Chapter 11 Fiscal Policy

Chapter 11Fiscal PolicyChapter OutlineNONDISCRETIONARY AND DISCRETIONARY FISCAL POLICYUSING FISCAL POLICY TO COUNTERACT “SHOCKS”EVALUATING FISCAL POLICYFiscal PolicyFiscal Policy is the purposeful movement in government spending or tax policy designed to direct an economyDiscretionary Fiscal Policy: government spending and tax changes enacted at the time of the problem to alter the economyNondiscretionary Fiscal Policy: that set of policies that are built into the system to stabilize the economyHow Nondiscretionary Fiscal Policy WorksNondiscretionary fiscal policy consists of policies that are built into the system so that an expansionary or contractionary stimulus can be given automatically.The welfare state and the progressive income tax serve as the built-in policies.If the economy is in recession, those who lose their jobs are granted unemployment and welfare benefits and they owe less in taxes.If the economy is growing at an unsustainable rate, people are making a lot of money and are faced with higher tax rates and there are fewer people eligible for government benefits.How Discretionary Fiscal Policy WorksIf we are in a recession the fiscal policy to stimulate the economy would consist ofIncreases in government spendingDecreases in taxesIf we are in an inflationary period the fiscal policy to contract the economy would consist ofDecreases in government spendingIncreases in taxesExpansionary Fiscal PolicyASADRGDPPIRGDP*PI*AD’RGDP’PI’Contractionary Fiscal PolicyASADRGDPPIPI*RGDP*AD’PI’RGDP’ShocksA Shock is any unanticipated economic event.Aggregate Demand Shock: an unexpected event which causes aggregate demand to increase or decrease, e.g. the Sept 11, 2001 terrorist attacks.Aggregate Supply Shock: an unexpected event which causes aggregate supply to increase or decrease, e.g. Iraq’s 1990 invasion of Kuwait and threat to Saudi Arabia.Nondiscretionary and Discretionary Fiscal Policy Combats a RecessionASPIRGDPAD1RGDP*PI*AD2ShockAD3DFPNDFPNondiscretionary and Discretionary Fiscal Policy Combats an Overheated EconomyASPIRGDPAD1RGDP*PI*AD2ShockAD3NDFPDFPNondiscretionary and Discretionary Fiscal in the Wake of a Negative Aggregate Supply ShockAS1PIRGDPAD1RGDP*PI*ShockAS2AD2NDFPAD3DFPAS1PIRGDPAD1RGDP*PI*Nondiscretionary and Discretionary Fiscal in the Wake of a Positive Aggregate Supply ShockShockAS2AD2NDFPEvaluating Nondiscretionary Fiscal PolicyMost economists believe that the built-in stabilizers have had a modestly positive effect on diminishing the severity of modern recessions.The Mistiming of Discretionary Fiscal Policy Recognition Lag: the time it takes to measure the state of the economyAdministrative Lag: the time it takes for Congress to agree on a course of action with the presidentOperational Lag: the time it takes for the full impact of a government program or tax change to have its effect on the economyPolitical Problems with Fiscal PolicyExpansionary bias is the problem where politicians are more willing to deal with recessions with tax cuts and spending increases than they are to deal with inflationary pressures with tax increases and spending cuts.The Political Business Cycle suggests that politically motivated fiscal policy is used for short term gain just prior to electionsThe 25-year Abandonment of Discretionary Fiscal PolicyBetween 1975 and 2001 fiscal policy was pretty much abandoned as a mechanism for controlling the economy. Monetary policy was used to expand or contract prices and GDP.In 2001, the impending recession motivated tax rebates and the Sept. 11 attacks motivated a variety of tax cut and spending increase ideas in Congress.