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CONTEMPORARY ECONOMICS © Thomson South-Western

15.1 The Evolution of Fiscal Policy

Identify the economy’s potential output level.

Distinguish between fiscal policy before and after the Great Depression.

Objectives


15.1 The Evolution of Fiscal Policy

potential outputnatural rate of unemploymentclassical economistsannually balanced budgetmultiplier effect

Key Terms


15.1 The Evolution of Fiscal Policy SLIDE3

Fiscal Policy and Potential OutputFiscal policy aims to use government

taxing and spending to move the economy toward full employment with price stability.The focus is mainly on shifts of the

aggregate demand curve.



Potential OutputPotential output is the economy’s

maximum sustainable output in the long run.Potential output also is referred to as the

full-employment output.The natural rate of unemployment is the

unemployment rate when the economy is producing its potential level of output.



Fiscal Policy and Potential Output The pink-shaded

area indicates real GDP below the economy’s potential.

The blue-shaded area indicates real GDP exceeding the economy’s potential.

Figure 15.1



Output Below PotentialThe economy is not producing as much as

it can. Unemployment exceeds its natural rate. The amount by which short-run output falls

short of the economy’s potential output is called a contractionary gap.



Output Exceeding PotentialUnemployment is below its natural rate.The amount by which actual output in the

short run exceeds the economy’s potential output is called the expansionary gap.


15.1 The Evolution of Fiscal Policy SLIDE8How Can Output Exceed the

Economy’s Potential?Potential output means not zero

unemployment, but the natural rate of unemployment. Even in an economy producing its

potential output, there is still some unemployed labor and some unused production capacity.


15.1 The Evolution of Fiscal Policy SLIDE9Discretionary Fiscal Policy

to Close a Contractionary GapThe aggregate demand

curve AD and the aggregate supply curve AS intersect at point e.

Output of $11.5 trillion falls short of the economy’s potential of $12.0 trillion.

The result is a contractionary gap of $0.5 trillion.

Figure 15.2


15.1 The Evolution of Fiscal Policy SLIDE10Discretionary Fiscal Policy

to Close a Contractionary Gap

Figure 15.2

(continued)

This gap could be closed by discretionary fiscal policy that increases aggregate demand by just the right amount.

An increase in government spending, a decrease in taxes, or some combination of the two could shift aggregate demand to AD*, moving the economy to its potential level of output at e*.



The Rise of Fiscal PolicyBefore the Great Depression, most policy

makers believed that an economy producing less than its potential in the short run would move to its potential in the long run without help from the federal government.They thought the government should just

balance its budget and forget about trying to stabilize the economy in the short run.



The Rise of Fiscal PolicyBefore the Great Depression, the federal

government played a relatively minor role in the economy.Federal spending as a percent of GDP3 percent at the onset of the Great

Depression 20 percent today

(continued)



View of Classical Economists Classical economists—A group of laissez-faire

economists, who believed that economic downturns corrected themselves in the long run through natural market forces

Annually balanced budget—Matching annual spending with annual revenue, except during war years; approach to the federal budget prior to the Great Depression



The Great Depression and KeynesKeynesian theory and policy were

developed to address the problem of unemployment during the Great Depression.



The Multiplier Effect Keynes also argued that any change in taxing or

government spending had a magnified effect on aggregate demand.

Each round of income and spending increases aggregate spending a little more.

The multiplier effect of fiscal policy says that any change in fiscal policy affects aggregate demand by more than the original change in spending or taxing.



The Rise of Fiscal PolicyThree developments in the years following

the Great Depression supported the use of fiscal policy in the United States.The influence of Keynes’s General TheoryThe powerful impact World War II had on

output and employmentThe passage of the Employment Act of 1946


15.2 Fiscal Policy Reconsidered

Identify the two tools of fiscal policy.Evaluate discretionary fiscal policy in light

of the time lags involved.

Objectives


15.2 Fiscal Policy Reconsidered

discretionary fiscal policyautomatic stabilizers recognition lagdecision-making lag implementation lageffectiveness lag

Key Terms


15.2 Fiscal Policy Reconsidered SLIDE3

Fiscal Policy ToolsThe tools of fiscal policy sort into two

broad categories: Discretionary fiscal policyAutomatic stabilizers



Discretionary Fiscal PolicyDiscretionary fiscal policy—legislative

changes in government spending or taxing to promote macroeconomic goals



Automatic StabilizersAutomatic stabilizers—government

spending and taxing programs that year after year automatically reduce fluctuations in disposable income, and thus in consumption, over the business cycle


15.2 Fiscal Policy Reconsidered SLIDE6Problems with

Discretionary Fiscal PolicyStagflationCalculating the natural rate of

unemployment



The Problem of Lags Recognition lag—the time it takes to identify a

problem and determine how serious it is Decision-making lag—the time needed to

decide what to do once the problem has been identified

Implementation lag—the time needed to execute a change in policy

Effectiveness lag—the time needed for changes in policy to affect the economy



Fiscal Policy and Aggregate SupplyFiscal policy can affect aggregate supply,

although often that effect is unintentional.Both automatic stabilizers and

discretionary fiscal policies may affect individual incentives to work, spend, save, and invest.

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