ECON102 Study Guide

Unit 5: Fiscal Policy

5a. Identify the major components of the U.S. government revenues and spending

What are some examples of government purchases?
What is the effect of a change in government spending on GDP?
What are 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?
What are the elements of federal government revenue: payroll taxes, individual income taxes, and corporate income taxes?
How does the tax rate change with the business cycle?
How does a change in the tax rate affect GDP?
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?

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).

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.

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5b. Define budget surplus, budget deficit, and balanced budget and how they are related to 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 in health and longevity?

Essentially, a budget surplus exists when income exceeds expenditures. In this case, the government may choose to lower taxes. A budget deficit has the opposite effect. When spending exceeds income, the government may need to borrow money in order to finance its activities.

Economists calculate the national debt as the sum of all past federal deficits minus all surpluses. As the baby boomer generation retires en masse, government spending on Social Security is one of the largest components of the U.S. national debt.

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5c. Identify the goals and tools of discretionary fiscal policy and distinguish them from automatic stabilizers

What is the difference between discretionary and nondiscretionary spending?
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 the government use spending programs and taxes to promote economic expansion and economic contraction?
What economic circumstances can prompt a government to employ an expansionary or contractionary fiscal policy?

Fiscal policy describes the power governments have to influence the aggregate economy, real GDP, and the price level (inflation or deflation) through spending and taxation. Governments use discretionary fiscal policy tools (laws and legislation) and automatic stabilizers to influence the economy.

As their name implies, automatic stabilizers work automatically and usually in a direction that is opposite to the direction the economy is taking to stabilize the economy. For example, automatic stabilizers stimulate aggregate demand and real GDP during periods of recession. They reduce aggregate demand and real GDP during economic upswings or periods of economic growth because too much expansion can cause inflation to spiral out of control. Unemployment and welfare benefits and the individual and business tax rate are examples of automatic stabilizers.

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 (Y_P − 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 − Y_P). A contractionary fiscal policy seeks to reduce aggregate demand to AD2 to close the gap."

Fiscal policy describes the policies governments enact to influence the aggregate economy, real GDP, and 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 is 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.

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5d. Identify the lags in carrying out discretionary fiscal policy

What are 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 over-inflated. 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 when a policy is enacted and when the economy feels its impact.

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5e. Analyze how government borrowing causes crowding out of private investment

Why does an increase in government borrowing increase interest rates?
What is the effect of increased demand for loanable funds on the incentives of lenders?

The crowding out effect is a negative effect of expansionary fiscal and monetary policy. Expansionary fiscal policy not only increases the government budget deficit but causes interest rates to increase, which can squeeze, reduce, or "crowd out" private investment. Higher interest rates will hurt businesses that borrow capital to expand or sustain their operations.

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5f. Use the Phillips curve to identify the relationship between inflation and unemployment

What is the Phillips Curve, and how does it show the relationship between inflation and unemployment?
What are the three phases of unemployment: the Phillips phase, stagflation, and the recovery phase?

The Short-Run Phillips Curve

In 1958, A. W. Phillips (1914–1975), a New Zealand economist, suggested that an inverse relationship exists between inflation and unemployment. In other words, a high inflation rate is associated with a low rate of unemployment and vice versa. This theory provides the basis for the Phillips curve.

The Short-Run Phillips Curve in the 1960s

Inflation – Unemployment Phases

An economy may move from a Phillips phase to a stagflation phase and then to a recovery phase. The theory behind the Phillips curve did not hold true during the 1970s when global oil shocks threw the economy into stagflation – a simultaneous increase in prices and unemployment.

Connecting the Points: Inflation and Unemployment

The figure shows the way an economy may move from a Phillips phase to a stagflation phase and then to a recovery phase.

Inflation – Unemployment Phases

In a typical Phillips Curve, increased inflation is associated with lower unemployment in the short run. The long-run Phillips curve reflects the natural rate of unemployment (full employment). This is shown as a vertical line because, at this natural rate, it does not depend on the rate of inflation, regardless of the price level. At the natural unemployment level, we have a certain output that is sustainable for the economy (full employment). Also, see Figure 16.10 in Learning Outcome 5g for an additional graphical representation of inflation and unemployment in the long run on the Phillips Curve.

To review, see Phillips Curve and Changes in the AD-AS Model and the Phillips Curve.

5g. Use the model of aggregate demand and aggregate supply to explain a Phillips, stagflation, and recovery phase

Under what economic circumstances is a Phillips phase likely to occur?
Under what economic circumstances is a stagflation phase likely to occur?
Under what economic circumstances is a recovery phase likely to occur?
How and why does the economy transition between phases?

In the long run, the economy operates at its full employment levels. The unemployment rate includes only structural and frictional unemployment. Consequently, the long-run aggregate supply curve is vertical at the potential level of real GDP. This means that in the long run, real GDP is fixed, and the unemployment rate is also fixed at the natural rate of unemployment.

Changes in aggregate demand can only lead to changes in the price level with no permanent effects on real GDP. Consequently, in the long run, the Phillips curve is vertical at the natural rate of unemployment and shows no trade-off between inflation and unemployment.

The Phillips Curve in the Long Run

"Suppose the economy is operating at YP on AD1 and SRAS1 in Panel (a) with a price level of P0, the same as in the last period. Panel (b) shows that the unemployment rate is UP, the natural rate of unemployment. If the aggregate demand curve shifts to AD2, in the short run, output will increase to Y1, and the price level will rise to P1. In Panel (b), the unemployment rate will fall to U1, and the inflation rate will be π1. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS2, and output returns to YP, as shown in Panel (a). In Panel (b), unemployment returns to UP, regardless of the rate of inflation. Thus, in the long run, the Phillips curve is vertical."

