3.8 Fiscal Policy

Fiscal policy is the government (Congress and the president, never the Fed) changing spending, taxes, or transfers to steer aggregate demand. Expansionary policy (more G, lower taxes, more transfers) shifts AD right to close a recessionary gap; contractionary policy (less G, higher taxes) shifts AD left to close an inflationary gap.

Government spending hits AD directly and gets the full spending multiplier (1/MPS); tax and transfer changes work through disposable income and get the smaller tax multiplier (−MPC/MPS). To close a $100 billion gap with MPC = 0.8, government needs only $20 billion of new spending, but a $25 billion tax cut.

Discretionary fiscal policy requires new legislation, which brings lags: recognizing the problem, passing the law, and waiting for spending to ripple through. Expansionary policy funded by borrowing also widens the budget deficit, the Unit 5 setup for crowding out.