Fiscal Policy Lecture notes 10 Instructor: MELTEM INCE.

Fiscal Policy

Lecture notes 10

Instructor: MELTEM INCE

Fiscal Policy

Fiscal policy is the use of the federal budget to achievemacroeconomic objectives, such as full employment,sustained long-term economic growth, and price levelstability.Expenditures are classified as transfer payments,purchases of goods and services, and debt interest.

Transfer payments are by far the largest expenditure,and are sources of persistent growth in expenditures.

Fiscal Policy

The federal government’s budget balance equals tax revenueminus expenditure.

If tax revenues exceed expenditures, the government has abudget surplus.

If expenditures exceed tax revenues, the governmenthas a budget deficit.

If tax revenues equal expenditures, the government hasa balanced budget.

Supply Side Effects

Government debt is the total amount that the government

has borrowed—that the government owes. It is the

accumulation of all past deficits.

Fiscal policy has important effects on employment and

potential GDP called supply side effects.

The Supply Side: Investment, Saving, and Economic Growth

A quick refresher of the national income

accounting equations is needed.

GDP = C + I + G + X – M.

GDP = C + S + T.

From these two equations, you can see that

I = S + T – G + M – X.

The Supply Side: Investment, Saving, and Economic Growth

The equation

I = S + T – G + M – X

says that investment, I, is financed by:

Private domestic saving, S,

Foreign saving, M – X,

Government saving, T – G

The Supply Side: Investment, Saving, and Economic Growth

Call saving S plus foreign saving M – X private

saving, PS.

Then investment is financed by the sum of

private saving and government saving.

That is

I = PS + T – G

The Supply Side: Investment, Saving, and Economic Growth

If taxes exceed government purchases, T > G,

the government has a budget surplus and government

saving is positive.

If taxes are less than government purchases,

T< G, the government budget is in deficit and

government saving is negative.

The Supply Side: Investment, Saving, and Economic Growth

Because government saving is part of total saving, the directeffect of a government budget deficit is a decrease in totalsaving.

When total saving decreases, the real interest rate risesand the equilibrium quantity of investment decreases.

The tendency to a government budget deficit todecrease investment is called a crowding-out effect.

Stabilizing the Business Cycle

Fiscal policy action that seek to stabilize the business cyclework by changing aggregate demand.

These policy actions can be: Discretionary AutomaticDiscretionary fiscal policy is a policy action that isinitiated by an act of Congress.

Automatic fiscal policy is a change in fiscal policytriggered by the state of the economy.

Stabilizing the Business Cycle

The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on aggregate demand.

The tax multiplier is the magnification effect a change in taxes on aggregate demand.

An increase in taxes decreases disposable income, which decreases consumption expenditure and decreases aggregate expenditure and real GDP.

Stabilizing the Business Cycle

Expansionary fiscal policy is an increase in

government purchases or a decrease in taxes.

Contractionary fiscal policy is a decrease in

government purchases or an increase in taxes.