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Fiscal Policy
Lesson 20


Fiscal Policy

1. Paradox of Thrift - if everyone believes they will be laid off, then everyone reduces consumption and increases savings

  • Businesses see profits fall and lower sales
  • Businesses lay off people which forces more people to save and reduce consumption
  • We get into this cycle
  • Keynes - gov. should pick up slack to get economy growing again

2. Fiscal policy - government changes levels of taxes (T) and/or government spending (G) to help the economy run at full employment

  • Promote economic growth (i.e. a growing real GDP)
  • Achieve low unemployment, etc.
  • Assume the money supply (Ms) is fixed
    • Holding monetary policy constant

3. Government budget

  • Balanced budget: Government Tax Revenue = Government Spending
    • Revenue - taxes, tariffs, and fees
    • Spending - military, social programs, etc.
    • T = G
  • Budget Deficit: Government Spending (G) > Government Tax Revenue (T)
    • Government debt grows by level of deficit
  • Budget Surplus: Government Revenue (T) > Government Spending (G)
    • Government debt falls
    • Government has extra money in its accounts
  • Budget deficit versus debt
    • Debt - total amount government owes
    • Budget deficit - difference between G - T
      • Add the deficit to the debt
    • Between 1960 and 2013, the U.S. government had a deficit every year except 1960, 1969, 1998, 1999, 2000, and 2001
    • Why?

4. Expansionary fiscal policy - government policy to cause the economy to expand

  • Lower taxes
  • Increase government spending
  • Aggregate Supply and Aggregate Demand are Shown below
    • Economy is in a recession and below Full Employment (FE)
    • Expansionary fiscal policy causes the AD function to shift right
    • Increase government spending
      • Degree of shift is the multiplier times the increase in G
    • Decrease taxes
      • Degree of shift is the tax time the multiplier times MPC
      • Households pay some taxes from savings
      • Decreasing taxes, increases disposable income
        • Households save and consume more
        • MPC is how much of a tax decrease expands the economy

The Aggregate Demand increases

5. Contractionary fiscal policy

  • Government increases taxes
  • Government decreases government spending
  • Example - Economy is growing too rapidly; graph is below
    • Demand pull inflation
    • Contractionary fiscal policy causes AD function to shift left
    • Economy slows down and runs at Full Employment
    • Decrease government spending
      • Degree of shift is the multiplier times the decrease in G
    • Increase taxes
      • Degree of shift is the multiplier times the MPC and increase in T
      • Households pay the higher taxes from savings and lower consumption

The Aggregate Demand decreases

6. Index of Leading Economics Indicators

  • Index is not perfect, but gives a reasonable approximation how the economy is doing
  • If most indicators are negative, then economy may be in a recession
  • If most indicators are positive, then economy may be expanding
  1. Average workweek
  2. Initial claims for unemployment
  3. New orders for consumer goods
  4. Vendor performance
  5. New orders for capital goods
  6. Building permits for houses
  7. Stock prices
  8. Money Supply
  9. Interest rate spread - difference between short-term and long-term interest rates
  10. Consumer expectations

Automatic Stabilizers

1. Automatic Stabilizers - government programs that have a countercyclical impact on the economy
  • Countercyclical impact
    • Slows down economy when economy is growing too fast
      • Helps increase a budget surplus (or lowers deficit)
    • Causes economy to grow when economy is slowing down
      • Helps increase a budget deficit
    • Benefit - does not require government's action
  • Automatic Stabilizers
    1. Unemployment compensation - unemployed workers receive temporary income from government
      • Recession - more workers are laid off and more people receive unemployment compensation
        • Government spending automatically increases
      • During an expansion - more workers are employed
        • Firms expand and hire more workers, so taxes increases
        • Government pays out fewer unemployment, so government spending decreases
    2. Corporate taxes - corporations pay taxes on their profits and investors pay taxes when they earn dividends
      • Recession - corporations earn smaller profits or losses, which reduces the amount of taxes paid
        • Example - 2008 Recession
        • New York State receives 25% of its income taxes from Wall Street
        • With many financial institutions bankrupting, New York State is expecting lower tax receipts
      • During an expansion - corporations pay more taxes as they earn more profits

3. Average tax rate = tax liability / taxable income.

        Example: Salary is $20,000 and tax liability is $5,000.

