Government and Fiscal Policy
Read this chapter to learn about how the government's fiscal actions influence aggregate demand. The chapter first introduces the components of the government's budget and then discusses discretionary fiscal policy and automatic stabilizers used to influence the economy. Some lags in the implementation of fiscal policy are identified and the concept of crowding out is introduced. Attempt the "Try It" exercises at the end of the section.
2. The Use of Fiscal Policy to Stabilize the Economy
Discretionary Fiscal Policy Tools
As we begin to look at deliberate government efforts to stabilize the economy through fiscal policy choices, we note that most of the government's taxing and spending is for purposes other than economic stabilization. For example, the increase in defense spending in the early 1980s under President Ronald Reagan and in the administration of George W. Bush were undertaken primarily to promote national security. That the increased spending affected real GDP and employment was a by-product. The effect of such changes on real GDP and the price level is secondary, but it cannot be ignored. Our focus here, however, is on discretionary fiscal policy that is undertaken with the intention of stabilizing the economy. As we have seen, the tax cuts introduced by the Bush administration were justified as expansionary measures.
Discretionary government spending and tax policies can be used to shift aggregate demand. Expansionary fiscal policy might consist of an increase in government purchases or transfer payments, a reduction in taxes, or a combination of these tools to shift the aggregate demand curve to the right. A contractionary fiscal policy might involve a reduction in government purchases or transfer payments, an increase in taxes, or a mix of all three to shift the aggregate demand curve to the left.
Figure 12.8 "Expansionary and Contractionary Fiscal Policies to Shift Aggregate Demand" illustrates the use of fiscal policy to shift aggregate demand in response to a recessionary gap and an inflationary gap. In Panel (a), the economy produces a real GDP of Y1, which is below its potential level of Yp. An expansionary fiscal policy seeks to shift aggregate demand to AD2 in order to close the gap. In Panel (b), the economy initially has an inflationary gap at Y1. A contractionary fiscal policy seeks to reduce aggregate demand to AD2 and close the gap. Now we shall look at how specific fiscal policy options work. In our preliminary analysis of the effects of fiscal policy on the economy, we will assume that at a given price level these policies do not affect interest rates or exchange rates. We will relax that assumption later in the chapter.
Figure 12.8 Expansionary and Contractionary Fiscal Policies to Shift Aggregate Demand