ECON 120 Grossmont Cuyamaca Community College District Fiscal Policy Discussion

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Economics

econ 120

Grossmont Cuyamaca Community College District

ECON

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Answer the following questions based on the notes that will be attached, lecture video, and response to classmate post.

Fiscal Policy Forum

Lecture video:https://www.youtube.com/watch?v=qk0FkrratoI&feature=youtu.be

In chapter 16 we learned about fiscal policy –the federal government’s tool kit for addressing business cycle fluctuations. In chapter 12 we learned that business cycle fluctuations are caused by changes in aggregate expenditure. One implication of this idea is that if we are in a recession, it is because total spending has decreased. Therefore, if we want to get out of a recession, total spending needs to increase. Chapter 16 offers two ways to stimulate total spending –through tax cuts or increases in government spending.

Typically, Republicans favor tax cuts, while democrats favor increases in government spending. There are economic rationales for both positions. Tax cuts put money into the pockets of consumers, who are better than the government at determining how resources should be allocated –this promotes “allocative efficiency” (from chapter 1). On the other hand, tax cuts have a lower multiplier effect than increases in government spending. This means that we get more economic stimulus from a given dollar value of government spending than the same dollar value in tax cuts.

The tradeoff here is between more efficiency (with tax cuts) vs. more economic stimulus (with government spending). Differences of opinion on this matter are cause for heated political debate and overblown political rhetoric.

So what do you think? Do you prefer economic stimulus from tax cuts or increases in government expenditure? Please post a response about the issue and support it with economic reasoning, information you learned from reading the chapter material, and with internet research (post a link to at least one article or website that passes the CRAAP Test (Links to an external site.)). Then, please respond to the position of at least one classmate, and use research evidence to try to convince the individual (and the class) that you are correct. Your response can be to someone who shares your view, but it will probably be more fun to debate someone on the other side of the issue.

