Unit 5: Fiscal Policy
Governments use policies and tools to steer the macroeconomy toward three primary goals: full employment, price stability, and economic growth. In this unit, we study fiscal policy, which involves taxing and spending policies, including the fiscal legislation Congress enacts in the United States.
Completing this unit should take you approximately 4 hours.
Upon successful completion of this unit, you will be able to:
- identify the major components of the U.S. government revenues and spending;
- define budget surplus, budget deficit, and balanced budget and how they are related to the national debt;
- identify the goals and tools of discretionary fiscal policy and distinguish them from automatic stabilizers;
- identify the lags in carrying out discretionary fiscal policy;
- analyze how government borrowing causes crowding out of private investment;
- use the Phillips curve to identify the relationship between inflation and unemployment;
- use the model of aggregate demand and aggregate supply to explain a Phillips, stagflation, and recovery phase;
- compare and contrast fiscal and monetary policy; and
- explain Classical, Keynesian, and Monetarist beliefs on policies to stabilize the economy.
5.1: Fiscal Policy
Governments enact fiscal and economic policies using their spending and taxation powers to influence or help drive the economy. Politicians can use their powers to drive fiscal policy to promote strong and sustainable economic growth and reduce poverty.
Read this text on U.S. government spending. It discusses the U.S. budget deficit and surplus trends during the past five decades. What is the difference between the U.S. federal, state, and local government budgets?
Americans pay two main categories of taxes to fund government spending initiatives: federal taxes and the taxes collected by state and local governments. The federal government collects individual income taxes, corporate income taxes, and social insurance and retirement receipts. State and local governments collect sales taxes, property taxes, and the revenue they receive from the federal government. Many state and local governments also levy personal and corporate income taxes and charge additional fees for certain services. Be sure you can explain the difference between regressive, proportional, and progressive taxes.
Economic growth and decline determine whether the government experiences a budget surplus or deficit.
Be sure you can explain the difference between the national debt and the budget deficit. The national debt refers to the total amount the government has borrowed over time, while the budget deficit refers to how much the government borrows in just one year.
Read this text, which offers a graphical depiction of how expansionary and contractionary fiscal policies shift aggregate demand.
The U.S. Congress enacts discretionary fiscal policies to stabilize the economy. For example, in 2020, Congress issued stimulus checks to those affected by the Covid pandemic. Automatic stabilizers are programs, such as unemployment insurance and food stamps, that Congress designed in the 1930s to increase automatically according to the state of the economy. These programs stimulate aggregate demand during a recession by putting money in people's pockets to spend, and they help hold aggregate demand in check during inflationary periods.
Read this text, which explains how fiscal and monetary policies are interconnected. Three types of delays often occur when governments try to implement fiscal policy: recognition, legislative, and implementation lag. Be sure you can define the reasons for each. What are some legal and political challenges governments face when trying to respond to economic problems?
Economists and politicians often argue over the benefits of requiring the U.S. Congress and the President to pass a balanced every fiscal year. Some argue that we may need to invest more in programs and initiatives that will benefit everyone now and in the future. Others complain that borrowing money is reckless and saddles our children and future generations with huge deficits and interest payments for programs they never approved or benefited from. This text presents some of those arguments.
5.2: The Impact of Government Borrowing
As our government continues to spend more, it needs to borrow more. This increased borrowing is what has led to tax rates continuously rising historically.
Read this text on the national savings and investment identity concerning supply and demand. What role do budget surpluses and trade surpluses play? The United States has two main sources of financial capital: private savings (S) and public savings (T-G or taxes collected minus government spending). Foreign investment capital equals imports (M) minus exports (X).
Read this text on twin deficits and the relationship between budget deficits, exchange rates, and inflation. What causes recessions?
David Ricardo (1772–1823) was an English classical economist who created the concept of Ricardian equivalence, the theory that private households can shift their savings to offset government saving or borrowing. In other words, private savings in the microeconomic context can completely offset budget deficits and surpluses. Figure 18.6 offers a graphical depiction of this theory.
Watch these videos to review components of the government's budget – taxation (revenue) and government spending as tools of discretionary fiscal policy. Crowding out results from excessive government borrowing.
Read this text on the effect crowding out has on physical capital investment, the relationship between budget deficits and interest rates, and why economic growth is tied to investments in physical and human capital and technology.
