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Fiscal Policy. Fiscal Policy is the Federal Government spending and taxing authority and is used in our context to influence the performance of the economy. AD review basic point. Price Level. shift the curve when a relevant factor changes. Price level.

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fiscal policy

Fiscal Policy

Fiscal Policy is the Federal Government spending and taxing authority and is used in our context to influence the performance of the economy

ad review basic point
AD review basic point

Price Level

shift the curve when a relevant factor changes

Price level

move along the curve when the price level changes



types of fiscal policy
Types of Fiscal Policy

There are two types of fiscal policy: discretionary and non-discretionary (automatic).

The discretionary policy is the government (federal) changing spending (G), changing taxes (on households) T, or some combination of the two. The logic of the change is to influence the performance of the economy. Back in 1946 the federal government pledged to have economic growth, price stability and full employment.

Non-discretionary policy is really the overall framework and design of the government spending and taxing authority. As an example, having a progressive tax system, once set up, works automatically in the economy.


We saw a recession could happen if C, I, G, or X fell. The short term effect was falling RGDP and raising unemployment. The ratchet effect kept the price level from falling

The short term rising unemployment is painful for many folks and the focus of Fiscal Policy is to try to counterbalance the fall in C, I, G, or X so that the unemployment does not result.

The tools the government would use are 1) Increasing G, or 2) lowering taxes (on households) and thus increasing C, or 3) some combination of the two.

discretion expansionary fiscal policy
Discretion – expansionary fiscal policy

If the AD curve is shifting to the left, then the way to counter this is to increase G and/or cut taxes. This would make the AD curve would shift back to the right. This is the discretionary expansionary fiscal policy.

The short run unemployment would not happen.

Let’s see this in a graph on the next slide. Note we start with AD1, , SRAS1, RGDP1, and P1. Let’s assume RGDP1 is the full employment level of output.

Then we have AD fall to AD2 for reasons you should recall from previous notes (this would be a good time to find those notes and think about the ideas). RGDP falls to RGDP2 by the full multiplier of the change in C, I, G, or X.

recession expansionary fp
Recession – expansionary FP


The expansionary fiscal policy would just reverse the arrows and have the AD curve end up back where it started.

The arrows pointing left signify the fall in AD and resulting fall in RGDP and rise in unemployment.







Recall that with the multiplier, fiscal policy makes up only a fraction of the change in AD. Additional rounds of spending kick in.


Similarly, if the economy was moving into a booming phase, when RGDP rises above the potential or full employment RGDP, a rising price level (inflation) is the end result.

The discretionary fiscal policy moves to counter a boom and the resulting inflation is to cut government spending and/or increase taxes and thus lower consumption, or some combination of the two.

On the next slide we start with an economy at its potential. Then we will see the economy grow in the short term from its potential and we will have demand pull inflation.

discretion contractionary fiscal policy
Discretion – contractionary fiscal policy


Note as AD rises we move up the SRAS and we get a higher price level – inflation! We are assuming here this inflation is higher than we care to have.








discretion contractionary fiscal policy1
Discretion – Contractionary fiscal policy


With the price level ratcheted up to P2, to stop further increase in inflation the fiscal policy is to shift AD back. But AD doesn’t have to fall as far to get back to RGDP1.








inflation contractionary fiscal policy
Inflation – contractionary fiscal policy

Note the cure for inflation is to lower AD. But the decrease in AD doesn’t have to be a large as the AD increase that created the problem. The logic here is that on the way up the price level adjusted and influenced the size of the rise in the RGDP.

On the way down if we didn’t have a ratchet effect on the price the AD would shift back and a falling price level would then encourage some additional spending. But since we won’t get the lower price level and the stimulus it would create, the AD just has to be lowered along the P2 line in the graph to above the RGDP1 level.

government budget
Government Budget

In the course of a year the government budget is kept track of and there are three large parts observed. We have

Government purchases (what we have called G) + transfer payments (like social security payments to beneficiaries) – tax revenue from all sources (which includes FICA, or social security taxes collected).

Let’s rewrite this as

Government budget = G – tax + transfers = G – (tax -transfers) = G – T, where T is net taxes, or taxes net of transfers.

