Government and Fiscal Policy

1. Slide 1 of 26
Government and Fiscal Policy
“When a business or an individual spends more than it makes, it
goes bankrupt. When government does it, it sends you the bill.”
-Ronald Reagan

2. Slide 2 of 26
Fiscal Policy: A second tool to
manage the economy
We’ve already studied Monetary Policy.
We’ve learned that it is a tool that the
Federal Government (the Fed) has to
manage the macroeconomy.
We now turn our attention to a second
(and final) tool: Fiscal Policy.

3. Slide 3 of 26
What is fiscal policy?
Fiscal policy is the use of federal
government spending and/or taxes to
influence the level of economic activity.
Think of it this way: In times of recession, a government
may choose to increase its spending (or cut taxes) to
counterbalance cutbacks in Consumption or some other
component of GDP.
Put another way…if C falls, then G can
be increased to offset it!
Changes in government spending or
taxation can be used to influence
economic activity…and that is a Key
Learning Outcome!

4. Slide 4 of 26
Remember that Aggregate Demand (AD)
comes from four sources
• C = Consumption
• I = Investment
• G = Government
• Xn = Net Exports
For fiscal policy,
we’ll be
exploring this
component!

5. Slide 5 of 26
The four pistons in the U.S. economic engine
Government
Spending isn’t the
biggest “piston” in
the U.S. economic
engine.
But it does comprise
about 20% of
economic activity in
this country.
Let’s look at that with
some
perspective…that is
20% of the world’s
largest economy!
That makes it a
powerful force in
determining what the
overall economy
does.

6. Slide 6 of 26
Government Expenditures
Given the size of government spending,
it is easy to imagine that it could be
used to manipulate an economy.
As an example, a government might
be able to accelerate economic
growth by spending more money.
That is one application of fiscal policy!
Let’s explore that in more detail on the
next few slides.

7. Slide 7 of 26
LRAS
$200b
P2
AD1
SRAS1
Imagine a hypothetical economy operating in
an ideal macroeconomic scenario
…And Real GDP is at full
employment and potential
GDP.
Perhaps prices are at an
acceptable level… Unfortunately this
does not always
happen.
Note: Potential GDP is the
GDP an economy can
obtain when it employs all
its resources
That means
unemployment is at the
natural rate…what we
assume to be 5%.

8. Slide 8 of 26
If AD falls, then a recession could occur
This economy is
underperforming. AD has
shifted to the left and Real
GDP has fallen. We presume
that unemployment has risen.
That is a recession!
LRAS
$200b
AD2
SRAS1
P1
$150b
“Recessionary Gap”
AD1

9. Slide 9 of 26
If AD increases, then
inflation could occur
What about the
other
direction…what if an
economy is
“overheating”?
In this economy, AD
is moving too
quickly. That
causes prices to
rise…which is
inflation!
LRAS
$250b
AD1
SRAS1
P3
$200b
“inflationary Gap”
AD2
How can fiscal
policy be used to
mitigate these
impacts?

10. Slide 10 of 26
So what can be done undesirable
movements in AD?
Fiscal policy can be used to manipulate
movements in the AD curve.
If AD is increasing too
quickly, contractionary fiscal
policy can be used to cool it
down!
If AD is increasing too
slowly, expansionary fiscal
policy can be used to heat it
up!

11. Slide 11 of 26
Expansionary versus
contractionary fiscal policy
Here we see the AD moving to the
right… That is inflationary.
Perhaps a government could increase
taxes or reduce spending.
Here we see the AD curve moving to
the left. That is a recession.
Perhaps a government could reduce
taxes or increase spending.
This might alarm a government as it can
lead to hyperinflation.
In this case, expansionary fiscal policy
can be used to combat recession.
In this case, contractionary fiscal policy
can be used to combat inflation.

12. Slide 12 of 26
LRAS
$200b
AD2
SRAS1
P1
$150b
“Recessionary Gap”
AD1
Let’s see how fiscal policy works. Here
we have a recession
With this leftward
movement of AD,
RGDP falls. That is
a recession.*
*Officially recession are measured using numerous indicators. But
loosely defined they involve two or more quarters of declines in
RGDP.
At this level of Real
GDP.
Unemployment is
above the natural
rate. Perhaps it is
8%.
A government may
use fiscal policy to
“stimulate” this
economy.

13. Slide 13 of 26
How does a government encourage
AD to shift to the right?
By either increasing government spending or
reducing taxes (or both), AD will increase.
Did you get one of those checks?
If so, what did you do with it? I
bet you spent some of it thereby
increasing AD.
George W. Bush did this in 2001 and in 2008 by reducing taxes
and sending each household a check.
A government could also choose
to increase spending…building
bridges dams and other things.

14. Slide 14 of 26
The Economy Recovery and Reinvestment
Act is a more recent example
Signed by President Obama in
2009 and designed to:
•Providing $288 billion in tax cuts
•Increasing federal funds for education
and health care and unemployment
benefits ($224 billion)
•Making $275 billion available for federal
contracts, grants and loans
•Learn more at here.
Have you seen any of
these signs? If so, you
have seen fiscal policy
in action.

