Introduction to Fiscal Policy

Summary

This video explains how fiscal policy, including expansionary and contractionary approaches, is used to manage economic fluctuations. During a recession, expansionary fiscal policy—such as increased government spending—can stimulate GDP growth by creating jobs and triggering a ripple effect throughout the economy. In contrast, when the economy is at full employment, increased spending may crowd out private investment. Contractionary fiscal policy involves saving during economic booms by raising taxes or cutting spending. The video also touches on political challenges in maintaining surpluses and controlling deficit spending.

Takeaways

• 🎯 Expansionary fiscal policy involves cutting taxes and increasing government spending to stimulate the economy.
• 📉 Fiscal policy is used to manage fluctuations in the business cycle, mitigating booms and busts.
• 🏗️ If an economy is at full employment, additional government spending could crowd out private spending, as resources are fully utilized.
• 🚧 In a recession, with underused labor and capital, government spending can boost GDP by increasing demand for idle resources.
• 💸 A dollar spent by the government during a recession may have a ripple effect, increasing GDP by more than the initial amount spent.
• 🌊 This ripple effect, where increased spending leads to further economic activity, is called the 'fiscal multiplier.'
• 🔄 Contractionary fiscal policy is the opposite of expansionary, involving saving during economic booms by raising taxes or cutting spending.
• 📈 Expansionary policy works best during recessions, where there is excess capacity in the economy.
• 💼 Fiscal policy involves managing taxes, spending, and borrowing to influence economic activity.
• 📊 There are challenges in maintaining government surpluses, and we'll explore the political difficulties of continual deficit spending.

Q & A

What is fiscal policy?

Fiscal policy refers to the government's policies on taxes, spending, and borrowing, used to mitigate fluctuations in the business cycle and even out booms and busts.

What is expansionary fiscal policy?

Expansionary fiscal policy is when the government cuts taxes or increases spending in order to stimulate the economy, particularly during periods of economic downturn.

Why doesn't expansionary fiscal policy increase GDP during full employment?

During full employment, resources like labor and capital are already fully utilized. If the government increases spending, it takes these resources away from the private sector, resulting in crowding out private investment rather than increasing GDP.

How does expansionary fiscal policy work during a recession?

During a recession, resources are underused, with unemployed labor and idle capital. Government spending can hire these unemployed resources, leading to an increase in GDP. This increased spending can have a multiplier effect throughout the economy.

What is the fiscal multiplier?

The fiscal multiplier is the ripple effect of increased government spending, where the initial spending leads to more spending in the economy as people use their income to purchase goods and services, which in turn causes further economic activity.

Can government spending during a recession increase GDP by more than the initial amount spent?

Yes, due to the fiscal multiplier effect. For example, if the government hires unemployed workers, those workers spend their new income, creating more demand in other sectors, which can further increase GDP.

What is contractionary fiscal policy?

Contractionary fiscal policy occurs when the government saves during an economic boom by either increasing taxes or decreasing spending. This is done to prevent overheating of the economy.

What are the challenges of achieving government surpluses?

Political economy issues, such as continual deficit spending and difficulty in reducing government spending during booms, make it challenging for governments to achieve and maintain surpluses.

Why might government spending crowd out private investment during full employment?

At full employment, the economy is already using its resources efficiently. Additional government spending would redirect resources (like labor and capital) away from private investment, rather than increasing overall production.

Why is it important for the government to save during economic booms?

Saving during booms helps prevent inflation and overheating in the economy. It also provides a financial cushion that can be used during economic downturns to stimulate the economy through expansionary fiscal policy.

Outlines

00:00

🎵 Understanding Expansionary Fiscal Policy

In this segment, Tyler discusses the government's response to the 2009 recession by implementing expansionary fiscal policy. This approach involves cutting taxes and increasing government spending to boost economic activity. Fiscal policy, which refers to the government's decisions on taxes, spending, and borrowing, is designed to mitigate business cycle fluctuations by addressing economic booms and busts. Tyler explains that expansionary fiscal policy is especially useful during a recession, but its effectiveness depends on whether the economy is operating at full employment or underutilizing resources.

