What Works and What Doesn’t: The Potential and Limitations of Fiscal Policy

Lesson Purpose:
While micro-economics gives us tools to analyze the operation of specific markets, we also need tools for understanding the big picture – the operation of the economy as a whole.  Adding the macro perspective means looking at totals – or “aggregates,” as economists call them.  Prices become price levels, and single product quantities become the economy’s total output. Macro models depict relationships that help us analyze and predict how policies will affect our efforts to reach our national economic goals. A number of theories exist about fiscal policy – attempts to fine-tune an economy that doesn’t always cope with ups and downs in quite the way we’d like it to.  This lesson looks at how we evaluate fiscal policy – the relationships between consumption and output, tax policy and government spending changes. It also considers how economic perspectives and theories about fiscal policy change over time. 

Key Terms:

fiscal policy

public choice theory

Content Standards:

Standard 17:  Students will understand that: Costs of government policies sometimes exceed benefits.  This may occur because of incentives facing voters, government officials, and government employees, because of actions by special interest groups that can impose costs on the general public, or because social goals other than economic efficiency are being pursued.

Benchmarks:
grade 12:

• Incentives exist for political leaders to implement policies that disperse costs widely over large groups of people and benefit relatively small, politically powerful groups of people.
• Incentives exist for political leaders to favor programs that entail immediate benefits and deferred costs. Few incentives favor programs promising immediate costs and deferred benefits, even though the latter programs are sometimes economically more effective than the former programs.

Standard 18: Students will understand that: A nation’s overall levels of income, employment, and prices are determined by the interaction of spending and production decisions made by all households, firms, government agencies, and others in the economy.

Benchmarks:
grade 8:

• When consumers make purchases, goods and services are transferred from businesses to households in exchange for money payments. That money is used in turn by businesses to pay for productive resources (natural, human, and capital) and to pay taxes.

Standard 20:  Students will understand that:  Federal government budgetary policy and the Federal Reserve System’s monetary policy influence the overall levels of employment, output, and prices.

Benchmarks:
grade 12:

• Fiscal policies are decisions to change spending and tax levels by the federal government.  These decisions are adopted to influence national levels of output, employment, and prices.
• In the short run, increasing federal spending and/or reducing taxes can promote more employment and output, but these policies also put upward pressure on the price level and interest rates.  Decreased federal spending and/or increased taxes tend to lower price levels and interest rates, but they reduce employment and output levels in the short run.
• In the long run, the interest-rate effects of fiscal policies lead to changes in private investment spending by businesses and individuals that partially, if not entirely, offset the output and employment effects of fiscal policy.
• When the government runs a budget deficit, it must borrow from individuals, corporations, or financial institutions to finance that deficit.

Session Objectives:

• Review national economic goals.  Pose the question:  What can government do effectively and what can it not do effectively to help the nation achieve its economic goals?  What are the possibilities and limitations of fiscal policy?
• Review PPF, using the example of an economy operating inside its frontier.  Tie changes over time that result in approaching the frontier to the national economic goal of full employment of resources, and tie pushing the frontier outward to the national economic goals of growth and stability.
• Review GDP = C + I + G + (X-M) and relate it to economic growth and PPF. 
• Review the business cycle model, emphasizing the variable nature of economic activity over time.
• Introduce the questions of:  (1) how changes in the variables of total demand can promote economic growth and affect the ups and downs of the business cycle, and (2) the effectiveness of government policies that manipulate these variables.
• Describe the tools of fiscal policy – taxation and government spending. 
• Explain the income multiplier and its importance in the context of fiscal policy.  (Relate to circular flow model.)
• Explain deficit spending.
• Discuss the potential and limitations of fiscal policy – both taxation and government spending – to promote national economic goals of full employment, stability, and growth.  Emphasize that government actions involving taxation and spending affect the national economy, regardless of whether they were adopted as “fiscal policy” – that is, for the specific purpose of addressing national economic goals.
• Discuss public choice theory.  Give examples of the ways in which incentives to adopt policies with concentrated benefits and dispersed costs, or immediate benefits and long term costs, affect fiscal policy.
• Provide examples and develop an explanation of how people’s rational responses to expectations limits the effectiveness of fiscal policy measures.
• Develop examples of applying fiscal policies to selected economic problems, i.e. inflation or unemployment.
• Discuss areas of controversy among economists regarding the effectiveness of fiscal policy, including the impact of automatic stabilizers, “crowding out” effects of deficit spending, lag times, and rational expectations.

Key Content:

• Output = Income.  Therefore, Y = GDP = C + I + G + (X-M).
• Fiscal policy is the use of government spending and taxation to shape total demand and supply in the economy in order to promote national economic goals of full employment, stability, and economic growth.
• Most government policies have fiscal effects – whether deliberate or not.
• The incentives and opportunity costs created by specific fiscal policies may work against achievement of the economic goal(s) for which the policy was adopted.
• Fiscal policy goals may be incompatible, each reducing the desired effect of the other.
• Savings is necessary for investment and economic growth.

Mythconceptions:

• Most economies function on their PPF.
• Savings dampen economic activity.
• Depressions are a natural condition of capitalism.
• Decisions made in Washington D.C. have little impact on the economy in the “real world.”
• Government can’t really solve large-scale problems in the economy.
• Government spending stimulates demand on a dollar-for-dollar basis.
• The impact of spending on the economy is the same whether the spending is by consumers, businesses, or government.
• Running federal deficits is bad for the economy.
• The economy would be better off if the national debt were $0.

Frequently Asked Questions:

• How can government spend money it doesn’t have?
• Are entitlement programs good for the economy as a whole?
• What is crowding out?
• Why doesn’t saving slow down the economy and cause recessions?
• Is raising taxes ever a good thing for consumers?
• Can fiscal policies “cancel out” each other?
• If fiscal policy works, why do we have ups and downs in the economy?

Classroom Activity Options

• Display a graphic showing the history of the business cycle in the U.S.  Identify the average rate of growth as 2%/yr., but note the significant fluctuations.  Explain that periods of rapid growth mean high employment, job growth, investment spending, and rising prices.  Periods of contraction mean rising unemployment, reduced business profits, fewer new home starts and home sales, and reduced personal income and retail sales.  These fluctuations are viewed by economists as short-term linkages/relationships. Demonstrate these relationships by using data, graphs, and personal experiences.  Create a Flow of Economic Activity (circular flow) diagram and discuss linkages coming from government to the other sectors. Suggest that this model will reinforce much of the content found in this lesson.
• Identify the fiscal policy tools as they influence the macroeconomic models.  Relate fiscal policy changes to the Y = C + I + G + (X-M) identity.  Note the influence on economic activity of each policy tool.
• Use historical and contemporary examples to discuss how the spending multiplier (1/MPS) may affect the results of various fiscal policy changes. 
• Identify the limitations of fiscal policy, and the role (and relative levels of success) that highlight automatic stabilizers.  (Demonstrate the possible influence of the multiplier on fiscal policies.)