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Chapter 9 Fiscal Policy
The basic economic problem is scarcity. Human wants are unlimited. Resources are limited. The
basic goal in dealing with the problem of scarcity is to produce as much consumer satisfaction as
possible with the limited resources available. Achieving each of the three macroeconomic goals
(price level stability, full employment, and economic growth) will contribute toward reaching this
basic goal.
We saw in earlier chapters that the ideal quantity of total output is called Natural Real GDP.
Natural Real GDP is the quantity of total output that results in the natural unemployment rate (full
employment). The economy may be producing at Natural Real GDP in the short run, or the
economy may be producing less than or more than Natural Real GDP, suffering from a
recessionary gap or an inflationary gap.
Whether or not the economy produces at Natural Real GDP in the short run may be affected by
the government’s fiscal policy. Fiscal policy may also affect the level of economic growth in the
long run (according to supply-side theory, discussed later in this chapter).
Fiscal policy – changes in government expenditures and taxation to achieve macroeconomic
goals.
Changes in fiscal policy affect the federal government’s budget. The federal government’s annual
budget could be balanced, with tax revenues equal to government expenditures. Typically, the
federal government’s annual budget will be in deficit or surplus.
Budget deficit – when government expenditures are greater than tax revenues.
Budget surplus – when tax revenues are greater than government expenditures.
A history of the federal government’s budget, detailing annual tax revenues, expenditures, and
budget surpluses (or deficits) is provided in an appendix to this chapter.
Keynesian Fiscal Policy Theory
According to Keynesian theory, the level of Real GDP is determined by the level of Total
Expenditures (see Chapter 8). An increase in Total Expenditures will cause an increase in Real
GDP. A decrease in Total Expenditures will cause a decrease in Real GDP.
The ideal level of Total Expenditures would cause the economy to produce at Natural Real GDP.
But there is no guarantee that the level of Total Expenditures will be ideal. The level of Total
Expenditures may be less than or greater than the level that will cause the economy to achieve
Natural Real GDP. If Total Expenditures is less than the ideal, the result will be a recessionary
gap. If Total Expenditures is greater than the ideal, the result will be an inflationary gap. The
government may be able to move the level of Total Expenditures toward the ideal level (and
move Real GDP toward Natural Real GDP) by using fiscal policy.
Keynesian Fiscal Policy Theory and a Recessionary Gap
According to Keynesian theory, fiscal policy can be used to move the economy toward Natural
Real GDP. If the economy is in a recessionary gap, Real GDP is less than Natural Real GDP. To
close a recessionary gap, Total Expenditures needs to increase. An increase in Total
Expenditures can be caused by expansionary fiscal policy (an increase in government
expenditures and/or a decrease in taxation). To close a recessionary gap, Keynesian theory calls
for the use of expansionary fiscal policy.
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Expansionary fiscal policy will alter the government’s budget situation. Assuming that the budget
is initially balanced, expansionary fiscal policy will create a budget deficit. Thus, Keynesian theory
calls for the use of deficit spending to close a recessionary gap.
9 - 1 Fiscal Policy