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Lesson summary: Fiscal policy

AP.MACRO:
POL‑1.A (LO)
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POL‑1.A.1 (EK)
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POL‑1.A.2 (EK)
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POL‑1.A.3 (EK)
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POL‑1.A.4 (EK)
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POL‑1.A.5 (EK)
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POL‑1.A.6 (EK)
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POL‑1.A.7 (EK)
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POL‑1.B (LO)
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POL‑1.B.1 (EK)
In this lesson summary review and remind yourself of the key terms, calculations, and graphs related to fiscal policy. Topics include how taxes and spending can be used to close an output gap, how to model the effect of a change in taxes or spending using the AD-AS model, and how to calculate the amount of spending or tax change needed to close an output gap.

Lesson Summary

Consider a tale of two economies. Marthlandia has an economic boom which has been going on for awhile. But as a result, Marthlandia struggles with high inflation.
Burginville, on the other hand, has been in a recession for quite some time, with high unemployment causing widespread suffering. But the self-correction mechanism isn't kicking in for either country. Is there anything that can be done?
Yes! Both governments can use fiscal policy as a tool to bring their countries back to “normal.” For example, they can use fiscal policy (changes in government spending or taxes), which will impact output, unemployment, and inflation.
Burginville needs to increase output to end its recession. Their government can increase output by using expansionary fiscal policy. Expansionary fiscal policy tools include increasing government spending, decreasing taxes, or increasing government transfers. Doing any of these things will increase aggregate demand, leading to a higher output, higher employment, and a higher price level.
Marthlandia’s inflation is caused by producing more than is sustainable, so reducing output would fix its problem. Instead, they can draw on contractionary fiscal policy tools, such as increasing taxes or decreasing government spending or government transfers.
Doing any of these things will decrease Marthlandia’s aggregate demand, which leads to lower output, lower employment, and a lower price level. Usually, governments engage in expansionary fiscal policy during recessions, and contractionary fiscal policy when they are concerned about inflation.
Altogether, this lesson is about how government spending and taxes have different impacts on aggregate demand (AD). Government spending impacts AD directly, while taxes impact AD indirectly. Because government spending immediately impacts AD, but some fraction of a change in taxes will be saved rather than spent, there is a difference in impact.
If we want to know the amount of taxes that will close an output gap, we need to use the tax multiplier to figure that out. If we want to use government spending to close an output gap, we need to use the spending multiplier to figure that out.

Key terms

Key termDefinition
stabilization policythe use of policy (such as fiscal policy or monetary policy) to reduce the severity of recessions and excessively strong expansions; the goal of stabilization policy is not to eliminate the business cycle, just to smooth it out.
fiscal policythe use of taxes, government spending, and government transfers to stabilize an economy; the word “fiscal” refers to tax revenue and government spending.
discretionary fiscal policyfiscal policy that requires an action by a government to occur; for example, if a government has to pass a law to change government spending or taxes. A future lesson in this course discusses automatic stabilizers, which are fiscal policies that require no action to be taken.
monetary policyusing changes in the money supply or the interest rate to affect key macroeconomic variables; fiscal policy is policy by governments, while monetary policy is policy by central banks.
lump-sum taxestaxes that do not depend on the taxpayer's income; an example of a lump-sum tax would be paying a fixed dollar amount in taxes that doesn’t depend on your income.
expansionary fiscal policythe use of fiscal policy to expand the economy by increasing aggregate demand, which leads to increased output, decreased unemployment, and a higher price level. Expansionary fiscal policy is used to fix recessions.
contractionary fiscal policythe use of fiscal policy to contract the economy by decreasing aggregate demand, which will lead to lower output, higher unemployment, and a lower price level. Contractionary fiscal policy is used to fix booms.
transfer paymentspayments made to groups or individuals when no good or service is received in return; transfers are the opposite of a tax (you receive transfers from the government, but pay taxes to the government).
laganother way of saying "delay"; fiscal policy is associated with data lags, recognition lags, decision lags, and implementation lags.
data lagthe time it takes to get macroeconomic data such as real GDP or the unemployment rate
recognition lagthe delay in fiscal policy caused by the time that it takes to realize that there is a problem to be corrected
decision lagthe delay in fiscal policy caused by the time that it takes to decide on a course of action
implementation lagthe time it takes to put action into practice
balanced budgetwhen expenditures equal income; a government has a balanced budget when tax revenue collected equals government spending.
deficitwhen expenditures exceed income; when the government spends dollar sign, 10, start text, m, end text more than it collects in tax revenue in a year, it has a dollar sign, 10, start text, m, end text deficit that year.
debtthe accumulated deficits over time; when the government runs a dollar sign, 10, start text, m, end text deficit every year for three years, it accumulates dollar sign, 30, start text, m, end text in debt.
balanced budget multiplierthe spending multiplier that will exist when any change in government spending is offset entirely by an equal change in taxes; the balanced budget multiplier is always equal to one.