🏗️ The Impact of Government Spending at Full Employment

Tyler explains that if an economy is at full employment, government efforts to increase spending, such as building a new road, will likely crowd out private sector activity. Since all workers and resources are already engaged, government spending would shift resources from one sector to another without raising GDP. Although building infrastructure may have long-term benefits, it doesn’t stimulate short-term economic growth in this scenario.

📉 Government Spending During a Recession

In contrast to full employment, Tyler highlights the positive effects of government spending during a recession. When workers and resources are idle, government projects like road construction can lead to an increase in GDP by directly employing people and stimulating further economic activity through a 'ripple effect.' This increased spending across different sectors boosts demand, a process referred to as the 'fiscal multiplier,' where each dollar spent leads to more than a dollar’s worth of economic growth.

🔄 Contractionary Fiscal Policy

Tyler introduces contractionary fiscal policy, which is the opposite of expansionary policy. During times of economic boom, the government can use this approach by increasing taxes or decreasing spending, essentially saving for future downturns. This helps to balance out economic growth over time. However, Tyler hints at challenges related to political decisions that make saving through surpluses difficult, leading to continual deficit spending.

🎓 Wrapping Up and Next Steps

The narrator concludes by encouraging viewers to solidify their understanding of economics through practice questions or by watching more videos. Acknowledging the importance of active engagement, the video offers pathways for continued learning, particularly in macroeconomics. Additionally, viewers are prompted to explore more content from Marginal Revolution University.

Keywords

💡Recession

A recession is a period of economic decline marked by reduced industrial activity and increased unemployment. In the video, the 2009 recession is discussed as a context where the federal government intervened with expansionary fiscal policy to stimulate the economy. During this time, labor and capital were underutilized, making government intervention more effective.

💡Expansionary Fiscal Policy

Expansionary fiscal policy refers to government actions aimed at increasing economic activity, typically through increased spending or tax cuts. The video explains how the federal government used this policy during the 2009 recession to boost GDP by utilizing underemployed labor and capital, contrasting it with periods of full employment when such policy may crowd out private investment.

💡Full Employment

Full employment is a situation where all available labor resources are being used in the most efficient way possible, leaving no idle workers or resources. The video discusses how, under full employment, expansionary fiscal policy might not increase GDP, as the economy is already operating at its capacity, leading to a crowding-out effect where government spending replaces private investment.

💡Crowding Out

Crowding out occurs when increased government spending reduces or displaces private sector spending. The video highlights that in an economy operating at full employment, government projects, such as building a new road, would not add to GDP because the resources used would have to be taken from other sectors, replacing rather than adding to economic activity.

💡GDP

Gross Domestic Product (GDP) is the total value of goods and services produced within a country. The video explains how government spending during a recession can directly increase GDP by using underutilized resources, but in times of full employment, the same spending might not increase GDP due to the crowding-out effect.

💡Fiscal Multiplier

The fiscal multiplier refers to the ripple effect that occurs when an initial increase in government spending leads to further increases in spending throughout the economy. The video illustrates this with the example of government hiring construction workers, who then spend their wages, causing a chain reaction of economic activity that boosts GDP beyond the initial government expenditure.

💡Labor

Labor refers to the human workforce used in the production of goods and services. In the video, labor is discussed in the context of unemployment during a recession, where government spending can help employ idle workers, thereby stimulating economic activity and increasing GDP.

💡Capital

Capital refers to the tools, machinery, and buildings used in production. The video contrasts periods of full employment, where capital is fully utilized, with recessions, where capital is idle. In the latter case, expansionary fiscal policy can increase the use of capital by initiating government projects like road construction.

