2. Fiscal Policy
PREPARED BY:
UMAIR

3. Introduction
Fiscal policy uses government purchases,
transfer payments, taxes, and borrowing to
affect macroeconomic variables such as
employment, the price level, and the level
of GDP.

4. Expansionary Fiscal Policy
 When the economy is in recession,
government wants to increase AD
 Tax cut: increases consumers disposable
income
 Increases AD as long as consumers don’t
increase savings or spending on imports
 Increase in government spending: directly
shifts the AD curve

5. Contractionary Fiscal Policy
 When economy is suffering from
inflation, government wants to decrease
AD
 Tax increase: decreases disposable
income of consumers
 AD curve shifts left, both inflation and
GDP decrease
 Decrease in government spending:
directly shifts the AD curve left

6. Tools of Fiscal Policy
1. Automatic Stabilizers
 Structural features of government
spending and taxation that smooth
fluctuations in disposable income, and
hence consumption, over the business
cycle.

7. Automatic Stabilizers
 There are several fiscal programs that
provide countercyclical policy and take
effect automatically, without a change in
legislation.

8. Automatic Stabilizers
1. Unemployment compensation
 When economy is in recession, people are laid off.
 Unemployment compensation spending goes up (G increases) to
pay unemployed workers and Unemployment compensation taxes
imposed on businesses will decrease because of the reduction in
employment.
 Government spend goes up, Government Tax Receipts go down,
pushing the budget toward a deficit during a recession, supplying
the expansionary fiscal policy at the right time.
 During an expansion, Unemployment compensation payments go
down, Unemployment compensation taxes go up.
 Government spending fall, government receipts rise, so the
budget moves toward a surplus (restrictive fiscal policy) at the
right time.

9. Automatic Stabilizers
2. Corporate Profit Tax Receipts
 Corporate profit tax receipts are highly
sensitive to economic conditions and thus
highly cyclical, going up during an
expansion and falling during a recession.
 By going down during a recession, falling
corporate taxes help move the budget
toward a deficit during a contraction.

10. Automatic Stabilizers
3. Progressive Income Tax System
 Progressive income tax system provides auto
stabilizer.
 When incomes are rising, economy is
expanding, people get forced into higher tax
brackets, raising income tax receipts, moving
the budget toward a surplus.
 When incomes are falling, people move to
lower tax brackets, reducing income tax
receipts and moving the economy toward a
deficit.

11. Automatic Stabilizers
 Conclusion, during a recession, budget
automatically moves toward a deficit, due to:
increased unemployment payments, decreased
unemployment taxes, corporate taxes and personal
income taxes.
 During an expansion, budgets automatically
moves toward surplus due to: reduced
unemployment payments, increased
unemployment taxes, corporate taxes and personal
taxes.

12. Tools of Fiscal Policy
2. Discretionary Fiscal Policy
 The deliberate manipulation of
government purchases, taxation, and
transfers in order to promote
macroeconomic goals such as full
employment, price stability, and economic
growth.

13. Discretionary Fiscal Policy
1. Changes in Government Purchases
 Can increase spending in normal budgetary
programs (health, education, welfare, etc.)
 Can increase spending on infrastructure
(underlying economic foundation of goods
and services that allows a society to function
e.g. build roads, schools, communication
systems)
 Added advantage of increasing capital goods
in economy which can shift AS in the future

14. Discretionary Fiscal Policy
2. Changes in Net Taxes
 Decrease in net taxes  increases
disposable income  consumption
increases  increases real GDP
demanded.
 Increase in net taxes  decreases
disposable income  consumption
decreases  decreases real GDP
demanded.

15. Discretionary Fiscal Policy
Discretionary Fiscal Policy in Response to a Contractionary
Gap
 Suppose that in short-run equilibrium, we have a
contractionary gap.
 Unemployment is above the natural rate.
 If the market adjusts naturally, the nominal price of resources
will drop in the long run; short-run aggregate supply would
shift out to achieve equilibrium at potential output.
 Often, however, wages and prices are slow to adjust.
 Government may introduce fiscal policy to move the
economy more quickly back to potential output.
 They might change net taxes or government spending or both.

16. Discretionary Fiscal Policy
 Discretionary Fiscal Policy in Response to
an Expansionary Gap
 If short-run equilibrium price level exceeds
the level on which long-term contracts were
based, output exceeds potential GDP.
 In the long run, we expect the short-run
aggregate supply curve to shift back,
returning the economy to potential output
and increasing the price level.
 Use of discretionary fiscal policy can avoid
inflation.

17. Fiscal Policy and the Multiplier
 Fiscal policy has a multiplier effect on the economy.
 Expansionary fiscal policy leads to an increase in real GDP
larger than the initial rise in aggregate spending caused by the
policy.
 The government spends an additional $4 Billion through
discretionary fiscal policy.
 The total effect on GDP will be larger than $4 Billion.
 The multiplier effect refers to the additional shifts in
aggregate demand that result when expansionary fiscal policy
increases income and thereby increases consumer spending.
 Conversely, contractionary fiscal policy leads to a fall in real
GDP larger than the initial reduction in aggregate spending
caused by the policy.

18. The Budget Balance
 Other things equal, discretionary expansionary
fiscal policies—increased government purchases
of goods and services, higher government
transfers, or lower taxes—reduce the budget
balance for that year.
 That is, expansionary fiscal policies make a
budget surplus smaller or a budget deficit bigger.
 Conversely, contractionary fiscal policies—
smaller government purchases of goods and
services, smaller government transfers, or higher
taxes—increase the budget balance for that year,
making a budget surplus bigger or a budget deficit
smaller.