Key takeaways

Fiscal policy is used to achieve macroeconomic goals

Imagine a government wants to fix a recession or dial back an expansion. Its concrete goals would be to return the economy to full employment, or to control inflation, respectively. Fiscal policy can help them achieve their goals.
The tools of fiscal policy are government spending and taxes (or transfers, which are like “negative taxes”). You want to expand an economy that is producing too little, so expansionary fiscal policy is used to close negative output gaps (recessions). Expansionary fiscal policy includes either increasing government spending or decreasing taxes.
An economy that is producing too much needs to be contracted. In that case, contractionary fiscal policy (either decreasing government spending or increasing taxes) is the correct choice.
For example, if Burginville is experiencing a recession, the government might give everyone a tax refund (an example of expansionary fiscal policy). Here’s what will play out: the tax refund leads to an increase in disposable income An increase in disposable income causes an increase in consumption, the increase in consumption increases aggregate demand An increase in aggregate demand leads to an increase in output and a decrease in unemployment As a side effect of the decrease in unemployment and the increase in output, inflation will increase.
Marthlandia is experiencing a boom and inflation. They cut government spending. Here’s what will play out in Marthlandia: First, the cut in government spending leads to a decrease in aggregate, because government spending is a component of AD. The decrease in AD leads to a decrease in output because the decrease in AD will lead to a new short-run equilibrium with a lower output, higher unemployment rate, and a lower price level.

Government spending directly affects AD; taxes indirectly affect AD

How are the effects of government spending and taxes different? When a government engages in fiscal policy using government spending, the effect is immediate because government spending is itself a component of AD. For example, if the government buys 600 pounds of rice for dollar sign, 1000 from a farmer in Burginville, that dollar sign, 1000 counted in the G component of AD and real GDP, and then the spending multiplier kicks in.
But when a government engages in fiscal policy by using taxes or transfers, the impact is indirect. If the government of Burginville gives that farmer a dollar sign, 1000 tax refund instead of buying something from him directly, the impact of that action won't have any effect until the farmer actually does something with that refund. In fact, if he puts all of that refund under his mattress, there would be no impact at all!
But, if the farmer saves dollar sign, 200 and spends the rest on airline tickets to Florida, the dollar sign, 800 is counted in consumption spending. The purchase of the plane ticket then triggers the multiplier effect.
Remember: the tax multiplier is always less than the spending multiplier because some of that amount is saved, and not spent, in the first step.

Choosing the correct amount

When a gap is negative, you want output to get bigger, and so expansionary fiscal policy the right choice. When a gap is positive, you want output to get smaller, and so contractionary fiscal policy is the right choice. Once you decide on the type of policy (expansionary or contractionary), you can then decide on which tool to use (taxes or spending).
Policymakers also have to be careful to "mind the gap." If they want to close an output gap, they need to know how much stimulus is necessary. Too little stimulus and you won't close the gap. Too much stimulus and you may cause a different kind of gap.
For example, suppose that the economy of Burginville has an output gap of dollar sign, 20 billion. They need to take a policy action that causes exactly the amount of change. The good news is that they don't actually have to spend dollar sign, 20 billion to close that gap. Why? Because they can count on multipliers.
Recall that the spending multiplier gave us the final impact on AD of an increase in any category of spending. If the spending multiplier is 4, then an increase in government spending of dollar sign, 20 billion would increase real GDP by 4, x, dollar sign, 20, equals, dollar sign, 80 billion.
The tax multiplier is always one less than the spending multiplier (and is negative). If the spending multiplier is 4, the tax multiplier must be minus, 3. That means that if the government cuts taxes by dollar sign, 20 billion, the final impact will be minus, 3, x, minus, dollar sign, 20, equals, dollar sign, 60 billion. In either of these cases, increasing output by too much will cause output to be higher than full employment output.

