Lesson summary: Fiscal policy (article) | Khan Academy (2024)

Consider a tale of two economies. Marthlandia has an economic boom which has been going on for awhile. But as a result, Marthlandia struggles with high inflation.

Burginville, on the other hand, has been in a recession for quite some time, with high unemployment causing widespread suffering. But the self-correction mechanism isn't kicking in for either country. Is there anything that can be done?

Yes! Both governments can use fiscal policy as a tool to bring their countries back to “normal.” For example, they can use fiscal policy (changes in government spending or taxes), which will impact output, unemployment, and inflation.

Burginville needs to increase output to end its recession. Their government can increase output by using expansionary fiscal policy. Expansionary fiscal policy tools include increasing government spending, decreasing taxes, or increasing government transfers. Doing any of these things will increase aggregate demand, leading to a higher output, higher employment, and a higher price level.

Marthlandia’s inflation is caused by producing more than is sustainable, so reducing output would fix its problem. Instead, they can draw on contractionary fiscal policy tools, such as increasing taxes or decreasing government spending or government transfers.

Doing any of these things will decrease Marthlandia’s aggregate demand, which leads to lower output, lower employment, and a lower price level. Usually, governments engage in expansionary fiscal policy during recessions, and contractionary fiscal policy when they are concerned about inflation.

Altogether, this lesson is about how government spending and taxes have different impacts on aggregate demand (AD). Government spending impacts AD directly, while taxes impact AD indirectly. Because government spending immediately impacts AD, but some fraction of a change in taxes will be saved rather than spent, there is a difference in impact.

If we want to know the amount of taxes that will close an output gap, we need to use the tax multiplier to figure that out. If we want to use government spending to close an output gap, we need to use the spending multiplier to figure that out.

Imagine a government wants to fix a recession or dial back an expansion. Its concrete goals would be to return the economy to full employment, or to control inflation, respectively. Fiscal policy can help them achieve their goals.

The tools of fiscal policy are government spending and taxes (or transfers, which are like “negative taxes”). You want to expand an economy that is producing too little, so expansionary fiscal policy is used to close negative output gaps (recessions). Expansionary fiscal policy includes either increasing government spending or decreasing taxes.

An economy that is producing too much needs to be contracted. In that case, contractionary fiscal policy (either decreasing government spending or increasing taxes) is the correct choice.

For example, if Burginville is experiencing a recession, the government might give everyone a tax refund (an example of expansionary fiscal policy). Here’s what will play out:the tax refund leads to an increase in disposable incomeAn increase in disposable income causes an increase in consumption, the increase in consumption increases aggregate demandAn increase in aggregate demand leads to an increase in output and a decrease in unemploymentAs a side effect of the decrease in unemployment and the increase in output, inflation will increase.

Marthlandia is experiencing a boom and inflation. They cut government spending. Here’s what will play out in Marthlandia:First, the cut in government spending leads to a decrease in aggregate, because government spending is a component of AD. The decrease in AD leads to a decrease in output because the decrease in AD will lead to a new short-run equilibrium with a lower output, higher unemployment rate, and a lower price level.

How are the effects of government spending and taxes different? When a government engages in fiscal policy using government spending, the effect is immediate because government spending is itself a component of AD. For example, if the government buys $600$‍ pounds of rice for $\mathrm{\$}1000$‍ from a farmer in Burginville, that $\mathrm{\$}1000$‍ counted in the G component of AD and real GDP, and then the spending multiplier kicks in.

But when a government engages in fiscal policy by using taxes or transfers, the impact is indirect. If the government of Burginville gives that farmer a $\mathrm{\$}1000$‍ tax refund instead of buying something from him directly, the impact of that action won't have any effect until the farmer actually does something with that refund. In fact, if he puts all of that refund under his mattress, there would be no impact at all!

But, if the farmer saves $\mathrm{\$}200$‍ and spends the rest on airline tickets to Florida, the $\mathrm{\$}800$‍ is counted in consumption spending. The purchase of the plane ticket then triggers the multiplier effect.

Remember: the tax multiplier is always less than the spending multiplier because some of that amount is saved, and not spent, in the first step.

When a gap is negative, you want output to get bigger, and so expansionary fiscal policy the right choice. When a gap is positive, you want output to get smaller, and so contractionary fiscal policy is the right choice. Once you decide on the type of policy (expansionary or contractionary), you can then decide on which tool to use (taxes or spending).

Policymakers also have to be careful to "mind the gap." If they want to close an output gap, they need to know how much stimulus is necessary. Too little stimulus and you won't close the gap. Too much stimulus and you may cause a different kind of gap.

For example, suppose that the economy of Burginville has an output gap of $\mathrm{\$}20$‍ billion. They need to take a policy action that causes exactly the amount of change. The good news is that they don't actually have to spend $\mathrm{\$}20$‍ billion to close that gap. Why? Because they can count on multipliers.

