Increase in government spending = $5 billion. Initial spending of $5 billion is still required but only .8 (= MPC) of a tax cut will be spent. So tax cut = $5/.8 = $6.25 billion. Because part of the tax reduction ($1.25 billion) is saved not spent. Combination: a $1 billion increase in government spending and a $5 billion tax cut.

Reduce government spending increase taxes or some combination of both. See Figure 12-2. If the price level is flexible downward it will fall. In the real world the goal is to reduce inflation -- to keep prices from rising so rapidly -- not to reduce the price level. A "conservative" economist might favor cuts in government spending since this would reduce the size of government. A "liberal" economist might favor a tax hike; it would preserve government spending programs.

The full-employment budget is a budget which indicates the amount the Federal deficit or surplus would be if the economy operated at full employment throughout the year (whether or not it did). This budget is a useful measure of fiscal policy. An increase in a full-employment deficit (or a decrease in a full-
employment surplus) indicates that fiscal policy is expansionary. A decrease in full-employment deficit (or an increase in a full-employment surplus) means that fiscal policy is contractionary. The actual budget simply compares G and T for the year. A structural deficit is another name for a full-employment deficit. A cyclical deficit is the difference between G and T caused by tax revenues being below those which are collected when the economy is at full employment.

At GDP_f the structural deficit is ab and the cyclical deficit is zero. Government should raise T or reduce G to eliminate this deficit but it may want to take this action over several years to avoid pushing the economy into recession.

It takes time to ascertain the direction in which the economy is moving (recognition lag) to get a fiscal policy enacted into law (administrative lag) and for the policy to have its full effect on the economy (operational lag). Meanwhile other factors may change rendering inappropriate a particular fiscal policy. Nevertheless discretionary fiscal policy is a valuable tool in preventing severe recession or severe demand-pull inflation.

A political business cycle is the concept that politicians are more interested in reelection than in stabilizing the economy. Before the election they enact tax cuts and spending increases to please voters even though this may fuel inflation. After the election they apply the brakes to restrain inflation; the economy will slow and unemployment will rise. In this view the political process creates economic instability.

The crowding-out effect is the reduction in investment spending caused by the increase in interest rates arising from an increase in government spending financed by borrowing. The increase in G was designed to increase AD but the resulting increase in interest rates may decrease I. Thus the impact of the expansionary fiscal policy may be reduced.

The net export effect also arises from the higher interest rates accompanying expansionary fiscal policy. The higher interest rates make U.S. bonds more attractive to foreign buyers. The inflow of foreign currency to buy dollars to purchase the bonds drives up the international value of the dollar making imports less expensive for the United States and U.S. exports more expensive for people abroad. Net exports in the United States decline and like the crowding-out effect diminish the expansionary fiscal policy.