Why are you going to college? To get a better paying job, of course. But what if the economy is in a recession when you graduate? Well, then it becomes more difficult to get a job. So, what type of economy would you like to have upon graduating from college? A growing economy. And, with any luck, the U.S. Government will be using the tools of fiscal policy at that time to encourage economic growth.
The U.S. government can also use the tools of fiscal policy to try to control inflation. Inflation can affect your purchasing power long before you graduate from college. For example, if the economy experiences run-away inflation, you might pay $5 for a loaf of bread today when just a month ago you only spent $2.50. (And, unfortunately, in that short period of time your salary did not double.) Clearly, your standard of living can deteriorate when inflation is not kept in check.
So, how does the government use fiscal policy to encourage economic growth and to control inflation? The government can change its current level of spending and/or taxation. Here is a graph of Fiscal Policy to give you a better idea of how it is divided.
- Automatic - No changes in legislation, designed to stabilize the economy
- Discretionary - Changes in legislation needed to affect government spending and taxes
Government spending as the name implies simply refers to our government purchasing computers for schools, building new freeways, buying a new fighter jet, and all the other goods and services the government buys in order to make our society a better place. Discretionary spending is that part which the government may increase or decrease at political will.
Ideally, fiscal policy takes into account the budget decisions made by the President and Congress. In order to better understand fiscal policy, we will need to take a closer look at the annual U.S. budget.
First, you will take a look at some of the decisions you make when creating a household budget. Then, you will use what you learned about a household budget to determine what you think a government budget might look like. Finally, you will go to the A Citizen's Guide to the Federal Budget to gather information about the current U.S. budget; before beginning this last activity, print out the accompanying worksheet.
Government Spending - The pie chart below illustrates how the government spends our money: Defense 15%, Social Security 23%, Non Defense Discretionary 17%, Net interest 13%, Medicare 12%, Medicaid 6%, Other Means tested Entitlements 6%, Remaining Entitlements 6% and Reserves Pending Social Security Reform 1%.
Source: Office of The President
The figure below shows an economy that is in equilibrium, the spending line represents how much money the consumers, the private firms, the government and our trading partners spend in the US. Now imagine that the government increases its spending, the red line will shift right and the GDP will grow. That is how fiscal policy helps the economy grow.
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Equilibrium Economy |
The graph above depicts Price Level on the vertical axis and GDP on the horizontal axis. A direct relationship for the total amount of production and an inverse relationship for total spending.
Crowding-out effect. Although government spending may help the economy grow, it has an adverse side effect called the "crowding-out" effect. When government incurs in deficit spending, it reduces the amount of money available for private firms, hence reducing the funds available for private investments. This reduction is called the "crowding-out" effect.
The concept of the multiplier is better explained by the snowball effect. Imagine a snowball rolling down hill, it gets bigger and bigger before it gets to the bottom of the hill. The multiplier is the impact that a certain amount of spending (marginal propensity to consume or MPC) in the economy percolates in changing the GDP. Imagine that the government decides to buy 100 fighter jets, the company that produces the fighter has to hire more engineers and workers. All these workers that now have paychecks will in turn spend more money at the malls, restaurants and music shops. The owners of these stores in turn will spend more money and the process will continue.
The multiplier process entails using a formula: 1/ (1- MPC) = multiplier. For example if we use the MPC of the US of 95% the multiplier is 20.
1/(1-.95)=20
Suppose now that the government spends $100 million dollars buying new, cool looking, helicopters. As the money changes hands in the economy, the GDP will grow by a factor of 20. Let's practice these concepts. See Worksheet
Summary of the multiplier process:
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