Chapter 12 Full Emplyment

Chapter 12: Fiscal Policy
The Employment Act of 1946
Gave the federal government the right and responsibility to take

monetary and fiscal policy action to maintain economic stability.
1. The responsibility of fulfilling the act rests with the executive
branch.
a. The President must submit an annual economic report describing
the current state of the economy and making policy
recommendations to maintain economic stability. (State of the
Union Message)
b. The Council of Economic Advisors (1 chairman of the CEA and
2 other members and staff) gathers data and advises the
President on economic policy issues.
c. The Joint Economic Committee (one of four such committees in
Congress) investigates a wide range of economic problems and
advises and educates Congress on these economic issues.
1
Discretionary Fiscal Policy is the deliberate
changes of taxes and government spending by
Congress to alter GDP and employment,
control inflation, and stimulate economic
growth.
2
Expansionary Fiscal Policy
1. Increase G
2. Decrease T
3. Both increase G and decrease T
Expansionary fiscal policy implies a budget

deficit.
3
Contractionary Fiscal Policy
1. Decrease G
2. Increase T
3. Both decrease G and increase T
Contractionary fiscal policy implies a budget

surplus.
4
Financing of Deficits and Disposing of
Surpluses
1. Financing a deficit by borrowing from US

citizens is less expansionary than creating
money.
2. Handling a surplus by reducing debt is less
contractionary than holding idle balances
(impounding).
5
Non-Discretionary Fiscal Policy: Built-in Stabilizers
A built-in stabilizer is anything that increases the government’s

budget deficit (or reduces its budget surplus) during a recession
and increases its budget surplus (or reduces its deficit) during
inflation without requiring explicit action by policymakers. (See
Figure 12-3.)
1. When the economy goes into a recession and GDP declines, tax
revenues decline and have a counter-cyclical effect on the
economy.
2. During periods of prosperity when GDP is rising tax revenues
increase and have a counter-cyclical effect on the economy.
6
Tax Progressivity and the impact on built-in stabilizers:
1. A progressive tax is one for which the average tax rate

rises with GDP.
2. A proportional tax is one for which the average tax rate
remains constant as GDP rises.
3. A regressive tax has the average tax rate declining as
GDP rises.
Note: The more progressive the tax system, the greater

the economy’s built-in stability. Built-in stability
reduces the severity of business fluctuations, but does
not eliminate the need for explicit changes in budget
policy to correct recessions and severe inflations.
7
Actual vs. Full-Employment Budget
In Figure 12-4 it is possible to determine the extent to which government budget

policy is expansionary, neutral or contractionary by examining the full-
employment deficit that exists in year 1.
1. The deficit in year 2 is greater than the deficit in year 1 simply because the
GDP is lower in year 2.
2. By examining the Full-Employment Budget one can determine the degree
to which the budget policy is expansionary, neutral or contractionary.
3. The full-employment budget or the standardized budget measures what
the Federal budget deficit or surplus would be with existing tax and
government-spending structures if the economy were at full employment
throughout the year.
4. Table 12-1 provides a historical comparison between Actual and full-
employment deficits and surpluses in the US.
8
Problems, Criticisms and Complications
Timing Problems of Fiscal Policy

1. Recognition lag is the time between the occurrence of the
problem and its recognition, i.e., recession or inflation.
2. Administrative lag is the time between the recognition of
the need for a policy change and the legislated change in
policy.
3. Operational lag is the time between when the policy
change is enacted and the impact is felt on the output,
employment or the price level.
9
Political Problems
1. Political Business Cycle: Politicians may not always act to stabilize

the economy, but rather to gain voter support. If politicians act to further
their popularity with the electorate, the results is likely to create business
fluctuations and not to counteract them. Pre-election recession:
Increase G and cut T. Post-election inflation: Cut G and increase T.
(Politicians stay more popular with the electorate when they cut T and
increase G. These deficit tendencies cause expansionary bias.)
2. Offsetting State and Local Finances: State and local governments

often take action that is pro-cyclical in nature, e.g., Virginia’s belt-
tightening moves during an economic slowdown make the condition
worse.
10
Crowding-Out Effect:
1. An expansionary fiscal policy that is financed with

borrowed money will drive interest rates up and reduce
investment spending and some consumer spending.
(See Figure 12-5b)
2. Some economists argue that little crowding out effect will
occur during a recession. The increased government
spending causes increased prosperity in the economy
and increase business profit expectations, and
increasing investment even with higher interest rates.
11
Fiscal Policy, Aggregate Supply and
Inflation
With an up sloping aggregate supply curve,

some portion of the potential effect of
expansionary fiscal policy on real GDP
may not happen due to inflation. (See
Figure 12-5c)
12
Fiscal Policy in the Open Economy
1. Economies are open and unforeseen international aggregate demand

shocks can affect domestic GDP and make domestic fiscal policy
inappropriate or less effective.
2. Suppose that the US imposes an expansionary fiscal policy that causes

interest rates to rise. Higher US interest rates will attract financial
capital from abroad, where interest rates have not changed. Foreign
investors will purchase US dollars to invest in US securities. The
increased demand for dollars causes the value of the dollar to
appreciate. Higher dollar value relative to other currencies will reduce
net exports. The reduction in net exports will somewhat offset the
effect of the expansionary fiscal policy. (Figure 12-5c and Table 12-2)
13
Suggestions:
Work problems pp. 229-230: 2., 3., 7., 10.
Work through M-C questions in study guide.
Take two quizzes for chapter from the
McConnell website.
14

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Chapter 12: Fiscal Policy

The Employment Act of 1946

Gave the federal government the right and responsibility to take

Expansionary fiscal policy implies a budget

Contractionary fiscal policy implies a budget

1. Financing a deficit by borrowing from US

A built-in stabilizer is anything that increases the government’s

1. A progressive tax is one for which the average tax rate

Note: The more progressive the tax system, the greater

In Figure 12-4 it is possible to determine the extent to which government budget

Timing Problems of Fiscal Policy

1. Political Business Cycle: Politicians may not always act to stabilize

2. Offsetting State and Local Finances: State and local governments

1. An expansionary fiscal policy that is financed with

With an up sloping aggregate supply curve,

1. Economies are open and unforeseen international aggregate demand

2. Suppose that the US imposes an expansionary fiscal policy that causes

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