Macroeconomics ECON202
Guided notes
Chapter 16 Fiscal Policy
Big Questions to study
A. What is fiscal policy?
• Fiscal policy involves the use of government’s budget tools, government spending, and taxes to
influence the macroeconomy, often through aggregate demand
• Countercyclical fiscal policy is designed to counteract business cycle fluctuations by increasing
aggregate demand during downturns and decreasing aggregate demand during expansionary periods
B. What are the shortcomings of fiscal policy?
• Fiscal policy is subject to three significant lags: a recognition lag, an implementation lag, and an
impact lag
• In addition, crowding-out can diminish the effects of fiscal policy
• Finally, according to the new classical critique, savings adjustments by private individuals can further
diminish the stimulation effects of fiscal policy
C. What is supply-side fiscal policy?
• Supply-side fiscal policy involves the use of government spending and taxes to affect the production
(supply) side of the economy. This is a long-run view that concentrates on institutional changes
• A key proposal of supply-side fiscal policy is that lower marginal income tax rates can actually lead to
greater tax revenue when tax rates are high
Flow of Chapter 16
- Fiscal Policy: expansionary fiscal policy and contractionary fiscal policy
1
, - Shortcomings of fiscal policy
- Supply side fiscal policy
A. What is fiscal policy?
Fiscal policy: using government budget tools to influence the economy.
Government budget tools: government spending (G) and taxes
• 2 types of policies that governments use:
• Monetary policy and fiscal policy
• Monetary Policy: is the use of the money supply to influence the economy
• Fiscal Policy: involves the use of government’s budget tools, government spending, and taxes to
influence the macroeconomy
• In the U.S. —> tax and spending changes are legislated and approved by both Congress
and the president
A1. Expansionary fiscal policy
Expansionary fiscal policy: To stimulate or expand the economy, the government can:
- Increase government spending (G)
- Decrease taxes
Suppose aggregate demand decreases, the economy enters recession.
The government can do two things, either:
- Do nothing; or
- Cut taxes/increase government spending (G), i.e., expansionary fiscal policy. This will increase
AD
During recession, AD decreases. The economy moves from point A to point b.
2
,A. If government does nothing, input prices will adjust in long run, SRAS shifts to the right, it will move
from point b to point C in long run.
B. Yet the adjustment can take a really long time, government can use expansionary policy by increasing
government spending (G)/ cutting taxes
This shifts AD(sub 2) back to AD(sub 1). The economy moves back from point b to point A.
• During a recession —> many expect the government to step in with tax reductions or spending
programs to help stimulate the economy
• Expansionary Fiscal Policy: occurs when the government increases spending or decreases taxes to
stimulate the economy toward expansion
• The aggregate demand-aggregate supply model helps us examine the effects of expansionary
fiscal policy
• Recessions can occur as a result of a drop in aggregate demand
• In theory —> the economy can move itself back to full employment in the long run when all
prices adjust
• *** Graph of Expansionary Fiscal Policy in notebook ***
• Initially —> when the economy is in long-run equilibrium at point A, with P = 100 (price level),
Y = Y* (full employment), and u = u* (the natural unemployment rate)
• If aggregate demand declines from AD(sub 1) to AD(sub 2) —> the economy moves to short-
run equilibrium at point b, with output at Y(sub 1) (which is less than full-employment output),
and an unemployment rate greater than the natural rate
• At equilibrium point b —> the government officials can wait for the economy to adjust
back to full-employment equilibrium at point C
• This adjustment occurs when all prices adjust downward and short-run aggregate
supply (SRAS) shifts downward to SRAS(sub 2)
3
, • But —> prices can take a while to adjust and recessions are difficult times for many
people
• Thus —> government officials often choose to use fiscal policy to try to shift
aggregate demand back to its original level
• If their policy works —> the economy returns to full-employment
equilibrium at point A
• The goal of expansionary fiscal policy is to shift aggregate demand back to AD(sub 1) so that the
economy returns to full employment without waiting for long-run adjustments
• Fiscal policy can make use of government spending, taxes, or a combination of the two
• Aggregate demand has four pieces: consumption (C), Investment (I), government spending (G), and
net exports (NX)
• Therefore —> increases in (G) government spending, directly increase aggregate demand
• When private spending (consumption, investment, and net exports) is low —> the government
can increase demand directly by increasing government spending (G)
• Fiscal policy can also focus on consumption (C) by decreasing taxes
• Decreases in taxes can increase aggregate demand because people have more of their income
left to spend after paying their taxes
• When people keep more of their paycheck —> they can afford more consumption
A1a. Fiscal policy during Great Recession
In the Fall of 2007, unemployment rate climbed from 4.6% to 5%.
