1. Fiscal policy consists of the changes made by the Federal government in its budget expenditures and tax revenues to expand or contract the economy. In making these changes, the Federal government may seek to increase the economy’s real output and employment, or control its rate of inflation.
a. Expansionary fiscal policy is generally used to counteract the negative economic effects of a recession or cyclical downturn in the economy (a decline in real GDP and rising unemployment). The purpose of the policy is to stimulate the economy by increasing aggregate demand. The policy will create a budget deficit (government spending greater than tax revenues) if the budget was in balance before the policy was enacted. If the price level is fixed, there are three options for increasing aggregate demand:
(1) The government can increase its discretionary spending. The initial increase from this spending will be increased by the multiplier effect. Since the price level is fixed, real output will rise by the full extent of the multiplier effect.
(2) Another option would be for the government to reduce taxes. Some of the tax cut would be saved, but some of it would be spent. The spent portion would provide an initial stimulus to the economy that would be magnified by the full extent of the multiplier effect since the price level is fixed.
(3) The government may decide to use some combination of increased government spending and tax reductions to increase aggregate demand.
b. Contractionary fiscal policy is a restrictive form of fiscal policy generally used to correct an inflation gap. If the economy is at a full-employment level of output, an increase in aggregate demand will increase output and at the same time pull up output prices. The purpose of contractionary fiscal policy is to reduce aggregate demand pressures that increase the price level. If the government budget is balanced before the policy is enacted, it will create a budget surplus (tax revenues are greater than government spending). The contractionary effect on the economy from the initial reduction in spending from the policy will be reinforced by the multiplier effect. Three policy options are used, but account should be taken of the ratchet effect (the price level is inflexible downward).
(1) The government can decrease spending. If the price level is fixed, the multiplier will have a full effect in decreasing output, but there will be no change in the price level. Government will have to take this effect into account to calibrate the decline in aggregate demand so it does not cause a recession.
(2) The government can increase taxes. The amount of the tax increase will need to be greater than a decrease in government spending because some of the tax increase will reduce saving and not just consumption.
(3) The government can use some combination of decreased government spending and increased taxes to reduce aggregate demand.
c. Whether government purchases or taxes should be altered to reduce recession and control inflation depends on whether an expansion or a contraction of the public sector is desired.
2. In the U.S. economy there are automatic or built-in stabilizers that serve as nondiscretionary or passive fiscal policy. Such stabilizers work through net tax revenues (tax revenues minus government transfer payments and subsidies). These net tax revenues automatically increase as the GDP rises and automatically decrease as the GDP falls.
a. The economic importance of this net tax system is that it serves as a built-in stabilizer of the economy. It reduces purchasing power during periods of prosperity to counteract increases in aggregate demand. On the other hand, it expands purchasing power during periods of declining output and high employment.
b. The degree of built-in stability in the economy depends on the responsiveness of net tax revenues to changes in GDP. As GDP increases, the average tax rates will increase in a progressive tax system, remain constant in a proportional tax system, and decrease in a regressive tax system. Thus, there is more built-in stability or net tax responsiveness for the economy in progressive tax systems. Built-in stabilizers, however, can only reduce and cannot eliminate economic fluctuations, so discretionary fiscal policy or monetary policy may be needed to moderate large fluctuations in the business cycle.
3. Certain problems, criticisms, and complications arise in enacting and applying fiscal policy.
a. There will be problems of timing. First, it takes time to recognize the need for fiscal policy because it takes time for data to be collected that provide strong evidence of downturns or upturns in the business cycles. Second, it takes time for the U.S. president and U.S. Congress to take the appropriate administrative and legislative actions to respond to a recognized problem. Third, there is the need for time for the policy to become operational and take the desired effect on output or inflation.
b. There may be political considerations with fiscal policy that counter the economic effects. Elected officials may cause a political business cycle if they lower taxes and increase spending before an election to stimulate the economy and then do the opposite after an election.
c. Fiscal policy may be less effective is people expect it to be reversed in the future, thus making the policy temporary rather than permanent.
d. The fiscal policies of state and local governments can run counter to Federal fiscal policy and offset it (for example, state and local fiscal policy can be contractionary while Federal fiscal policy is expansionary).
e. An expansionary fiscal policy may, by raising the level of interest rates in the economy, reduce investment spending and weaken the effect of the policy on real GDP. The extent of this crowding-out effect depends on the condition of the economy. The crowding-out effect is likely to be relatively small when the economy is in a recession and experiences slack investment demand. It is likely to be more serious when the economy is near full employment because the public demand for money to finance government competes with the private demand for money to fund economic investments.
4. The false contentions about a large debt are that it will eventually bankrupt the government and that borrowing to finance expenditures passes the cost on to future generations.
a. The debt cannot bankrupt the government because the government can refinance it by selling new bonds and using the proceeds to pay existing bondholders. It also has the constitutional authority to levy taxes to pay the debt.
b. The burden of the debt cannot be shifted to future generations because U.S. citizens and institutions hold most of the debt. Repayment of any portion of the principal and the payment of interest on it do not reduce the wealth or purchasing power in the United States because it would be paid to U.S. citizens and institutions. The only exception is the payment of the part of debt that would go to foreign owners of the debt.
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