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CHAPTER TWELVE. FISCAL POLICY. LEGISLATIVE MANDATES. Employment Act of 1946. It is the government’s responsibility to maintain economic stability through the use of monetary and fiscal policy. LEGISLATIVE MANDATES. Employment Act of 1946 Council of Economic Advisors (CEA).

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FISCAL POLICY

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CHAPTERTWELVE

FISCAL POLICY


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LEGISLATIVE MANDATES

Employment Act of 1946

It is the government’s responsibility to maintain economic

stability through the use of monetary and fiscal policy.


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LEGISLATIVE MANDATES

Employment Act of 1946

Council of Economic Advisors (CEA)


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LEGISLATIVE MANDATES

Employment Act of 1946

Council of Economic Advisors (CEA)

Joint Economic Committee (JEC)

Presidential Advisors

Committee of Congress


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Discretionary Fiscal Policy

Two Situations....

  • Recession


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Discretionary Fiscal Policy

Two Situations....

  • Recession

  • Demand-pull Inflation

Discretionary – the deliberate manipulation of taxes and

government spending by Congress to alter GDP.


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Discretionary Fiscal Policy

Two Situations....

  • Recession

  • Demand-pull Inflation

Expansionary Fiscal Policy Options....


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Discretionary Fiscal Policy

Two Situations....

  • Recession

  • Demand-pull Inflation

Expansionary Fiscal Policy Options....

  • Increase Government Spending


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Discretionary Fiscal Policy

Two Situations....

  • Recession

  • Demand-pull Inflation

Expansionary Fiscal Policy Options....

  • Increase Government Spending

  • Reduce Taxes


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Discretionary Fiscal Policy

Two Situations....

  • Recession

  • Demand-pull Inflation

Expansionary Fiscal Policy Options....

  • Increase Government Spending

  • Reduce Taxes

  • Some Combination of the Two


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Expansionary Fiscal Policy

P

$5 billion initial

increase in spending

Price level

P1

AD2

Q

Real GDP (billions)


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Expansionary Fiscal Policy

P

$5 billion initial

increase in spending

Price level

P1

AD2

Q

Real GDP (billions)


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Expansionary Fiscal Policy

the multiplier at work...

P

$5 billion initial

increase in spending

Full $20 billion

increase in

aggregate

demand

Price level

P1

AD1

AD2

Q

Real GDP (billions)


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NOTES:

Increased government

spending

The multiplier makes

GDP increase by a

multiple of the original

amount

Expansionary Fiscal Policy

the multiplier at work...

P

$5 billion initial

increase in spending

Full $20 billion

increase in

aggregate

demand

Price level

P1

AD1

AD2

Q

Real GDP (billions)


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NOTES:

Tax reductions:

The multiplier requires

a tax decrease of more

than the desired GDP

increase since the

household sector only

consumes part of its

income (MPC).

Expansionary Fiscal Policy

the multiplier at work...

P

$5 billion initial

increase in spending

Full $20 billion

increase in

aggregate

demand

Price level

P1

AD1

AD2

Q

Real GDP (billions)


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Contractionary Fiscal Policy

P

$5 billion initial

decrease in spending

Price level

AD4

P1

Q

Real GDP (billions)


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Contractionary Fiscal Policy

P

$5 billion initial

decrease in spending

Price level

AD4

P1

Q

Real GDP (billions)


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Contractionary Fiscal Policy

the multiplier at work...

P

$5 billion initial

decrease in spending

Full $20 billion

decrease in

aggregate

demand

Price level

AD4

P1

AD5

Q

Real GDP (billions)


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The Federal Budget!

Total Revenues (Taxes)

– Total Costs (Expenditures)

+ Budget Surplus

0 Balanced Budget

- Budget Deficit

2005 Deficit:

$319 Billion

Sum of all yearly deficits and surpluses is the National Debt of:

8.2 Trillion Dollars!

$28,000 per citizen


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Financing Deficits and

Disposing of Surpluses

  • Borrowing vs. New Money


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Financing Deficits and

Disposing of Surpluses

  • Borrowing vs. New Money

    • Borrowing

Government enters the money market and borrows.

Now it is competing with private business for borrowed $

UP!

Impact on Interest Rates??

This is a concept called crowding out. It may reduce the

Expansionary impact of deficit spending.


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Financing Deficits and

Disposing of Surpluses

  • Borrowing vs. New Money

    • Borrowing

    • Money Creation

Increasing the money supply will avoid crowding out but

now what will be the primary concern???

Inflation!


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Financing Deficits and

Disposing of Surpluses

  • Borrowing vs. New Money

    • Borrowing

    • Money Creation

  • Debt Retirement vs. Idle Surplus

What to do with surpluses??


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Financing Deficits and

Disposing of Surpluses

  • Borrowing vs. New Money

    • Borrowing

    • Money Creation

  • Debt Retirement vs. Idle Surplus

    • Debt Reduction

If the government decides to pay off some of its debt, it now

“floods” the money market.

