Topic 3.8 Notes – Fiscal Policy

1. What Fiscal Policy Is

Fiscal policy is the use of government spending (G) and taxes (T) to influence macroeconomic outcomes like real GDP, unemployment, and the price level.

The goal is to move the economy toward full employment output, which you see at LRAS (potential GDP) on the AD-AS graph.

The Tools

• Government spending (G)
  Directly increases aggregate demand because $AD = C + I + G + (X - M)$. If G rises, AD rises immediately.
• Taxes and transfers
  Affect AD indirectly by changing disposable income and therefore consumption (C).

Two Types

• Expansionary fiscal policy
  • ↑ G and/or ↓ T
  • Used during a recessionary (negative) output gap
  • Shifts AD right
• Contractionary fiscal policy
  • ↓ G and/or ↑ T
  • Used during an inflationary (positive) output gap
  • Shifts AD left

Historical anchors you should recognize:

• New Deal (1930s) during the Great Depression → expansionary
• American Recovery and Reinvestment Act (2009) → expansionary after the 2008 financial crisis
• COVID-19 stimulus packages (2020-21) → expansionary
• Efforts to fight high inflation in the late 1960s and 1970s included contractionary attempts

2. How Fiscal Policy Shifts Aggregate Demand in the Short Run

Fiscal policy works by shifting AD, while SRAS and LRAS stay the same in the short run.

Recessionary Gap → Expansionary Policy

Starting point:

• AD intersects SRAS left of LRAS
• Output below potential
• High unemployment

Policy:

• ↑ G or ↓ T → AD shifts right

Short-run results:

• ↑ Real GDP
• ↓ Unemployment
• ↑ Price level

That price level increase is normal. You’re moving closer to potential output.

Inflationary Gap → Contractionary Policy

Starting point:

• AD intersects SRAS right of LRAS
• Output above potential
• Inflationary pressure

Policy:

• ↓ G or ↑ T → AD shifts left

Short-run results:

• ↓ Real GDP
• ↓ Price level (or lower inflation)

On tests, students often forget to mention the price level change. Always connect fiscal policy to both output and prices.

3. Spending and Tax Multipliers

Multipliers tell you how much total GDP changes from a policy change.

You need two definitions:

• MPC (marginal propensity to consume) = fraction of extra income spent
• MPS (marginal propensity to save) = fraction saved
• $MPC + MPS = 1$

Government Spending Multiplier

$$\text{Spending Multiplier} = \frac{1}{MPS}$$

This is larger because government spending enters AD directly.

Tax Multiplier

$$\text{Tax Multiplier} = \frac{-MPC}{MPS}$$

It’s smaller in absolute value because households save part of a tax cut.

Spending multiplier > tax multiplier. That’s tested constantly.

Example Calculation

Suppose:

• Output gap = 80 billion dollars
• MPC = 0.75 → MPS = 0.25

Spending multiplier:

$$\frac{1}{0.25} = 4$$

Required increase in G:

$$80 \div 4 = 20 \text{ billion}$$

Tax multiplier:

$$\frac{-0.75}{0.25} = -3$$

To close the gap with taxes:

$$80 \div 3 \approx 26.7 \text{ billion tax cut}$$

Notice the tax change must be larger.

4. Discretionary vs Automatic Fiscal Policy and Policy Lags

Discretionary Fiscal Policy

New laws passed to change spending or taxes.

Examples:

• Stimulus checks (2020-21)
• Infrastructure spending bills
• ARRA (2009)

These require Congress and the president to act.

Automatic Stabilizers

Built-in policies that stabilize the economy without new laws:

• Progressive income taxes
• Unemployment benefits
• Social Security
• Welfare programs

In a recession:

• Tax revenue falls
• Transfer payments rise
• AD increases automatically

In an expansion:

• Tax revenue rises
• Transfers fall
• AD cools down

Policy Lags

Discretionary fiscal policy is slow because of:

1. Recognition lag - realizing there’s a problem
2. Decision lag - political debate and approval
3. Implementation lag - putting policy into effect

By the time policy kicks in, the economy may already be changing. That’s a common critique.