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Let’s begin with a definition of fiscal policy, which is typically a policy set by a central government authority whereby spending by the government is adjusted to stabilize economic activity.
The government also uses taxation as a policy to do the same.
Therefore, we have two tools of fiscal policy:
As a reminder, business cycles are the movement of an economy through expansion, peak, contraction, and trough over time. They are assessments of our economic activity through time.
In review, this is what a business cycle looks like. Notice the expansion, peak, contraction, and trough; then, the cycle would start over.
It is usual for the economy to go through periods of growth and contraction, but fiscal policy’s goal is to make sure that expansions are not too rapid, experiencing a lot of inflation, and contractions are not too severe, ending up in major recessions or even depressions.
Now, let’s talk about spending in the economy, circling back to the expenditure approach. You may recall that the expenditure approach to calculating GDP or economic activity does this by adding up what people are spending in the economy.
This is the activity in the output market from our circular flow model.
Notice the money being spent up at the top. In this case, we are only going to focus on the domestic market, so we are going to take the imports, exports, and rest of the world out of this equation. We will be looking at movement in the output market on goods and services.
Here is the expenditure formula and its component parts:
For now, we are going to take (X − M) out of the equation because we are just considering the domestic market.
So, if we only consider domestic spending, then there are basically three ways money is spent in our economy:
Let’s start by solving for I, investment. This is also the same as savings in an economy. Solving for I provides the following:
If we add and subtract T, which represents the taxes collected, this provides the following:
In this formula, Y minus C plus T is our public savings, and T minus G is our government savings.
We will come back to these shortly to show the impact on government savings.
Savings is defined as income that is not consumed or paid in the form of taxes.
Sometimes, the term investment creates some confusion among students in economics because they associate the word “investment” with investing in the stock market or portfolio investments.
Investment in economics is defined as money that is used on capital resources. For businesses, this would be land, equipment, or buildings. For individuals, it could be something like a home. This is not the same as portfolio investment, so it is not to be confused with the purchase of stocks, bonds, and other investments related to wealth accumulation.
As mentioned at the beginning of this lesson, the government has two tools of fiscal policy: government spending and taxation.
Now, we know that our government affects the economy by spending money in many areas, such as the following:
If it needs to slow down an overheated economy where inflation is a concern, it can cut spending levels.
All levels of government—federal, state, and local—collect taxes from us in order to fund their programs.
If they want to stimulate the economy, they can cut taxes to give people more money to spend in the economy.
If they need to slow it down, they can raise taxes to slow down our spending—essentially, taking money out of our pockets.
Again, considering only the domestic market, we have these formulas for public savings and government savings.
During recessions, government spending should be greater than taxation.
During recessions: G > T
As mentioned, during recessions, the government wants to cut taxes and give us more money, but at the same time, they could also be increasing government spending by creating more programs and giving people more money to spend.
Therefore, you can see why the term T minus G is going to be negative if government spending is greater than taxation. This means that government savings during recessions would be negative. Instead of having savings, the government would be in debt or running a deficit.
In expansions, in theory, T should be greater than G to offset these deficits that we have incurred during the recession.
In expansions: T > G
Once we recover, taxes should be increased again, and/or government spending programs should be cut down.
However, this is politically difficult. Once the government cuts people’s taxes, it is never popular to raise them again. Once it creates government programs, it is not popular to eliminate them.
In reality, it is easy to see why our government deficit has grown so much over the years.
Source: Adapted from Sophia instructor Kate Eskra.
