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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