Expansionary and Contractionary Fiscal Policies I - PDF

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Expansionary and Contractionary Fiscal Policies I - PDF Powered By Docstoc
					Chapter 29                  Economics                   Fiscal Policy
Chapter 12                  Macroeconomics                   - in references to figures, X refers to the relevant chapter - either 12 or 29

Chapter Objectives In this chapter, students will learn:
 - what fiscal policy is and why it is an important tool in managing economic fluctuations
 - which policies constitute an expansionary fiscal policy and which constitute a contractionary fiscal policy
 - why fiscal policy has a multiplier effect and how this effect is influenced by automatic stabilizers
 - why tax and transfer multipliers are less than the government purchases multiplier
 - why governments calculate the cyclically adjusted budget balance
 - why a large public debt may be a cause for concern
 - why implicit liabilities of the government are also a cause for concern

Chapter Outline Opening Ex:          The level of spending by the Japanese govt in 1990s on bridges, dams, roads & other
                                     infrastructure, in an effort to move its economy out of a slump, is an example of discretionary
                                     fiscal policy

A. Fiscal Policy: The Basics
   - stabilization through manipulation of the federal government budget (taxing and spending) is called fiscal policy
   - in the Employment Act of 1946 Congress formally declared the government role in economic stabilization
         the Act proclaimed government’s role in promoting:
              1- maximum employment and production (similar to the Fed’s goal of full-employment output)
              2- maximum buying power (similar to the Fed’s goal of stable prices)
         as with Fed’s monetary policy, these goals are not always compatible (one goal must be traded off against the other)
   - sources of govt tax revenue in U.S. (2004):                       - total govt spending in U.S. (2004):
         - personal income taxes:              35%                          - education:                    17%
         - social insurance taxes:             28%                          - Medicare and Medicaid:        16%
         - corporate profit taxes:              8%                          - national defense:             15%
         - other taxes (mostly state & local): 29%                          - Social Security:              14%
                                                                            - other goods and services:     29%
                                                                            - other govt transfers:          9%

    - social insurance programs (e.g., Social Security) are govt programs intended to protect families against economic hardship
    - the govt: - directly controls govt spending (G),
                   - indirectly influences consumer spending (C) with transfer payments and taxes
                   - indirectly influences investment spending (I) with tax policies
    - it can be difficult to implement fiscal policy at the right time because: - a long time is needed to implement fiscal policies, and
                                                                               - a long period is required before a policy's effects are felt

  Expansionary Fiscal Policy         - includes:   - increases in govt purchases of goods & services (G)
                                                   - decreases in taxes (T)
                                                   - increases in govt transfer payments (TR)
    - expansionary fiscal policies increase aggregate demand (AD) & thereby shift the AD curve to the right
    - a budget deficit is expansionary fiscal policy

  Contractionary Fiscal Policy       - includes:   - decreases in govt purchases of goods & services
                                                   - increases in taxes
                                                   - decreases in govt transfer payments
    - contractionary fiscal policies decrease AD & thereby shift the AD curve to the left
    - a budget surplus is contractionary fiscal policy

B. Fiscal Policy and the Multiplier
  -Multiplier Effects of a Change in Government Purchases (G) of goods & services
    - an increase or decrease in G changes real GDP by an amount larger than the initial change due to the multiplier effect
    - the magnitude of the shift of AD curve, due to a change in G, is determined by the value of the multiplier
         - the multiplier associated with changes in G is expressed mathematically as:        1 / 1- MPC

  -Multiplier Effects of Changes in Government Transfers (TR) and Taxes (T)
    - an increase or decrease in TR or T changes real GDP by an amount larger than the initial change due to the multiplier effect
    - size of multiplier effect associated with a change in TR or T is smaller than the multiplier effect associated with a change in G
         - because part of any change in TR or T is absorbed by savings in the first round of spending
    - the magnitude of the shift of the AD curve, due to a change in TR or T, is determined by the value of the multiplier
    - the multiplier associated with changes in TR or T is expressed mathematically as:           MPC / 1 - MPC
C.     Two (2) types of fiscal policy: discretionary and non-discretionary
      -discretionary fiscal policy: -is the result of deliberate actions by policy makers rather than preset rules
                                   -occurs at Congress’s option & involves deliberate manipulation of taxes & spending
           - influences real output (i.e., real GDP) and the employment level
           - may control inflation or stimulate the economy

      -over the course of the business cycle, government fiscal policy attempts to dampen the swings in level of economic activity
          -combat recession w/ expansionary policy (i.e., running a budget deficit)
                 involves increased spending, lower taxes or both
          -combat demand-pull inflation w/ contractionary policy (i.e., running a budget surplus)
                 involves decreased spending, higher taxes or both

      - in a broad sense, views on discretionary fiscal policy define political philosophy (not practice) in the U.S.
           -liberal approach:         -increase taxes to combat demand-pull inflation
                                      -increase govt. spending to combat recession
           -conservative approach: -cut govt. spending to combat demand-pull inflation
                                      -cut taxes to combat recession

