Fiscal Policy

Fiscal policy: Government policy that attempts to influence the direction of

the economy through changes in government spending or taxes.

Fiscal policy is the use of government spending and taxation to influence the
economy. Governments use fiscal policy to influence the levers of aggregate
demand in the economy in an effort to achieve the economic objectives of
price stability, full employment, and economic growth.

The government has two levers when setting fiscal policy:

1. Change the level and composition of taxation, and/or

2. Change the level of spending in various sectors of the economy.

There are three main types of fiscal policy:

1. Neutral: This type of policy is usually undertaken when an economy is

in equilibrium. In this instance, government spending is fully funded by
tax revenue, which has a neutral effect on the level of economic activity.
2. Expansionary: This type of policy is usually undertaken during
recessions to increase the level of economic activity. In this instance, the
government spends more money than it collects in taxes.
3. Contractionary: This type of policy is undertaken to pay down
government debt and to cap inflation. In this case, government spending
is lower than tax revenue.

In times of recession, Keynesian economics suggests that increasing

government spending and decreasing tax rates is the best way to stimulate
aggregate demand. Keynesians argue that this approach should be used in
times of recession or low economic activity as an essential tool for building the
foundation for strong economic growth and working towards full employment.
In theory, the resulting deficit would be paid for by an expanded economy
during the boom that would follow.

Times of Recession: In times of recession, the government uses

expansionary fiscal policy to increase the level of economic activity and
increase employment.

In times of economic boom, Keynesian theory posits that removing

spending from the economy will reduce levels of aggregate demand and
contract the economy, thus stabilizing prices when inflation is too high.
How Fiscal Policy Relates to the AD-AS Model
Expansionary policy shifts the aggregate demand curve to the right, while
contractionary policy shifts it to the left.

When setting fiscal policy, the government can take an active role in changing
its spending or the level of taxation. These actions lead to an increase or
decrease in aggregate demand, which is reflected in the shift of the aggregate
demand (AD) curve to the right or left respectively.

It is helpful to keep in mind that aggregate demand for an economy is divided

into four components: consumption, investment, government spending, and net
exports. Changes in any of these components will cause the aggregate
demand curve to shift.

Expansionary fiscal policy is used to kick-start the economy during a

recession. It boosts aggregate demand, which in turn increases output and
employment in the economy. In pursuing expansionary policy, the government
increases spending, reduces taxes, or does a combination of the two. Since
government spending is one of the components of aggregate demand, an
increase in government spending will shift the demand curve to the right. A
reduction in taxes will leave more disposable income and cause consumption
and savings to increase, also shifting the aggregate demand curve to the
right. An increase in government spending combined with a reduction in taxes
will, unsurprisingly, also shift the AD curve to the right. The extent of the shift
in the AD curve due to government spending depends on the size of the
spending multiplier, while the shift in the AD curve in response to tax cuts
depends on the size of the tax multiplier. If government spending exceeds
tax revenues, expansionary policy will lead to a budget deficit.

A contractionary fiscal policy is implemented when there is demand-pull

inflation. It can also be used to pay off unwanted debt. In pursuing
contractionary fiscal policy the government can decrease its spending, raise
taxes, or pursue a combination of the two. Contractionary fiscal policy shifts
the AD curve to the left. If tax revenues exceed government spending, this
type of policy will lead to a budget surplus.

Expansionary Versus Contractionary Fiscal Policy

Multiplier: A ratio used to estimate total economic effect for a variety of
economic activities.

Keynesian economists argue that private sector decisions sometimes lead to

inefficient macroeconomic outcomes which require active policy responses by
the public sector in order stabilize output over the business cycle. Keynes
advocated counter-cyclical fiscal policies (policies that acted against the tide
of the business cycle). This means deficit spending and decreased taxes
when an economy suffers from a recession and decreased government
spending and higher taxes during boom times.

According to Keynesian economics, if the economy is producing less than

potential output, government spending can be used to employ idle resources
and boost output. Increased government spending will result in increased
aggregate demand, which then increases the real GDP, resulting in an rise in
prices. This is known as expansionary fiscal policy. Conversely, in times of
economic expansion, the government can adopt a contractionary policy,
decreasing spending, which decreases aggregate demand and the real GDP,
resulting in a decrease in prices.

In instances of recession, government spending does not have to make up for

the entire output gap. There is a multiplier effect that boosts the impact of
government spending. The government could stimulate a great deal of new
production with a modest expenditure increase if the people who receive this
money consume most of it. This extra spending allows businesses to hire
more people and pay them, which in turn allows a further increase in
spending, and so on in a virtuous circle.