The balanced budget multiplier always equals 1

A government has a balanced budget when its expenditures are equal to its revenues. In other words, if a government wants to spend dollar sign, 20, but it also wants to maintain a balanced budget, then it needs to take in dollar sign, 20 in taxes. Governments run deficits when spending is higher than tax revenue, and they run surpluses when spending is lower than tax revenue. Over time, those deficits accumulate into national debt.
What if a government wants to use expansionary fiscal policy, but it also wants to maintain a balanced budget? If Burginvlle is in a recession and has a dollar sign, 100 million negative output gap, it needs to use expansionary fiscal policy to close that gap. Because it has a spending multiplier of 10, it decides to increase government spending by dollar sign, 10 million to close that gap:
10, times, dollar sign, 10, start text, space, m, i, l, l, i, o, n, end text, equals, dollar sign, 100, start text, space, m, i, l, l, i, o, n, end text.
However, to maintain a balanced budget, it also raises taxes by dollar sign, 10 million. But wait . . . that will have its own multiplier effect! Remember that the tax multiplier is always one less than the spending multiplier, and negative. Therefore, if the spending multiplier is 10, the tax multiplier is minus, 9. The impact of the tax increase will be:
minus, 9, times, dollar sign, 10, start text, space, m, i, l, l, i, o, n, end text, equals, dollar sign, minus, 90, start text, space, m, i, l, l, i, o, n, end text.
To find the final impact of these actions, we add them together:
dollar sign, 100, start text, space, m, i, l, l, i, o, n, end text, plus, minus, dollar sign, 90, start text, space, m, i, l, l, i, o, n, end text, equals, dollar sign, 10, start text, space, m, i, l, l, i, o, n, end text.
Notice that the final impact is exactly equal to the increase in government spending. The balanced budget multiplier will always be equal to one. Why? Because if you increase spending by dollar sign, 10 million, but then increase taxes by dollar sign, 10 million to pay for that spending, the final impact on real GDP is only dollar sign, 10 million.

Lags can complicate fiscal policy in the real world

In reality, four things can slow down a fiscal policy’s implementation and e effectiveness:
  1. Data lag
This is the time to collect information about the economic conditions in a country. Suppose there is some shock to an economy, such as a decline in consumer confidence. A policymaker might not notice this until data on real GDP and unemployment rate are collected.
  1. Recognition lag
This is the time it takes to realize there might be a problem. The policy-maker gets handed a report from their intern that says unemployment is up and real GDP is down. But is this a temporary thing? Or is the start of a long-run trend? If it is temporary, there isn't any need to take any action. If it is a long-run trend, that trend has already started by the time it is recognized.
  1. Decision lag
Our policymaker reviews all of the evidence and decides that action is definitely needed. Ok, now what? Should the government take a wait-and-see approach and let the self-correction mechanism kick in? Even if they decide that the self-correction mechanism might take too long or, even deciding to actually do something will take time. Should we lower taxes? Increase spending? Now the legislature needs to get together to decide the actual policy action to take. That will take awhile.
  1. Implementation lag
Now that the legislature passed a spending bill, it will take time to put it into place. A new agency might need to be set up to coordinate the spending. Burginville decides to implement a new infrastructure development program, building bridges and roads. Which river needs a bridge? Where should we build the road? Deciding on this will take time too.

Key Equations

Closing the output gap

To determine the size of a policy action needed (such as how much government spending or how much taxes will need to change), you divide the size of the gap by the relevant multiplier.
size of tax cut needed=size of gaptax multipliersize of government spending needed=size of gapspending multiplier\begin{aligned}\text{size of tax cut needed} &=\dfrac{\text{size of gap}}{\text{tax multiplier}}\\\\ \text{size of government spending needed} &=\dfrac{\text{size of gap}}{\text{spending multiplier}}\end{aligned}

Key graphs

We can show the impact of fiscal policy on output and the price level using the AD-AS model.
Figure 1: The impact of contractionary fiscal policy on an economy experiencing a positive output gap
Figure 1 shows an economy that has an initial AD curve of A, D, start subscript, 1, end subscript and is producing real GDP worth dollar sign, 130 billion. However, the full employment output for this economy is dollar sign, 100 billion (we can tell this because the LRAS curve is always vertical at the full employment output). Positive output gaps like this one are usually associated with higher inflation, so the government decides to take action in order to bring inflation under control.
The government knows that its M, P, C, equals, 0, point, 75, so its tax multiplier is minus, 3. If the government engages in contractionary fiscal policy by increasing taxes by dollar sign, 10 billion, then the final impact of that increase will be
minus, 3, times, dollar sign, 10, start text, space, b, i, l, l, i, o, n, end text, equals, minus, dollar sign, 30, start text, space, b, i, l, l, i, o, n, end text
As a result, AD will decrease by dollar sign, 30 billion. This is hown by the shift from A, D, start subscript, 1, end subscript to A, D, start subscript, 2, end subscript in Figure 1. The decrease in AD restores the economy to full employment output.

