CHAPTER 12: FISCAL POLICY

LEGISLATIVE MANDATES

•  Employment Act of 1946 – it commits the Federal government to use all practicable means, consistent with the market system, “to create economic conditions under which there will be…employment opportunities including self-employment, for those able, willing and seeking to work, and to promote maximum employment, production and purchasing power.”

• Council of Economic Achievers (CEA) – to assist and advise the president on economic matters.

• Joint Economic Committee (JEC) – investigated a wide range of economic problems of national interest.

FISCAL POLICY AND THE AD-AS MODEL

• Discretionary Fiscal Policy – is the purposeful change of government expenditures and tax collections by government to promote full employment, price stability and economic growth.

• Expansionary Fiscal Policy – the government uses this to shift the aggregate demand curve rightward in order to expand real output. This policy entails:

·         Increased government spending

·         Tax reductions

·         Combined government spending increases and tax reductions

•  Contractionary Fiscal Policy – the government uses this to shift the aggregate demand curve leftward in an effort to halt demand- pull inflation. This policy entails:

·         Reductions in government spending

·         Tax increases

·         Combined government spending decreases and tax increases

• Financing of Deficits and Disposing of Surpluses

·         Borrowing versus New Money – There are two ways the government can finance a deficit:

-Borrowing from the public

-Money creation

·         Debt  Retirement versus Idle Surplus

-Debt reduction

-Impounding

BUILT-IN STABILITY

• Automatic or Built-in Stabilizer

Built-in Stabilizer – is anything that increases the government’s budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policy makers.

·         Economic Importance

Taxes reduce spending and aggregate demand.

Reductions in spending are desirable when the economy is moving toward inflation.

·         Tax progressivity

The more progressive the tax system, the greater the economy’s built-in stability.

-Progressive tax system – the average tax rate (= tax revenue/GDP) rises with GDP.

-Proportional tax system – the average tax rate remains constant as GDP rises.

-Regressive tax system – the average tax rate falls as GDP rises.

EVALUATING FISCAL POLICY

• Assess deficits and surpluses to eliminate automatic changes to tax revenues.

• Compare the sizes of the adjusted budget deficits to the levels of potential GDP.

• Full-Employment Budget/ Standardized Budget – it measures the Federal budget deficit or surplus that would occur if the economy operated at full employment throughout the year.

PROBLEMS, CRITICISMS AND COMPLICATIONS

• Problems of Timing

·         Recognition lag – it is the time between the beginning of recession or inflation and the certain awareness that it is actually happening.

·         Administrative lag – is the time between the need for fiscal action is recognized and the time action is taken.

·         Operational lag – occurs between the time fiscal action is taken and the time that action affects output, employment, or the price level.

• Political Considerations

The potential for misuse of fiscal policy for political rather than economic purposes.

• Future Policy Reversals – potential ineffectiveness if households expect future policy reversals.

• Offsetting Local and State Finance – the fact that state and local finances tend to be pro-cyclical/ meaning that they worsen rather than correct recession or inflation.

• Crowding-Out Effect – indicates that an expansionary fiscal policy may increase the interest rate and reduce investment spending.

• Net Export Effect – which works through changes in:

·         Interest Rate

·         Exchange Rates

·         Exports and Imports.