      -non discretionary fiscal policy: refers to automatic or built-in stabilizers
         - automatic stabilizers - govt spending & taxation rules that cause fiscal policy to be expansionary when the economy contracts
                                   and contractionary when the economy expands

         - automatic stabilizers include:
           1- the tax system: -net tax collections rise automatically when GDP increases (because a rise in GDP increases incomes)
                                -net tax collections fall automatically when GDP falls
                -net tax is taxes minus transfers or subsidies (e.g., welfare, unemployment insurance)
                     -taxes rise when GDP rises & fall when GDP falls; transfers & subsidies tend to rise when economy slows
                -tax increases act as a brake on economy when it overheats; falling taxes act as a stimulus when the economy slows
                -the more progressive the tax system is, the more it acts as an automatic stabilizer
                     -a flat tax would not serve as an automatic stabilizer

           2- unemployment insurance is also an automatic stabilizer - by buffering the decline in income of individuals when they
                   lose employment, unemployment insurance also buffer the decline in consumer spending and, thus, GDP
               -unemployment insurance today does not provide as much of a buffer to individuals or the economy as it used to since
                   the payments made to the unemployed have not kept pace with the growth in salaries over the past several decades

D. The Budget Balance as a Measure of Fiscal Policy
   - the budget balance is equal to government savings (SGovt), expressed mathematically as:            SGovt = T – G – TR
            where T is tax revenue, G is govt purchases and TR is govt transfer payments

      - the following reduce the budget balance (making a budget surplus smaller or a budget deficit larger) ceteris paribus:
                - increases in government purchases on goods and services,
                - increases in government transfers, or
                - reductions in taxes

      - the following increase the budget balance (making a budget surplus bigger or a budget deficit smaller) ceteris paribus:
                - decreases in government purchases on goods and services,
                - decreases in government transfers, or
                - increases in taxes

      - different changes in fiscal policy with equal effects on the budget balance may have quite unequal effects on AD
                - e.g. changes in govt. spending vs. changes in transfers or taxes

     The Business Cycle and the Cyclically Adjusted Budget Balance
      - budget deficits tend to rise during recessions and fall during expansions due, in part, to the business cycle
      - the cyclically adjusted budget balance is an estimate of what the budget balance would be if actual GDP was equal to
           potential (full employment) GDP                                                                        see Fig X-9
     Cyclically adjusted budget balance (full-employment budget):
     -what Federal budget deficit or surplus would be with current taxes & govt spending if economy were at potential GDP
         -the actual budget deficit/surplus may differ greatly from the cyclically adjusted budget balance (full-employment estimate)
         -could have an actual budget deficit that would disappear if economy were at the full-employment level

     Structural deficits occur when there is a deficit in the full-employment budget as well as in the actual budget
         -large structural deficits from 1981 until the mid-1990s crowded out private investment and increased interest rates

     - most economists believe that govts should run budget surpluses during expansionary periods of the business cycle and
         budget deficits during contractionary periods
     - some economists believe that laws requiring a balanced budget would undermine the role of automatic stabilizers in the economy

E.   Long-Run Implications of Fiscal Policy
     - U.S. govt budget accounting is calculated on the basis of fiscal years
     - fiscal years run from Oct. 1 to Sept. 30 and are named by the calendar year in which they end

     - public debt is govt debt held by individuals and institutions outside the government
         - persistent budget deficits result in increases in the public debt
         - rising public debt can lead to crowding out of private investment or, in extreme situations, government default

     - the debt-GDP ratio is govt debt as a percentage of GDP
          - countries with rising GDP can have stable debt-GDP ratios, even if they run budget deficits
               - if GDP grows with than debt

     - implicit liabilities are spending promises made by govts
         - they are effectively a debt despite the fact that they are not included in the usual debt statistics
               - Social Security, Medicare, and Medicaid represent large implicit liabilities of the U.S. government

     Balanced budget amendment: in strict form it would eliminate fiscal policy as a stabilization tool
     -would force govt to increase taxes or cut spending during recession (would make recession worse)

     Issues/Problems with Fiscal Policy
     1- time lags: associated w/ recognizing recession/inflation, modifying policy, implementing policy change & seeing an effect

     2- political problems: -economy is not the only goal
                            -in democracies, politics shows expansionary bias
                            -state/local govt finance are often procyclical
                            -political business cycle (more expansionary in election yr)

     3- crowding out: in expansionary policy w/ deficit spending, govt borrowing increases interest rates, reduces private spending
          -this weakens (or could cancel) the stimulus effect of the fiscal policy
          -some economists argue there would be little crowding out during a recession (because private demand is low)

     4- if economy is in the intermediate portion of aggregate supply (AS) curve, expansionary fiscal policy will yield some inflation

     5- net export effect: will reduce the effectiveness of expansionary policy

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