Economic Stimulus Act 2008
- Tax rebate for Americans (tax cut)
- Totaled $168 billion
4
Guided notes
Chapter 16 Fiscal Policy
Big Questions to study
A. What is fiscal policy?
• Fiscal policy involves the use of government’s budget tools, government spending, and taxes to
influence the macroeconomy, often through aggregate demand
• Countercyclical fiscal policy is designed to counteract business cycle fluctuations by increasing
aggregate demand during downturns and decreasing aggregate demand during expansionary periods
B. What are the shortcomings of fiscal policy?
• Fiscal policy is subject to three significant lags: a recognition lag, an implementation lag, and an
impact lag
• In addition, crowding-out can diminish the effects of fiscal policy
• Finally, according to the new classical critique, savings adjustments by private individuals can further
diminish the stimulation effects of fiscal policy
C. What is supply-side fiscal policy?
• Supply-side fiscal policy involves the use of government spending and taxes to affect the production
(supply) side of the economy. This is a long-run view that concentrates on institutional changes
• A key proposal of supply-side fiscal policy is that lower marginal income tax rates can actually lead to
greater tax revenue when tax rates are high
Flow of Chapter 16
- Fiscal Policy: expansionary fiscal policy and contractionary fiscal policy
1
, - Shortcomings of fiscal policy
- Supply side fiscal policy
A. What is fiscal policy?
Fiscal policy: using government budget tools to influence the economy.
Government budget tools: government spending (G) and taxes
• 2 types of policies that governments use:
• Monetary policy and fiscal policy
• Monetary Policy: is the use of the money supply to influence the economy
• Fiscal Policy: involves the use of government’s budget tools, government spending, and taxes to
influence the macroeconomy
• In the U.S. —> tax and spending changes are legislated and approved by both Congress
and the president
A1. Expansionary fiscal policy
Expansionary fiscal policy: To stimulate or expand the economy, the government can:
- Increase government spending (G)
- Decrease taxes
Suppose aggregate demand decreases, the economy enters recession.
The government can do two things, either:
- Do nothing; or
- Cut taxes/increase government spending (G), i.e., expansionary fiscal policy. This will increase
AD
During recession, AD decreases. The economy moves from point A to point b.
2
,A. If government does nothing, input prices will adjust in long run, SRAS shifts to the right, it will move
from point b to point C in long run.
B. Yet the adjustment can take a really long time, government can use expansionary policy by increasing
government spending (G)/ cutting taxes
This shifts AD(sub 2) back to AD(sub 1). The economy moves back from point b to point A.
• During a recession —> many expect the government to step in with tax reductions or spending
programs to help stimulate the economy
• Expansionary Fiscal Policy: occurs when the government increases spending or decreases taxes to
stimulate the economy toward expansion
• The aggregate demand-aggregate supply model helps us examine the effects of expansionary
fiscal policy
• Recessions can occur as a result of a drop in aggregate demand
• In theory —> the economy can move itself back to full employment in the long run when all
prices adjust
• *** Graph of Expansionary Fiscal Policy in notebook ***
• Initially —> when the economy is in long-run equilibrium at point A, with P = 100 (price level),
Y = Y* (full employment), and u = u* (the natural unemployment rate)
• If aggregate demand declines from AD(sub 1) to AD(sub 2) —> the economy moves to short-
run equilibrium at point b, with output at Y(sub 1) (which is less than full-employment output),
and an unemployment rate greater than the natural rate
• At equilibrium point b —> the government officials can wait for the economy to adjust
back to full-employment equilibrium at point C
• This adjustment occurs when all prices adjust downward and short-run aggregate
supply (SRAS) shifts downward to SRAS(sub 2)
3
, • But —> prices can take a while to adjust and recessions are difficult times for many
people
• Thus —> government officials often choose to use fiscal policy to try to shift
aggregate demand back to its original level
• If their policy works —> the economy returns to full-employment
equilibrium at point A
• The goal of expansionary fiscal policy is to shift aggregate demand back to AD(sub 1) so that the
economy returns to full employment without waiting for long-run adjustments
• Fiscal policy can make use of government spending, taxes, or a combination of the two
• Aggregate demand has four pieces: consumption (C), Investment (I), government spending (G), and
net exports (NX)
• Therefore —> increases in (G) government spending, directly increase aggregate demand
• When private spending (consumption, investment, and net exports) is low —> the government
can increase demand directly by increasing government spending (G)
• Fiscal policy can also focus on consumption (C) by decreasing taxes
• Decreases in taxes can increase aggregate demand because people have more of their income
left to spend after paying their taxes
• When people keep more of their paycheck —> they can afford more consumption
A1a. Fiscal policy during Great Recession
In the Fall of 2007, unemployment rate climbed from 4.6% to 5%.
Economic Stimulus Act 2008
- Tax rebate for Americans (tax cut)
- Totaled $168 billion
4
