. The U.S. has been running budget deficits of around $1 Trillion per year each year since 2002. 4. When Expansionary Fiscal Policy is used and G increases and/or taxes decrease, the nation moves toward a budget deficit (at the very least).

Budget Surplus: 1. When the Federal Government spends less than it collects in taxes (G < T). 2. The last U.S. budget surplus was in 2001. Balanced Budget: 1. When the government spends exactly what it collects in taxes. 2. If there is a balanced budget and the government increases government spending to conduct Expansionary Fiscal Policy, a budget deficit will occur. D. National Debt: The total of all budget deficits and budget surpluses since the beginning of a nation. (in the U.S. it is now over $20 Trillion).