Summary
Fiscal Policy Basics
- 1. The government plays a significant role in the economy by collecting a large share of GDP in taxes and spending a large share both to purchase goods and services and to make transfer payments, mainly for social insurance.
- 2. Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve.
- 3. Government purchases of goods and services directly affect aggregate demand, and changes in taxes and government transfers affect aggregate demand indirectly by changing households’ disposable income.
- 4. Expansionary fiscal policy shifts the aggregate demand curve rightward, and leads to an increase in real GDP. Contractionary fiscal policy shifts the aggregate demand curve leftward, and leads to a reduction in real GDP.
- 5. Only when the economy is at full employment is there potential for crowding out of private spending and private investment spending by expansionary fiscal policy.
- 6. The argument that expansionary fiscal policy won’t work because of Ricardian equivalence—that consumers will cut back spending today to offset expected future tax increases—appears to be untrue in practice.
- 7. Very active fiscal policy may make the economy less stable due to time lags in policy formulation and implementation.
Fiscal Policy and the Multiplier
- 8. Expansionary and contractionary fiscal policies have a multiplier effect on the economy, the size of which depends on the fiscal policy. Except in the case of lump-sum taxes, an increase in taxes will reduce the size of the multiplier.
- 9. Since part of any change in taxes or transfers is absorbed by savings in the first round of spending, changes in government purchases of goods and services have a more powerful effect on the economy than equal-sized changes in taxes or transfers.
- 10. Some taxes and transfers act as automatic stabilizers, reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle. Lump-sum taxes do not change as real GDP changes, and therefore do not act as automatic stabilizers.
- 11. Discretionary fiscal policy arises from deliberate actions by policy makers rather than automatic adjustment caused by the business cycle.
Budget Deficits and Public Debt
- 12. Some of the fluctuations in the budget balance are due to the effects of the business cycle. In order to separate the effects of the business cycle from the effects of discretionary fiscal policy, governments estimate the cyclically adjusted budget balance, an estimate of the budget balance if the economy were at potential output.
- 13. U.S. government budget accounting is calculated on the basis of fiscal years.
- 14. Persistent budget deficits have long-run consequences because they lead to an increase in public debt. This can be a problem for two reasons. Public debt may crowd out investment spending, which reduces long-run economic growth. In extreme cases, rising debt may lead to government default, resulting in economic and financial turmoil.
- 15. A widely used measure of fiscal health is the debt–GDP ratio. This number can remain stable or fall even in the face of moderate budget deficits if GDP rises over time.
- 16. A stable debt–GDP ratio may give a misleading impression that all is well because modern governments often have large implicit liabilities. The largest implicit liabilities of the U.S. government come from Social Security, Medicare, and Medicaid, the costs of which are increasing due to the aging of the population and rising medical costs.