Recall that the spending multiplier gave us the final impact on AD of an increase in any category of spending. If the spending multiplier is 4, then an increase in government spending of $\mathrm{\$}20$‍ billion would increase real GDP by $4x\mathrm{\$}20=\mathrm{\$}80$‍ billion.

The tax multiplier is always one less than the spending multiplier (and is negative). If the spending multiplier is $4$‍, the tax multiplier must be $-3$‍. That means that if the government cuts taxes by $\mathrm{\$}20$‍ billion, the final impact will be $-3x-\mathrm{\$}20=\mathrm{\$}60$‍ billion. In either of these cases, increasing output by too much will cause output to be higher than full employment output.

A government has a balanced budget when its expenditures are equal to its revenues. In other words, if a government wants to spend $\mathrm{\$}20$‍, but it also wants to maintain a balanced budget, then it needs to take in $\mathrm{\$}20$‍ in taxes. Governments run deficits when spending is higher than tax revenue, and they run surpluses when spending is lower than tax revenue. Over time, those deficits accumulate into national debt.

What if a government wants to use expansionary fiscal policy, but it also wants to maintain a balanced budget? If Burginvlle is in a recession and has a $\mathrm{\$}100$‍ million negative output gap, it needs to use expansionary fiscal policy to close that gap. Because it has a spending multiplier of $10$‍, it decides to increase government spending by $\mathrm{\$}10$‍ million to close that gap:

$10\times \mathrm{\$}10\text{million}=\mathrm{\$}100\text{million}$‍.

However, to maintain a balanced budget, it also raises taxes by $\mathrm{\$}10$‍ million. But wait . . . that will have its own multiplier effect! Remember that the tax multiplier is always one less than the spending multiplier, and negative. Therefore, if the spending multiplier is $10$‍, the tax multiplier is $-9$‍. The impact of the tax increase will be:

$-9\times \mathrm{\$}10\text{million}=\mathrm{\$}-90\text{million}$‍.

To find the final impact of these actions, we add them together:

$\mathrm{\$}100\text{million}+-\mathrm{\$}90\text{million}=\mathrm{\$}10\text{million}$‍.

Notice that the final impact is exactly equal to the increase in government spending. The balanced budget multiplier will always be equal to one. Why? Because if you increase spending by $\mathrm{\$}10$‍ million, but then increase taxes by $\mathrm{\$}10$‍ million to pay for that spending, the final impact on real GDP is only $\mathrm{\$}10$‍ million.

In reality, four things can slow down a fiscal policy’s implementation and e effectiveness:

1. Data lag

This is the time to collect information about the economic conditions in a country. Suppose there is some shock to an economy, such as a decline in consumer confidence. A policymaker might not notice this until data on real GDP and unemployment rate are collected.

2. Recognition lag

This is the time it takes to realize there might be a problem. The policy-maker gets handed a report from their intern that says unemployment is up and real GDP is down. But is this a temporary thing? Or is the start of a long-run trend? If it is temporary, there isn't any need to take any action. If it is a long-run trend, that trend has already started by the time it is recognized.

3. Decision lag

Our policymaker reviews all of the evidence and decides that action is definitely needed. Ok, now what? Should the government take a wait-and-see approach and let the self-correction mechanism kick in? Even if they decide that the self-correction mechanism might take too long or, even deciding to actually do something will take time. Should we lower taxes? Increase spending? Now the legislature needs to get together to decide the actual policy action to take. That will take awhile.

4. Implementation lag

Now that the legislature passed a spending bill, it will take time to put it into place. A new agency might need to be set up to coordinate the spending. Burginville decides to implement a new infrastructure development program, building bridges and roads. Which river needs a bridge? Where should we build the road? Deciding on this will take time too.

To determine the size of a policy action needed (such as how much government spending or how much taxes will need to change), you divide the size of the gap by the relevant multiplier.

We can show the impact of fiscal policy on output and the price level using the AD-AS model.

Figure 1 shows an economy that has an initial AD curve of $A{D}_1$‍ and is producing real GDP worth $\mathrm{\$}130$‍ billion. However, the full employment output for this economy is $\mathrm{\$}100$‍ billion (we can tell this because the LRAS curve is always vertical at the full employment output). Positive output gaps like this one are usually associated with higher inflation, so the government decides to take action in order to bring inflation under control.

The government knows that its $MPC=0.75$‍, so its tax multiplier is $-3$‍. If the government engages in contractionary fiscal policy by increasing taxes by $\mathrm{\$}10$‍ billion, then the final impact of that increase will be

As a result, AD will decrease by $\mathrm{\$}30$‍ billion. This is hown by the shift from $A{D}_1$‍ to $A{D}_2$‍ in Figure 1. The decrease in AD restores the economy to full employment output.