Common misperceptions

  • When first learning about stabilization policies, some people think that the objective of stabilization policies is to eliminate the business cycle. But that is not the case. The objective of stabilization policy is not to “fine-tune” the economy. The goal of stabilization isn’t to make the business cycle go away completely, but to make the ups and downs less dramatic. In other words, we don’t want to make the business cycle a flat line, just less “bumpy”.
  • Some people mistakenly assume that fiscal policy (or any kind of discretionary policy) is as easy as some simple calculations. Unfortunately, that isn’t very realistic. Lags make active stabilization policy tricky. For one, the self-correction mechanism may be working in the background, so by the time a policy is finally implemented, it might not be the correct action anymore. Another problem is they make it longer before a corrective action kicks in. One potential solution is to have some form of passive, or automatic, stabilizers that will kick in automatically when a problem arises. We learn more about those in the next lesson.
  • Some learners confuse two important types of stabilization policy: fiscal policy and monetary policy. Fiscal policy is the domain of governments. Monetary policy is the domain of central banks (which are usually independent of government budgetary actions).
  • Another common misperception is that if government spending increases by the same amount as a tax increase, they completely cancel each other out. A dollar sign, 100 million increase in government spending that is paid for by increasing taxes by dollar sign, 100 million won’t completely cancel each other out. The balanced budget multiplier is equal to one, not zero. When there is a balanced budget, the final impact on real GDP is a dollar sign, 100 million increase as a result of the balanced budget multiplier.
  • When first learning about discretionary stabilization policies, it can be tricky to remember what specific actions are expansionary and what are contractionary. The table below can be your guide:
ProblemType of policy neededAppropriate tax responseAppropriate government spending response
Negative output gap left parenthesis, Y, start subscript, 1, end subscript, is less than, Y, start subscript, f, end subscript, right parenthesisExpansionary fiscal policyDecrease TaxesIncrease government spending
Positive output gap left parenthesis, Y, start subscript, 1, end subscript, is greater than, Y, start subscript, f, end subscript, right parenthesisContractionary fiscal policyIncrease TaxesDecrease government spending
Discussion questions
  • The nation of Xela as an output gap of dollar sign, 100 million. If the marginal propensity to consume (MPC) is 0, point, 80, how much would the government need to spend in order to close that gap? How much would taxes need to change to close that gap?
  • What are some reasons that a government might want to remove a positive output gap?
  • Explain what a decision lag is, and how it impacts the effectiveness of fiscal policy.

Want to join the conversation?

  • old spice man blue style avatar for user Liam Mullany
    How does a gov't ascertain what the natural rate of unemployment/output is? (in order to know if the country has an output gap.
    Also, how does a gov't ascertain what their nation's MPC is? (so they know how much to increase/decrease spending/taxes)
    (7 votes)
    Default Khan Academy avatar avatar for user
    • starky tree style avatar for user melanie
      The natural rate of unemployment is estimated using some fairly complicated statistical models. Similarly, the MPC is estimated using data and statistical models. For example, one methodology I have seen is using data from the Consumer Expenditure Survey which collects data on household income and expenditures.
      (8 votes)
  • blobby green style avatar for user sarahbelle
    Is a tax return a transfer payment?
    (5 votes)
    Default Khan Academy avatar avatar for user
  • male robot donald style avatar for user Mark Ehrmantraut
    In case of farmer's example, if govt is reducing the tax then it will have impact of tax multiplier, but he has his rice with himself and he can sell it to someone and it can again be a cause of spending multiplier. So it can expand GDP many folds, So wouldn't it be better to give tax relief instead of spending on it directly?
    (1 vote)
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    • hopper cool style avatar for user gosoccerboy5
      You might be mixing it up. Government spending affects the economy more than tax refunds because the money is spent on items in the first place, so the tax relief is less effective than spending. If I wasn't very clear, you might want to visit the earlier section MPC And Multiplier for more info.
      (1 vote)