Introduction to Fiscal Policy: Study with Video Lessons, Practice Problems & Examples

Fiscal policy, managed by the government, involves government spending and taxation, impacting GDP. Increased government spending raises GDP, while higher taxes reduce disposable income, leading to lower consumption. Automatic stabilizers adjust spending and taxes based on the business cycle without proactive government action. For instance, during economic booms, taxes rise, reducing consumption, while in recessions, lower taxes and increased unemployment benefits boost spending. Understanding these dynamics is crucial for grasping how fiscal policy influences economic stability and growth.

Introduction; Discretionary Policy and Automatic Stabilizers

Alright. Now, let's move into another big topic for this course, fiscal policy. Alright. So remember, we've got fiscal policy and monetary policy. Monetary policy, we discussed that in other videos. Generally, it's an entirely different chapter in the book, but sometimes they put it together. But monetary policy, that's done by the Fed, right? The Federal Reserve, the Central Bank in the US. Here, we're talking about fiscal policy. So what's fiscal policy? Fiscal policy involves setting the level of government spending and taxes by, well, the government, alright? So this is different than monetary policy, okay? So don't get those two confused. Monetary policy is the Fed and they're dealing with the money supply and interest rates. Here, we're talking about fiscal policy with government spending and taxes. Okay? So fiscal policy is the government. And here we're focusing specifically on the spending and taxes of the Federal government. Okay? So this is the national government here in the US. So we're going to focus on the government spending and the taxes. So why are these important? Well, remember, government spending is an important part of our GDP calculation, right? Remember GDP, how did we calculate it? It? Consumption plus investment plus government spending plus net exports. Right? And there we go. Government spending right there, an important part of that GDP calculation. So you can imagine when we have more government spending, well, more government spending means more GDP, right? Pretty straightforward. It's part of our calculation there and the higher the government spending is, the higher GDP is. And the opposite, less government spending, less GDP. So that's one of the big takeaways of this chapter. So it's a little straightforward there and we'll go into more detail in other videos. Okay. So that's how government spending affects this. How about taxes? Taxes also influence our GDP calculation but in a different way. They're going to affect the level of disposable income. So if you guys remember, disposable income we'll we'll go into it right now. Disposable income, this is the money you have left after taxes, after-tax income. And you can use it either the money that you have as disposable income. You're either going to use it for consumption or you're going to save it for future consumption, right? Either the money you have, you're either going to use it now or you're going to use it later, consumption and savings. So the more disposable income you have, well, that's what's available for household consumption, right? So remember, this is after taxes that we're thinking about our disposable income. So if we have more taxes, what does that do? That's going to make our disposable income lower Because we're paying more taxes, we have less disposable income, meaning we'll have less to spend on our consumption. And the opposite is true if we have less taxes, right? So if there's less taxes, well, disposable income goes up and consumption goes up, right? So this has more of an inverse relationship, right? As taxes go up, consumption goes down, right? So they're opposites there. But you can notice consumption is also an important part of our GDP calculation, right? So the policymaking of our government spending and our taxes is going to affect our GDP, in different ways. So now, let's go into one little, one more topic here that they love to talk about in fiscal policy. Let's introduce it here now. It's a difference between discretionary fiscal policy and automatic stabilizers, automatic fiscal policy. Okay? So discretionary fiscal policy is a little straightforward. It's when the government takes action to change their spending or change their level of taxes. They're doing something discretionary. They're actually taking action, being proactive in changing their spending or taxes. That's something like a tax decrease passed through Congress, right? They voted on a bill and this bill changed the tax structure. So they're being proactive about what's happening. They approve a 100,000,000,000 project to expand the highway system, right? They're doing something proactive to change the level of spending or taxes, but automatic stabilizers is a little different. And they love to talk about automatic stabilizers because it's kind of like one of those buzzwords here in fiscal policy. So let's go into a little more detail about what this means. Automatic stabilizers. So this is spending and taxes that change automatically through the business cycle. Okay? So this means that the government isn't doing anything proactive. They're not passing a bill in Congress. They're not changing anything they're doing but it's going to change the level of spending or taxes automatically. So let's see how that works. We'll do one with taxes and one with spending here. So taxes is a little straightforward. Let's think about what's happening here. So taxes during an economic boom. So remember, the government isn't changing anything about their tax policy. This is changing the level of taxes just based on where we are in the business cycle. So as the economy is expanding, well the GDP, inflation, and income is going up right? The economy is expanding, more people are employed, more people are making money. So income is increasing. And as income increases, well, our taxes are going to increase as well, right? So what did we say above? As taxes go up, how does that affect our consumption? Higher taxes mean lower disposable income and lower consumption, right? So although people are making more money, they're paying more taxes. So this is actually going to stabilize that extra consumption that's coming in from the higher income a little bit is going to taxes and lowering consumption, too. It's keeping it under, you know, in place a little bit. So the opposite happens during a recession. So notice, there's been no policy made. There's just more money being made, more taxes being paid, consumption is affected. And during a recession, the opposite. The economy is now contracting, and we see GDP, inflation, and income going down. There's more unemployed people. We're in a recession. So people are making less money. And when people are making less money, well, they're paying less taxes and the opposite is true. When there's less taxes, well, disposable income goes up and consumption goes up. And that's exactly what we want during a recession. During a recession, our aggregate demand is low. We're not spending as much as we want and we want to boost up spending. So this automatic stabilizer increases our spending. Just by being in a recession, consumption will increase because of these lower taxes being paid. Okay? So now the opposite side. Now, I don't want to say we're in a don't get confused that we're in a recession, so consumption is going to decrease. But this helps stabilize it. It's not going to decrease as much because of this stabilization happening, right? Some consumption is going to be recovered because of this lower taxes being paid. Now, the other side of the equation is some spending. So we'll we'll say that this unemployment insurance is some government spending. So imagine this as the government paying money when people are unemployed, right? So this is more of a government transfer, but it stays the same here. Let's think of how this works. So unemployment insurance during an economic boom. So when the economy is booming, so this is more of the spending side. They're not changing any policy they have during towards unemployment insurance, but as the economy is expanding, GDP inflation, and income are increasing and more people are employed, right? The economy is booming, we're growing, so there's more employment. So if people are employed, the government doesn't make as many unemployment payments. So those unemployment payments go down and government spending goes down, right? And that's exactly what we want during this economic boom. We want to keep the reins on this GDP. We don't want the inflation to get out of control. So we want to lower our spending a little bit and that's exactly what's happening here, during an economic boom. We see that the consumption is going down or the government spending is going down in either of these automatic stabilizers, right? That's bringing down our GDP a little bit. And the opposite during a recession. So now the economy is contracting. There's less money being made and GDP is down. So they wanna boost GDP a little bit. And we get some of that straight out of the automatic stabilizer. Since there's fewer people employed during the recession, there's more unemployment. Well, there's more unemployment payments, right? And that's going to increase our government spending. Okay? So you could see how this automatic stabilizer works. There's no fiscal policy being made no action being taken by Congress or by the government, but the level of consumption or government spending is changing just based on where we are in the business cycle. Okay? So automatic stabilizers, it's things that happen automatically that change levels of taxes and spending in the government. Cool? So this is some of the main things we're going to be dealing with when we deal with fiscal policy. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the difference between fiscal policy and monetary policy?

