AD and AS is a useful mechanism for looking at how the macroeconomy can be deliberately expanded or contracted by the government.
Fiscal policy measures how government spending and tax collection affect economic output, unemployment, and the price level.
Fiscal policy stresses the importance of a “hands-on” role for the government in manipulating AD to “fix” the economy.
Expansionary
Fiscal Policy
When
the economy is suffering a recession, real GDP is low and unemployment is high.
If
the government increases its spending or lowers net taxes, the AD curve increases
(G). (see graph) REVIEW: Net taxes are tax revenues minus transfer
payments.
In this range of SRAS, the economy should experience the full magnitude of the multiplier with very little inflation.
Remember that if the government is using a tax cut (rather then spending) to stimulate the economy, it must go through each consumer’s consumption multiplier. To get the same increase in real GDP, the size of the tax cut must be larger than an increase in government spending.
Contractionary
Fiscal Policy
If
the economy is operating beyond full employment, and inflation is becoming a problem,
the government may need to contract the economy. (see graph).
This inflationary equilibrium is seen in the vertical range of the AS curve (see graph).
This can be done by decreasing government spending or increasing taxes, both of which would cause a leftward shift in AD. (see graph)
In this range of SRAS the economy may see very little decrease in real GDP but ideally a substantial decrease in the rate of inflation.
Are prices sticky?
Do prices fall as this graph seems to indicate? Is it really this simple?
One of the points of contention is whether the price level can fall.
Many economists (Keynesians) predict that prices are fairly inflexible, or sticky, in the downward direction. This means that efforts to fight inflation are really efforts to SLOW inflation and not actually lower the price level.
Conversely, Classical economist believe that the long-run economy naturally adjusts to full employment and so they see the AS curve as vertical. This implies that prices are flexible and can rise/fall as see in our example.
Who pays for this crap?
Budget deficit = government spends more it takes in through revenue.
Budget surplus = government collects more then it spends.
Expansionary
policy
When the government spends more then it collects, it runs a deficit. To pay for this debt, it must borrow funds. When this occurs regularly, the nations accumulates a national debt.
Expansionary policy is often expensive. It is common to run a deficit in these cases. There are two ways governments pay for this and both have the potential to weaken the expansion.
1) Borrow
If a household wants to spend beyond its means, it enters the market for loanable funds as a borrower. The borrowed funds provide a short-term ability to purchase goods and services, but must be paid back with interest.
The same is true with the federal government borrows. However, when the federal government enters the market for loanable fun it ruins the party for everyone else. The government can borrow from the banking system or issue government securities (bonds).
This decreases the available of loanable funds available to private borrowers. This decrease in supply will increase the price of what’s left to borrow (interest rates).
This
makes the cost of borrowing money more expensive, counteracting the expansion
the government is trying to encourage. This is known as the crowding out effect.
2) Create Money
The creation of new money can fund a deficit however printing money can cause inflation, counteracting the purpose of expansionary policy. The higher the rate of inflation, the less effective the multiplier becomes.
Contractionary
Fiscal Policy
If the government is contracting the economy is spending less or raising taxes. Budget surpluses can appear. How the government handles these surplus can determine the effectiveness of contractionary policy.
1) Pay down debt
If the government pays down debt and retires bonds ahead of schedule, the supply of loanable funds increase and interest rates decrease. What do firms and households do when interest rates are down? Lower interest rates stimulate investment and consumption which counters the contractionary fiscal policy and lessens the downward effects on the price level.
2) Do Nothing
By making regular payments and not retiring bonds earlier, idle surplus funs are removed from the economy. By not allowing these funds to be recirculated, the anti-inflationary fiscal policy can be more effective.
Automatic
Stabilizers
An automatic stabilizer is anything that increases a deficit during a recessionary period and increases a budget surplus during an inflationary period without any discretionary change on the part of government.
There are some mechanisms built into the tax system that automatically regulate, or stabilize, the macroeconomy as it moves through the business cycle by changing net taxes collected by the government.
Progressive Taxes and Transfers
Example:
Booming Economy – GDP is increasing
More and more households and firms begin to fall into higher and higher tax brackets. This means that a larger percentage of income is taken as income tax, which slows down the consumption of both households and firms.
In addition, a strong economy reduces the need for such transfer payments as unemployment insurance and welfare. Thus net taxes increase with GDP. Progressive taxes are therefore contractionary when the economy is very strong.
It automatically puts the breaks on spending which reduces the threat of inflation and contributes to a budget surplus.
Example:
Sluggish Economy – GDP is falling
Households and firms find themselves in lower tax brackets. With a smaller percentage of income being taken as income tax, this provides a way for more consumption than would have been possible at the higer tax rate.
Simultaneously, a weak economy ncreases the need for transfer payments like welfare. Thus net taxes decrease with GDP. When the economy is sluggish, the progressive tax system is expansionary in nature. It automatically forces the government to collect less taxes.
For a given level of government spending, net taxes rise and fall with GDP. These automatically reduce the threat of inflation when the economy I strong (GDPi) and reduce the negative effects of a recession when the economy is weak (GDPr). Ideally, at GDPf the budget is balanced.
Difficulties
of Fiscal Policy
Crowding
Out
If the government must borrow funds to pay for expansionary fiscal policy, the government has an effect on the market for loanable funds.
Public
savings affects the supply of loanable funds. A government deficit, or negative
public savings, is a reduction in the total savings and decreases the supply of
loanable funds available to private borrowers. 
