Economics Online Tutor
Fiscal Policy:
An Overview
The remainder of this section on fiscal policy focuses primarily on discretionary fiscal policy.

Government Spending

Government purchases (but not transfer payments) are part of real GDP.  They are the G in C + I + G +
(X-M).  Government purchases form an autonomous portion of aggregate demand.

Government spending is not affected by the price level, but it can change the equilibrium price level.  A
change in government spending will shift the aggregate demand curve.

If a recessionary gap exists, equilibrium real GDP is below potential real GDP.  The amount by which real
GDP is below potential GDP is called a GDP gap.

An increase in government spending can shift the aggregate demand curve to the right, increasing
equilibrium real GDP towards the level of potential real GDP, closing the GDP gap.

How much does government spending have to increase in order to eliminate a recessionary gap?

With an upward sloping aggregate supply curve, won't part of the increase in government
spending simply go towards higher prices instead of higher real output?

The answers to these questions depends on a number of factors.  These factors are discussed
on the following page called
The Effectiveness of Discretionary Fiscal Policy.
Fiscal policy is the policy of the government relating to
government spending and taxing decisions.  The entire
budget of the government is the result of fiscal policy.

Fiscal policy affects the economy's total output (real
GDP) and price level because it affects
demand both directly and indirectly.  Because fiscal
policy can change aggregate demand, it has been called
demand side economics, or Keynesian Economics.

Fiscal policy includes components that are discretionary
in nature.  Discretionary fiscal policies are policies that
are designed to achieve specific economic outcomes.  
Decreasing unemployment, for example.  Discretionary
fiscal policies are deliberate government interventions in
the economy.
Fiscal policy also includes automatic stabilizers.  These are policies that kick in whenever aggregate
income changes.  Automatic stabilizers work to offset the effects of changes in income.

For example, unemployment compensation will partially offset lost income, and the associated loss of
consumer demand, when people lose jobs.  When the unemployment rate increases, so does the
aggregate amount of unemployment compensation paid by the government.  Similar types of automatic
stabilizers are welfare payments and food stamps.

These automatic stabilizers are transfer payments.  Transfer payments represent money that government
collects in taxes from one group of people and pays out in benefits to another group of people.  Since
transfer payments do not represent government purchases of goods and services, and do not reflect
current production, they are not included in GDP.

Transfer payments do not affect aggregate demand directly, but they do change aggregate demand
indirectly through changes in disposable income.  For example, if the transfer is from a group with a
relatively low
MPC (people who tend to save a large portion of their disposable income) to a group with a
relatively high MPC (people who tend to spend a large portion of their disposable income), then
aggregate consumption spending will increase.

Another type of automatic stabilizer is a progressive income tax.  When incomes fall, taxpayers are moved
to a lower tax bracket.  The amount of taxes collected from income falls.  This partially offsets the loss of
disposable income by taking less in taxes out of personal income.  This helps offset the decrease in
consumption spending caused by a recession.
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