Study Session 6: Fiscal Policy

2. Needs-tested Spending

refers to government expenditures for programs that pass a needs test, such as unemployment. During a recession unemployment pay outs are high, but those pay outs stimulate the economy. Vica versa in an expansion.

The Laffer Curve

Because of the supply side effect on potential GDP, an increase in tax rates will not always result in an increase in tax revenue. Beyond a certain point, the increase in taxes per dollar earned will be more than offset by the decrease in the total number of dollars earned. When the tax rate is low, increasing the rate increases total revenue, at higher rates however the supply side reduction in potential GDP is greater. Beyond a certain rate (Tm) increasing the rate reduces economic output so much that the total tax revenues actually decline.

Automatic Stabilizers

Built in fiscal devices triggered by the state of the economy. Two main categories: 1. Induced Taxes 2. Needs-tested Spending

Government Expenditure Multiplier

Changes in Gov. spending, taxation or both have magnified effects on agg. demand. This multiplier refers to the magnitude of the eventual impact on agg. demand per dollar of change in government spending.

Autonomous Tax Multiplier

Changes in taxes also have a magnified effect on agg. demand. A decrease in taxes that is not offset by a change in government spending will increase consumption expenditures and increase AD. This increase incomes which further increases AD, which leads to HIGHER incomes. Since some of this initial increase in incomes from the tax cut will be saved the tax multiplier is smaller than the government expenditure multiplier.

Sources of Financing

Investment is one of the major components of GDP. The sources of financing for investment are: 1. National Savings 2. Borrowing From Foreigners 3. Government Savings 1 and 2 are private sources of financing, the third equals the difference between government tax revenues and expenditures. Government budget surpluses increase the sources of total investment, but deficits decrease them.

Crowding Out Effect

Large government budget deficits decrease the quantity of savings, which increases the real interest rate, leading firms to reduce their borrowing of financial capital and their investment in physical capital. This adverse effect of a budget deficit on private investment in capital is referred to as the crowding out effect. The decrease in the growth rate of capital will reduce potential GDP.

Limitations of Discretionary Fiscal Policy

Not an exact science: 1. Recognition Delay - May take time for admin to recognized the extent of problems. 2. Admin Or Law Making Delay - Cannot vote and enact decisions over night. Legal changes are delayed during debates. 3. Impact Delay - Time passes before effects of fiscal policy changes are felt.

1. Induced Taxes

Refer to the amount of taxes collected as a percentage of income. Incomes are positively related to GDP, and rise during an economic boom. As incomes rise the total amount of taxes collected automatically increases which slows the economy. Converse reaction in a recession.

Generational Effects of Fiscal Policy

Refer to the effects of postponing fiscal imbalances, defined as the present value of future expected government deficits. Eventually the fiscal imbalance must be corrected by increasing taxes or decreasing government spending. Generational Accounting measures the taxes owed by and the benefits owed to each generation. Almost half the imbalance gets passed on to future generations.

Supply-Side Effects

Refer to the influence that fiscal policy, especially taxation, has on long-run aggregate supply (potential real GDP). Income taxes reduce the incentive work by creating a tax wedge between pretax and after tax wages. Taxes (both income and sales) shift the supply curve down, and real GDP drops as a result of the decrease in the equilibrium quantity.

Ricardo-Barro Effect

Refers to the fact that increases in the current deficit mean greater taxes in the future. Rational taxpayers will increase current savings and decrease consumption in order to offset the effect of higher future taxes.

Fiscal Policy

Refers to the federal government's use of spending and taxation to meet macroeconomic goals. The federal budget is said to be balanced when tax revenues equal federal government expenditures. A budget surplus occurs when government tax revenues exceed expenditures, and a budget deficit occurs when government expenditures exceed tax revenues. Administration through President and Congress enact fiscal policy to stabilize the economy. To smooth economic cycles taxes are increased or gov. spending is reduced during inflationary periods, and taxes are decreased or gov. spending is increased during recessionary periods.

Discretionary Fiscal Policy

Refers to the spending and taxing decisions of a national government that are intended to stabilize the economy. Recessions v Expansions (change taxes and gov spending to cool off or heat up the economy).

Balanced Budget Multiplier

Since the gov expenditure multiplier is > autonomous tax multiplier the balanced budg multiplier is positive. An increase in gov spending that is accompanied by an equal increase in taxes, the increase in AD from spending will be > than the decrease in AD from taxes. = Net Increase in AD.