Lower interest rate may spur new investment and spending - Inflation


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Financing Deficits and

Disposing of Surpluses

  • Borrowing vs. New Money

    • Borrowing

    • Money Creation

  • Debt Retirement vs. Idle Surplus

    • Debt Reduction

    • Impounding

Hold in a “Lock Box” no

Inflationary risk!


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Financing Deficits and

Disposing of Surpluses

  • Borrowing vs. New Money

    • Borrowing

    • Money Creation

  • Debt Retirement vs. Idle Surplus

    • Debt Reduction

    • Impounding

Which Policy Option? T or G?

It depends on your political affiliation!


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Deficits vs Surplus

3.5

3.0

2.5

2.0

1.5

Taxes

Surplus

T>G

Expenditures & Revenues (trillions)

Gov Spending

Deficit

G>T

9 10 11 12 13

Real domestic product, GDP (trillions of dollars)


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Nondiscretionary Fiscal Policy:

Automatic -Built-In Stabilizers

These are intended to speed the economy or slow the economy

when needed automatically.

Two Points....


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Two Points....

Net tax revenues vary directly

with GDP

The higher the GDP the higher the tax

revenues.


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Two Points....

Net tax revenues vary directly

with GDP

Transfer payments behave the opposite way as tax collections

The higher the GDP the lower the transfer payments.


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Automatic or Built-In Stabilizers

Currently existing policies – progressive tax system, welfare,

unemployment compensation, agricultural subsidies


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Automatic or Built-In Stabilizers

  • Tax Progressivity

You want higher taxes (surpluses) in expansionary times as a

check against inflation. Opposite for times of recession.


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Automatic or Built-In Stabilizers

  • Tax Progressivity

    • Progressive


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Automatic or Built-In Stabilizers

  • Tax Progressivity

    • Progressive

    • Proportional


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Automatic or Built-In Stabilizers

  • Tax Progressivity

    • Progressive

    • Proportional

    • Regressive

The more progressive the tax system, the greater the built in stability

The built in stability provided by the tax system has reduced

fluctuations, but other policies may be needed during more severe

recessions or inflationary times.


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Automatic or Built-In Stabilizers

  • Tax Progressivity

  • Actual Budget

The mere fact that the government operates has an effect on

the economy. Complications arise when the impact of the

business cycle impacts the budget. It is difficult to tell what

effect discretionary policies have versus the built in stabilizers.


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Automatic or Built-In Stabilizers

  • Tax Progressivity

  • Actual Budget

  • Cyclical Budget


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Automatic or Built-In Stabilizers

  • Tax Progressivity

  • Actual Budget

  • Cyclical Budget

    • Cyclical Deficit


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Types of Deficits

3.5

3.0

2.5

2.0

1.5

Taxes

Expenditures & Revenues (trillions)

A

A

Gov Spending

B

B

C

9 10 11 12 13

Real domestic product, GDP (trillions of dollars)

If Full Employment GDP is at 10 Trillion, AB is a planned “Structural Deficit”

If a Recession occurs and GDP falls to $9 Trillion, the Deficit is AC the sum of

AB (Structural Deficit) and BC (Cyclical Deficit).


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Automatic or Built-In Stabilizers

  • Tax Progressivity

  • Actual Budget

  • Cyclical Budget

    • Cyclical Deficit

  • Full-Employment Budget


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Automatic or Built-In Stabilizers

  • Tax Progressivity

  • Actual Budget

  • Cyclical Budget

    • Cyclical Deficit

  • Full-Employment Budget

    • Structural Budget & Deficit


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Types of Deficits

3.5

3.0

2.5

2.0

1.5

Taxes

Expenditures & Revenues (trillions)

A

A

Gov Spending

B

B

C

9 10 11 12 13

Real domestic product, GDP (trillions of dollars)

If Full Employment GDP is at 10 Trillion, AB is a planned “Structural Deficit”

If a Recession occurs and GDP falls to $9 Trillion, the Deficit is AC the sum of

AB (Structural Deficit) and BC (Cyclical Deficit).


