Chapter 12: Fiscal Policy (G)

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 collections—to 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 mandates—The Employment Act of 1946 A. Congress proclaimed government’s role in promoting maximum employment, production, and purchasing power.

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

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).

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: A change in the state of the economy, or A change in discretionary fiscal policy -- that is, through either government spending and/or changes in taxation.

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

Expansionary Fiscal Policy to Promote Full-Employment Goods & Services (real GDP) Price level LRAS AD1 Y F P 1 SRAS1 e1 AD2 SRAS2 P 2 E2 Expansionary fiscal policy stimulates demand and directs the economy to full-employment P 3 E1 Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process. Y F Y F We begin in the short run at Y1, below the economy’s potential capacity (YF). There are 2 routes to long-run full-employment equilibrium: Wait for both lower wages and resource prices to reduce costs (increasing supply to SRAS2). Alternatively, expansionary fiscal policy could stimulate aggregate demand (shift AD1 to AD2) and guide the economy back to E2, at YF.

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

Contractionary Fiscal Policy to Combat Inflation Goods & Services (real GDP) Price level LRAS Y F P 1 SRAS1 AD1 E1 SRAS2 AD2 P 3 E3 Restrictive fiscal policy restrains demand and helps control inflation. P 2 E2 Y F Y F Strong demand such as AD1 will temporarily lead to an output rate beyond the economy’s long-run potential (YF). If maintained, the high level of demand will lead to the long-run equilibrium E3 at a higher price level (as SRAS shifts back to SRAS2). However, contractionary fiscal policy could restrain demand to AD2 and guide the economy to a non-inflationary equilibrium (E2).

Fiscal Policy Choices 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?