Fiscal Policy

Fiscal Policy

·     Changes in the expenditures or tax revenues of the federal government.

o  2 tools of fiscal policy: controlled by congress

§  Taxes – government can increase or decrease taxes

§  Spending – government can increase or decrease spending

Deficit, Surpluses, and Debt

·       Balanced budget

o   Revenues = Expenditures

·       Budget deficit

o   Revenues < Expenditures

·       Budget Surplus

o   Revenues >Expenditures

·       Government Debt

o   Sum of all deficits – sum of all surpluses

·       Government Borrows money when it runs a budget deficit from:

o   Individuals

o   Corporations

o   Financial Institutions

o   Foreign entities or foreign governments

Discretionary Fiscal Policy (action)

·       Expansionary fiscal policy – think deficit

·       Contractionary fiscal policy – think surplus

Non –Discretionary Fiscal Policy (no action)

Discretionary vs. Automatic

·     Discretionary

o  Increasing or decreasing government spending and/or taxes in order to return economy to pull full employment.

o  Involves policy makers doing fiscal policy in response to an economic problem

·     Automatic

o  Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate effects of a recession and inflation

o  Automatic fiscal policy takes places without policy makers

Contractionary Fiscal Policy – policy designed to decrease aggregate demand

·     Strategy for controlling inflation

·     Inflation is countered

o  Government spending decrease

o  Taxes increase

   Expansionary Fiscal policy – policy designed to increase aggregate demand

·       Strategy for GDP combating recession and reducing unemployment

·       Recession is countered with expansionary policy

o   Government spending increases

o   Taxes decreases

Automatic or Built in stabilizers

·       Anything that increases the government’s budget deficit during a recession and increases its budget surplus inflation without requiring explicit action by policymakers

Automatic Stabilizers

1.   Transfer Payments

a.   Welfare Checks

b.   Food Stamps

c.   Unemployment Checks

d.   Corporate Dividends

e.   Social Security

f.     Veteran’s benefits

2.   Progressive income taxes

a.   Automatic stabilizers take 33-50% out

   Progress Tax System

·       Average tax rate (tax revenue/ GDP) rises with GDP

   Proportional Tax System

·       Average tax rate (remains constant as GDP changes)

    Regressive tax System

·       Average tax rate fall with GDP 

Disposable Income

Disposable Income

·       Income after taxes or net income

·       DI = Gross income – Taxes

·       Two choices:

o   With disposable income, households can either

§  Consume (spend money on goods and services)

§  Save (not spend money on goods and services)

Consumption:

·       Household spending

·       The ability to consume is constrained by:

o   The amount of disposable income

o   The propensity to save

·       Do households consume if DI = 0?

o   Autonomous consumption

o   Dissaving

·       Average Propensity to Consume

o   APC = C/Di = % of DI that is spend

Saving

·       Household not spending

o   The ability to save is constrained by:

§  The amount of disposable income

§  The propensity to consume

o   Do households save if DI = 0?

§  No

o   Average Propensity to Save

§  APS = S/DI = % of DI that is not spent

APC and APS:

·       APC + APS = 1

·       1 - APC = APS

·       1 - APS = AP

·       APC > 1 = Dissaving

·       -APS = Dissaving

Marginal Propensity to Consume

·       MPC = ΔC/ΔDI

·       % of every dollar earned that is spent

Marginal Propensity to Save

·       MPS = ΔS/ΔDI

·       % of every extra dollar earned that is saved

·       MPC + MPS = 1

·       1 - MPC = MPS

·       1 - MPS = MPC

The Spending Multiplier Effect:

·       An initial change in spending causes a larger change in aggregate spending or aggregate demand

·       Multiplier = Change in AD (ΔC, Ig, G, Xn) / Change in spending

·       Why does this happen?

o   Expenditures and income flow continuously which sets off a spending increase in the economy

Calculating the Spending Multiplier: 

·       Multiplier = 1/1-MPC or 1/MPS

o   Multiplier are positive when there is an increase in spending and negative when there is a decrease

o   Spending multiplier can be calculated from the MPC or MPS

Calculating the Tax Multiplier:

·       The government taxes the multiplier works in reverse.

·       Why?

o   Because now money is leaving the circular flow

·       Tax Multiplier (note: it is negative)

o   -MPC/ 1-MPC or –MPC/MPS

·       If tax cut, multiplier is positive because now money is in the circular flow.