💡Contractionary Fiscal Policy

Contractionary fiscal policy involves reducing government spending or increasing taxes to cool down an overheated economy. The video mentions this type of policy in the context of saving during economic booms, highlighting the idea that fiscal policy aims to stabilize the business cycle by balancing periods of growth and recession.

💡Business Cycle

The business cycle refers to the natural rise and fall of economic growth over time, including periods of expansion (booms) and contraction (busts). The video explains how fiscal policy is used to manage these fluctuations, with expansionary measures taken during recessions and contractionary measures during booms, to smooth out the extremes of the business cycle.

Highlights

In 2009, the federal government cut taxes and increased spending to stimulate the economy.

Expansionary fiscal policy involves government actions related to taxes, spending, and borrowing to smooth out business cycle fluctuations.

Expansionary fiscal policy may not always work, especially when the economy is at full employment.

When at full employment, additional government spending can crowd out private sector spending and investment.

During full employment, government spending does not increase GDP in the short run.

Expansionary fiscal policy is more effective during a recession, when resources like labor and capital are underutilized.

In a recession, government spending can increase GDP, and the impact may be larger than the initial amount spent.

The fiscal multiplier refers to the ripple effect of government spending, where one dollar spent leads to more spending throughout the economy.

Government spending during a recession can trigger additional spending by consumers and businesses, further boosting the economy.

Fiscal policy can also be contractionary, where the government saves by increasing taxes or reducing spending during economic booms.

Contractionary fiscal policy is designed to control inflation and reduce overheating in the economy during periods of strong growth.

Ideally, the government should balance expansionary and contractionary policies to manage economic cycles effectively.

Political challenges can arise with continuous deficit spending, making it difficult to achieve surpluses.

Persistent deficit spending can lead to long-term issues in fiscal policy management.

Understanding both expansionary and contractionary policies is crucial to mastering economics.

Transcripts

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- [Tyler] When the recession of 2009 hit,

the federal government tried to stimulate the American economy.

It cut taxes and increased spending.

In other words, it conducted expansionary fiscal policy.

Fiscal policy -- the government's policies

on taxes, spending and borrowing --

that's used to try to mitigate fluctuations in the business cycle,

to even out the booms and the busts.

But, how is it that expansionary fiscal policy

is capable of actually working?

Imagine an economy that's operating at full employment.

Workers have jobs,

and factories are operating near capacity.

If in that case, the federal government tries

to increase spending to, say, build a new road,

then it necessarily has to take away some people and some capital

from other sectors of the economy.

GDP wouldn't increase,

because there's already full employment.

So government spending would simply be crowding out

private spending and investment.

Building the new road?

It may or may not be a good idea,

depending on how valuable that road would be.

But still, the increased government spending would not,

in the short run, stimulate the economy.

But now, in contrast,

imagine an economy during a recession.

The fundamental factors of production are underused.

Labor and capital are unemployed or underemployed.

Machines and buildings are idle.

In this case, government spending on a new road

probably would increase GDP.

In fact, an extra dollar spent during a recession

might even increase GDP by more than a dollar.

Say, for instance, the government hires

unemployed construction workers.

These construction workers then use their new income

to, say, eat out at restaurants.

This causes restaurant owners to hire more workers,

and these newly employed waiters and waitresses --

they then spend their money throughout the economy.

There's a kind of ripple effect,

and the people who receive that money

in turn spend more money themselves.

The subsequent increases in spending

caused by the initial increase in government spending --

that's known as the "fiscal multiplier."

Now, expansionary fiscal policy

is not the only kind of fiscal policy.

The government also conducts contractionary fiscal policy

by saving during an economic boom --

by either increasing taxes or by decreasing spending.

At least that's how fiscal policy is supposed to work.

Later, we'll discuss some of the political economy issues

of continual deficit spending

and why government surpluses sometimes are so hard to come by.

- [Narrator] You're on your way to mastering economics.

Make sure this video sticks by taking a few practice questions.

Or, if you're ready for more macroeconomics,

click for the next video.

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