Watch this lecture on the tax level of fiscal policy and how governments can impact aggregate demand with taxation while keeping spending unchanged. We may see a budget surplus when governments collect more tax revenue from businesses, individuals, and other countries, a rare event for countries like the United States.
5.3: Inflation and Unemployment
In 1958, William Phillips (1914–1975), an New Zealand economist, discovered an inverse relationship between unemployment and inflation in the economic data he was studying. This relationship was later called the Phillips Curve. Prices rise when unemployment falls – more people have jobs and can afford to buy more. Prices fall when unemployment increases – fewer people have jobs and less money to spend. Hence the inverse relationship between these two variables. Naturally, higher levels of unemployment prompt businesses and customers to budget more – which is contractionary spending.
Watch this video on the Phillips Curve and the macroeconomic debates this concept has stirred over time.
Watch this video on the AD-AS Model we studied in Unit 3 and the Phillips curve. Sal Kahn examines the long-run Phillips curve and explains the links between changes in the AD-AS model and the Phillips curve model.
Watch this video which compares fiscal and monetary policy. Both policies have similar goals in trying to eliminate recessionary and inflationary gaps in the economy. Contractionary fiscal policy means the government spends less and taxes people and businesses more, so they also spend less. Contractionary spending creates a budget surplus and reduces inflationary pressures. Expansionary fiscal policy means the government spends more and taxes less, so people and businesses spend more to expand the economy and fend off a recessionary gap.
The Federal Reserve promotes expansionary monetary policy by decreasing interest rates to increase spending to eliminate a recession. The Federal Reserve promotes contractionary monetary policy by increasing interest rates to reduce spending and eliminate inflationary pressures. These two types of economic policy use different tools, implementation, and entities making policy decisions.
5.4: The Keynesian Perspective
John Maynard Keynes (1883–1946), an English economist, stated that three things affect consumption: disposable income, expected future income, and wealth or credit. The Keynesian perspective focuses on aggregate demand. Keynes argued that the amount of goods and services that sell (real GDP) depends on demand across the economy. If AD falls, we experience a recessionary gap; if it rises, we see an inflationary gap.
Read this text, which explores the Keynesian perspective. What are the determining factors of consumption and investment expenditure? What factors promote government spending and net exports?
Read this text on the Keynesian understanding of recessions, sticky wages and prices, and aggregate demand. What is the coordination argument? Menu costs refer to how much it costs to change costs, such as how much it costs to print new menus in a restaurant. What is a macroeconomic externality? The expenditure multiplier refers to the Keynesian concept that changes in spending have a multiplied or more than proportional effect on GDP.
Read this text on the Phillips Curve, which examines a tradeoff between unemployment and inflation from a Keynesian perspective. Keynes argued that governments should employ expansionary fiscal policy measures to shift aggregate demand to the right to end a recession by cutting taxes and increasing government spending. Governments should adopt a contractionary fiscal policy to shift aggregate demand to the left to alleviate inflationary periods by increasing taxes and cutting government spending.
Read this text for examples of Keynesian perspective in government economic policy.
5.5: The Neoclassical Perspective
The Neoclassical view of macroeconomics is a revision of classical theories of the economy that predated the Great Depression during the 1930s. According to this perspective, the economy fluctuates around potential GDP and the natural unemployment rate in the long run. Neoclassical economics is a broad theory that focuses on supply and demand as the driving forces behind producing, pricing, and consuming goods and services. It emerged around 1900 to compete with the earlier theories of classical economics. This school of thought emphasizes the innate rationality of consumers, the importance of the profit motive for companies, the need for governments to advocate for market equilibrium, and the influence of utility on prices.
Read this text, which explains this theory, the role of flexible prices, the neoclassical model of aggregate demand and aggregate supply, and different ways to measure the speed of macroeconomic adjustment. What are the theories of rational and adaptive expectations?
Read this text, which explores how economists measure inflation expectations, the impacts of fiscal and monetary policy on aggregate supply and aggregate demand, and the Neoclassical Phillips Curve. Be sure you can compare Neoclassical and Keynesian economics.
Read this text on the interrelationship between Neoclassical and Keynesian models and how their economists react to recent recessions in the United States.
Read this chapter for a historical perspective on fiscal and monetary policy, its evolution, and its functionality.
Unit 5 Assessment
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