Fiscal Policy

Fiscal Policy


• Keynesian economics • What is fiscal policy • Keynesian view of fiscal policy • Criticism to fiscal policy – Alternative views

• US Fiscal Policy

Keynesian Economics

Prior to Keynes

Classical economists believe the market to be self- correcting and focus on long-run growth aimed at expanding the LRAS.

Motivation: The Great Depression

Keynesian Economics-Overview

A school of economic thought that emerged as an outgrowth of the Great Depression in the 1930s.

Led by John Maynard Keynes, who is considered the most influential economist of the 20th Century.

Keynes developed a theory that provided both an explanation for the persistent unemployment of the 1930s.

He argued against the self-correcting mechanism through resource & output prices.

Keynesian economists believe that market corrections can take a long time due to sticky wages, and focus on policy aimed at AD.

Rather, he advocated for increasing output by increasing spending.

Equilibrium in the Keynesian Model

Equilibrium occurs when total spending (aggregate demand) equals current output. When this is the case, producers have no reason to expand or contract output.

Firms will only produce the amount of goods and services they believe people plan to buy.

If total spending is less than full employment output, inventories will rise and firms will reduce output & employment …. And vice versa!

The Multiplier Effect

The principle that a $1 increase in any of the components of spending will lead the economy to expand by more than the initial $1 spending.

That is because an individuals spending is an income of another individual.

The Multiplier Effect- Example

Consider the construction of a new interstate highway.

Costs about $410 million financed by the State government.

This should increase spending directly by $410 million.

However, the project is using construction workers, masons, cement, steel, … etc.

The project generates $410 million in income for providers of the resources.

The resource suppliers will be spending fraction of their additional income on goods & services.

This spending is income for people who supply these goods and services (who will spend a fraction of it).

And so on!

Multiplier Effect

The Multiplier Effect


If the MPC=3/4, what would be the total change in income that would result in an addition of your consumption by $1200?

A $1000

B $1600

C $1800

D $200

B. $1600


Overview of Fiscal Policy


Fiscal Policy: A form of government deliberate intervention that uses taxes and government expenditure policies as tools to achieve some economic goals.

Who conducts fiscal policy?

Initiated by the Council of Economic Advisers (CEA) — A council of 3 economists appointed by the president.

Requires legislative approval through the Congress


Government Budget: A record of all government revenue from multiple sources and government expenditure on different areas.

Budget Balance: Total government spending = Total revenue

Budget deficit: Total government spending > total revenue

◦ When the money supply is constant, deficits must be covered with borrowing. The U.S. Treasury borrows by issuing bonds.

Budget surplus: Total government spending is < total revenue.

◦ Surpluses reduce the magnitude of the government’s outstanding debt.

Government Budget


Taxes Non-tax revenue



Recurring spending on wages and salaries

Spending on transfer programs

Interest payments on debt



Grants/aid to other countries

Budget Surpluses and Deficits

Changes in the size of the budget deficit or surplus may arise from either:

◦ a change in cyclical economic conditions ◦ a change in discretionary fiscal policy (the government is stimulating

or restraining demand)

The federal budget is the primary tool of fiscal policy. Differentiate between Mandatory Spending & Discretionary Spending

2012 US Government Spending

Mandatory vs Discretionary Spending

Mandatory Spending:

Government spending that is determined by ongoing programs like Social Security and Medicare.

Discretionary changes in fiscal policy:

Deliberate changes in government spending and/or taxes designed to affect the size of the budget deficit or surplus.

Fiscal Policy in the Keynesian View

Fiscal policy in the Keynesian View

Keynesian theory emphasis the role of AD in stimulating the economy.

The government can only control the its spending! Fiscal policy is a tool to reduce fluctuations in AD.

A balanced budget is not optimal.

Rather a counter-cyclical policy should be used to offset fluctuations

in AD.

During a recession, the government should increase spending

(expansionary fiscal policy) which will result in a budget deficit.

During a boom, the government should reduce spending (contractionary fiscal policy) which will result in a budget surplus.

Expansionary Fiscal Policy

Used in Recessions Leads to budget deficit Can be achieved by either:

Increase government spending on goods and services, or

Reduce taxes

Use AD-AS model to explain the behavior of the economy during a

recession. There are two solution:

Self adjusting economy

Expansionary fiscal policy .

Contractionary/Restrictive Fiscal Policy

Used in economic booms, when inflation is high Leads to budget surplus Can be achieved by either:

Reduce government spending on goods and services, or

Increase taxes

Use AD-AS model to explain the behavior of the economy during an

inflationary period. There are two solution:

Self adjusting economy

Restrictive fiscal policy .

Policy Options: G or T?

Depends on the size of the government

If a government has many unmet infrastructure obligations, then it might be a better option to increase government expenditure during recessions, and increase taxes in times of high inflation.

But if the government is too large (and potentially inefficient), then tax cuts during recessions and cutting government spending during high-inflation periods is more recommended.

Why Should Fiscal Policy Work

When unemployment is high, the initial spending can be a reason to bring more people into employment.

But in normal times, additional spending will bid resources away from other activities, which means there will be upward pressure on prices and the additions to income will be smaller.

Automatic Stabilizers

Built-in features that automatically promote budget deficit during a recession and a budget surplus during an inflationary boom, without the need to change in policy.

• Unemployment benefits

• Corporate profit tax • Progressive income tax

Criticism to Fiscal Policy

Criticism to Fiscal Policy

Critiques of Fiscal policy cite three major reasons:

Timing issues

Secondary effects of fiscal policy which undermine its effectiveness – such as crowding out and saving shifts by households.

Incentive effects of fiscal changes that includes changes in the composition of government spending and the supply-side effects.


The key issue in using fiscal policy is timing.

It is always difficult to accurately time fiscal policy due to 3 lag effects:

◦ Recognition lag: sound policy requires knowledge of economic conditions 9 to 18 months in the future, which is hard.

◦ Implementation lag: It takes time to institute a legislative change.

◦ Impact Lag: There is a time lag between when a change is instituted and when it causes significant impact.

Crowding Out Theory

Crowding-out effect: occurs when private spending falls in response to increases in government spending.

An increase in borrowing to finance a budget deficit will push real interest rates up and thereby reduce private consumption and investment, which counteracts the impact of the expansionary fiscal policy.

Crowding-Out in an Open Economy

Larger budget deficits and higher real interest rates lead to an inflow of capital, appreciation in the dollar, and a decline in net exports.

Crowding Out Summary

Neoclassical View-Saving Shifts

According to the Neoclassical economists: • The government budget deficit in the current period will be financed by higher future taxes.

• Because HH and individuals know this, they will save their increased income to be able to pay for the higher future taxes.

• Because in the current period the government is borrowing and HH are saving their additional income, the interest rates are unchanged.

• Accordingly, the higher government spending does not stimulate higher demand.

Fiscal Policy in the US

US Federal Tax Revenue

US Federal Spending

Fiscal Policy During the Great Recession (2008-2009)

As the economy dipped into the recession of 2008-2009, both the Bush and Obama administrations moved to increase federal spending and enlarge the deficit just as Keynesian analysis proscribes.

Was the expansionary fiscal policy effective?

Keynesians answer “Yes.” They believe the recession would have been much worse in the absence of the expansionary fiscal policy.

Critics respond “No.” The recovery was the weakest of the post WWII era.

What happened to the US Federal Debt?

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