Fiscal Policy,

Deficits, and
Debt
Discretionary fiscal policy refers to the deliberate
manipulation of taxes and government spending by
Congress to alter real domestic output and
employment, control inflation, and stimulate economic
growth.
Discretionary " active" means the changes are at the
option of the Federal government.
Discretionary Fiscal policy changes are often initiated
by the President, on the advice of the Council of
Economic Advisers (CEA).
Eliminate recessionary or inflationary gap
Expansionary fiscal policy
Increased spending and/or lower
taxes
Budget deficit
Contractionary fiscal policy
Lower spending and/or higher taxes
Budget surplus
Policy options?
30-3
Fiscal Policy
30-4
Real Domestic Output, GDP
P
r
i
c
e

L
e
v
e
l

AD
2
Recessions
Decrease
Aggregate
Demand
AD
1
$5 Billion
Additional
Spending
Full $20 Billion
Increase in
Aggregate Demand
AS

$490 $510
P
1
30-5
Real Domestic Output, GDP
P
r
i
c
e

L
e
v
e
l

AD
3
Reduce
Demand Pull
Inflation
AD
4
$5 Billion
Initial Decrease
In Spending
Full $20 Billion
Decrease in
Aggregate Demand
AS

$510 $522
P
1
Built in stability arises because net taxes change with
GDP.
net taxes = taxes minus transfers and subsidies
taxes reduce incomes and therefore, spending.
It is desirable for spending to rise when the economy
is slumping and vice versa when the economy is
becoming inflationary.
30-6
30-7
G
T
Deficit
Surplus
GDP
1
GDP
2
GDP
3
Real Domestic Output, GDP
G
o
v
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r
n
m
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n
t

E
x
p
e
n
s
e
s
,

G

a
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d

T
a
x

R
e
v
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n
u
e
s
,

T

how the built-in stability system behaves.
Taxes automatically rise with GDP because
incomes rise and tax revenues fall when GDP
falls.
Transfers and subsidies rise when GDP falls;
when these government payments (welfare,
unemployment, etc.) rise, net tax revenues
fall along with GDP.
The size of automatic stability depends on
responsiveness of changes in taxes to
changes in GDP:
The more progressive the tax system, the
greater the economy's built in stability.

30-8
How can we determine whether a
government's discretionary Fiscal policy is
expansionary, neutral, or contractionary?
We cannot simply examine the actual
budget deficits or surpluses Because they
will include the automatic changes in tax
revenues that accompany every change in
GDP.
The expansionary or contractionary
strength depends on how large it is
relative to the size of the economy.
30-9
30-10
G
T
GDP
2
GDP
1
Real Domestic Output, GDP
G
o
v
e
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n
m
e
n
t

E
x
p
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n
s
e
s
,

G

a
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d

T
a
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R
e
v
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n
u
e
s
,

T

(Year 2) (Year 1)
$500
$450
a b
c
Cyclical deficit
Fiscal policy
neutral
measures what the Federal budget deficit or surplus would
have been under existing tax rates and government
spending levels if the economy had achieved its full-
employment level of GDP.
line G represents government expenditures and line T
represents tax revenues.
in Year 1, budget revenues = Expenditures = $500 billion
when full employment exists at GDP1 and point a.
A standardized budget in Year 1 is zero.
The government's discretionary Fiscal policy is neutral.
Now suppose that a recession occurs and GDP falls from
GDP1 to GDP2 in year 2.


30-11
At GDP2 there is unemployment and assume
no discretionary government action, so lines
G and T remain as shown.
Tax revenues fall to $450 billion at point c.
Government spending remains unaltered at
$500 billion at point b.
This $50 billion cyclical deficit is a by-
product of the economy's slide into
recession, not the result of discretionary
Fiscal actions by the government.
The government's discretionary Fiscal policy
is still neutral.

30-12
We now consider the standardized budget in
this situation.
The standardized budget measures what the
Federal budget deficit or surplus would be
with existing taxes and government spending
if the economy is at full employment.
Government spending is $500 billion at point
b on line G. Tax revenues would be $500
billion at point a on line T if the economy is
at full employment.
A standardized budget is zero.
Actual budget deficit (or surplus) may differ
greatly from standardized budget deficit (or
surplus) estimates.

30-13
30-14
G
T
1
GDP
4
GDP
3
Real Domestic Output, GDP
G
o
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e
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n
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t

E
x
p
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n
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e
s
,

G

a
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T
a
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R
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e
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T

(Year 4) (Year 3)
$500
$450
d e
f
$475
$425
g
T
2
h
Standardized deficit
Expansionary fiscal
policy
the government reduced tax rates from T1 to T2,
now there is a standardized deficit.
a recession occurs and GDP falls from GDP3 to
GDP4.
Government expenditures are $500 billion, as
shown by point e on line G.
Tax revenues would be $475 billion at point h on
line T if the economy is at full employment.
standardized budget deficit = $25 billion (=$500
billion - $475 billion).
standardized budget deficit has increased from
zero to $25 billion/GDP3 * 100.
Structural deficits occur when there is a deficit
in the standardized budget as well as the actual
budget.

30-15
This increase in the relative size of the full
employment deficit between the two years
reveals that the new fiscal policy is
expansionary.
This is expansionary policy because true
expansionary policy occurs when the
standardized budget has a deficit.
If the standardized deficit of zero in one year,
followed by a standardized budget surplus in
next year, fiscal policy has changed from being
neutral to being contractionary.
the standardized budget adjusts for automatic
change in tax revenues, the increase in the
standardized budget surplus reveals that
government either decreased it spending (G) or
increased tax rates to get higher tax revenues
(T).Fiscal policy becomes contractionary.


30-16
Problems of timing
Recognition lag
Administrative lag
Operational lag
Political considerations
Future policy reversals
Offsetting state and local finance
Crowding-out effect
Current thinking on fiscal policy
30-17
Problems, Criticisms, and Complications