9.4 Fiscal Policy

Notes

Fiscal policy is the use of government spending and taxes to influence the economy. Congress and the President make fiscal policy.

• Expansionary fiscal policy (increase spending or cut taxes) aims to raise total demand during a recession, boosting output and jobs.
• Contractionary fiscal policy (cut spending or raise taxes) aims to slow total demand when inflation is high.
• The multiplier effect: each dollar of new spending becomes income for someone who spends part of it, so total spending rises by more than the original amount.
• The marginal propensity to consume (MPC) is the share of extra income people spend. $\displaystyle \text{Multiplier} = \frac{1}{1 - MPC}$.
• Worked example: if $MPC = 0.8$, the multiplier is $\displaystyle \frac{1}{0.2} = 5$, so $20 billion of new government spending could raise total spending by up to $20 \times 5 = 100$ billion dollars.
• Automatic stabilizers work without new laws: in a recession, tax collections fall and unemployment benefits rise; in a boom, the reverse happens.