Chapter 12

The Federal Government
sometimes uses budgetary actions to "stimulate the economy" or "rein in inflation"
Contercyclical fiscal policy
consists of deliberate changes in government spending and tax collections designed to achieve full employment control inflation, and encourage economic growth
Contercyclical fiscal policy is defined as
discretionary (or "active")
Council of Economic Advisers (CEA)
a group of 3 economists appointed by the President to provide expertise and assistance on economic matters.
Discretionary changes in government spending and taxes
are at the option of the federal government
Nondiscretionary (or "passive" or "automatic") changes
changes that occur without congressional action
When recession occurs
an expansionary fiscal policy may be in order (Figure 12.1 - where a sharp decline in investment spending has shifted the economy's aggregate demand curve to the left from AD-1 to AD-2
When recession occurs, the cause may be that...
profit expectations on investment projects have dimmed, curtailing investment spending and reducing aggregate demand
Suppose the economy's potential or full-employment output is $510 billion. If the price loevel is inflexible downward at P-3, the broken horizontal line
becomes the relevant aggregate supply curve. The aggregate demand curve moves leftward and reduces real GDP from $510 billion to $490 billion. A NEGATIVE GDP GAP OF $20 BILLION (= $490 billion - $510 billion) arises. AN INCREASE IN UNEMPLOYMENT ACCOMPANIES THIS NEGATIVE GDP GAP because fewer workers are needed to prodce the reduced output. (In short, the economy depicted is suffering both recession and cyclical unemployment)
The three main options the Federal government can adopt to try to stimulate the economy are:
1. Increase government spending; 2. reduce taxes; or 3. use some combination of the two
If the Federal budget is balanced at the onset, expansionary fiscal policy will create
a government budget deficit
Budget Defict
government spending in excess of tax revenues
Other things equal, a sufficient increase in government spending will...
shift an economy's aggregate demand curve to the right from AD-2 to AD-1 (figure 12.1)
If a recession prompts the government to initiate $5 billion of new spending on highways, education, and health care; the new $5 billion of government spending
will be representated as the horizontal distance between AD-2 and the dashed line immediately to its right. At each price level, the amt of real output that is demanded is now $5 billion greater than that demanded before the expansion of government spending
The initial increase in aggregate demand is not the end of the story. Through the "multiplier effect, the aggregate demand curve shifts to AD-1, a distance that exceeds that represented by the originating $5 billion increase in gov'mt purchases.
This greater shift occurs because the multiplier process magnifies the initial change in spending into successive rounds of new consumption spending. If the economy's MPC is .75, then the simple multiplier is 4. So the aggregate demand curve shifts rightward by four times the distance between AD-2 and the broken line.
With this particular increase in aggregate demand occuring along the horizontal broken-line segment of aggregate supply,...
real output rises by the full extent of the multiplier. Real output rises to $510 billion, up $20 billion from its recessionary level of $490 billion. Concurrently, unemployment falls a firms increase their employment to the full-employment level that existed before the recession.
Discretionary Fiscal Policy is..
the purposeful change of government expenditures and tax collections by government to promote full employment, price stability, and economic growth.
The government uses expansionary fiscal policy to...
shift the aggregate demand curve rightward in order to expand real output. This policy entails increases in government spending, reductions in taxes, or some conbinations of the two.
The government uses contractionary fiscal policy to...
shift the aggregate demand curve leftward in an effort to halt demand-pull inflation. This policy entails reductions in government spending, tax increases, or some combination of the two.
To be implemented correctly, contractionary fiscal policy..
must properly account for the ratchet effect and the fact that prices will not fall as the government shifts the aggregate demand curve leftward.
START ON PAGE 233-Tax Reductions
The Government could use Tax reductions to..
shift the aggregate demand curve rightward, as from AD2 to AD-1
Part of a tax reduction...
increases saving, rather than consumption
To increase consumption by a specific amount, the government..
must reduce taxes by more than that amount
The Government may combine spending increases and tax cuts to...
produce the desired initial increase in spending and the eventual increase in aggregate demand and real GDP.
When demand-pull inflation occurs,
a restrictive or Contractionary fiscal policy may help control it.
Budget surplus
tax revenues in excess of government spending.
Decreased or Reduced Government spending...
shifts the aggregate demand curve leftward to control demand-pull inflation.
The Government can use Tax Increases to..
reduce consumption spending
The Government may choose to combine spending decreases and tax increases
in order to reduce aggregate demand and check inflation.
Discretionary fiscal policy designed to stabilize the economy can be associated with...
either an expanding government or a contracting government
The US Tax system is such that...
net tax revenues vary directly with GDP
Transfer payments or "negative taxes"
behave in the opposite way from tax revenues.
Built-in Stabilizer
is anything that increases the government's budget deficit (or reduces its budget surplus) during a recession and increases its budget surplus (or reduces its budget deficit) during an expansion without requiring explicit action by policymakers.
The economic imiportance of the direct relationship between tax receipts and GDP becomes apparent when we consider that...
Taxes reduce spending and aggregate demand. and Reductins in spending are desirable when the economy is moving toward inflation, whereas increases in spending are desirable when the economy is slumping.
Tax revenues automatically increase..
as GDP rises during prosperity
Since taxes reduce household and business spending,
they restrain the economic expansion.