To review, see Changes in the AD-AS Model and the Phillips Curve.

5h. Compare and contrast fiscal and monetary policy

What economic agency is responsible for implementing fiscal policy in the United States?
What economic agency is responsible for implementing monetary policy in the United States?
What are some similarities between fiscal and monetary policy?
What is the difference in lags between fiscal and monetary policy?
Is fiscal or monetary policy better for achieving a country's economic goals?

Governments use fiscal and monetary policy to influence the country's real GDP and price level. They use expansionary fiscal policies and expansionary monetary policies to shift the aggregate demand curve to the right. They use contractionary fiscal policies and contractionary monetary policies to shift the aggregate demand curve to the left.

There are several significant differences between fiscal and monetary policy. While both policies can shift AD to the right or left, monetary policy is indirect manipulation through the central bank (the Federal Reserve in the U.S.) printing money to increase the supply of money to be lent. This lowers the interest rates and leads to a willingness to borrow and invest money.

The government drives fiscal policy. It refers to government spending and tax policies used to influence the economy. It is up to Congress to approve various bills that are proposed and to oversee the budgets for income dollars (taxes) and spending. Fiscal policy directly impacts the economy because the government buys goods and services by ratcheting up debt.

An expansionary fiscal policy lowers the tax rates to increase spending to increase aggregate demand and economic growth. A contractionary fiscal policy raises rates or cuts spending to prevent or reduce inflation.

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5i. Explain Classical, Neoclassical, Keynesian, and Monetarist beliefs on policies to stabilize the economy

How did the Great Depression shatter these classical macroeconomic beliefs?
What policy prescriptions did neoclassical and Keynesian economists promote?
What economic thought prevailed during the economic expansion in the 1960s?
How can we reconcile the existence of contradictory schools of economic thought?

Economic events during the past century have influenced how economists analyze the effects the economy has on a country's real GDP and price level.

The Keynesian perspective focuses on macroeconomics in the short run and on aggregate demand. The neoclassical perspective looks at the macroeconomy in the long run and focuses on the crucial role of supply.

As the name neoclassical implies, this macroeconomic perspective is a "new" version of the "old" classical economic model. The classical perspective was the predominant economic philosophy before the Great Depression. It argued that any short-term fluctuations in economic activity would adjust back to full employment rather quickly, with flexible prices. This perspective suggested that when the economy is at full employment, increasing demand won't boost the overall GDP; it would only lead to higher prices. Therefore, it recommended a "hands-off" approach, meaning the government and central bank should avoid intervening.

For example, an economy that slips into recession (a leftward shift of the aggregate demand curve) will temporarily exhibit a surplus of goods. Falling prices will eliminate this surplus, and the economy will return to a full employment level of GDP. No active fiscal or monetary policy is needed. The classical perspective held that if the government or central bank tried to stimulate the economy by spending more money or cutting interest rates, it would mostly lead to inflation instead of boosting economic output or GDP. However, the long-lasting effects of the Great Depression shifted this mindset. Keynesian economics prescribed active fiscal policy to alleviate weak aggregate demand and became the more mainstream perspective.

According to classical economic theorists, free markets will automatically adjust to clear any disequilibrium that occurs in the labor and products markets. Governments do not need to intervene to help an economy recover from any negative shocks. Many economists disagree. For example, they argue that this theory does not explain why so many countries are plagued by sustained unemployment that lingers after a recession has ended (a period of disequilibrium).

Neoclassical economists say the government should focus on long-term growth and on controlling inflation rather than worry about recession or cyclical unemployment. This perspective is more useful for long-term economic analysis. Conversely, the Keynesian economic perspective encourages short-run analysis.

John Maynard Keynes (1883–1946), a British economist, argued that wage and price stickiness or rigidity can cause disequilibrium, allowing an economic downturn to persist for an extended period of time. He thought that government intervention was needed to push aggregate demand toward recovery.

Keynes' income-expenditure model suggests recessions occur when the level of demand for goods and services is less than what is produced when labor is fully employed. When consumption expenditures decline, firms will anticipate a drop in profits and decrease their investment expenditure. When aggregate demand declines, the demand for labor and goods shifts to the left. Due to sticky wages and prices, wages and prices remain at their original level.

This creates an excess supply of labor and goods that leads to additional spending and additional income. The economy is in a recession when this happens to many labor markets and goods markets across an economy.

According to Keynes, spending not only affects the equilibrium level of GDP but it causes a disproportionate change in GDP. Because one person's spending is another person's income, that leads to additional spending and additional income. The cumulative impact on GDP is larger than the initial increase in spending. Conversely, when spending collapses, it causes a much larger decrease in real GDP. The size of the multiplier is a critical element in formulating fiscal policies.

Economists use the neoclassical and Keynesian perspectives to analyze the economy in the long and short term.

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Unit 5 Vocabulary

automatic stabilizer
budget deficit
budget surplus
classical perspective
crowding out effect
discretionary fiscal policy tools
discretionary spending
fiscal policy
impact lag
implementation lag
income-expenditure model
John Maynard Keynes
Keynesian perspective
multiplier
national debt
neoclassical perspective
non-discretionary spending
Phillips phase
price level
recognition lag
recovery phase
stagflation phase