Chapter # Chapter
Chapter 30 Government
and Fiscal Policy
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The great recession
Yellowstone National Park is one of the many national parks forced to close down during the
government shut down in October 2013.
Trend of Government spending
Since 1960, total federal spending has ranged from about 18% to 22% of GDP, although it climbed above that level in
2009. The share spent on national defense has generally declined, while the share spent on Social Security and on
healthcare expenses (mainly Medicare and Medicaid) has increased.
Distribution of government spending
About 71% of government spending goes to four major areas: national defense, Social Security, healthcare, and interest
payments on national debt. This leaves about 29% of federal spending for all other functions of the U.S. government.
State and local government spending
Spending by state and local government increased from about 10% of GDP in the early 1960s to 14–16% by the mid1970s. It has remained at roughly that level since. The single biggest spending item is education, including both K–12
spending and support for public colleges and universities, which has been about 5–6% of GDP in recent decades.
Federal tax revenues have been about 17–20% of GDP. The primary sources of federal taxes are individual income taxes
and the payroll taxes that finance Social Security and Medicare. Corporate income taxes, excise taxes, and other taxes
provide smaller shares of revenue.
State and local tax revenues
State and local tax revenues from about 8% to over 10% of the GDP. They have increased to
match the rise in state and local spending.
Federal government deficit
The federal government has run budget deficits for decades. The budget was briefly in surplus in the late 1990s,
before heading into deficit again in the first decade of the 2000s—and especially deep deficits in the recession of
Federal government deficit
When government spending exceeds taxes, the gap is the budget deficit. When taxes exceed spending, the gap is a
budget surplus. The recessionary period starting in late 2007 saw higher spending and lower taxes, combining to create
a large deficit in 2009.
Federal government debt
During the 1960s and 1970s, the government often ran small deficits, but since the debt was growing more slowly
than the economy, the debt/GDP ratio was declining over this time. In the 2008–2009 recession, the debt/GDP ratio
Illustration of a healthy economy
In this well-functioning economy, each year AD AND AS rise so that the economy proceeds from equilibrium E 0 to E1 to
E2. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level.
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Fiscal Policy: The government’s spending and taxing policies to stabilize economic
Discretionary Fiscal Policy: Changes in taxes or spending that are the result of
deliberate changes in government policy.
Expansionary Fiscal Policy: Increased government spending and/or
reduced taxes to increased AD to help the economy grow faster.
Contractionary Fiscal Policy: decreased government spending and/or
increased taxes to reduce the AD and reduce inflation.
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Expansionary fiscal policy
An expansionary fiscal policy shifts the AD to the right. The economy will recover from a recession to
reach full employment equilibrium.
Contractionary fiscal policy
An contractionary fiscal policy shifts the AD to the left. The economy will recover from rapid inflation
to reach full employment equilibrium.
The crowding-out effect
To pay for an expansionary fiscal policy, the government borrows money, increasing the
demand for loanable funds and causing the rate of interest to rise.
Effectiveness of Stabilization Policy
Stabilization policy describes both monetary and fiscal policy, the goals of which are to
smooth out fluctuations in output and employment and to keep prices as stable as
Time lags: Delays in the economy’s response to stabilization policies.
Attempts to stabilize the economy can prove to be destabilizing because of time lags.
Recognition Lag: The time that takes for policy makers to recognize the existence of a boom
Implementation Lag: The time that takes to put the desired policy into effect once policy
makers realize the economy is in a boom or bust.
Response Lag: The time that takes for the economy to adjust to the new
conditions after a new policy is implemented; the lag that occurs because of the
operation of the economy itself.
Response Lags for Fiscal Policy:
There is a long delay between the time a fiscal policy action is initiated
and the time the full change in GDP is realized.
Until individuals or firms can revise their spending plans, extra
government spending does not stimulate extra private spending.
Response Lags for Monetary Policy:
Monetary policy works by changing interest rates, which then change
planned investment and consumption spending on durable goods.
The response of consumption and investment to interest rate changes