Question

Aim: What can the government do to adjust the economy?

Topic: Fiscal Policy

Fiscal Policy: Government spending policy (passed by Congress). This is changes in government spending (government buying goods or paying for services) and taxes. Fiscal policy is used to fight inflation or recession. Government Spending is known as Discretionary Spending.

Two forms of fiscal policy:

1) Expansionary: the government is trying to expand the economy. (shift graph to the right)

When: Recession

How: Increase government spending, reduce taxes.

*a change in taxes does not directly change real GDP. Changes in taxes affect the disposable income of households and/or businesses. These changes are felt through consumption spending and investment spending.

2) Contractionary: the government is trying to shrink the economy/reduce spending by other factors (I and C) in economy. (shift graph to the left)

When: Inflation

How: Decrease government spending, increase taxes.

* An increase in taxes decreases disposable income of consumers and businesses. A decrease in disposable income decreases consumption, but by less than the increase in taxes.

*Fiscal policy primarily shifts the aggregate demand curve as it affects Consumer Spending, Investment Spending and Government Spending. Regulations and taxes can also protect against imports and help exports (Nx).

*Fiscal tax policy focused on businesses may also shift SRAS if this leads to a change in capital production and their ability to produce more/less.

Discretionary Spending vs. Automatic Stabilizers.

Besides the direct fiscal policy tools of government spending and taxes, there are many tools embedded in the economy that respond to the different phases of the business cycle. They are government policies already in place that promote deficit spending (borrowing money to spend and increase economy) during recessions and surplus budgets (saving money) during contractions. These tools are called automatic stabilizers. They are automatic because they adjust without an action by Congress or the President. They serve as stabilizers because they limit the increase in real GDP during inflation/expansions and reduce the decrease in real GDP during a recession.

Examples of Automatic Stabilizers:

1) Income Taxes (both personal and corporate/capital gains tax): increase as wages rise: people pay a larger fraction of their income in taxes. However, as income falls during a recession, so do income taxes, which help to increase spending

2) Unemployment Compensation: when people are unemployed, they receive unemployment checks from the government to help sustain spending in the economy (counters recession)

3) Anti-Poverty, entitlement programs and “Safety net” programs: TANF (Temporary Aid to Needy Families), unemployment benefits, social security, food stamps, welfare benefits, etc. These programs are to help struggling families and keep spending in the economy (counters recession)

1) What are the differences between contractionary and

expansionary fiscal policy?

 1a) Why is expansionary policy used during recession?  

1b) Why is contractionary policy used during inflation?

2) Why does fiscal policy primarily shift the AD curve?

3) Why might fiscal policy focused on capital investment shift LRAS/SRAS over the long term?

4) What are the differences between discretionary spending and automatic stabilizers?

5) Define: Deficit, Debt and Surplus. How is each created?

Answer 1

1) CONTRACTIONARY FISCAL POLICY- When government tries reduce the amount of money in the economy by raising taxes or cuts spending.

EXPANSIONARY FISCAL POLICY - When government infuses more money in the economy by increasing government spending.

1) a) - EXPANSIONARY POLICY USED DURING RECESSION - During receesion government reduce taxes and increase government spending so that more money should be there in the economy and these also affect consumption and investment spending.As reducing taxes not directly affect the real GDP but it directly affect the disposable of household and business.

1) b) - CONTRACTIONARY POLICY USED DURING INFLATION - During inflation government increase taxes which decreases the disposable income consumer and business which further decreases consumption but by less than the increased taxes. By this government take out the money from the economy which occured during inflation.

2) FISCAL POLICY PRIMARILY SHIFT THE AD CURVE - Fiscal policy shift the AD curve through changes in government spending and taxes as these affect the consumer spending ,investment psending and government spending.

3)FISCAL POLICY FOCUSED ON CAPITAL INVESTMENT SHIFT LRAS/SRAS OVER THE LONG TERM- If fiscal want to change capital production and ability to produce more or less they shift LRAS/SRAS over the long term.

4) DISCRETIONARY SPENDING - Government spending through appropriate bills are discreatinary spending.

AUTOMATIC STABLIZERS- These are ongoing policies that automatically adjust tax rates.