Fiscal Policy in Macroeconomics

Introduction

Fiscal policy is a central topic in macroeconomics, involving the use of government spending and taxation to influence the economy. This study guide covers the federal budget process, the impact of fiscal policy, expansionary and contractionary fiscal policy, policy lags, and the effects of fiscal multipliers.

The Federal Budget

Definition and Purposes

• Federal budget: The annual statement of the federal government's outlays (spending) and tax revenues.

• Purposes of the federal budget:

  1. To finance federal government programs and activities.

  2. To achieve macroeconomic objectives (such as full employment, sustained economic growth, and price level stability).

• Fiscal policy: The use of the federal budget to achieve macroeconomic objectives.

Institutions and Laws

• Fiscal policy is made by the President and Congress.

• The Employment Act of 1946 established the government's responsibility to promote maximum employment, production, and purchasing power.

• The Council of Economic Advisers monitors the economy and provides data and forecasts to inform the budget-making process.

Federal Budget Example: Fiscal Year 2018

• Receipts: $3,654 billion

• Outlays: $4,094 billion

• Deficit: $440 billion

• Main sources of receipts: Personal income taxes, Social Security taxes, corporate income taxes, indirect taxes.

• Main outlays: Transfer payments, expenditure on goods and services, debt interest.

Budget Balance

• Budget surplus: Receipts > Outlays

• Budget deficit: Outlays > Receipts

• Balanced budget: Receipts = Outlays

Expenditure Classification

• Expenditures are classified as:

  • Transfer payments

  • Purchases of goods and services

  • Debt interest

• Transfer payments are the largest and fastest-growing expenditure.

Historical Perspective

• Persistent deficits since the 1980s, except for a few years around 2000.

• Budget deficit peaked at almost 10% of GDP in 2008.

• Tax revenues have generally increased, expenditures have decreased as a percentage of GDP (1990–2018).

Budget Balance and Debt

• Government debt: The total amount borrowed by the government, equal to the sum of past deficits minus past surpluses.

State and Local Budgets

Overview

• The total government sector includes federal, state, and local governments.

• In 2018, state and local outlays were $3,600 billion, with major expenditures on education, police, fire services, and roads.

Supply-Side Effects of Fiscal Policy

Definition and Impact

• Fiscal policy can affect employment, potential GDP, and aggregate supply—these are called supply-side effects.

• The magnitude of supply-side effects is debated among economists.

• Changes in income tax rates can influence full employment and potential GDP.

Tax Revenues and the Laffer Curve

• The Laffer curve illustrates the relationship between the tax rate and the amount of tax revenue collected.

• At the tax rate , tax revenue is maximized.

• For tax rates below , increasing the tax rate increases tax revenue.

• For tax rates above , increasing the tax rate decreases tax revenue.

Fiscal Stimulus

Definition and Types

• Fiscal stimulus: The use of fiscal policy to increase production and employment.

• Types of fiscal stimulus:

  • Automatic fiscal policy: Triggered by the state of the economy without government action.

  • Discretionary fiscal policy: Initiated by an act of Congress.

Automatic Fiscal Policy and Budget Balances

• Two items in the government budget change automatically:

  • Tax revenues

  • Needs-tested spending

• Tax revenues vary with real GDP; increase in expansion, decrease in recession.

• Needs-tested spending (e.g., unemployment benefits) increases in recession, decreases in expansion.

Automatic Stimulus

• In recession: Receipts decrease, outlays increase—providing automatic stimulus to shrink the recessionary gap.

• In boom: Receipts increase, outlays decrease—providing automatic restraint to shrink the inflationary gap.

Cyclical and Structural Balances

• Structural surplus/deficit: The budget balance if the economy were at full employment and real GDP equaled potential GDP.

• Cyclical surplus/deficit: The actual surplus/deficit minus the structural surplus/deficit; occurs because real GDP does not equal potential GDP.

Fiscal Stimulus and Aggregate Demand

Discretionary Fiscal Stimulus

• Focuses on effects on aggregate demand.

• Changes in government expenditure and taxes have multiplier effects.

Fiscal Multipliers

• Government expenditure multiplier: Quantitative effect of a change in government expenditure on real GDP.

• Tax multiplier: Quantitative effect of a change in taxes on aggregate demand.

• Multiplier process: An increase in government expenditure increases real GDP, which raises incomes and consumption, further increasing aggregate demand.

• If only the direct effect is considered, the multiplier would be >1.

• Crowding-out effect: Increased government borrowing raises the real interest rate, reducing investment and partially offsetting the increase in government expenditure. This can make the multiplier <1.

• Consensus: Crowding-out effect dominates, so the multiplier is typically <1.

• Tax cuts have smaller demand-side effects than equivalent increases in government expenditure.

Fiscal Policy Multipliers and the Price Level

• Expansionary fiscal policy (increase in government expenditures or decrease in tax revenues) shifts the AD curve rightward.

• Contractionary fiscal policy (decrease in government expenditures or increase in tax revenues) shifts the AD curve leftward.

• The increase in GDP is less than the multiplied increase in aggregate expenditure because the price level rises.

• In the long run, fiscal policy multipliers are zero because real GDP equals potential GDP and changes in aggregate demand affect only the price level.

Fiscal Policy: Lowering Inflation and Unemployment

Benefits and Costs

• Lowering inflation: Benefit is price stability; cost may be reduced output or higher unemployment.

• Lowering unemployment: Benefit is higher employment; cost may be increased inflation or budget deficit.

• Trade-offs must be considered when using fiscal policy to target inflation or unemployment.

Effects and Limitations of Fiscal Multipliers

Magnitude of Stimulus

• Economists disagree on the size of fiscal multipliers due to insufficient empirical evidence.

• Uncertainty makes it difficult for Congress to determine the exact amount of stimulus needed to close an output gap.

• The actual output gap is not precisely known and can only be estimated with error.

• Discretionary fiscal policy is risky and may overshoot or undershoot the natural rate of output.

Time Lags in Fiscal Policy

• Recognition lag: Time to figure out that fiscal policy action is needed.

• Law-making (Implementation/Inside) lag: Time for Congress to pass laws needed to change taxes or spending.

• Impact (Effectiveness/Outside) lag: Time from passing a tax or spending change to its effect on real GDP being felt.

Summary Table: Key Fiscal Policy Concepts

Key Equations

• Budget Balance:

• Multiplier Effect:

Example Application

• If the government increases spending by \text{Change in GDP} = 0.8 \times 100 = 80$ billion

Additional info: These notes are based on lecture slides and may require further reading for complete understanding of supply-side effects and empirical multiplier estimates.