Isues in economics today 6th by guell chapter09

Chapter 09
Fiscal
Policy

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Chapter Outline
• Nondiscretionary And Discretionary
Fiscal Policy
• Using Fiscal Policy To Counteract
“Shocks”
• Evaluating Fiscal Policy
• Obama Stimulus Plan
• Kick It Up a Notch: Aggregate Supply
Shocks

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Fiscal Policy
• Fiscal Policy is the purposeful
movement in government spending or
tax policy designed to direct an economy

• Discretionary Fiscal Policy:
government spending and tax changes
enacted at the time of the problem to
alter the economy
• Nondiscretionary Fiscal Policy: that
set of policies that are built into the
system to stabilize the economy

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How Nondiscretionary
Fiscal Policy Works

• Nondiscretionary fiscal policy consists of policies
that are built into the system so that an
expansionary or contractionary stimulus can be
given automatically.
• The welfare state and the progressive income
tax serve as the built-in policies.
• If the economy is in recession, those who lose
their jobs are granted unemployment and
welfare benefits and they owe less in taxes.
• If the economy is growing at an unsustainable
rate, people are making a lot of money and

are faced with higher tax rates and there are
fewer people eligible for government benefits.
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How Discretionary Fiscal
Policy Works
• If we are in a recession the fiscal
policy to stimulate the economy
would consist of
• Increases in government spending
• Decreases in taxes

• If we are in an inflationary period
the fiscal policy to contract the
economy would consist of
• Decreases in government spending
• Increases in taxes
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Expansionary Fiscal Policy
PI

AS

PI’
PI*
AD’
AD
RGDP*
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RGDP’

RGDP

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Contractionary Fiscal Policy
PI

AS

PI*
PI’

AD
AD’
RGDP’
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RGDP*

RGDP

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Shocks
• A Shock is any unanticipated
economic event.
• Aggregate Demand Shock: an
unexpected event which causes
aggregate demand to increase or
decrease, e.g. the Sept 11, 2001 terrorist
attacks.
• Aggregate Supply Shock: an
unexpected event which causes
aggregate supply to increase or decrease,
e.g. Iraq’s 1990 invasion of Kuwait and
threat to Saudi Arabia.

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Nondiscretionary and Discretionary
Fiscal Policy Combats a Recession
PI

AS

Shock
NDFP
PI*
AD3

DFP

AD1

AD2
RGDP*
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RGDP

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Nondiscretionary and Discretionary
Fiscal Policy Combats an Overheated
Economy

PI

AS
Shock

NDFP

DFP

PI*

AD2
AD3

AD1

RGDP*
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RGDP

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Evaluating
Nondiscretionary Fiscal Policy
• Most economists believe that the
built-in stabilizers have had a
modestly positive effect on
diminishing the severity of modern
recessions.

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The Mistiming of
Discretionary Fiscal Policy
• Recognition Lag: the time it takes
to measure the state of the economy
• Administrative Lag: the time it
takes for Congress to agree on a
course of action with the president
• Operational Lag: the time it takes
for the full impact of a government

program or tax change to have its
effect on the economy
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Political Problems
with Fiscal Policy
• Expansionary bias is the problem
where politicians are more willing to
deal with recessions with tax cuts and
spending increases than they are to
deal with inflationary pressures with
tax increases and spending cuts.
• The Political Business Cycle
suggests that politically motivated
fiscal policy is used for short term
gain just prior to elections.
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The Rise, Fall and Rebirth of
Discretionary Fiscal Policy
• Between 1975 and 2001 fiscal policy was
pretty much abandoned as a mechanism
for controlling the economy.
• Monetary policy was used to expand or
contract prices and GDP.
• In 2001, the impending recession
motivated tax rebates and the Sept. 11
attacks motivated a variety of tax cut and
spending increase ideas in Congress.
• In 2003, the continuing slow growth
motivated a renewal of the tax credit
rebate idea.
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Growth Rates by Presidential Terms
First
Truman

Second

Third

Fourth

-0.5%

8.7%

7.7%

3.8%

Eisenhower I

4.6%

-0.7%

7.1%

1.9%

Eisenhower II

2.0%

-1.0%

7.1%

2.5%

Kennedy/Johnson

2.3%

6.1%

4.4%

5.8%

Johnson

6.4%

6.5%

2.5%

4.8%

Nixon I

3.1%

0.2%

3.4%

5.3%

Nixon II/ Ford

5.8%

-0.5%

-0.2%

5.3%

Carter

4.6%

5.6%

3.2%

0.2%

Reagan I

2.5%

-1.9%

4.5%

7.2%

Reagan II

4.1%

3.5%

3.4%

4.1%

Bush GHW

3.5%

1.9%

-0.2%

3.3%

Clinton I

2.7%

4.0%

2.5%

3.7%

Clinton II

4.5%

4.2%

4.4%

3.7%

Bush GW I

0.8%

1.9%

3.0%

4.0%

Bush GW II

3.2%

3.3%

2.2%

-2.8%

Obama

0.2%

2.8%

Average

3.1%

2.8%

3.7%

3.5%

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The 2003 Rebate

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Obama Stimulus Plan
Stimulus Plan Element
Non-Discretionary Fiscal Policy:
Unemployment, Welfare, Medicaid
Aid to States

Amount
in
Millions
$135,832
$53,600

Discretionary Fiscal Policy: Tax Cuts

$301,135

Discretionary Fiscal Policy: Spending
Increases

$300,047

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Kick it Up a Notch
Aggregate Supply
Shocks

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Nondiscretionary and Discretionary Fiscal in
the Wake of a Negative Aggregate Supply
Shock
AS
2

PI

Shock

AS1

NDFP

DFP

AD3

PI*
AD1

RGDP*
McGraw-Hill/Irwin

AD2

RGDP

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Nondiscretionary and Discretionary Fiscal in
the Wake of a Positive Aggregate Supply
Shock
PI

AS1

Shock

AS2

PI*

NDFP
AD2
RGDP*
McGraw-Hill/Irwin

AD1

RGDP

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