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Econ Chapter 20 Key Concepts – Fiscal Policy

Fiscal policy involves
adjusting government spending (on goods and services), transfer payments, and taxes with the express purpose of managing the macro economy.
– Congress (at the urging of the President) passed a huge ($787B) stimulus package that included tax reductions and rebates with a large dose on infrastructure spending.
– They also implemented monetary policy changes which will be covered in a subsequent chapter.
– When an economy faces underutilization of resources because it is struck in equilibrium below full employment,
increases in aggregate demand can move the economy toward full employment without generating excessive inflation pressures.
– When an economy is in an inflationary equilibrium above full employment
contracting aggregate demand brings about other tradeoffs: decreasing output dampens inflation but leads to unemployment.
– Discretionary spending
The part of the budget that works its way through the appropriations process of Congress each year and includes such programs as defense, veterans benefits, education, environmental, transportation and science.
Mandatory spending
Spending authorized by permanent laws that does not go through the same appropriations process as discretionary spending. Mandatory spending includes such programs as social security, Medicare, and interest on the national debt.
Discretionary Fiscal Policy:
– Involves adjusting government spending and tax policies with the express short-run goal of moving the economy toward full employment, expanding economic growth, or controlling inflation.
o Tax cuts during the Kennedy, Reagan and George W. Bush administrations were meant to influence both aggregate demand and aggregate supply.
o Tax increases enacted during the George H. Bush and Clinton administrations were aimed at reducing the government deficit
– Change in Government spending will cause income and output to rise or fall by the spending change times the multiplier.
– Changes in Taxes has less of a direct impact on income, employment, and output than an equivalent change in government spending.
o Why – consumers pay a tax increase in part, by reducing their savings. If taxes are increased by $100 and they withdraw $25 from savings, only $75 in reduced spending get multiplied. The reduction in savings of $25 dampens the effect of the tax on equilibrium income because the amount withdrawn from savings had been previously removed from the spending stream.
o A tax increase or decrease has less direct impact on income, employment and output than an equivalent change in government spending.
• This is why the 2009 $787 billion stimulus package was more heavily structured toward spending.
o Transfer payments are
money payments directly paid to individuals. They include social security, unemployment compensation and welfare.
– Expansionary fiscal policy involves
increasing government spending, increasing transfer payments or decreasing aggregate demand to expand output and the economy.
o Aggregate demand curve will move up (to the right)
o When an economy is at full employment, expansionary policies lead to no long term improvement in GDP – prices rise.
– Contractory fiscal policy involves
increasing withdrawals from the economy by reducing government spending, transfer payments or raising taxes to decrease aggregate demand to contract output and the economy.
o Politicians are loath to support contractionary policies that control inflation by reducing aggregate demand since high unemployment can cost politicians their jobs. Politician often look to the Federal
o Reserve to use its tools to keep inflation in check.
– Policies that focus on shifting the long-run aggregate supply curve to the right, expanding the economy with output increasing inflationary pressures. Unlike policies to increase aggregate demand, supply side policies take longer to have an impact on the economy.
o Fiscal policies which allow the economy to expand
• Investment in human capital (education)
• Development of new technologies
• Reducing tax rates
• Promotion of investment in new capital equipment, research and development, and trim regulations
– High marginal tax rates can have an adverse effects on the economy. When marginal tax rates become too high, the incentives to work and for business to take on added risk can be harmed.
o President Reagan reduced the top marginal rate form 50% to 28% and reduced tax deductions as well.
– Automatic Stabilizers:
Tax revenues and transfer payments automatically expand or contract in ways that reduce the intensity of business fluctuations without any overt action by Congress or other policy makers.

o The income tax is a powerful stabilizer because of its progressivity. When incomes fall, tax revenues fall faster since people pay taxes at a lower rate as their incomes fall.

– Fiscal Policy Timing Lags:
o Using fiscal policy to smooth the short-term business cycle is a challenge because of several lags associated with the implementation.
• Information lag
the time policy makers wait for economic data to be collected, processed and reported.
• Recognition lag
the time it takes for policymakers to confirm that the economy is tending in or out of a recession.
• Decision lag
the time it takes Congress and the administration to decide on a policy once a problem is recognized.
• Implementation lag
the time required to turn fiscal policy into law and eventually have an impact on the economy.

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