15. Slide 15 of 26
The question is, which is better: Increased
government spending or reduced taxes?
Which you think is better may be largely dependent on your
opinion of the size of government. There is no “right answer”.
Should
Government
get bigger or
smaller?
?

16. Slide 16 of 26
Now we know that increased government spending will
increase AD. But how much fiscal stimulus is needed?
Fortunately, it is
not necessary for
the government
to inject enough
money to
completely
eliminate this
gap.
Why not?
The multiplier
effect
Assume the policy goal would be to move AD
from AD3 to AD4.
LRAS
$200b
AD3
SRAS1
P1
$150b
AD4

17. Slide 17 of 26
Recall the circular flow diagram
Business
Buy Resources
Sell Products
Households
Sell Resources
Buy Products
Resource
Market
Product
Market
Goods & Services
Land,Labor,
capital,Entrepreneurs
Goods&Services
Resources
Wages, Rents, Interest, profits
Consumption
Expenditures
Costs
Revenue
When we set this up early in the
semester, we ignored an important
player: The government.

18. Slide 18 of 26
The multiplier process
Business
Buy Resources
Sell Products
Households
Sell Resources
Buy Products
Resource
Market
Product
Market
Wages, Rents, Interest, profits
Consumption
Expenditures
Costs
Revenue
Government
Spends$100million
Wages, Rents, Interest, profits
Consumption
Expenditures
Costs
Revenue
Wages, Rents, Interest, profits
Consumption
Expenditures
Costs
Revenue
Wages, Rents, Interest, profits
Consumption
Expenditures
Costs
Revenue
This is fiscal
policy.
New expenditures
work their way
through the
economy.
Some is saved but
most is spent

19. Slide 19 of 26
Example of the multiplier process
Assume that households spend 90% and save
10% of all new income
These concepts are referred to as the marginal propensity to consume
(MPC) and the marginal propensity to save (MPS)
MPC and MPS determine how big the multiplier effect will be
Notice the government’s initial spending increase of $100 million
caused $1 billion in economic activity!

20. Slide 20 of 26
Let’s try an example!
Assume you are presiding over an
economy with GDP of $1 trillion.
Your economy is in recession and
your advisers estimate the GDP
gap is $500 billion.
Your advisors also estimate the
MPC to be 0.80. In other words,
consumers spend 80% of all new
income.
That means the multiplier is 5.
1/(1-MPC)=
1/(1-0.8)=
1/(0.2)=
=5
If the GDP gap is $500 billion and
the multiplier is 5…..
Then $100 billion in new
government spending will “close
the gap”!

21. Slide 21 of 26
Try one on your own!
You are the Economic Advisor to the president
of a hypothetical developed country.
You have watched unemployment begin to
rise and RGDP fall below Potential GDP.
You estimate the following:
-The GDP gap is $600 billion
-The country’s MPC is 0.75
The President wants to solve this problem
using Fiscal Policy-by increasing Government
Spending –to garner votes in the next election.
You recommend that the government increase
its spending by $_____ billion150

22. Slide 22 of 26
Try another one!
You are the Economic Advisor to the president
of a hypothetical developed country.
You have watched unemployment begin to
rise and RGDP fall below Potential GDP.
You estimate the following:
-The GDP gap is $500 billion
-The country’s MPC is 0.9
The President wants to solve this problem
using Fiscal Policy-by increasing Government
Spending –to garner votes in the next election.
You recommend that the government increase
its spending by $_____ billion50
Understanding how can be
used to achieve economic
growth,, full employment
and stable prices is a Key
Learning Outcome!

23. Slide 23 of 26
So what is the Current U.S. MPC?
That is a tough number to
estimate.
It routinely changes and during
the last recession, people got
scared and stopped spending
pulling the figure down.
Some economists estimate that
the U.S. MPC is between 0.5 and
0.66.
What is yours?If I gave you $100 right now, how
much would you spend?I wish I could!

24. Slide 24 of 26
There are several disadvantages
to Fiscal Policy
Perhaps one of the largest
problems with fiscal policy is that
we got only half the message.
In bad times, politicians have
historically been eager to increase
spending.
It helps the economy and it gives
them support back home as they
build new bridges and other items.
In good times, politicians are
reluctant to raise taxes or cut back
spending.
It is politically unpalatable and
hurts their chances for reelection.
I put it to you – if the economy
were doing well and I ran for office
saying “WE SHOULD RAISE
TAXES”…
…would you vote for me?

25. Slide 25 of 26
We got half the message!
That means governments have
accrued larger and larger amounts
of debt.
That is easily seen here: The red
line is what the U.S. Federal
Government spends.
The blue line is what the U.S.
Federal Government receives.
All that over spending has
resulted in trillions in debt.

26. Slide 26 of 26
In Summary
Federal Governments can use
changes in spending and taxes to
manipulate an economy.
When growth slows and
unemployment increases, taxes
can be lowered or spending
increased to stimulate growth.
When growth accelerates and
inflation increases, taxes can be
increased or spending decreased
to reign in growth.
Governments have routinely done
this, taking advantage of the
multiplier effect to close GDP
gaps and return an economy to
healthy growth!
In doing so, they have
accumulated a large amount of
debt…which limits their ability to
continue to use this policy tool!