Chapter 12: Fiscal Policy Major function of government is to stabilize the economy Prevent unemployment & Inflation Stabilization can be achieved by manipulating public budget to increase output, employment or reduce inflation Government Spending Tax Collections

Fiscal Policy & the AD – AS Model Discretionary Fiscal Policy: Deliberate manipulation of Taxes & Gov’t Spending by Congress to alter real domestic output & employment, control inflation, & stimulate economic growth Discretionary means the changes are optional for Federal gov’t

Simplifying Assumptions Assume Initial Gov’t Purchases DO NOT depress or stimulate Private Spending Assume Fiscal Policy affect ONLY demand, not supply side of the economy

Fiscal Policy Choices 1. Expansionary Fiscal Policy 2. Contractionary Fiscal Policy

Expansionary Fiscal Policy Used to combat Recession Eg, Decline in Investment decreased AD  Real GDP & Employment fell Possible Solutions: Increase Government Spending Decrease Taxes Combination of Increased Gov’t Spending & Reduced Taxes

Contractionary Fiscal Policy Used to combat Inflation Eg, Increase in Investment or Net Exports increased AD  Prices rose Possible Solutions: Decrease Government Spending Increase Taxes Combination of Decreased Gov’t Spending & Higher Taxes

Financing Deficits 1. Borrowing: Gov’t competes w/ private borrowers for funds & drive up interest rates, “crowding out” private borrowing, offsets the gov’t expansion 2. Money creation: When the Federal Reserve loans directly to the Gov’t by buying bonds, expansionary effect is greater since private investors are not buying bonds

Disposing of Surpluses Debt Reduction is good but may cause interest rates to fall and stimulate spending  inflationary Impounding or letting the surplus funds remain idle would have greater anti- inflationary impact. Gov’t holds these tax revenues, keeps funds from being spent

Policy Options: G or T? Economists favor higher G during recessions & higher taxes during inflationary times if they are concerned with unmet social needs or infrastructure Other economists favor lowering T for recessions & lower G during inflationary periods when they think government is too large & inefficient

Problems, Criticisms, & Complications Timing Recognition Lag: Time between beginning of recession / inflation & awareness Administrative Lag: Reflects difficulties in changing policies Operational Lag: Time between policy change & impact on the economy

Political Considerations Political Business Cycle: Election years have been characterized by more expansionary policies regardless of economic conditions State & Local Finance policies may offset federal stabilization efforts “Crowding – out” may occur w/ gov’t deficit spending: increased interest rate, reduces private spending, weakening/canceling the stimulus of fiscal policy

Last Word: The Leading Indicators Index comprises 10 variables that have indicated changes in Real GDP: Average Workweek Initial Claims for Unemployment New Orders for Consumer Goods Vendor Performance New Orders for Capital Goods Building Permits for Houses Stock Market Prices Money Supply Interest Rate Spread Index of Consumer Expectations