average tax rate = $5,000 / $20,000 X 100% = 25%

  • Tax rates are classified into three types
  1. Progressive tax rate - average tax rate rises with income.
    • Example: U.S. Income taxes - low-income households pay small average tax rates, while high-income households pay higher tax rates.
    • Progressive income tax system - households pay higher tax rates when their incomes are increasing
    • Recession - as households incomes fall, the average tax rate paid by families decrease
    • Business Expansion - as household incomes are rising, families are pushed into higher tax brackets.
  2. Proportional tax - the average tax rate stays the same across all income levels.
  3. Regressive tax - the average tax rate falls with income, i.e. higher income results in lower average tax rate.
    • Excise taxes on alcohol, cigarettes and gasoline
    • Property taxes


Problems of Fiscal Policy

1. Views of Fiscal Policy

  • Before 1930s - economists believed government should not interfere with the economy
  • During the Great Depression and by 1960s - economists believed government should use fiscal and monetary policy to influence the economy
    • Maynard Keynes - wrote and supported the use of fiscal policy
  • After 1970s, the OPEC petroleum price increases and stagflation changed the view of economists
    • Macroeconomics breaks up into several schools of thought
      • Strong support for monetary policy
      • Disagreement on fiscal policy
    • Government hires Keynesian economists
      • Government is supposed to have budget surpluses during economic expansions
      • Instead, we have budget deficits during expansions and recessions
      • Government continually increases its size, scope, and mission

2. Time lags - causes problems when government tries to stimulate the economy

  1. Recognition (or information) lag - takes time to collect data
    • Recession - two consecutive quarters of negative growth for real GDP
    • If government takes 3 months to collect data, then economy could already be in a recession
  2. Administrative (or legislative) lag - government requires time to make a decision
    • Congress and the President have to agree to change taxes or increase levels of the U.S. debt
    • Congress and the President could agree quickly or take up to a year to implement a fiscal policy
  3. Impact lag - takes time for the fiscal policy to impact the economy
    • Could be a from a six to twelve month delay for fiscal policy to impact economy
  • Problem - time lags could make economy more unstable
    • Fiscal policy can take up to a year or more before impacting the economy
    • Some U.S. recessions were short-lived, lasting less than a year
      • An expansionary fiscal policy for a short lived recession could lead to more inflation
      • Once fiscal policy impacts the economy, the economy is already growing
        • Fiscal policy gives it a boost

3. Political Problems

  1. Political business cycle - politicians decrease taxes and/or increase gov. spending before an election
    • They pass fiscal policies that are popular with the public before the election
    • Stimulates the economy before the election
    • Usually voters vote out incumbents when economy is performing poorly
  2. Political leaders may use temporary fiscal policy
    • A temporary fiscal policy may not impact the economy
    • Example - U.S. economy is entering a recession in 2008
    • President Bush approved an economic stimulus package
    • Each household gets between $300 and $600 boost on tax refunds
    • Bush wants households to spend this money, but households may end up saving it for the impending recession

4. State and local governments finance are pro-cyclical

  • Pro-cyclical - taxes and spending reinforce the business cycle
    • State and local governments are required to operate balanced budgets
  • Business cycle
    • Low unemployment and job creation create higher incomes
    • More tax revenue flows to state and local governments
    • Government pays less unemployment, welfare payments, etc
    • Government builds more schools, highways, etc.
    • Helps boost the economy
  • Recession
    • High unemployment and job destruction
    • Less tax revenue flows to state and local governments
    • Government pays more unemployment, welfare payments, etc.
      • Boosts the economy
    • In turn, government raises taxes
      • Government almost never reduces its budget
      • Helps weaken the economy
      • Financial crisis during downturns in the economy

5. Crowding Out Effect - government deficits and debt crowd out private investment

  • Government deficit - government spending > taxes collected
    • Stimulates the economy's growth
    • Government borrows money from the public
    • Government competes with private companies for loans
    • If market has limited funds, a large budget deficit and debt can increase interest rates
      • Private sector borrows less money because interest rate is higher
    • Lower investment leads to lower growth
    • Problem - public sector may be expanding relative to the private sector
  • Global Impact
    • High interest rates attract foreign investors
    • Causes currency to appreciate
      • Imports increase
      • Exports decrease
    • Thus, large deficits could reduce domestic production and encourage that country to import more

