ECON102 Study Guide

Unit 5: Fiscal Policy

5a. Explain the effect of government spending, taxation, and budget deficits and surpluses on GDP

The government budget typically includes government spending (government purchases), transfer payments, and taxation. Government spending and transfer payments cause an outflow of government funds (expenses); taxation causes an inflow of funds (income or revenue).

Government Spending

Name some examples of government purchases.
Have federal government purchases increased during the past 50 years in the United States?
Have state and local government purchases increased during the past 50 years in the United States?
Have government purchases, as a percentage of GDP, increased during the past 50 years in the United States?
How do government purchases change with the business cycle?
What is the effect of a change in government spending on GDP?

Transfer Payments

Define and name some examples of transfer payments.
What does a drastic increase in transfer payments, as a percentage of GDP, say about the state of our welfare system?
How do transfer payments change with the business cycle?

Government Revenues

Define elements of federal government revenue: payroll taxes, individual income taxes, and corporate income taxes.
Define elements of state and local government revenue: property taxes, sales taxes, individual income taxes, corporate income taxes, and federal government revenue.
How has the tax rate changed during the past 50 years in the United States?
How does the tax rate change with the business cycle?
How does a change in the tax rate affect GDP?

Government Budget

How do governments finance a budget deficit?
How does the government budget fluctuate with the business cycle?
Is it better for a government to have a budget surplus, a budget deficit, or a balanced budget?

When government revenues exceed total government spending and transfer payments, we experience a budget surplus. When government revenues are less than total government spending and transfer payments, we experience a budget deficit. When government revenues equal total government spending and transfer payments, we have a balanced budget.

To review, see:

5b. Explain how the various kinds of lags influence the effectiveness of discretionary fiscal policy

Define recognition lag, implementation lag, and impact lag.
Name some inherent obstacles in government that exacerbate these time lags.

Governments often run into delays, or time lags, when they use fiscal policy to influence the economy.

A recognition lag describes a delay in the time it takes policymakers to become aware of a problem in the economy. For example, while the housing bubble grew in the United States in 2004-07, most policymakers ignored indicators that suggested housing prices were overinflated and the banking system was systematically offering risky loans to people who could not afford to repay them. Officials should not have been surprised when the housing bubble burst in 2007-08.

An implementation lag refers to a delay in the time it takes policymakers to enact a remedy for a problem. For example, Congress waited until 1964 to enact a tax cut President John Kennedy proposed in 1960 to alleviate a mild economic slowdown. By the time Congress passed the legislation, the U.S. economy was beginning to experience inflation and needed a different fiscal remedy.

An impact lag describes a delay between the time a policy is enacted and when the economy feels its impact.

To review policy lags, see Problems and Controversies of Monetary Policy.

5c. Explain how discretionary fiscal policy works and influences aggregate demand

Define fiscal policy.
Define and differentiate between discretionary and nondiscretionary spending.
Define automatic stabilizer in terms of fiscal policy (review this material in Unit 2).
How do changes in household taxes influence disposable income, consumption, and aggregate demand?
How do changes in business taxes influence investment and aggregate demand?
How do changes in government spending influence aggregate demand?
How do changes in aggregate demand influence real GDP and inflation?
How does government use spending programs and taxes to promote economic expansion and economic contraction?
Describe the economic circumstances that prompt a government to employ an expansionary or contractionary fiscal policy.

Fiscal policy describes the policies governments enact to influence the aggregate economy, real GDP, and the price level. Policymakers use two primary discretionary fiscal policy tools: government spending and taxation.

Discretionary spending refers to spending policies federal, state, and local legislators approve or enact via the appropriations and legislative process. For example, in the United States, Congress, the legislative branch that has the "power of the purse". Congress authorizes spending to fund programs that support national defense, transportation, education, foreign aid, etc.

Congress has also passed certain automatic, mandatory, non-discretionary spending programs that they have agreed do not warrant annual authorization. These programs receive automatic, annual, funding increases. These non-discretionary spending programs include social security, Medicare, and Medicaid. Keep in mind that Congress has the power to reduce or eliminate these programs, but chooses not to.

Automatic stabilizers (reviewed in Unit 2) describe the programs Congress has legislated that automatically stimulate aggregate demand during an economic slowdown, and automatically reduce aggregate demand during a period of inflation. Examples of automatic stabilizers include unemployment and welfare benefits, and the individual and business tax rate.

Recall how we measured aggregate expenditure and aggregate demand in Unit 2:

Aggregate Demand = Consumption + Investment + Government Spending + Net Exports

Expansionary and Contractionary Fiscal Policies to Shift Aggregate Demand

In Panel (a), the economy faces a recessionary gap (YP − Y1). An expansionary fiscal policy seeks to shift aggregate demand to AD2 to close the gap. In Panel (b), the economy faces an inflationary gap (Y1 − YP). A contractionary fiscal policy seeks to reduce aggregate demand to AD2 to close the gap.

To review fiscal policy, see:

5d. Identify the major components of US government spending and their sources

Review the major components of U.S. government spending and their sources in learning outcome 5a above.

5e. Define the terms budget surplus, budget deficit, and balanced budget

Review what it means for the government to project a budget surplus, budget deficit, and balanced budget in learning outcome 5a above.

5f. Explain the difference between a budget deficit and the national debt

What happens to the national debt when a country runs chronic budget deficits over many years?
How does the U.S. national debt compare with that of other countries, in absolute terms and as a percentage of GDP?
Should Americans be concerned about the national debt level in the United States?
How do economists project the U.S. national debt will fare in the coming years as more baby boomers retire and we experience improvements to health and longevity?

Economists calculate the national debt as the sum of all past federal deficits, minus all surpluses. Government spending on the social security program, as the baby boomer generation retires en masse, is one of the largest components of the U.S. national debt.

To review the budget deficit and the national debt, see:

Unit 5 Vocabulary

Automatic stabilizers
Balanced budget
Budget deficit
Budget surplus
Contractionary fiscal policy
Corporate income tax
Discretionary spending
Expansionary fiscal policy
Fiscal policy
Government purchases
Government revenue
Impact lag
Implementation lag
Individual income tax
National debt
Nondiscretionary spending
Payroll tax
Property tax
Recognition lag
Sales tax
Taxes
Transfer payments