Understanding Fiscal Policy

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Understanding Fiscal Policy

• What is fiscal policy and how does it affect the
  economy?
• How is the federal budget related to fiscal
  policy?
• How do expansionary and contractionary fiscal
  policies affect the economy?
• What are the limits of fiscal policy?

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What Is Fiscal Policy?

• Fiscal policy is the federal governments use of
  taxing and spending to keep the economy stable.

• Government spending and taxing has a large impact
  on the economy.

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Fiscal Policy and the Federal Budget

• Federal budget - document indicating amount of
  money the government expects to receive and can
  spend that year.

• Fiscal year October September for the federal
  government
• stop-gap funding used when budget is not
  approved in time.

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The Budget Process
Federal agencies send requests to OMB
Pres OMB create budget, send to Congress
Congress makes changes, sends to Pres
Pres signs into law
Pres vetoes, compromise with Congress
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Fiscal Policy and the Economy
Keynesian Economics The total level of
government spending can be changed to help
increase or decrease the output of the economy.
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Fiscal Policy and the Economy

• Fiscal policies that try to increase output are
  known as expansionary policies.

• Fiscal policies intended to decrease output are
  called contractionary policies.

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Expansionary Fiscal Policies

• Increasing Government Spending
• Triggers a chain of events that raise output and
  creates jobs.
• Cutting Taxes
• Consumers and businesses have more money to spend
  or invest. This increases demand and output.

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Expansionary Fiscal Policies
Aggregate Supply
Higher output, higher prices
Aggregate demand w/govt spending
Lower output, lower prices
Original Aggregate demand
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Contractionary Fiscal Policies

• Decreasing Government Spending
• Triggers a chain of events that may lead to
  slower GDP growth.
• Raising Taxes
• Consumers and businesses have fewer dollars to
  spend or save. This also slows growth of GDP.

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Contractionary Fiscal Policies
Aggregate Supply
Higher output, higher prices
Lower output, lower prices
Original Aggregate demand
Aggregate demand lower spending
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Limits of Fiscal Policy

• Difficulty of Changing Spending Levels
• must come from the small part of the federal
  budget (discretionary spending)
• Predicting the Future
• Predicting future economic performance is very
  difficult, and economists often disagree.
• Difficult to know when or if to enact changes in
  fiscal policy.

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Limits of Fiscal Policy

• Delayed Results
• it takes time for the changes to take effect.
• Political Pressures
• Pressures from the voters can hinder fiscal
  policy decisions, such as decisions to cut
  spending or raising taxes.

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Coordinating Fiscal Policy

• Branches and levels of government must plan and
  work together.
• Policies need to take into account regional
  economic differences.
• Fiscal policy needs to be coordinated with the
  monetary policies of the Federal Reserve.

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Section 1 Review

• 1. What is fiscal policy?
• 2. Name two types of expansionary policies.

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Fiscal Policy Options

• What are classical, Keynesian, and supply-side
  economics?
• What is the multiplier effect?
• What role do automatic stabilizers play?
• What role has fiscal policy played in American
  history?

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Classical Economics

• Classical economics The idea that markets
  regulate themselves.
• Adam Smith, David Ricardo, and Thomas Malthus
• The Great Depression that began in 1929
  challenged the ideas of classical economics.

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Keynesian Economics

• Keynesian economics is the idea that the economy
  is composed of three sectors individuals,
  businesses, and government and that government
  actions can make up for changes in the other two.

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Keynesian Economics

• Fiscal policy can be used to fight both recession
  or depression and inflation.
• Government could increase spending during a
  recession to counteract the decrease in consumer
  spending. (spending against the wind)

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Keynesian Economics
High output
Productive Capacity
Government
Consumer spending
Consumer spending
Business spending
Business spending
Low output
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The Multiplier Effect
The multiplier effect is the idea that every
dollar change in fiscal policy creates a greater
than one dollar change in economic activity.
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The Multiplier Effect

• For example, if the federal government increases
  spending by 10 billion, there will be an initial
  increase in GDP of 10 billion.
• The businesses that sold the 10 billion in goods
  and services to the government will spend part of
  their earnings, and so on.