6. Laffer Curve - shows relationship between tax rates and tax revenues.

  • Two points:
    • 0% tax rate = 0 tax revenue
    • 100 % tax rate = 0 tax revenue
  • As the tax rate increases, the tax base decreases (the activity being taxed),
    • Tax changes behavior.
    • Deadweight loss increases.
  • Example: The tax rate is 50% and the government wants to increase tax revenue.
    • If the tax rate is increased, tax revenue declines further.
    • If tax rate is lowered, then tax revenue increases!
    • Nobody knows the shape of these curves!!!
  • Basis of Reaganomics.
    • Tax rates decreased, which caused tax revenue to increase.
    • During the 1980s, the average tax rates for the "rich" decreased.
    • Between 1980 and 1990 real income tax revenue collected from the top 1 % of earners rose a whopping 51.4%
Laffer Curve
Tax Revenue
The Laffer Curve
Tax Rate


The U.S. Government Debt

1. Public Debt - total amount the U.S. government owes

  • Debt is the total amount of all deficits and minus budget surpluses
  • Reasons
    • Finance wars
    • Tax cuts
    • Lack of control by Congress and the President

2. U.S. Treasury Securities (Loans)

  1. Treasury Bill - a security with a maturity less than a year
  2. Treasury Notes - a security with a maturity between 1 and 10 years
  3. Treasury Bonds - a security with a maturity exceeding 10 years
  4. U.S. Savings Bonds - long-term, non-marketable bonds

3. Debt Statistics

  • Currently the debt is $17 trillion dollars(2013)
  • U.S. government agencies hold approximately 42% of the debt
    • Social Security surpluses are invested into the debt
    • U.S. government worker retirement accounts
    • Does not include Federal Reserve
  • Federal Reserve holds some of the debt
  • Foreigners hold about $1.8 trillion dollars or 18% (July 2008)
  • U.S. debt relative to the economy is shown below
    • Absolute size of the debt is not relevant
    • It is how it compares to the economy

The U.S. Debt relative to the economy

Comparing the United States to other countries

Debt to GDP Ratios for Several Countries
Country Debt to GDP Rank
Zimbabwe 211.90 1
Japan 195.50 2
Singapore 101.20 8
Canada 64.20 22
United States 60.80 27
Mexico 22.80 91

4. Future Concern

  1. Can U.S. government bankrupt?
    • Not likely
    • Government is not like a business
      • Has the power to tax
      • Has the power to print money
      • Government can refinance the debt
      • As old debt matures, the U.S. Treasury issues new debt
  2. As the level of debt increases, the U.S. government pays interest on that debt
    • Interest is the third largest item on the debt
    • Interest becomes larger as debt becomes larger
    • Government cannot use this for the military, infrastructure, etc.
  3. Burdens Future Generations
    • Future generations inherit this debt
    • Future generation may not get the same level of government benefits
      • Interest becomes a larger budget item
  4. Crowding out effect
    • Economy has less investment
    • Economy grows less
  5. Financial crisis
    • Every day, some of the debt becomes due and government issues new debt
    • If investors do not want to buy new debt, then government has a crisis
  6. High inflation rates - Gov. may print money to cover budget deficits
  7. Government increases future taxes
  8. Government may grow relative to the economy
    • A large controlling gov. may be detrimental to society
Blue arrow Ronald Reagan - "If it moves, tax it! If it keeps moving, regulate it! If it stopped moving, subsidize it!"


  • Paradox of Thrift
  • fiscal policy
  • balanced budget
  • budget deficit
  • budget surplus
  • expansionary fiscal policy
  • contractionary fiscal policy
  • index of leading economic indicators
  • automatic stabilizer
  • unemployment compensation
  • average tax rate
  • progressive tax system
  • proportional tax system
  • regressive tax system
  • time lags
  • recognition lag
  • administrative lag
  • impact lag
  • political business cycle
  • pro-cyclical
  • crowding-out effect
  • Laffer curve
  • public debt
  • U.S. Treasury Bills
  • U.S. Treasury Notes
  • U.S. Treasury Bonds
  • U.S. Savings Bonds

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