Lesson summary: Fiscal policy
|stabilization policy||the 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 policy||the use of taxes, government spending, and government transfers to stabilize an economy; the word “fiscal” refers to tax revenue and government spending.|
|discretionary fiscal policy||fiscal 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 policy||the use changes in the money supply or the interest rate to stabilize an economy; fiscal policy is policy by governments, while monetary policy is policy by central banks.|
|lump-sum taxes||taxes 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 policy||the 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 policy||the 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 payments||payments 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).|
|lag||another way of saying "delay"; fiscal policy is associated with data lags, recognition lags, decision lags, and implementation lags.|
|data lag||the time it takes to get macroeconomic data such as real GDP or the unemployment rate|
|recognition lag||the delay in fiscal policy caused by the time that it takes to realize that there is a problem to be corrected|
|decision lag||the delay in fiscal policy caused by the time that it takes to decide on a course of action|
|implementation lag||the time it takes to put action into practice|
|balanced budget||when expenditures equal income; a government has a balanced budget when tax revenue collected exceeds government spending.|
|deficit||when expenditures exceed income; when the government spends more than it collects in tax revenue in a year, it has a deficit that year.|
|debt||the accumulated deficits over time; when the government runs a deficit every year for three years, it accumulates in debt.|
|balanced budget multiplier||the 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.|
Fiscal policy is used to achieve macroeconomic goals
Government spending directly affects AD; taxes indirectly affect AD
Choosing the correct amount
The balanced budget multiplier always equals 1
Lags can complicate fiscal policy in the real world
- Data lag
- Recognition lag
- Decision lag
- Implementation lag
Closing the output gap
- 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 budget 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 million increase in government spending that is paid for by increasing taxes by 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 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:
|Problem||Type of policy needed||Appropriate tax response||Appropriate government spending response|
|Negative output gap||Expansionary fiscal policy||Decrease Taxes||Increase government spending|
|Positive output gap||Contractionary fiscal policy||Increase Taxes||Decrease government spending|
- The nation of Xela as an output gap of million. If the marginal propensity to spend is , 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.