Fiscal policy involves discretionary changes to government spending and taxes to achieve economic goals like high employment, price stability, and economic growth. An increase in spending or tax cut expands aggregate demand, while a spending cut or tax increase contracts it. However, fiscal policy faces offsets like crowding out private investment. It also has long and variable time lags making timely responses difficult. Automatic stabilizers like unemployment insurance partially offset downturns. While fiscal policy may be ineffective in normal times, it can boost demand during severe downturns like the Great Depression.

1. 1
Chapter 13: Fiscal Policy
End of
Chapter 10
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ECON 151 – PRINCIPLES OF MACROECONOMICS
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2. Discretionary Fiscal Policy
 Discretionary Fiscal Policy
 The discretionary changes in government
expenditures and/or taxes in order to achieve certain
national economic goals is the realm of fiscal policy.
 High employment (low unemployment)
 Price stability
 Economic growth
 Improvement of international payments balance

3. Discretionary Fiscal Policy
(cont'd)
 Fiscal Policy
The discretionary changing of government
expenditures or taxes to achieve national
economic goals, such as high employment
with price stability

4. Discretionary Fiscal Policy
(cont'd)
 An increase in government spending will
stimulate economic activity
 Changes in government spending
Military spending
Education spending
Budgets for government agencies

5. Figure 13-1 Expansionary and
Contractionary Fiscal Policy: Changes in
Government Spending, Panel (a)
If there is a recessionary gap
in panel (a), fiscal policy can
presumably increase
aggregate demand

6. Figure 13-1 Expansionary and
Contractionary Fiscal Policy: Changes in
Government Spending, Panel (b)
If there is an inflationary gap,
fiscal policy can presumably
decrease aggregate demand

7. Figure 13-2 Contractionary and
Expansionary Fiscal Policy: Changes
in Taxes, Panel (a)
• In panel (a), the economy is
initially at E1, where real GDP
exceeds long-run equilibrium
• Contractionary fiscal policy can
move aggregate demand to
AD2 via a tax increase
• A new equilibrium is at E2 at a
lower price level
• Real GDP is now consistent
with LRAS

8. Figure 13-2 Contractionary and
Expansionary Fiscal Policy: Changes
in Taxes, Panel (b)
• In panel (b) with a
recessionary gap (in this case
$500 billion) taxes are cut
• AD1 moves to AD2
• The economy moves from E1
to E2, and real GDP is now at
$12 trillion per year
• We are at the long-run
equilibrium level

9. Discretionary Fiscal Policy
(cont'd)
 Change in taxes
A rise in taxes causes a reduction in
aggregate demand because it can reduce
consumption spending, investment
expenditures, and net exports.

10. Possible Offsets to Fiscal Policy
 Fiscal policy does not operate in a vacuum
and important questions must be
answered.
How are expenditures financed and
by whom?
If taxes are increased what does government
do with the taxes?
What will happen if individuals worry about
increases in future taxes?

11. Possible Offsets
to Fiscal Policy (cont'd)
 Crowding-Out Effect
The tendency of expansionary fiscal policy to
cause a decrease in planned investment or
planned consumption in the private sector;
this decrease normally results from the rise of
interest rates.

12. Figure 13-3 The Crowding-Out
Effect, Step by Step

13. Figure 13-4
The Crowding-Out Effect
Expansionary policy causing
deficit spending initially shifts
from AD1 to AD2
Due to crowding out,
AD shifts inward to AD3
Equilibrium GDP
below full-employment
GDP—recessionary gap

14. Possible Offsets to Fiscal Policy (cont'd)
 Planning for the future:
the Ricardian equivalence theorem
Ricardian Equivalence Theorem
 The proposition that an increase in the government
budget deficit has no effect on aggregate demand
The reason for the offset
 People anticipate that a larger deficit today will
mean higher taxes in the future and adjust their
spending accordingly.

15. Possible Offsets
to Fiscal Policy (cont'd)
 Direct Expenditure Offsets
Actions on the part of the private sector in
spending income that offset government fiscal
policy actions
Any increase in government spending
in an area that competes with the
private sector will have some direct
expenditure offset.

16. Possible Offsets
to Fiscal Policy (cont'd)
 The supply-side effects of changes
in taxes
Expansionary fiscal policy could involve
reducing marginal tax rates.
 Advocates argue this increases productivity since
individuals will work harder and longer, save more,
and invest more.
 The increased productivity will lead to more
economic growth.

17. Possible Offsets
to Fiscal Policy (cont'd)
 Supply-Side Economics
The suggestion that creating incentives for
individuals and firms to increase productivity
will cause the aggregate supply curve to shift
outward

18. Figure 13-5 Laffer Curve
Tax rates and
tax revenues
rise together
Tax revenues
are at a maximum
Tax rates and tax
revenues fall
together

19. Discretionary Fiscal Policy in Practice:
Coping with Time Lags
Recognition Time Lag
 The time required to gather information about the
current state of the economy
Action Time Lag
 The time required between recognizing an
economic problem and putting policy into effect
Effect Time Lag
 The time it takes for a fiscal policy to affect
the economy

20. Discretionary Fiscal Policy in Practice:
Coping with Time Lags (cont'd)
 Fiscal policy time lags are long and a policy designed to
correct a recession may not produce results until the
economy is experiencing inflation.
 Fiscal policy time lags are variable in length (1–3 years),
and the timing of the desired effect cannot be predicted.
 Because fiscal policy time lags tend to be variable,
policymakers have a difficult time fine-tuning the
economy.

21. Automatic Stabilizers
 Automatic or Built-In Stabilizers
Changes in government spending and
taxation that occur automatically without
deliberate action of Congress
 The tax system
 Unemployment compensation
 Welfare spending

22. Figure 13-6 Automatic
Stabilizers
The automatic changes
tend to drive the economy
back toward its full-
employment output level

23. What Do We Really Know
About Fiscal Policy?
 Fiscal policy during normal times
Congress ends up doing too little too late to
help in a minor recession.
Fiscal policy that generates repeated
tax changes (as has happened)
creates uncertainty.

24. What Do We Really Know
About Fiscal Policy? (cont'd)
 Fiscal policy during abnormal times
Fiscal policy can be effective
 The Great Depression—fiscal policy may be able
to stimulate aggregate demand.
 Wartime—during World War II real GDP increased
dramatically.

25. What Do We Really Know
About Fiscal Policy? (cont'd)
 The “soothing” effect of Keynesian fiscal
policy
Should we encounter a severe downturn,
fiscal policy is available.
 Knowing this may reassure consumers
and investors.
 Stable expectations encourage a smoothing of
investment spending.

26. 26
Chapter 13: Fiscal Policy
End of
Chapter 10
26
ECON 151 – PRINCIPLES OF MACROECONOMICS
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.