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Stabilizing the Economy: the Role of Fiscal Policy

8 important questions on Stabilizing the Economy: the Role of Fiscal Policy

Two kinds of stabilization policies are:

Expansionary policies: government policy actions intended to increase planned spending and output
Contractionary policies: government policy actions designed to reduce planned spending and output

The two major tools of stabilization policy are:

Monetary policy: refers to decisions about the size of the money supply
Fiscal policy: refers to decisions abut the government's budget

When analyzing the role and effectiveness of fiscal policy, it will ne important to distinguish between:

Discretionary fiscal policy: decisions by government to increase or decrease the levels of government purchases, transfer payments and taxation.
Automatic stabilizers: automatic changes in the government budget deficit, which help to dampen fluctuations in economic activity.

Changes in net taxes have the same qualitative effect as changes in government expenditures. The only difference is that:

Whereas a 100-unit increase in government purchase increases PAE by 100 units, a 100-unit cut in et taxes increases PAE by c (the marginal propensity to consume)

Why is the fall in output lower when taxes vary with income?

Because less tax is paid to the government as income falls, disposable or after-tax income (Y - T) falls by a smaller amount when taxes vary with income and consumption expenditure falls less.

While discretionary and automatic changes in the deficit are important stabilization instruments, sustained government deficits can be harmful to the economy in two ways:

Higher government deficits reduce national saving, which in turn reduces investment in new capital goods - an important source of long-run economic growth
Deficits have to be financed by borrowing and if they persist over long periods, the government's debt will increase continuously

The cyclically adjusted, or structural, budget deficit separates:

Automatic from discretionary changes by evaluation each year's deficit at a constant level of output.

Two qualifications about the use of fiscal policy as a stabilization tool are:

Fiscal policy may affect potential output as well as PAE. Thus, in making fiscal policy, government officials should take into account not only the need to stabilize PAE but also the likely effects of government spending, taxes and transfers on the economy's productive capacity.
Fiscal policy is not always flexible enough to be useful for stabilization.

The question on the page originate from the summary of the following study material:

Principles of economics | 9780077132736 | Moore McDowell

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