Question

1. Over the last several years, fiscal policy has attempted to stimulate the economy. Do a short search in OCLS or the Internet.
2. Summarize a recent article (one-year-old or less) about current fiscal policy and its effects on the overall economy (no more than one paragraph and please include the citation).
3. Discuss your view of the policy and how the concept of government spending multipliers is used to forecast the policy effects.
4. Post Credible sources and citations please. Thanks!

Answer 1

Fiscal policy is the use of government spending and taxation to influence the economy. When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular groups—a tax cut for families with children, for example, raises their disposable income. Discussions of fiscal policy, however, generally focus on the effect of changes in the government budget on the overall economy. Although changes in taxes or spending that are “revenue neutral” may be construed as fiscal policy—and may affect the aggregate level of output by changing the incentives that firms or individuals face—the term “fiscal policy” is usually used to describe the effect on the aggregate economy of the overall levels of spending and taxation, and more particularly, the gap between them.

Fiscal policy is said to be tight or contractionary when revenue is higher than spending (i.e., the government budget is in surplus) and loose or expansionary when spending is higher than revenue (i.e., the budget is in deficit). Often, the focus is not on the level of the deficit, but on the change in the deficit. Thus, a reduction of the deficit from $200 billion to $100 billion is said to be contractionary fiscal policy, even though the budget is still in deficit.

Figure 1 shows the federal budget surplus over the period 1962–2003. The data in the figure are corrected to remove the effects of business cycle conditions. For example, in fiscal year 2003, the actual budget deficit was $375 billion, of which an estimated $68 billion was due to the lingering effects of a recession, so that the cyclically adjusted deficit was $307 billion. The data are also “standardized” to eliminate the effects of inflation and the effects of quirks in the timing of revenues and outlays, such as the receipt of payments from Desert Storm allies that arrived in the fiscal years following the war itself. Notable on the figure are the fiscal stimulus of the Vietnam War, the Kemp-Roth tax cuts of the early 1980s, and the program of tax cuts enacted under George W. Bush.

The most immediate effect of fiscal policy is to change the aggregate demand for goods and services. A fiscal expansion, for example, raises aggregate demand through one of two channels. First, if the government increases its purchases but keeps taxes constant, it increases demand directly. Second, if the government cuts taxes or increases transfer payments, households’ disposable income rises, and they will spend more on consumption. This rise in consumption will in turn raise aggregate demand.

Fiscal policy also changes the composition of aggregate demand. When the government runs a deficit, it meets some of its expenses by issuing bonds. In doing so, it competes with private borrowers for money loaned by savers. Holding other things constant, a fiscal expansion will raise interest rates and “crowd out” some private investment, thus reducing the fraction of output composed of private investment.

In an open economy, fiscal policy also affects the exchange rate and the trade balance. In the case of a fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital. In their attempt to get more dollars to invest, foreigners bid up the price of the dollar, causing an exchange-rate appreciation in the short run. This appreciation makes imported goods cheaper in the United States and exports more expensive abroad, leading to a decline of the merchandise trade balance. Foreigners sell more to the United States than they buy from it and, in return, acquire ownership of U.S. assets (including government debt). In the long run, however, the accumulation of external debt that results from persistent government deficits can lead foreigners to distrust U.S. assets and can cause a deprecation of the exchange rate.

Figure 1 Cyclically Adjusted and Standardized Budget Surplus as a Percentage of GDP: 1962-2003