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Chapter 16: Fiscal Policy Fiscal Policy is all about how the federal government, specifically the congress and the president, can affect macroeconomic policy objectives. Fiscal Policy: Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and economic growth. We typically reserve the term fiscal policy for actions of the federal government, not state and local governments. This is because state and local governments’ actions are typically directed at the local economy, whereas the federal government’s actions are directed at the national economy. We are probably all aware that there are aspects of the behavior of the federal government that affect the economy, but we should be sure to make the distinction between the deliberate actions of the federal government takes to stimulate the economy, and changes in spending that occur passively. For example, when the economy starts slow down, tax revenues typically fall, and lower taxes typically stimulate the economy. Also, as the economy does poorly, unemployment rises, and the government spends more on unemployment insurance. Typically increased government spending stimulates the economy. The opposite of these effects are true also. These types of automatic improvements are called: Automatic Stabilizers: Government spending and taxes that automatically increase or decrease along with the business cycle. We know that some increases in spending by governments happen automatically, and we call those automatic stabilizers, or automatic fiscal policy. We will reserve the term fiscal policy for new laws created by the government, which are specifically intended to pursue macroeconomic objectives. –In other words, increases in spending or decreases in taxation that occur as a change in policy, not automatically. This is often referred to as: Fiscal Policy (or sometimes Discretionary Fiscal Policy): Deliberate changes in government spending or tax policy intended to achieve economic goals. Fiscal policy changes in response to two types of problems. If the economy is in a recession, fiscal policy may change to stimulate the economy with tax cuts and/or increases in government spending. This type of policy change is called expansionary fiscal policy. The other type of problem that fiscal policy may try to address is inflation. If inflation becomes a problem, the government will try to reduce GDP growth by increasing taxes and/or decreasing government spending, which will in turn reduce the inflation rate. This type of policy is called contractionary fiscal policy. Basically, fiscal policy works like this: when the economy is performing poorly, the government will increase its spending or cut taxes. Increasing government spending will increase aggregate expenditure because government expenditure is a part of aggregate expenditure. Also, don’t forget about the multiplier effect. When the government increases its expenditures, others in the economy experience higher income, some of which they spend. The other approach to expansionary fiscal policy is cutting taxes, which will put more money in people’s pockets with the hope that they will spend that money to stimulate the economy. Sometimes the economy is growing too quickly, and inflation can become a problem. In this case, the government may increase taxes or decrease spending to decrease AE, which will reduce GDP and the inflation rate. Fiscal policy is an important tool, but it does have considerable limitations. One problem is timing. It takes a long time to gather economic data, and sometimes the wrong policy can be instituted because the economy is not where we think it is. For example, during the summer of 2008, when oil prices were very high, there was a lot of talk about rising inflation. However, we were already in a recession and didn’t know it yet. Imagine if we tried to combat the inflation by using contractionary fiscal policy. We would have been in a recession already, and instituting policy to contract the economy even further. We didn’t do that, but we were close. So timing is one issue. Another issue is that increasing government expenditure increases the demand for money. As we saw last chapter, increasing the demand for money, all things equal, will increase the interest rate. Here is a graph showing how this occurs: With higher interest rates, as we know, consumption and investment (and also net exports) will decrease. We say in this case that government spending is crowding out private expenditure. Crowding Out: A decline in private expenditures as a result of an increase in government purchases. One last thing to consider regarding fiscal policy are deficits, surpluses and government debt. When the economy enters a recession, we think that the federal government should spend more money to try to stimulate the economy. However, recall from our discussion of automatic stabilizers that when the economy enters a recession, tax revenues fall. So at the same time as tax revenues are falling, we think the government should be spending more. This is not good for the budget of the United States Treasury, and can possibly lead to or exacerbate a: Budget deficit: The situation in which the government’s expenditures are greater than its tax revenues. Although very uncommon, it is also possible for the government to bring in more in tax revenue than it spends on goods and services, and this situation is called a: Budget Surplus: The situation in which tax revenues exceed government expenditures. Deficits should not be confused with government debt, which is: Government Debt: The sum of all previous year’s deficits and surpluses. Our federal government has been running deficits for years. In fact, every year from 1970 to 1997 we had budget deficits. Not one year during that period was our government balancing its budget. Then, from 1998 to 2001 we ran a surplus, until the wars in Iraq and Afghanistan, and we have been running deficits again ever since. Currently we have a large and growing debt. This means that we will, for some period of time, have to pay higher taxes and have fewer government services in order to pay off the debt. Since an entire generation underpaid its taxes (deficits from 1970 through 1997), future generations will have to pay the difference, plus interest. Prolonged budget deficits therefore represent a wealth transfer between generations. Some economists suggest heavily taxing the estates of those who die as a way of mitigating the inter-generational wealth transfer. Having a large debt is bad for several reasons, most importantly because we have to pay interest on it, and that money could be spent elsewhere. An important question to ask, though, is how bad is the debt? When thinking about a debt burden, one should consider the ability of the debtor to repay. For example, if I owed someone $1 million, that would be a big problem for me because my income is relatively low… but if a professional athlete making $20 million per year had that same debt, it would be no problem. Similarly, when considering how bad the USA’s debt is, we should consider that the government can pay this off by taxing a very rich economy, so it isn’t nearly as bad as if a poorer country had that debt. Since it makes sense to consider the ability of a debtor to repay when analyzing the severity of a debt burden, economists compare debt across countries by calculating something called the debt to GDP ratio: Debt to GDP Ratio = [Government Debt/ GDP]*100 Currently the debt to GDP ratio for the USA is a bit over 100%, which isn’t great. However, by this measure, we are doing fine compared to other countries. By far, Japan is in the worst shape of any country (at well over 200%). Compounding matters for Japan is the fact that their population is shrinking, so the debt is being spread over fewer and fewer people each year. So although we have by far the most debt of any country in the world, this is greatly mitigated by the fact that we have the largest economy in the world.
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