19. Government Budgets
 Deficit budget: government spends more than it receives in tax revenue
(must borrow money to cover shortfall)
 Surplus budget: government collects more in taxes than it spends
 Balanced budget: government spends amount equal to collected tax
revenue
 Debt: total amount owed by the government
 Deficits Versus Debt
 A deficit is the difference between the amount of money a government
spends and the amount it receives in taxes over a given period.
 A debt is the sum of money a government owes at a particular point in time.
 Deficits and debt are linked, because government debt grows when
governments run deficits.
 But they aren’t the same thing, and they can even tell different stories.

20. Should the Budget Be
Balanced?
 Most economists don’t believe the
government should be forced to run a
balanced budget every year because this
would undermine the role of taxes and
transfers as automatic stabilizers.
 Yet policy makers concerned about
excessive deficits sometimes feel that
rigid rules prohibiting—or at least setting
an upper limit on—deficits are necessary.

21. Problems Posed by Rising
Government Debt
 Public debt may crowd out investment
spending, which reduces long-run economic
growth.
 And in extreme cases, rising debt may lead
to government default, resulting in economic
and financial turmoil.
 Can’t a government that has trouble
borrowing just print money to pay its bills?
 Yes, it can, but this leads to another problem:
inflation.

22. Drawbacks and Limitations of
Fiscal Policy
Time lags are significant
 Recognition lag: time it takes government to
recognize there is a problem
 Decision lag: time required for government
to determine most appropriate policy
 Implementation lag: time it takes to figure
out how to implement new directives
 Impact lag: time it takes to be felt through
multiplier effect

23. Drawbacks and Limitations of
Fiscal Policy
 Difficulties in changing spending and
taxation policies
 It is far easier to increase spending and
decrease taxes then to increase taxes and
decrease spending
 Conflict between levels of government over
appropriate policies. Federal, provincial and
city governments may differ on what needs
to be done.
 Regional variations: Some provinces can be
in recession while others are still growing.

24. Drawbacks and Limitations of
Fiscal Policy
Crowding Out
Scenario I
 Economy is in recession.
 Government runs budget deficit to stimulate the economy back to
full output.
 Deficit requires borrowing.
 Government borrowing puts upward pressure on interest rates.
 Government competes for limited funds with businesses.
 At higher interest rates, private investment gets "crowded out.“
 Less private investment at higher interest rates, so AD may not shift
all the back to full employment output.
 Also, less private investment has negative effect on output in future
periods due to lower supply of capital equipment.

25. Drawbacks and Limitations of
Fiscal Policy
Scenario II
 Economy is expanding.
 Government decreases spending and/or
raises taxes and runs smaller budget deficit.
 Reduces demand for credit, putting
downward pressure on interest rates.
 Lower interest rates stimulate the economy
and may prevent the economy from returning
to full output - economy will stay above full
output.

26. Drawbacks and Limitations of
Fiscal Policy
Feedback Effects of Fiscal Policy on Aggregate
Supply
 Fiscal policy may affect aggregate supply, often
unintentionally.
 Changes in transfer payments/taxes not only affect
AD, but could cause changes in the labor supply.

 Both automatic stabilizers, unemployment
insurance and the progressive income tax, and
discretionary fiscal policy, such as changes in tax
rates, may affect individual incentives to work,
spend, save, and invest, although these effects are
usually unintended.

27. Drawbacks and Limitations of
Fiscal Policy
Discretionary Policy and Permanent Income
 Permanent Income – Income individuals expect to
receive on average over the long term.
 People base their consumption decisions not just
on current income but also on permanent income.
 If people view tax changes as only temporary,
they will not have their desired effect.
 To the extent that consumers base spending
decisions on their permanent income, attempts to
fine-tune the economy with tax-rate adjustments
thought to be temporary will be less effective.

28. The Evolution of Fiscal Policy
 Prior to the Great Depression, public
policy was based on the views of classical
economists.
 The object of fiscal policy was only to
balance the budget.

29. The Evolution of Fiscal Policy
 Classical economists – A group of 18th- and 19th-
century economists who believed that recessions
were short-run phenomena that corrected
themselves through natural market forces; thus
they believed the economy was self-correcting.
 They believed that most economic crises were
caused by sources other than market forces (wars,
poor growing seasons, and changes in tastes.)
 They felt that active fiscal policy would do more
harm than good.
 Recessions/inflation temporary and would be
fixed by market forces.

30. The Evolution of Fiscal Policy
Great Depression and WWII
3 things happened to increase the use of discretionary
fiscal policy
1. 1936 Keynes' The General Theory
 Keynesian theory and policy were developed to
address the problem of unemployment arising from
the Great Depression.
 He argued that prices, wages were not flexible enough
to ensure full employment of resources.
 Business expectations might at times be so grim, that
even high low rates wouldn’t get firms investing.

31. The Evolution of Fiscal Policy
2. WWII increased production and
eliminated cyclical unemployment during
the war years, pulling the economy out of
the depression.
3. Employment Act of 1946 gave the
federal government the responsibility for
promoting full employment and price
stability.

32. The Evolution of Fiscal Policy
 MODERN VIEW OF FISCAL POLICY
(Accepted by most Keynesian and non-Keynesians)
1. When substantial unused capacity is present during a recession,
expansionary fiscal policy may be able to help stimulate the
economy back to full employment.
2. During normal economy times, fiscal policy is relatively
ineffective at stimulating AD, due to the secondary effects of
crowding out, exports declining and/or people saving tax cuts.
3. Proper timing of discretionary policy is both extremely difficult
to achieve and extremely crucial if it is to help the econ. Because of
this, most economy favor active, discretionary fiscal policy only in
response to a major recession.