NIPD - Fiscal Policy Lesson

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Fiscal Policy

Introduction

StabilizationPolicies_fiscalpolicytypes.png Changes in taxes and government spending designed to affect the level of aggregate demand in the economy are called fiscal policy.

Recall that aggregate demand is the total amount of spending on goods and services in the economy during a stated period of time and is made up of consumer spending (C), investment (I), government spending (G), and net exports (Xn). Aggregate supply is the total amount of goods and services available in the economy.

During a recession, the short-run equilibrium is below the full-employment level of output. Aggregate demand is too low to bring about full-employment of resources. Government can increase aggregate demand by spending more and/or cutting taxes. Increasing aggregate demand to move the economy toward full employment is expansionary fiscal policy. Expansionary fiscal policy increases employment but also can raise the price level and result in budget deficits.

If the level of aggregate demand is too high, it creates inflationary pressures. Government can decrease aggregate demand by reducing spending and/or increasing taxes. Decreasing aggregate demand to decrease inflationary pressures is contractionary fiscal policy. Contractionary fiscal policy reduces inflationary pressures but can also decrease output and employment. Contractionary fiscal policy can result in budget surpluses (or smaller budget deficits).

 

The Use of Fiscal Policy to Stabilize the Economy

We need to emphasize that fiscal policy is the use of government spending and tax policy to alter the economy. Fiscal policy does not include all spending (such as the increase in spending that accompanies a war).

Aggregate demand and aggregate supply do not always move neatly together. Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even shift left, for a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes.

Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand. This shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions.

  • If recession threatens, the central bank uses an expansionary monetary policy to increase the supply of money, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right.
  • If inflation threatens, the central bank uses contractionary monetary policy to reduce the supply of money, reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left.
  • Fiscal policy is another macroeconomic policy tool for adjusting aggregate demand by using either government spending or taxation policy.

Take a closer look at each type of fiscal policy. 

Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. Contractionary fiscal policy is most appropriate when an economy is producing above its potential GDP.

Watch the presentation below to learn more about fiscal policy.

 

 

The conflict over which policy tool to use can be frustrating to those who want to categorize economics as “liberal” or “conservative,” or who want to use economic models to argue against their political opponents. But the AD–AS model can be used both by advocates of smaller government, who seek to reduce taxes and government spending, and by advocates of bigger government, who seek to raise taxes and government spending. Economic studies of specific taxing and spending programs can help to inform decisions about whether taxes or spending should be changed, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is, in part, a political decision rather than a purely economic one.

Watch the video below to learn how these all work together.

 

 

Review

Review what you have learned by completing the activities below.

 

In Summary . . .

What's Your takeaway? Icon Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. Contractionary fiscal policy is most appropriate when an economy is producing above its potential GDP.

 

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