A decrease in the supply of loanable funds increase the interest rate and decreases the dollars that are borrowed for investment.
Less investment spending on capital goods is likely to reduce a nation’s growth rate.
When
the interest rate increases, households and firms are “crowded out” of the market
for loanable funds. This decrease in C and I dampens the effect of expansionary
fiscal policy. (SEE GRAPH)
When the government is fighting inflation with contractionary policy, we are likely to see the opposite of crowding out. If a budget surplus is the result of contractionary policy, and government debt is retired, the supply of loanable funds increases, interest rates fall, and investment increasing thus lessening the impact of contraction.
NET EXPORT EFFECT
This will be discussed in more depth later.
If government borrowing to conduct fiscal policy results in rising interest rates, this same crowding out effect will hamper next exports through foreign exchange rates.
Example:
You are a German and you see interest rates rising in
Remember, these higher interest rates are driven by a decrease in the supply of loanable funds due to expansionary policy.
As a German who wants to buy a governmental security, you need dollars. This increased demand for dollars on a macro level drives up the “price” for dollars. (Remember: demand high, supply low = prices rise) The “price of a dollar” is measured by how many Euros, for example, it would take to buy a dollar on the currency market.
When
the price of a dollar rises from E0 to E1, it now becomes more expensive for foreign
citizens to buy goods made in the
All else remaining equal, when the dollar is more expensive (stronger), foreigners buy less American goods.
Falling next exports decreases AD which lessens the impact of expansionary policy.
If the government is using fiscal policy to fight inflation and interest rates begin to fall, the demand for dollars falls, depreciating the dollar and increasing net exports because American goods become “cheaper”.
This increase in net exports lessens the effectiveness of the contractionary fiscal policy.
State
and Local Policy
State and local governments that are sometimes required, by law, to balance their budgets can thwart federal policy.
During a recession S/L governments are forced to raise taxes and cut spending to balance the budget while the federal government is cutting taxes to increase DI.
REVIEW:
Production possibilities curve or PPF can move outward over time. The PPF is useful to see how growth can be impacted by fiscal policy.
The PPF or nations production possibilities can grow over time.
1) the quantity of economic resources increases
2) the quality of those resources increases
3) the nation’s technology improves.
This graph measures production.
Production is typically described as measuring the quantity of output that can be produced per worker in a given period of time. More production = a shift outward.
The determinants of productivity help to explain why some nations have grown at faster rates then other countries. This list helps policy makers decide on a list of targets that can help to focus policy on factors that will increase a nation’s growth rate.
1)
Stock of Physical Capital
Workers are more productive with tools. Painting a house, digging a hole, or writing a term paper become much easier with the proper tools. Increasing the quantity of physical capital will often help to increase the quantity of more capital.
There should be policies that provide incentives to invest in physical capital.
2)
Human Capital
Labor is more productive when it has more human capital. Human capital is the amount of knowledge and skills that labor can apply to the work they do.
An accountant who takes extra courses so that she can earn her stockbroker’s license has increased her human capital, for example. Cheaper public education, etc.
Human capital also includes the general health of the nation’s labor force. Vaccinations…
There should be policies that provide incentives to invest in human capital.
3)
Natural Resources
A nation’s stock of minerals, soil, timber, or navigable waterways, for example, contribute to productivity.
Renewable resources can repopulate themselves
Non-renewable resources are finite in their supply.
Environmental protection laws are designed to protect our productivity in these areas.
4)
Technology
Technology is thought of as a nation’s knowledge of how to produce goods in the best possible way.
There should be policies that produce incentives to increase the rate of technological progress. (Research grants to university professors, for example).
What
do all these productivity determinants have in common?
They all require investment and funds because investment come from savings.
Firms invest = physical and human capital
Nations invest = conservation of resources
Entrepreneurs invest = new technology
Productivity “friendly” policies should make it easier to invest, save, or both.
Some economists believe that supply side policies have the potential to increase productivity and therefore economic growth.
Supply
Side Policies
We have spent some time discussing taxing/spending to expand or contract AD.
Some economists believe that government policy should not be so proactive in manipulation of AD. These economists believe that the economy generally moves to full employment without governmental investment. However, if the government does get involved, fiscal policy should focus on the AS side of the equation by providing incentives to increase savings and investment.
The main idea behind Supply Side fiscal policy is that tax reductions targeted to AS increase AS so that real GDP increases with very little inflation. (Best Possible World)
Supply-side
proponents would suggest policies that lower, or remove, taxes on income earned
from savings. This would encourage savings and increase the supply of loanable
funds, decrease the real interest rate, and increase the amount of money that
firms invest.
These same economists would suggest an investment tax credit, which reduces a firm’s taxes if it invest in physical capital.
Lower income taxes increases DI for households which increases C and S and increases the profitability of firms.
This increase in savings and investment allows for an increase in the productivity capacity of a nation because more capital stock is accumulated.
Ideally this increase in investment increases the long-run AS.
Tax incentives to increase savings and investment on the supply side are likely to also increase AD which may, or may not increase price levels.
Not all economists agree with these policies.
Supply side economists advocate other explanations for how lower taxes can increase AS as well as AD.
Productivity Incentives
Lower taxes means workers take more of the pay home which may prompt wage earners to work harder, take less time off, and be more productive.
IF the government has a large role in social programs, citizen learn to rely on the government and do less on their own.
Risk Taking
Entrepreneurs
take big risk to start businesses and invest in new capital. Lowering the tax
rate on profits increase the expected rate of return and encourages more investment.