5 Fiscal policy
5.1 What it is
Discretionary fiscal policy: deliberate changes in \overline{G} and \overline{T} aimed at moving Y^* closer to the full-employment level Y^{FE}.
| gap | what to do |
|---|---|
| Recessionary: Y^* < Y^{FE} | Expand. Raise \overline{G} or cut \overline{T}. |
| Inflationary: Y^* > Y^{FE} | Contract. Cut \overline{G} or raise \overline{T}. |
5.2 Closing a gap of size \Delta Y
At MPC c = 0.75 (K_G = 4, K_T = -3, K_{BB} = 1):
| instrument | required change |
|---|---|
| Increase \overline{G} alone | \Delta\overline{G} = \Delta Y / K_G |
| Cut \overline{T} alone | \Delta\overline{T} = \Delta Y / K_T (negative) |
| Balanced budget: \overline{G} and \overline{T} both up by same \Delta | \Delta = \Delta Y / K_{BB} = \Delta Y |
The balanced-budget option leaves the deficit unchanged but still raises Y^*. The K_G effect outweighs the K_T effect by exactly 1.
5.3 Worked example
Y^* = 1{,}300. Y^{FE} = 1{,}400. Recessionary gap = 100. MPC = 0.75.
- Increase \overline{G} alone: \Delta\overline{G} = 100 / 4 = 25.
- Cut \overline{T} alone: \Delta\overline{T} = 100 / (-3) \approx -33.33.
- Balanced budget: raise \overline{G} by 100 and raise \overline{T} by 100. \Delta Y^* = 100 \cdot 4 + 100 \cdot (-3) = 100. Deficit unchanged.
A tax cut that does the same work as a $25 spending increase requires a $33 tax cut. The tax instrument is weaker per dollar because some of the tax change leaks into saving.
5.4 Federal budget vocabulary
| term | meaning | type |
|---|---|---|
| Federal surplus / deficit | T - G this period | flow |
| Federal debt | cumulative deficits over all time | stock |
| Privately held federal debt | the portion held outside the government | stock |
Don’t confuse a $1 trillion deficit (one-year flow) with a $33 trillion debt (cumulative stock). They are different beasts measured in the same units.
5.5 Crowding out (forward look)
When \overline{G} rises and Y rises, M^D rises (transactions motive), pushing r^* up. Higher r depresses I^d. Some of the original boost to Y is undone. This is crowding out of private investment by government spending. We work out the chain in the Money market chapter.