McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 11 Fiscal Policy

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Outline NONDISCRETIONARY AND DISCRETIONARY FISCAL POLICY USING FISCAL POLICY TO COUNTERACT “SHOCKS” EVALUATING FISCAL POLICY

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Fiscal Policy Fiscal Policy is the purposeful movement in government spending or tax policy designed to direct an economy Discretionary Fiscal Policy: government spending and tax changes enacted at the time of the problem to alter the economy Nondiscretionary Fiscal Policy: that set of policies that are built into the system to stabilize the economy

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. How Nondiscretionary Fiscal Policy Works Nondiscretionary fiscal policy consists of policies that are built into the system so that an expansionary or contractionary stimulus can be given automatically. The welfare state and the progressive income tax serve as the built-in policies. –If the economy is in recession, those who lose their jobs are granted unemployment and welfare benefits and they owe less in taxes. –If the economy is growing at an unsustainable rate, people are making a lot of money and are faced with higher tax rates and there are fewer people eligible for government benefits.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. How Discretionary Fiscal Policy Works If we are in a recession the fiscal policy to stimulate the economy would consist of –Increases in government spending –Decreases in taxes If we are in an inflationary period the fiscal policy to contract the economy would consist of –Decreases in government spending –Increases in taxes

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Expansionary Fiscal Policy AS AD RGDP PI RGDP* PI* AD’ RGDP’ PI’

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Contractionary Fiscal Policy AS AD RGDP PI PI* RGDP* AD’ PI’ RGDP’

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Shocks A Shock is any unanticipated economic event. –Aggregate Demand Shock: an unexpected event which causes aggregate demand to increase or decrease, e.g. the Sept 11, 2001 terrorist attacks. –Aggregate Supply Shock: an unexpected event which causes aggregate supply to increase or decrease, e.g. Iraq’s 1990 invasion of Kuwait and threat to Saudi Arabia.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Nondiscretionary and Discretionary Fiscal Policy Combats a Recession AS PI RGDP AD 1 RGDP* PI* AD 2 Shock AD 3 DFP NDFP

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Nondiscretionary and Discretionary Fiscal Policy Combats an Overheated Economy AS PI RGDP AD 1 RGDP* PI* AD 2 Shock AD 3 NDFP DFP

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Evaluating Nondiscretionary Fiscal Policy Most economists believe that the built-in stabilizers have had a modestly positive effect on diminishing the severity of modern recessions.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Mistiming of Discretionary Fiscal Policy Recognition Lag: the time it takes to measure the state of the economy Administrative Lag: the time it takes for Congress to agree on a course of action with the president Operational Lag: the time it takes for the full impact of a government program or tax change to have its effect on the economy

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Political Problems with Fiscal Policy Expansionary bias is the problem where politicians are more willing to deal with recessions with tax cuts and spending increases than they are to deal with inflationary pressures with tax increases and spending cuts. The Political Business Cycle suggests that politically motivated fiscal policy is used for short term gain just prior to elections

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. The Rise, Fall and Rebirth of Discretionary Fiscal Policy Between 1975 and 2001 fiscal policy was pretty much abandoned as a mechanism for controlling the economy. Monetary policy was used to expand or contract prices and GDP. In 2001, the impending recession motivated tax rebates and the Sept. 11 attacks motivated a variety of tax cut and spending increase ideas in Congress.  In 2003, the continuing slow growth motivated a renewal of the tax credit rebate idea.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Growth Rates by Presidential Terms FirstSecondThirdFourth Truman-1.6%13.4%5.1%5.3% Eisenhower I0.4%2.7%6.5%1.9% Eisenhower II0.3%2.3%5.1%0.6% Kennedy/Johnson6.3%4.1%5.2%5.1% Johnson8.5%4.4%2.3%5.0% Nixon I1.9%-0.1%4.4%7.2% Nixon II/ Ford4.0%-2.1%2.6%4.6% Carter5.0%6.6%1.4%-0.1% Reagan I1.2%-1.6%7.6%5.6% Reagan II4.0%2.8%4.4%3.7% Bush GHW2.6%0.5%0.9%4.0% Clinton I2.5%4.1%2.2%4.1% Clinton II4.3%4.6%5.0%4.1% Bush GW0.3%2.4% Average2.8%3.2%4.0%3.9%

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Kick it Up a Notch Aggregate Supply Shocks

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Nondiscretionary and Discretionary Fiscal in the Wake of a Negative Aggregate Supply Shock AS 1 PI RGDP AD 1 RGDP* PI* Shock AS 2 AD 2 NDFP AD 3 DFP

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. AS 1 PI RGDP AD 1 RGDP* PI* Nondiscretionary and Discretionary Fiscal in the Wake of a Positive Aggregate Supply Shock ShockAS 2 AD 2 NDFP