As the economy moves toward a higher GDP,
tax revenues automatically rise and move the budget from deficit toward surplus.
As GDP falls during recession,
tax revenues automatically decline, increasing spending and cushioning the economic contraction
With a falling GDP,
tax receipts decline and move the government's budget from surplus toward defict
The low level of income GDP
will automatically yield an expansionary budget deficit.
In a progressive tax system,
the avg tax rate rises with GDP.
In a proportional tax system,
the avg tax rate remains constant as GDP rises
In a regressive tax system,
the avg tax rate falls as GDP rises
Of the progressive, proportional, and regressive tax systems..
the progressive tax system has the steepest tax line T of the three.
Tax revenues will rise with GDP under
both the progressive and proportional tax systems
Tax revenues will rise, fall, or stay the same/constant with GDP under
a regressive tax system.
The more progressive the tax system,
the greater the economy's built-in stability
US Securities
financial instruments issued by the Federal Gov'mt to borrow money to finance expenditures that exceed tax revenues.
The four types of US securities (loan instruments) are:
Treasury bills (short-term securities); Treasury notes (medium-term securities); Treasury bonds (long-term securities) and US savings bonds (long-term, nonmarketable bonds).
The built-in stability provided by the US tax system ...
has reduced the the severity of business fluctuations, perhaps by as much as 8 to 10 percent of the change in GDP that otherwise would have occurred. But built-in stabilizers can only diminish, not eliminate swings in real GDP.
Discretionary fiscal policy (changes in tax rates and expenditures) or monetary policy (central bank-caused changes in interest rates) are needed
to correct a recession or inflation of any appreciable magnitude.
Economists use the standardized budget (also called the full-employment budget)
to adjust actual Federal budget deficits and surpluses to account for the changes in tax revenues that happen automatically whenever GDP changes.
Standardized Budget
measures what the Federal budget deficit or surplus would have been under existing tax rates and government spending levels if the economy had achieved its full-employment level of GDP (its potential output).
Cyclical deficit
is simply a by-product of the economy's slide into recession, NOT the result of discretionary fiscal actions by the government.
Some problems, criticisms and complications governments can encounter in enacting and apply fiscal policy include:
problems of timing; political considerations, future policy reversals, offsetting state and local finance, crowding-out effect
Public debt
the total accumulation of the deficits (minus the surpluses) the Federal government has incurred through time.
Recognition lag
is the time between the beginning of recessin or inflation and the certain awareness that it is actually happening.
The recognition lag arises because...
the economy does not move smoothly through the business cycle
Administrative lag
a significant lag between the time the need for fiscal action is recognized and the time action is taken
Operational lag
between the time fiscal action is taken and the time that action affects output, employment, or the price level
Discretionary fiscal policy has increasingly relied on...
tax changes rather than on changes in spending as its main tool.
Fiscal policy conducted in a political arena
may create the potential for political considerations swamping economic considerations in its formulation.
At the extreme, elected officials and political parties might collectively
hijack fiscal policy for political purposes, cause inappropriate changes in aggregate demand, and thereby cause (rather than avert) economic fluctuations.
Political business cycles
scenarios whereby political considerations weigh heavily in the formulation of fiscal policy.
Fiscal policy may fail to achieve its intended objectives ...
if households expect future reversals of policy.
The lesson is that tax-rate changes that households view as permanent
are more likely to alter consumption and aggregate demand than tax changes they view as temporary.
Fiscal policies of state and local governments are frequently
pro-cyclical, meaning they worsen rather than correct recession or inflation.
Like households and private businesses, state and local governments
increase their expenditures during prosperity and cut them during recession.
The crowding-out effect indicates that...
an expansionary fiscal policy may increase the interest rate and reduce investment spending.
In view of the complications and uncertain outcomes of fiscal policy, some economists argue that...
it is better not to engage in it at all. Those holding that view point to the superiority of omnetary policy (changes in interest rates engineered by the Federal REserve) as a stablizing device or believe that most economic fluctuations tend to be mild and self-correcting.
Most economists believe that fiscal policy remains...
an important, useful policy lever in the government's macroeconomic toolkit. The current view is that fiscal policy can help push the economy in a particular direction but cannot fine-tune it to a precise macroeconomic outcome.
Mainstream economists generally agree that
monetary policy is the best month-to-month stabilization tool for the US economy.
If monetary policy is doing its job, the government...
should maintain a relatively neutral fiscal policy, with a standardized budget deficit or surplus of no more than 2 percent of potential GDP. It should hold major discretionary fiscal pollicy in reserve to help counter situations where recession threathens to be deep and long-lasting or where a substantial reduction in aggregate demand might help to eliminate a large inflationary gap and aid the Federal Reserve in its efforts to quell the major bout of inflation caused by that large inflationary gap.
Finally, economists agree that proposed fiscal policy
should be evaluated for its potential positive and negative impacts on long-run productivity growth. The short-run policy tools used for conducting active fiscal policy often have long-run impacts. Countercyclical fiscal policy should be shaped ti strengthen, or at least not impede, the growth of long-run affregate supply (shown as a rightward shift of the long-run aggregate supply curve.
Alternatively, an increase in government spending might center on...
preplanned projects for public capital (highways, mass transit, ports, airports), which are complementary to private investment and thus support long term economic growth.