What fiscal policy is and its main tools

Fiscal policy involves government actions to influence the economy through adjustments in spending and taxation. Governments use fiscal policy to achieve macroeconomic goals, such as full employment, which means an economy operating at its potential output level without excessive unemployment.

Key tools of fiscal policy

• Government spending - This includes expenditures on goods, services, infrastructure, and public programs. Increases in spending can stimulate economic activity directly.
• Taxes and transfers - Taxes are payments collected from individuals and businesses, while transfers are payments like unemployment benefits or subsidies given to households. Changes in taxes or transfers affect disposable income, which influences spending indirectly.

These tools help governments address economic issues like recessions or inflation by altering overall demand in the economy.

How fiscal policy affects aggregate demand

Aggregate demand (AD) represents the total spending on goods and services in an economy at different price levels. Fiscal policy influences AD by changing government spending or household disposable income, which in turn affects consumption, investment, and overall economic output.

Direct and indirect effects on aggregate demand

• Direct effects from government spending - When the government increases spending, it directly adds to AD because the funds go straight into purchasing goods and services. This occurs because government expenditures are a component of AD.
• Indirect effects from taxes and transfers - Reducing taxes or increasing transfers raises households' disposable income, leading to higher consumer spending. This boosts AD indirectly as people have more money to buy goods and services. Conversely, raising taxes or cutting transfers reduces disposable income and lowers AD.

As a result, these changes can shift the AD curve: increases move it to the right, signaling higher demand, while decreases move it to the left.

Government spending and tax multipliers

The multiplier effect describes how an initial change in spending leads to a larger overall impact on the economy due to successive rounds of spending. In fiscal policy, multipliers quantify this effect, with the government spending multiplier being larger than the tax multiplier because spending changes directly affect AD, while tax changes work through consumer behavior.

The marginal propensity to consume (MPC) is the proportion of additional income that households spend on consumption. For example, if MPC is 0.8, households spend 80% of extra income and save 20%.

Formula for the government spending multiplier

$\text{Government spending multiplier}=\frac{1}{1-\text{MPC}}$

Where:

• MPC = Marginal propensity to consume (a value between 0 and 1)

This formula shows the total increase in AD from an initial change in government spending.

Formula for the tax multiplier

$\text{Tax multiplier}=-\frac{\text{MPC}}{1-\text{MPC}}$

Where:

• MPC = Marginal propensity to consume (a value between 0 and 1)

The negative sign indicates that tax increases reduce AD, while tax cuts increase it. The tax multiplier is smaller in magnitude than the spending multiplier because not all of a tax change translates into spending—some is saved.

Worked example - Calculating the government spending multiplier

Suppose the MPC in an economy is 0.75, and the government increases spending by $200 million. Calculate the government spending multiplier and the total increase in aggregate demand.

Step 1: Identify the values

• MPC = 0.75
• Change in government spending = $200 million

Step 2: Apply the government spending multiplier formula

$\text{Government spending multiplier}=\frac{1}{1-0.75}$

Step 3: Calculate the multiplier

$\text{Government spending multiplier}=\frac{1}{0.25}=4$

Step 4: Calculate the total change in aggregate demand

Total change in AD = change in government spending × multiplier

Total change in AD = $200 million × 4 = $800 million

Worked example - Calculating the tax multiplier

In an economy with an MPC of 0.75, the government cuts taxes by $150 million. Calculate the tax multiplier and the total increase in aggregate demand.

Step 1: Identify the values

• MPC = 0.75
• Change in taxes = -$150 million (negative indicates a tax cut)

Step 2: Apply the tax multiplier formula

$\text{Tax multiplier}=-\frac{0.75}{1-0.75}$

Step 3: Calculate the multiplier

$\text{Tax multiplier}=-\frac{0.75}{0.25}=-3$

Step 4: Calculate the total change in aggregate demand

Total change in AD = change in taxes × multiplier

Total change in AD = -$150 million × -3 = $450 million

Expansionary and contractionary fiscal policies and their short-run effects

Fiscal policies are classified based on their goal to either expand or contract economic activity. These policies are used to close output gaps, where actual output differs from potential output.

An output gap occurs when actual output differs from potential output. A negative (recessionary) gap occurs when actual output is below potential, often during recessions with high unemployment. A positive (inflationary) gap happens when actual output exceeds potential, leading to inflation.

Expansionary fiscal policy

Expansionary fiscal policy aims to increase AD to close a negative output gap. This involves increasing government spending or cutting taxes (or increasing transfers), which boosts real output and reduces unemployment but may raise the price level.

In the aggregate demand-aggregate supply (AD-AS) model, this shifts the AD curve rightward, moving the economy toward full employment. For example, during a recession, higher spending stimulates production and hiring.

Contractionary fiscal policy

Contractionary fiscal policy seeks to decrease AD to close a positive output gap. This includes decreasing government spending or raising taxes (or reducing transfers), which lowers real output and curbs inflation but may increase unemployment temporarily.

In the AD-AS model, this shifts the AD curve leftward, reducing pressure on prices. For instance, in an overheating economy, tax hikes reduce spending and help stabilize prices.

Short-run effects of fiscal policy

These effects are short-run because they assume sticky prices and wages, meaning they do not adjust immediately. Fiscal policy can also influence exchange rates, but that is covered in related topics.

Lags in discretionary fiscal policy

Discretionary fiscal policy refers to deliberate changes in government spending or taxation decided by policymakers to address economic conditions. However, implementing these policies involves delays, known as lags, which can reduce their effectiveness.

Types of lags in discretionary fiscal policy

• Recognition lag - The time it takes to identify that an economic problem exists, such as realizing a recession has begun.
• Decision lag - The period required for policymakers to agree on and approve a policy response, which can involve debates and legislative processes.
• Implementation lag - The delay in putting the policy into action, like distributing funds or collecting new taxes.

These lags mean that by the time a policy takes effect, economic conditions may have changed, potentially making the policy less appropriate or even counterproductive.