Remember with fiscal policy changes in G shifts AD and changes in T shift C and thus AD.

government budget1
Government Budget

If G – T > 0 we have a budget deficit in the year,

If G – T < 0 we have a budget surplus in the year, and

If G – T = 0 we have a balanced budget in the year.

On the next screen we place G and T in a graph with RGDP. We have seen G before in the context of the AE model. But we have not put taxes in the graph like we will see on the next screen.

government budget2
Government budget

G, T

Note that G is set by government, as we have said before. T is also set by government in terms of the tax structure. This is the non-discretionary part I mentioned before.




Budget surplus

Budget deficit

government budget3
Government Budget

On the previous slide you can see if the level of RGDP grows for reasons other than government policy the budget can move from deficit to surplus. Basically as RGDP grows tax revenues will grow and with a fixed amount of spending the budget moves toward surplus. Moreover, as RGDP grows more people work and so less is paid out in transfers like unemployment insurance.

Conundrum: Fiscal policy can change course by itself as RGDP moves or it can change by discretionary fiscal policy. Let’s look at this next.


Let’s say the economy falls into a recession. Policy makers can use discretion and increase G, or lower T, or some combination of the two. This expansionary fiscal policy moves the government budget into more of a deficit. But even without the expansionary move the budget will move more into deficit. With lower RGDP less taxes will be paid and more transfers like unemployment insurance will be paid out. This cyclical deficit could fool people into thinking that we have done something to cure the problem, when in fact nothing has been done.

Solution: Look at the standardized budget!

standardized budget
Standardized budget

G, T




Full employment RGDP

standardized budget1
Standardized budget

The graph on the previous screen shows what the state of the budget would be if the economy was at full employment. Plus, if we move away from the full employment level we can see how the budget would change automatically.

Here the state of the budget at full employment is called the standardized budget – here we see it is a deficit. We look here to see about discretionary policy. When the economy moves away from full employment the budget status will change, but for automatic reasons.

Say we have expansionary fiscal policy due to a recession. The G line would shift up and our standardized budget will be in even larger deficit at full employment.

problems of fiscal policy
Problems of Fiscal Policy

We have a simple theory of the economy here and policy makers also have models of the economy (perhaps more sophisticated than what you see here). The size of the economy is so large we as people may not be able to fully understand all the details of the workings of the economy. For this and other reasons fiscal policy may be difficult to implement. Let’s explore these ideas next.

problems of timing
Problems of timing

The recognition, administration and operational lags all have to do with the idea that things in the economy can not be changes in an instant.

It takes time to recognize a recession or inflation has started to occur. Then it takes time to put into action the appropriate discretionary course of action.

A real bummer would be we recognize too late that a recession has occurred. Then while the economy is “healing” itself we implement expansionary policy and thus throw the economy into an inflationary spiral.

other problems
Other problems

Other problems you can read about are political considerations, future policy reversals and offsetting state and local finance. I do want to mention more about crowding out.

Some folks think expansionary policy in the form of higher G might mean I and C will fall and we thus really do not get any change in RGDP, but just a reshuffling of its mix from I and C to G. Here is the logic. If G is raised without getting more taxes the government will have to borrow more. This increased borrowing will raise the interest arte and thus I and C will be “crowded out” by the new G.

the debt
The debt

Deficit or surplus

The year timeline

Each of these vertical parts of the line signify both the end of one year and the beginning of the next year. During any year we may have a government budget deficit or surplus (or balanced budget).

When we pick a particular date – like then end of a year – and add up all the past deficits and surplus the net amount that has not been paid is called the debt.

the debt1
The debt

In the US the only way the federal government can go into deficit in a year is to borrow. It does this by issuing US government securities called bills, notes and bonds, depending on their maturity (when the government says they will pay back – you should check what is difference between bills, notes and bonds). So, the debt is all past borrowing not paid off.

Note in 2005 the debt was around 8 trillion dollars, is largely held by Americans, and has a component called interest that grows if the debt is not paid off.

What has happened often lately is that some debt will come due, the government pays off the person who held the debt, and then the government re-issues more debt to cover what it just paid off? Can the federal government do this for ever?