12 C H A P T E R FISCAL POLICY

Council of Economic Advisors (CEA) LEGISLATIVE MANDATES Employment Act of 1946 Council of Economic Advisors (CEA) Joint Economic Committee (JEC)

Expansionary Fiscal Policy FISCAL POLICY AND THE AD-AS MODEL Two Options Discretionary Fiscal Policy Non-Discretionary Fiscal Policy Expansionary Fiscal Policy To Reduce Unemployment… Increase Government Spending Tax Reductions Combinations of the Two

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 $490 $510 Real GDP (billions)

FISCAL POLICY AND THE AD-AS MODEL Contractionary Fiscal Policy To Reduce Inflation… Decrease Government Spending Tax Increases Combinations of the Two

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)

FINANCING OF DEFICITS AND DISPOSING OF SURPLUSES Borrowing vs. New Money Borrowing From The Public Money Creation Debt Retirement vs. Idle Surplus Debt Reduction Impounding Which Policy Option? G or T?

BUILT-IN STABILITY Net tax revenues vary directly with GDP Transfer payments behave the opposite way as tax collections Automatic or Built-In Stabilizers Economic Importance

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

BUILT-IN STABILITY Tax Progressivity Progressive Tax System Proportional Tax System Regressive Tax System The more progressive the tax system, the greater the economy’s built-in stability.

FULL-EMPLOYMENT DEFICITS No Change in Fiscal Policy T1 G, and Tax Revenues, T (billions) Government Expenditures, a b $500 475 450 425 G c GDP2 GDP1 (Year 2) (Year 1) Real Domestic Output, GDP

FULL-EMPLOYMENT DEFICITS Discretionary Fiscal Policy Tax Decrease G, and Tax Revenues, T (billions) Government Expenditures, d e $500 475 450 425 G f h g GDP4 GDP3 Year 4 Year 3 Real Domestic Output, GDP

EVALUATING FISCAL POLICY Full-Employment Budget Cyclical Deficit Recent U.S. Deficits & Surpluses Actual Deficit or Surplus Full-Employment Deficit or Surplus Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 -3.9% -4.5% -4.7% -2.9% -2.2% -1.4% -0.3% +0.8% +1.4% +2.4% +1.3% -1.5% -2.1% -2.4% -2.9% -2.8% -2.0% -1.3% -0.9% -0.4% +0.3% +1.1% +0.8% -1.5%

GLOBAL PERSPECTIVE BUDGET DEFICITS OR SURPLUSES AS A PERCENTAGE OF GDP, 2002 -6 -4 -2 0 2 4 Italy Sweden Canada United Kingdom France United States Ireland Norway Japan Source: Organization for Economic Development and Cooperation

PROBLEMS, CRITICISMS, AND COMPLICATIONS Problems of Timing Recognition Lag Administrative Lag Operational Lag Political Considerations Political Business Cycles Offsetting State & Local Finance Crowding-Out Effect

FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION AS Fiscal Policy: No Complications P1 Price level AD1 AD2 $490 $510 Real GDP (billions)

FISCAL POLICY, AGGREGATE SUPPLY AND INFLATION AS Fiscal Policy: Showing Crowding-out Effect or Net Export Effect P1 Price level AD1 AD’2 AD2 $490 $510 $504 Real GDP (billions)

FISCAL POLICY IN THE OPEN ECONOMY Shocks Originating from Abroad Net Export Effect

Forecasting the Future The Leading Indicators Average Workweek Initial Claims for Unemployment Insurance New Orders for Consumer Goods Vendor Performance New Orders for Capital Goods Building Permits for Houses Stock Prices Money Supply Interest-Rate Spread Consumer Expectations

KEY TERMS fiscal policy Employment Act of 1946 Council of Economic Advisers (CEA) expansionary fiscal policy budget deficit contractionary fiscal policy budget surplus built-in stabilizer progressive tax system proportional tax system regressive tax system full-employment budget cyclical deficit political business cycle crowding-out effect net export effect Copyright McGraw-Hill/Irwin, Inc., 2005 BACK END

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