Fiscal policy and monetary policy are two key tools used to influence a country's economy. Fiscal policy is managed by the government and involves adjusting government spending and taxation levels to impact the economy. For example, increasing government spending can boost GDP, while higher taxes can reduce disposable income and lower consumption. On the other hand, monetary policy is managed by the Federal Reserve (the Fed) and involves controlling the money supply and interest rates. The Fed might lower interest rates to encourage borrowing and investment or raise them to control inflation. Both policies aim to stabilize and grow the economy but operate through different mechanisms.

How does government spending affect GDP?

Government spending is a crucial component of GDP, which is calculated as the sum of consumption, investment, government spending, and net exports. When the government increases its spending, it directly boosts GDP because government expenditures are part of the GDP calculation. Conversely, when government spending decreases, GDP tends to fall. This relationship is straightforward: more government spending injects more money into the economy, leading to higher economic output, while less spending results in lower economic activity.

What are automatic stabilizers in fiscal policy?

Automatic stabilizers are mechanisms in fiscal policy that automatically adjust government spending and taxes based on the business cycle without proactive government intervention. For example, during an economic boom, higher incomes lead to higher tax revenues, which can reduce disposable income and consumption, helping to cool down the economy. Conversely, during a recession, lower incomes result in lower tax revenues and increased unemployment benefits, which boost disposable income and consumption, helping to stimulate the economy. These automatic adjustments help stabilize economic fluctuations.

How do taxes influence disposable income and consumption?

Taxes directly impact disposable income, which is the income left after taxes. Higher taxes reduce disposable income, leaving households with less money to spend on consumption. This decrease in consumption can lower overall economic activity. Conversely, lower taxes increase disposable income, giving households more money to spend, which can boost consumption and stimulate economic growth. Therefore, changes in tax policy can significantly influence consumer behavior and, consequently, the broader economy.

What is discretionary fiscal policy?

Discretionary fiscal policy involves deliberate actions by the government to influence the economy through changes in government spending and taxation. This type of policy requires proactive measures, such as passing new legislation to increase infrastructure spending or reduce taxes. For example, during a recession, the government might implement a stimulus package to boost spending and investment. Discretionary fiscal policy is distinct from automatic stabilizers, which adjust spending and taxes automatically based on economic conditions without new legislative action.