Lecture 15
FISCAL POLICY

1. Effect of fiscal policy on GDP

• Expansionary fiscal policy:
  Policy that leads to higher output
• Contractionary fiscal policy:
  Policy that leads to lower output

2. Consider an increase in G

• Increase in aggregate expenditure
• The AE line shifts upwards
• The DD curve shifts to the right
• Result: Rise in GDP; rise in price level
• Note: Rise in P will reduce the value of the multiplier

3. Consider an increase in income taxes (T)

• Decrease in consumption demand (why?)
• The AE line shifts down
• The DD curve shifts to the left
• Result: GDP falls; so does the price level
• Note: Fall in the price level reduces the multiplier

4. Question

Which has a bigger impact on GDP:
(a) An increase in G, or
(b) A decrease in taxes?

Answer:
An increase in government expenditure (why?)

5. Shortcomings of fiscal policy

• Today's policy may have undesirable effects in the future
  • Crowding out:
    Higher budget deficit today leads to less private investment ...
    ... resulting in slower capital accumulation in the future
• Lack of information:
  Govt doesn't know the exact magnitude of the multiplier
• Moving target:
  Full-employment GDP changes over time (why?)
• Policies may be used for political purposes (no kidding!):
  Pork-barrel politics
• Lags involved in policymaking:
  Both Congress and President have to agree