Question

Identify each of the following as (1) part of an expansionary fiscal policy, (2) part of a contractionary fiscal policy, or (3) not part of fiscal policy. a. The corporate income tax rate is increased. b. Defense spending is increased. c. The Federal Reserve lowers the target for the federal funds rate. d. Families are allowed to deduct all their expenses for day care from their federal income taxes. e. The individual income tax rates are decreased.

Short answer

a. Contractionary fiscal policy. b. Expansionary fiscal policy. c. Not part of fiscal policy. d. Expansionary fiscal policy. e. Expansionary fiscal policy.

Step-by-step solution

Identify Fiscal Policies

In this step, we identify each scenario and whether it is a fiscal policy and whether it's expansionary or contractionary. a. The corporate income tax rate is increased. This is a part of a contractionary fiscal policy. The government is increasing taxes, thereby likely reducing expenditure and hence, economic activity. b. Defense spending is increased. This is a part of an expansionary fiscal policy. The government is increasing spending which is likely to stimulate the economy. c. The Federal Reserve lowers the target for the federal funds rate. This is not a part of fiscal policy. It is a part of monetary policy, which is managed by the Federal Reserve in order to control money supply and interest rates. d. Families are allowed to deduct all their expenses for day care from their federal income taxes. This is a part of an expansionary fiscal policy. By allowing deductions, the government is effectively reducing taxes, likely stimulating expenditure and hence, economic growth. e. The individual income tax rates are decreased. This, again, is an expansionary fiscal policy. The government is reducing taxes which should increase personal spending and stimulate the economy.

Key concepts

Expansionary Fiscal Policy

Fiscal policy refers to the use of government spending and tax policies to influence economic conditions. Expansionary fiscal policy involves increasing government spending or decreasing taxes to stimulate economic growth. This type of policy is typically used during a recession to increase aggregate demand and encourage economic activity.

For instance, if a government increases defense spending as seen in the textbook exercise, it injects more money into the economy, potentially leading to job creation in the defense sector and its supply chains. Similarly, reducing individual income tax rates leaves citizens with more disposable income. They are likely to spend this extra money, contributing to economic growth. Therefore, both these actions - increasing government expenditure and reducing taxes - are typical examples of expansionary fiscal policy designed to boost the economy.

Contractionary Fiscal Policy

Contractionary fiscal policy aims to slow down economic growth, often to combat inflation. This includes raising taxes or decreasing government spending. By increasing the corporate income tax rate, as highlighted in the exercise, the government can reduce the amount of money businesses have to invest or spend. This action can decrease a company's net profit, potentially leading to a contraction in business investments or workforce size, therefore slowing economic growth.

Implementing contractionary fiscal policy can be necessary when an economy is overheating and price levels are rising too quickly. This policy is a deliberate attempt to decrease the money supply within the economy, which can suppress the levels of consumer spending and investment.

Monetary Policy

Monetary policy, another key pillar of economic management, is not a direct tool of fiscal policy but rather involves managing the money supply and interest rates. It is typically executed by a central bank, such as the Federal Reserve in the United States. When the Federal Reserve lowers the target for the federal funds rate – the interest rate at which banks lend to each other overnight – it makes borrowing cheaper for banks, which often leads to lower interest rates for consumers and businesses.

This decrease in interest rates can encourage people to take loans and make investments, spurring economic activity. However, this also means that savings yield lower returns, which might incentivize spending rather than saving. While part of a broader economic strategy along with fiscal policy, monetary policy operates through different mechanisms and targets different aspects of the economy.

Federal Income Tax

Federal income tax is a critical component of fiscal policy as it represents a significant portion of government revenue. When federal income tax rates are adjusted, it can have a direct impact on an individual's disposable income and, subsequently, on consumer spending and saving behaviors. For example, allowing families to deduct day care expenses from their federal income taxes, as mentioned in the exercise, acts similar to a tax cut. This policy can provide financial relief and increase households' budgets for other expenditures. Lower taxes can lead to higher spending among consumers, fueling economic growth, which aligns with the goals of expansionary fiscal policy.

Government Spending

Government spending is a key facet of fiscal policy and refers to any expenditure by the government sector. This includes spending on infrastructure, education, defense, social services, and more. Increasing government spending can have immediate effects on stimulating the economy - a concept central to expansionary fiscal policy. As the government contracts for goods and services, companies may hire more staff or raise wages to meet increased demand, thus boosting overall economic activity.

On the other hand, if the government needs to cool down an overheated economy or reduce a budget deficit, it may cut back on spending, which is indicative of a contractionary fiscal policy. By decreasing its expenditure, the government attempts to rein in excess demand, which can help to stabilize prices and moderate economic growth.