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Automatic Stabilizers

• A stable economy is one in which there are no
  rapid changes in economic factors. Certain
  fiscal policy tools can be used to help ensure a
  stable economy.

• An automatic stabilizer is a government tax or
  spending category that changes automatically in
  response to changes in GDP or income.

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Automatic Stabilizers

• Automatic stabilizers
• Transfer payments such as unemployment payments
  increase with the unemployment rate.
• Falling tax revenues increases money held by
  consumers and consumer spending

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Supply-Side Economics

• Supply-side economics stresses the influence of
  taxation on the economy. Supply-siders believe
  that taxes have a strong, negative influence on
  output.
• The Laffer curve shows how both high and low tax
  rates can produce the same tax revenues.

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Supply-Side Economics
Laffer Curve
High revenues
b
Tax revenues
Low revenues
a
c
100 High taxes
50
0 Low taxes
Tax rate
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Fiscal Policy in American History

• The Great Depression
• Franklin D. Roosevelt increased government
  spending.
• World War II
• Government spending helped lift the country out
  of the Depression.

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Fiscal Policy in American History

• The 1960s
• JFK cut taxes to stimulate the economy.
  Government spending increased because of the
  Vietnam war.
• Supply-Side Policies in the 1980s
• In 1981, Ronald Reagans administration helped
  pass a bill to reduce taxes by 25 percent over
  three years.

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Section 2 Assessment

• What are the two main economic problems that
  Keynesian economics seeks to address?
• What are automatic stabilizers?

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Budget Deficits and the National Debt

• What are budget surpluses and budget deficits?
• How does the government respond to budget
  deficits?
• What are the effects of the national debt?
• How can government reduce budget deficits and the
  national debt?

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Balancing the Budget
A balanced budget is a budget in which revenues
are equal to spending.

• Budget surplus - when revenues exceed
  expenditures.
• Budget deficit - when expenditures exceed revenue.

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Balancing the Budget
Source www.usgovernmentspending.com
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Balancing the Budget
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Responding to Budget Deficits

• Creating Money
• The government can pay for budget deficits by
  creating money.
• Creating money increases demand and can lead to
  inflation.

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Responding to Budget Deficits

• Borrowing Money
• The government can also pay for budget deficits
  by borrowing money.
• The government borrows money by selling bonds,
  such as
• Treasury bills repaid in year or less
  Treasury notes 2-10 years Treasury
  bonds up to 30 years

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The National Debt
The national debt is the total amount of money
the federal government owes. The national debt
is owed to anyone who holds U.S. Savings Bonds or
Treasury bills, bonds, or notes.
Biggest holders of U.S. debt.
Biggest foreign holders of U.S. debt.
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Who do we owe?
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The National Debt

• The Difference Between Deficit and Debt
• Deficit - overspending in one fiscal year.
  National debt - accumulated deficits.
• Measuring the National Debt
• Currently 12 trillion, going up 3.9B/day,
  39K/person. Economists often measure the debt
  as a percent of GDP.

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Is the Debt a Problem?

• Problems of a National Debt
• Crowding-out effect money spent on bonds to
  cover deficit takes money away from private
  investment.
• Dollars spent paying interest on the debt cannot
  be spent on anything else, such as defense,
  education, or health care.

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Is the Debt a Problem?

• Other Views of a National Debt
• Keynesian economists argue that if government
  borrowing and spending help the economy achieve
  its full productive capacity, then the national
  debt outweighs the costs.

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Deficit and Debt Reduction

• Legislative Solutions
• Congress passed the Gramm-Rudman laws in 1980s
  which would have automatically cut spending
  across-the-board if spending increased too much.
• The Gramm-Rudman laws were declared
  unconstitutional in the early 1990s.

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Deficit and Debt Reduction

• Constitutional Solutions
• In 1995 Congress came close to passing a
  Constitutional amendment requiring balanced
  budgets.
• Opponents argue that it is not flexible enough to
  deal with rapid changes in the economy.

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Balancing the Budget
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Section 3 Assessment

• 1. What is a balanced budget?
• 2. What are some problems associated with a
  national debt?