Transcript Chapter 11

Chapter 11
Fiscal Policy
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
Chapter Outline
• NONDISCRETIONARY AND
DISCRETIONARY FISCAL POLICY
• USING FISCAL POLICY TO
COUNTERACT “SHOCKS”
• EVALUATING FISCAL POLICY
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Fiscal Policy
• Fiscal Policy is the purposeful movement in
government spending or tax policy designed
to direct an economy
• Discretionary Fiscal Policy: government
spending and tax changes enacted at the
time of the problem to alter the economy
• Nondiscretionary Fiscal Policy: that set of
policies that are built into the system to
stabilize the economy
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How Nondiscretionary Fiscal Policy Works
• Nondiscretionary 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.
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How Discretionary Fiscal Policy Works
• If we are in a recession the fiscal policy to
stimulate the economy would consist of
– Increases in government spending
– Decreases in taxes
• If we are in an inflationary period the fiscal
policy to contract the economy would consist
of
– Decreases in government spending
– Increases in taxes
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Expansionary Fiscal Policy
PI
AS
PI’
PI*
AD’
AD
RGDP*
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RGDP’
RGDP
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Contractionary Fiscal Policy
PI
AS
PI*
PI’
AD
AD’
RGDP’
RGDP*
RGDP
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Shocks
• A 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.
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Nondiscretionary and Discretionary Fiscal Policy
Combats a Recession
PI
AS
Shock
NDFP
PI*
AD3
DFP
AD1
AD2
RGDP*
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RGDP
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Nondiscretionary and Discretionary Fiscal Policy
Combats an Overheated Economy
PI
AS
Shock
NDFP
DFP
PI*
AD2
AD3
AD1
RGDP*
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RGDP
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Evaluating Nondiscretionary Fiscal Policy
• Most economists believe that the built-in
stabilizers have had a modestly positive
effect on diminishing the severity of
modern recessions.
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The Mistiming of Discretionary Fiscal Policy
• Recognition Lag: the time it takes to measure
the state of the economy
• Administrative Lag: the time it takes for
Congress to agree on a course of action with
the president
• Operational Lag: the time it takes for the full
impact of a government program or tax
change to have its effect on the economy
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Political Problems with Fiscal Policy
• Expansionary 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 elections
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The Rise, Fall and Rebirth of
Discretionary Fiscal Policy
• Between 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.
 In 2003, the continuing slow growth motivated
a renewal of the tax credit rebate idea.
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Growth Rates by Presidential Terms
First
Truman
Second
Third
Fourth
-1.6%
13.4%
5.1%
5.3%
Eisenhower I
0.4%
2.7%
6.5%
1.9%
Eisenhower II
0.3%
2.3%
5.1%
0.6%
Kennedy/Johnson
6.3%
4.1%
5.2%
5.1%
Johnson
8.5%
4.4%
2.3%
5.0%
Nixon I
1.9%
-0.1%
4.4%
7.2%
Nixon II/ Ford
4.0%
-2.1%
2.6%
4.6%
Carter
5.0%
6.6%
1.4%
-0.1%
Reagan I
1.2%
-1.6%
7.6%
5.6%
Reagan II
4.0%
2.8%
4.4%
3.7%
Bush GHW
2.6%
0.5%
0.9%
4.0%
Clinton I
2.5%
4.1%
2.2%
4.1%
Clinton II
4.3%
4.6%
5.0%
4.1%
Bush GW
0.3%
2.4%
Average
2.8%
3.2%
4.0%
3.9%
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Kick it Up a Notch
Aggregate Supply Shocks
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Nondiscretionary and Discretionary Fiscal in the
Wake of a Negative Aggregate Supply Shock
AS2
PI
Shock
AS1
NDFP
DFP
AD3
PI*
AD1
RGDP*
McGraw-Hill/Irwin
AD2
RGDP
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Nondiscretionary and Discretionary Fiscal in the
Wake of a Positive Aggregate Supply Shock
PI
AS1
Shock
AS2
PI*
NDFP
AD2
RGDP*
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AD1
RGDP
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