Unit III: Fiscal Policy

Fiscal policy is the changes in the expenditures or tax revenues of the federal government. It is enacted to promote our nation's economic goals: full employment, price stability, and economic growth. There are two tools of fiscal policy:

• Taxes--government can increase or decrease taxes
• Spending--government can increase or decrease spending

Here is some information about deficits, surpluses, and debt:

• Balanced budget
• Revenues = Expenditures
• Budget deficit
• Revenues < Expenditures
• Budget surplus
• Revenues > Expenditures
• Government debt
• Sum of all deficits - Sum of all surpluses
• The government must borrow money when it runs a budget deficit
• The government borrows from:
• Individuals
• Corporations
• Financial institutions
• Foreign entities or foreign governments

There are two options for fiscal policy:

• Discretionary fiscal policy (action)
• Expansionary fiscal policy -- think deficit
• Contractionary fiscal policy -- think surplus
• Non-discretionary fiscal policy (no action)

Discretionary fiscal policies increase or decrease government spending and/or taxes in order to return the economy to full employment. It involves policymakers doing fiscal policy in response to an economic problem.

Automatic fiscal policies are exemplified by unemployment compensation and marginal tax rates, which help mitigate the effects of recession and inflation. It takes place without policymakers having to respond to current economic problems.

Expansionary fiscal policy is used to counter recessions. The price level is increased, which means that expansionary fiscal policy creates some inflation.

• Increase in government spending (G up)
• Decrease in taxes (T down)

Contractionary fiscal policy is used to counter inflation. The unemployment rate is increased, which means that contractionary fiscal policy creates some unemployment.

• Decrease in government spending (G down)
• Increase in taxes (T up)

There are some weaknesses of fiscal policy called lags. There are two types:

• Inside lags take time to recognize economic problems and to promote solutions to those problems
• Outside lags take time to implement solutions to problems

Supply-side policies stimulate production (supply) to spur output. They cut taxes and government regulations to increase incentives for businesses and individuals. Businesses invest and expand, creating jobs; people work, save, and spend more. An increase in investment and productivity lead to an increase in output.

Demand-side policies stimulate the consumption of goods and services (demand to spur output). They cut taxes or increase federal spending to put money into people's hands. With more money, people buy more. Businesses increase output to meet the growing demand.

Automatic or built-in stabilizers are anything that increases the government's budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policymakers. Transfer payments are types of automatic stabilizers. Here are some examples:

• Welfare checks
• Food stamps
• Unemployment checks
• Corporate dividends
• Social Security
• Veteran's benefits

There are three types of tax systems: progressive, proportional, and regressive tax systems.

• There is a progressive tax system when the average tax rate (tax revenue/GDP) rises with GDP
• There is a proportional tax system when the average tax rate remains constant as GDP changes
• There is a regressive tax system when the average tax rate falls with GDP

Note: the more progressive the tax system, the greater the economy's built-in stability.

For more information, please refer to these videos on Khan Academy:

Fiscal policy to address output gaps: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/national-income-and-price-determinations/fiscal-policy-ap/v/fiscal-policy-to-address-output-gaps-ap-macroeconomics-khan-academy?modal=1

Calculating change in spending or taxes to close output gaps: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/national-income-and-price-determinations/fiscal-policy-ap/v/calculating-change-in-spending-or-taxes-to-close-output-gaps?modal=1

Automatic stabilizers: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/national-income-and-price-determinations/automatic-stabilizers-ap/v/automatic-stabilizers-ap-macroeconomics-khan-academy?modal=1

Crowding out: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/ap-long-run-consequences-of-stabilization-policies/crowding-out/v/crowding-out-ap-macroeconomics-khan-academy?modal=1

Deficits and debts: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/ap-long-run-consequences-of-stabilization-policies/deficits-and-debts/v/deficits-and-debt-ap-macroeconomics-khan-academy?modal=1