Fiscal Policy 12 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Fiscal Policy Deliberate changes in: Government spending Taxes 2009 Stimulus Package included roughly $550 billion in new spending and $275 billion in tax reductions. Designed to: Achieve full-employment Control inflation Encourage economic growth LO1 30-2

Expansionary Fiscal Policy Used during a recession Increase government spending Decrease taxes Combination of both Creates a deficit LO1 30-3

Expansionary Fiscal Policy Real GDP (billions) Price level AD 2 AD 1 $5 billion increase in spending Full $20 billion increase in aggregate demand AS $490$510 P1P1 LO1 Recessions Decrease AD 30-4 What is the MPC?

Contractionary Fiscal Policy Used during demand-pull inflation Decrease government spending Increase taxes Combination of both Create a surplus LO1 30-5

Contractionary Fiscal Policy Real GDP (billions) Price level AD 1 AD 2 $3 billion initial decrease in spending Full $12 billion decrease in aggregate demand AS $ 522 P2P2 AD 3 $ 510 b a P1P1 c LO1 30-6

Policy Options: G or T? To expand the size of government If recession, then increase government spending If inflation, then increase taxes To reduce the size of government If recession, then decrease taxes If inflation, then decrease government spending LO1 30-7

Built-In Stability Automatic stabilizers Taxes vary directly with GDP Transfer payments vary inversely with GDP Reduces severity of business fluctuations Progressive tax system LO2 30-8

Built-In Stabilizers G T Deficit Surplus GDP 1 GDP 2 GDP 3 Real domestic output, GDP Government expenditures, G, and tax revenues, T LO Note: The red line, indicating govt. expenditures, should actually slope downward. Why?

Evaluating Fiscal Policy Is the fiscal policy… Expansionary? Neutral? Contractionary? Use the cyclically adjusted budget to evaluate LO

Cyclically Adjusted Budgets G T GDP 2 GDP 1 Real domestic output, GDP Government expenditures, G, and tax revenues, T (billions) (year 2)(year 1) $ a b c LO

Cyclically Adjusted Budgets G T1T1 GDP 4 GDP 3 Real domestic output, GDP Government expenditures, G, and tax revenues, T (billions) (year 4)(year 3) $ d e f g T2T2 h LO

Recent U.S. Fiscal Policy Federal Deficits (-) and Surpluses (+) as Percentages of GDP, (1) Year (2) Actual Deficit – or Surplus + (3) Cyclically Adjusted Deficit – or Surplus +* As a percentage of potential GDP Source: Congressional Budget Office, LO

Fiscal Policy: The Great Recession Financial market problems began in 2007 Credit market freeze Pessimism spreads to the overall economy Recession officially began December 2007 and lasted 18 months LO

Budget Deficits and Projections Source: Congressional Budget Office, $ Budget Deficit (-) or Surplus, Billions Actual Projected LO

Global Perspective LO

Problems, Criticisms, & Complications Problems of Timing Recognition lag Administrative lag Operational lag Political business cycles Future policy reversals Off-setting state and local finance Crowding-out effect LO

Current Thinking on Fiscal Policy Let the Federal Reserve handle short- term fluctuations Fiscal policy should be evaluated in terms of long-term effects Use tax cuts to enhance work effort, investment, and innovation Use government spending on public capital projects LO

The U.S. Public Debt $11.9 trillion in 2009 The accumulation of years of federal deficits and surpluses Owed to the holders of U.S. securities Treasury bills Treasury notes Treasury bonds U.S. savings bonds LO

The U.S. Public Debt LO4 Debt held outside the Federal government and the Federal Reserve: 57% Debt held by the Federal government and the Federal Reserve: 43% 30-20

The U.S. Public Debt LO

Global Perspective Public Sector Debt as Percentage of GDP, 2009 Italy Japan Greece Belgium France United States France Germany United Kingdom Spain Netherlands Canada Source: Organization for Economic Cooperation and Development, OECD LO

The U.S. Public Debt Interest charges on debt Largest burden of the debt 1.3% of GDP in 2009 False Concerns Bankruptcy Refinancing Taxation Burdening future generations LO

Substantive Issues Income distribution Incentives Foreign-owned public debt Crowding-out effect revisited Future generations Public investment LO

Crowding-Out Effect Real interest rate (percent) Investment (billions of dollars) ID 1 ID 2 a bc Increase in investment demand Crowding-out effect LO This diagram demonstrates the “crowding out” effect. However, most economists believe that increased AD will spur businesses to new investment (increase investment demand) if the economy is not at full employment.

Social Security, Medicare Shortfalls More Americans will be receiving benefits as they age Social security shortfalls Income during retirement Funds will be depleted by 2037 Medicare shortfalls Medical care during retirement Funds will be depleted by

Social Security, Medicare Shortfalls Possible options “to fix” include: Increasing the retirement age Increasing the portion of earnings subject to the social security tax Disqualifying wealthy individuals Redirecting low-skilled immigrants to higher-skilled, higher paying work Defined contribution plans owned by individuals 30-27