Ch. 29 Fiscal Policy

What are the two types of policies the government uses to push the economy? And what are they?

1) Fiscal policy: Involves the use of government budget tools, spending, and taxes to influence the macroeconomy. 2) Monetary policy: The use of the money supply to influence the economy.

What are the 3 shortcomings of fiscal policy?

1) Time lags: (a) Recognition lag occurs when it is hard to recognize turns in the business cycle. (b) Implementation lag occurs when it takes longer to implement fiscal policy because of the time it takes to pass legislation through government bodies. (c) Impact lag occurs because of the time it takes for the complete effects of fiscal or monetary policy to materialize. It takes time to ripple through the economy. Can overall cause excessive or below aggregate demand and inflation when the fiscal policy finally hits after the contraction or expansion finishes. 2) Crowding-out: Occurs when private spending falls in response to increases in government spending. If government spending substitutes or crowds-out private spending, the overall change in aggregate demand diminishes more. 3) Savings shifts: In response to increases in government spending or lower taxes, people may increase their current savings to help pay for inevitably higher future taxes. The effects of a stimulus thus are negated.

Let's look at aggregate demand...

Aggregate demand (total spending in the economy) = consumption (C) + investment (I) + government spending (G) + net exports (NX)

When do economists suggest implementing fiscal policy and reducing budget deficits?

Fiscal policies during recessions and reduced budget deficits during expansions.

What is countercyclical fiscal policy?

Fiscal policy that seeks to counteract or reduce business cycles fluctuations. It consists of expansionary policy during economic downturns and contractionary policy during economic expansions.

What is supply-side fiscal policy?

It involves the use of government spending and taxes to affect the supply, or production, side of the economy. When long-run aggregate supply shifts, the result is a shift to a new level of full-employment output (Y* to Y**). Shifts in long-run aggregate supply are caused by changes in resources, technology, and institutions. The government can implement fiscal policy and use the tax code to encourage technological advancement. Incentives to encourage innovation and ultimately generate a greater supply of output. Other fiscal policy initiative that focus on the supply side of the economy: 1) Research and development (R&D) tax credits 2) Policies that focus on education 3) Lower corporate profit tax rates 4) Lower marginal income tax rates

What is expansionary fiscal policy?

It occurs when the government increases spending or decreases taxes to stimulate the economy toward expansion. We use the aggregate demand-aggregate supply model to examine the effects of expansionary fiscal policy. In this model, recession can occur as a result of a drop in aggregate demand. When this happens, the economy moves to short-run equilibrium with less than full-employment output (Y<Y*) and greater unemployment rate than the natural rate (u>u*). In the long run, all prices adjust given that the short-run aggregate supply adjusts or shifts forward, moving the economy back to full-employment equilibrium. The goal of expansionary fiscal policy is to shift aggregate demand back so the economy returns to full employment without waiting for long-run adjustments. The government can do this by focusing on increasing either/or government spending or consumption. By decreasing taxes, citizens consumer more.

What is the Laffer Curve?

It shoes how tax rates ultimately effects the total tax revenue when there are incentives and disincentives from high tax rates. Eventually, increases in the tac rate lead to less tax revenue to the point that net tax revenue falls. There are less incentives to work and earn more income.

What is contractionary fiscal policy?

Occurs when the government decreases spending or increases taxes to slow economic expansion. Two reasons to do this are: 1) Due to increased deficits during recessions caused by expansionary fiscal policy, increasing taxes and/or decreasing spending during an economic expansion can work to reduce the budget deficit and pay off some government debt. 2) The government believes the economy is expanding beyond its long-run capabilities. Unemployment rate falls below the natural rate (u<u*) and full-employment level is greater (Y>Y*), which can lead the economy to "overheat" from too much spending and eventually inflation. Not sustainable in the long-run basically because there is upward pressure on the price level. Contractionary fiscal policy tries to reduce the increase in aggregate demand before the short run aggregate supply decreases and causes inflation to rise even more in the long-run.

Why is fiscal policy important to politicians and a nation's perspective to the whole world?

People and nations prefer smoothness and predictability in their financial affairs.

What is fiscal policy?

Policy that uses government spending and taxes to influence the economy.

What is one way to alleviate the lag problems?

Programs that automatically adjust government spending and taxes when economic conditions change. Automatic stabilizers are government programs that automatically implement countercyclical fiscal policy in response to economic conditions. 1) Progressive income tax rates guarantee that individual tax bills fall when incomes fall during recessions and rise when incomes rise during expansions. 2) Taxes on corporate profits lower total tax bills when profits are lower during contractions and raise tax bills when profits are higher during expansions. 3) Unemployment compensation increases government spending automatically when unemployment rises and decreases when unemployment decreases. 4) Welfare programs increase government spending during downturns and decrease during expansions.

What was the Tax Cuts and Jobs Act?

The TCJA was a fiscal policy passed under President Donald Trump in an effort to move the economy forward, even though it wasn't in recession. It diid contribute to a larger government budget deficit in 2018.

How does the government pay for spending or reduction in tax revenue?

The difference is paid for by borrowing. It can sell Treasury bonds, which also increases the federal budget deficit and national debt because tax revenue falls too even if tax rates don't change (remember that tax revenue accounts for 80% of total revenue).

How does the U.S. government try to boost the economy and what was the American Recovery and Reinvestment Act?

The government tries to boost the economy by using fiscal policy. The American Recovery and Reinvestment Act was signed by the newly elected President Barack Obama in February of 2009. Like all other fiscal policies, this act was first passed by both houses. It primarily focused on government spending and was used to counteract the business cycle during at time when the economy was spiraling into deep recession.

How does multipliers occur after fiscal policy?

The initial effect can snowball overtime. Some effects are felt immediately when fiscal policy shifts aggregate demand while a large share of the impact occurs later as spending effects ripple throughout the economy. Here's why: 1) Spending by one person becomes income to others. True for both private and government spendings. 2) Increases in income generally lead to increases in consumption. The marginal propensity to consume (MPC) is the portion of additional income spent on consumption = change in consumption / change in income. The MPC is multiplied over and over again to the rise in income as it snowballs. Aggregate demand increases each round, but less than the previous round until it becomes stale. The spending multiplier (m to the power of s) tells us the total impact on spending from an initial change of a given amount. It depends on MPC. The greater the MPC, the greater the spending multiplier. Spending multiplier is equal to 1 / (1 - MPC) *Sometimes called the Keynesian multiplier or fiscal multiplier. Government spending multipliers are not very large. The largest multipliers occur with temporary deficit-financed increases in government spending, but even these rarely go above 1.5.

What is a dilemma encountered with increased tax rates?

Yes, increased tax rates increase tax revenue but they also provide negative incentives for production. A reduction in tax rates when they are high could actually lead to an increase in tax revenue.