Fiscal Policy

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Fiscal Policy
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Fiscal Policy

• Fiscal policy is government spending and taxation
  policy
• Fiscal policies that the government changes to
  stabilize the economy are called discretionary
  policies
• Fiscal policies that take effect without specific
  action by legislators are called automatic
  stabilizers

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Discretionary Fiscal Policy

• As weve already seen, when the government
  changes its spending or taxation policies it
  affects aggregate expenditure and aggregate
  demand
• Is it a good idea for the government to use its
  discretionary policy?
• This is the nature of the controversy about the
  use of activist policy

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Discretionary Fiscal Policy and AD Volatility

• If there is volatility in private consumption and
  investment, fiscal policy can be used to
  stabilize AD
• Consider a contractionary gap
• Economists that believe in activist policies
  believe that fiscal policy should be used to
  stabilize AD

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Counter Argument

• Other economists believe that the instability of
  AD is due to not solved by discretionary fiscal
  policy
• They believe that private demand is stable
• They also consider that deviations from Y are
  due to errors in expectations
• They believe that fiscal policy isnt effective
  due to lags

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Price Expectations

• Remember, our justification for deviations from
  Y are based in part on errors in expectations
• If this is the case, we would like economic
  agents to have the best ability to forecast
  economic variables
• The way to have the best forecasts is if policy
  is stable and predictable
• Therefore, new classical economists believe the
  government should not be changing their policies
  in any unpredictable way

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Lags

• New classical economists also think that the lags
  associated with discretionary policy limit its
  effectiveness
• There are four kinds of lags
• Recognition
• Decision making
• Implementation
• Effectiveness

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Lags

• These lags, when combined, might be very long
  relative to a recession
• It could be that the policy will be mistimed and
  could result in more volatility in AD rather than
  less
• For these reason new classicals do not believe in
  activist policies

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Automatic Stabilizers

• Wouldnt it be nice to fiscal policies that
  worked without lags?
• These types of policies are called automatic
  stabilizers
• Automatic stabilizers act to stabilized aggregate
  demand without requiring any action on the part
  of decision makers

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Automatic Stabilizers

• What policies act as automatic stabilizers?
• Progressive income tax rates these rates take a
  larger share of income when income rises and a
  smaller share of income as income falls
• Unemployment compensation and welfare payments
  keep spending up for those hardest hit by a
  recession
• These policies are counter cyclical

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Supply Shocks

• So far weve considered fiscal policy when the
  cyclical effects have been due to AD changes
• What happens if there is a shock to AS?
• In this case AD oriented policies will be
  inflationary