In addition to changes in spending, the government can also close

recessionary gaps by decreasing income taxes, which increases aggregate
demand and real GDP, which in turn increases prices. Conversely, to close an
expansionary gap, the government would increase income taxes, which
decreases aggregate demand, the real GDP, and then prices.

The effects of fiscal policy can be limited by crowding out. Crowding out
occurs when government spending simply replaces private sector output
instead of adding additional output to the economy. Crowding out also occurs
when government spending raises interest rates, which limits investment.
Fiscal Levers: Spending and Taxation
Tax cuts have a smaller affect on aggregate demand than increased
government spending.

Tax multiplier: The change in aggregate demand caused by a change in

taxation levels.

Spending and taxation are the two levers available to the government for
setting fiscal policy. In expansionary fiscal policy, the government increases its
spending, cuts taxes, or a combination of both. The increase in spending and
tax cuts will increase aggregate demand, but the extent of the increase
depends on the spending and tax multipliers.

The government spending multiplier is a number that indicates how much

change in aggregate demand would result from a given change in spending.
The government spending multiplier effect is evident when an incremental
increase in spending leads to an rise in income and consumption. The tax
multiplier is the magnification effect of a change in taxes on aggregate
demand. The decrease in taxes has a similar effect on income and
consumption as an increase in government spending.

However, the tax multiplier is smaller than the spending multiplier. This is
because when the government spends money, it directly purchases
something, causing the full amount of the change in expenditure to be applied
to the aggregate demand. When the government cuts taxes instead, there is
an increase in disposable income. Part of the disposable income will be spent,
but part of it will be saved. The money that is saved does not contribute to the
multiplier effect.

The multipliers are calculated as follows:

• Government expenditure multiplier=1/(1−MPC) or 1/MPS

• Tax multiplier =−MPC/(1−MPC) or −MPC/MPS (always negative
because increase in tax reduces spending/consumption)

where MPC is the marginal propensity to consume (the change in

consumption divided by the change in disposable income), and MPS is the
marginal propensity to save (the change in savings divided by the change in
disposable income).

The government spending multiplier is always positive. In contrast, the tax

multiplier is always negative. This is because there is an inverse relationship
between taxes and aggregate demand. When taxes decrease, aggregate
demand increases.
The multiplier effect of a tax cut can be affected by the size of the tax cut, the
marginal propensity to consume, as well as the crowding out effect. The
crowding out effect occurs when higher income leads to an increased demand
for money, causing interest rates to rise. This leads to a reduction in
investment spending, one of the four components of aggregate demand,
which mitigates the increase in aggregate demand otherwise caused by lower
taxes.

How Fiscal Policy Can Impact GDP

Fiscal policy impacts GDP through the fiscal multiplier.

Fiscal multiplier: The ratio of a change in national income to the change in

government spending that causes it.

Expansionary fiscal policy can impact the gross domestic product (GDP)
through the fiscal multiplier. The fiscal multiplier (which is not to be confused
with the monetary multiplier) is the ratio of a change in national income to the
change in government spending that causes it. When this multiplier exceeds
one, the enhanced effect on national income is called the multiplier effect.

The multiplier effect arises when an initial incremental amount of government

spending leads to increased income and consumption, increasing income
further, and hence further increasing consumption, and so on, resulting in an
overall increase in national income that is greater than the initial incremental
amount of spending. In other words, an initial change in aggregate demand
may cause a change in aggregate output (and hence the aggregate income
that it generates) that is a multiple of the initial change. The multiplier effect
has been used as an argument for the efficacy of government spending or
taxation relief to stimulate aggregate demand.

For example, suppose the government spends $1 million to build a plant. The
money does not disappear, but rather becomes wages to builders, revenue to
suppliers, etc. The builders then will have more disposable income, and
consumption may rise, so that aggregate demand will also rise. Suppose
further that recipients of the new spending by the builder in turn spend their
new income, raising demand and possibly consumption further, and so on.
The increase in the gross domestic product is the sum of the increases in net
income of everyone affected. If the builder receives $1 million and pays out
$800,000 to sub contractors, he has a net income of $200,000 and a
corresponding increase in disposable income (the amount remaining after
taxes). This process proceeds down the line through subcontractors and their
employees, each experiencing an increase in disposable income to the
degree the new work they perform does not displace other work they are
already performing. Each participant who experiences an increase in
disposable income then spends some portion of it on final (consumer) goods,
according to his or her marginal propensity to consume, which causes the
cycle to repeat an arbitrary number of times, limited only by the spare capacity
available.

Fiscal Multiplier Example: The money spent on construction of a plant becomes wages to
builders. The builders will have more disposable income, increasing their consumption and the
aggregate demand.

In certain cases multiplier values of less than one have been empirically
measured, suggesting that certain types of government spending crowd out
private investment or consumer spending that would have otherwise taken
place.