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CHAPTER 12
FISCAL POLICY
MASTERY GOALS
The objectives of this chapter are to:
1. Explain the concept of countercyclical fiscal policy.
2. Understand the mechanics of countercyclical fiscal policy.
3. Describe the problems associated with countercyclical fiscal policy.
4. Summarize the long run e"ects of budget deficits.
5. Understand how to put budget deficit and national debt numbers into perspec$ve.
6. Describe the di"erence between the deficit and the debt.
7. Understand how to separate genuine from mythical concerns about the national debt.
8. Explain the use of countercyclical fiscal policy with respect to the recession of
2008-2009.
THE CHAPTER IN A NUTSHELL
This chapter examines the government’s role in the macroeconomy, exploring recent trends in
the government’s budget, and the causes and e"ects of those trends. It also explores the
di"erences between fiscal policy’s long-run e"ects on the economy and its short-run e"ects.
If a government changes its spending or taxes specifically to counteract an expansion or
recession, it is engaging in countercyclical fiscal policy. In the short run, these changes can have
an impact on output and employment. When there is a change in government purchases, for
example, GPD will change via the multiplier process as found in the short run macro model. The
same logic can be applied to a change in taxes, with the caveat of a di"erence between the
expenditure multiplier and the net tax multiplier.
Even though theoretically, countercyclical fiscal policy is e"ec$ve, it can be plagued by several
issues. Today, however, many believe that fiscal policy should be reserved for addressing
long-run resource allocation issues, and that monetary policy should be used for stabiliza$on
purposes. Fiscal policy is not as 4exible as monetary policy—in practice, there are important
$ming problems, and it is not easy to reverse. In addition, the Fed is likely to view fiscal policy
action as demand shocks and neutralize them.
When total tax revenue exceeds total government spending in any year, the government runs a
budget surplus in that year. When the reverse occurs, and total government spending is greater
than total tax revenue, the government runs a budget deficit. The national debt is the total
amount that the federal government owes at a given point in $me. The national debt is the total
value of government bonds held by the public. Deficits add to the national debt, while surpluses
subtract from the national debt. Since the cumula$ve total of the government’s deficits has
been greater than its surpluses, the national debt has grown in recent decades.
Cau$on must be exercised when looking at the size of the deficit and national debt. Just looking
at the raw numbers does not paint an accurate picture of the true size of the figures. As a
consequence, economists usually look at budget related information in relation to a na$on’s
total income—as percentages of GDP.
Given the size of the national debt, should we be concerned about it? Although budget deficits
and growing debt may have nega$ve e"ects on resource allocation and growth, most
economists agree that we are not headed for a debt disaster. This is because the debt never has
to be paid back (the government can always issue new bonds to pay back the old ones) and
because the government has kept its deficit within the range where the debt to GDP ratio
remains stable.
There are three scenarios that should cause concern about the national debt: a national debt
that rises faster than nominal GDP; a debt approaching the national credit limit; and failing to
account for future obligation.
Lastly, a Using the Theory section is included that discusses the fiscal policy response during the
recession of 2008-2009.
DEFINITIONS
In order presented in chapter.
Countercyclical scal policy: A change in government purchases or ne taxes designed to
reverse or prevent a recession or a boom.
Net tax multiplier: The amount by which real GDP changes for each one-dollar change in
net taxes.
Balanced budget multiplier: The multiplier for a change in government purchases that is
matched by an equal change in taxes.
National Debt: The total amount the federal government still owes to the general public
from past borrowing.
Government outlays: Total disbursements by the government for purchases, transfer
payments, and interest on the debt.
Debt ratio: Publicly held national debt as a percentage of GDP.
Burden of the debt: Interest payments on the national debt as a percentage of GDP.
TEACHING TIPS
1. When discussing the di"erence between the national debt and the deficit, it helps to
define the national debt as the cumula$ve sum of each year’s deficit.
2. See hBp://www.cbo.gov/ and click on the Monthly Budget Review for the Congressional
Budget OHce’s updated budget projec$ons.
DISCUSSION STARTERS
1. The government can influence the macroeconomy in many ways other than by changing
its spending and taxes. Some people think that the government should be required to
publish an annual regulatory budget that explicitly measures regulatory costs.
Unfortunately, regulatory costs are hard to measure.
Read the following examples and decide how each ac$on would a"ect the budget deficit
and the economy overall.
a. Congress mandates that companies with more than 25 workers allow them to take
up to 12 weeks of uncompensated $me o" to care for newborn children and ill
family members. (The Family and Medical Leave Act of 1993)
b. Congress mandates that side-impact air bags must be installed in all automobiles
sold in the United States.
c. The Department of Agriculture introduces stricter agricultural pes$cide use
guidelines.
2. President Bill Clinton used the presidential line-item veto for the first $me on August 17,
1997. Explain that this veto power was approved by Congress in order to overcome the
power of special interest groups to have legisla$on passed that benefit them at the
expense of taxpayers or the public in general. Have students analyze the e"ect of
line-item veto power on the budget deficit. The U.S. Supreme Court struck down this
veto power in June 1998. For information, see
hBp://www.washingtonpost.com/wp-srv/national/longterm/supcourt/1997-98/lineitem
.htm .