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Nondiscretionary Fiscal Policy:

Built-In Stabilizers

Automatic or Built-In Stabilizers

  • Tax Progressivity

  • Actual Budget

  • Cyclical Budget

    • Cyclical Deficit

  • Full-Employment Budget

    • Structural Budget & Deficit

Proposed Balanced-Budget Requirement


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GLOBAL PERSPECTIVE

BUDGET DEFICIT AS A PERCENT OF GDP - 1996

0 2 4 6 8

Greece

Italy

Britain

Japan

France

Germany

Sweden

Canada

United States


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GLOBAL PERSPECTIVE

BUDGET DEFICIT AS A PERCENT OF GDP - 1996

0 2 4 6 8

Greece

Italy

Britain

Japan

France

Germany

Sweden

Canada

United States


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GLOBAL PERSPECTIVE

BUDGET DEFICITS OR SURPLUSES

AS A PERCENTAGE OF GDP, 1999

-8 -6 -4 -2 0 2 4

Denmark

Canada

Sweden

United Kingdom

United States

Germany

Italy

France

Czech Republic

Hungary

Japan

Source: Organization for Economic Development and Cooperation


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Problems, Criticisms, and Complications


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Problems, Criticisms, and Complications

  • Problems of Timing

    • Recognition Lag

    • Administrative Lag

    • Operational Lag


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Problems, Criticisms, and Complications

  • Problems of Timing

    • Recognition Lag

    • Administrative Lag

    • Operational Lag

  • Political Problems

    • Other Goals

    • State & Local Finance

    • Expansionary Bias

    • A Political Business Cycle?


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Problems, Criticisms, and Complications

  • Problems of Timing

    • Recognition Lag

    • Administrative Lag

    • Operational Lag

  • Political Problems

    • Other Goals

    • State & Local Finance

    • Expansionary Bias

    • A Political Business Cycle?

  • Crowding-Out Effect


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Problems, Criticisms, and Complications

  • Problems of Timing

    • Recognition Lag

    • Administrative Lag

    • Operational Lag

  • Political Problems

    • Other Goals

    • State & Local Finance

    • Expansionary Bias

    • A Political Business Cycle?

  • Crowding-Out Effect

Debate as to its impact.


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Aggregate Supply and Inflation

AS

P

Fiscal Policy:

Pure & Simple

Price level

P1

AD1

AD2

Q

Q1

Q2

Real GDP (billions)


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Demonstrating

the crowding-

out effect....

Aggregate Supply and Inflation

AS

P

Fiscal Policy:

Pure & Simple

Price level

P1

AD1

AD2

Q

Q1

Q2

Real GDP (billions)


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Aggregate Supply and Inflation

AS

P

Fiscal Policy:

AD does not reach

potential due to

crowding out effect

by government

Price level

P1

AD1

AD’2

AD2

Q

Q1

Q2

Real GDP (billions)


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Demonstrating

the effect of

inflation....

Aggregate Supply and Inflation

(the same graph)

Fiscal Policy:

AD does not reach

potential due to the

net export effect

AS

P

Price level

P1

AD1

AD’2

AD2

Q

Q1

Q2

Real GDP (billions)


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Aggregate Supply and Inflation

AS

P

Price level

P1

AD1

Q

Q1

Q2

Real GDP (billions)


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Aggregate Supply and Inflation

AS

P

A more realistic

AS curve in the

intermediate

range

Price level

P2

P1

AD1

AD2

Q

Q1

Q2

Real GDP (billions)


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Fiscal Policy in the Open Economy

Shocks Originating from Abroad

AD shocks which alter the effect of fiscal policy


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Fiscal Policy in the Open Economy

Shocks Originating from Abroad

Net Export Effect


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Demonstrating

the net export

effect....

Aggregate Supply and Inflation

AS

P

Fiscal Policy:

AD does not reach

potential due to

crowding out effect

by government

Price level

P1

AD1

AD’2

AD2

Q

Q1

Q2

Real GDP (billions)


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Aggregate Supply and Inflation

(the same graph)

Fiscal Policy:

AD does not reach

potential due to the

net export effect

AS

P

Price level

P1

AD1

AD’2

AD2

Q

Q1

Q2

Real GDP (billions)


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Problems in Macro

  • Not all problems are demand side problems!

  • Errors in timing and interpretation!

It’s all

BS???


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Supply-Side Fiscal Policy


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Supply-Side Fiscal Policy

Emphasis on spending restraint

and expansionary tax cuts

Three primary tools – taxes, regulation, interest rates

This will shift AS to the right.


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Supply-Side Fiscal Policy

Emphasis on spending restraint

and expansionary tax cuts

Impact upon....

  • Saving and Investment


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Supply-Side Fiscal Policy

Emphasis on spending restraint

and expansionary tax cuts

Impact upon....

  • Saving and Investment

  • Work Incentives


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Supply-Side Fiscal Policy

Emphasis on spending restraint

and expansionary tax cuts

Impact upon....

  • Saving and Investment

  • Work Incentives

  • Risk Taking


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Problems, Criticisms, and Complications

Or “It’s all BS!”

  • Incentive argument isn’t very strong

  • AS movements take longer than AD

It's all B.S ?!?


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Forecasting the Future

The leading indicators....


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Forecasting the Future

The leading indicators....

  • Average Workweek


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Forecasting the Future

The leading indicators....

  • Average Workweek

  • Initial Claims for Unemployment Insurance


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Forecasting the Future

The leading indicators....

  • Average Workweek

  • Initial Claims for Unemployment Insurance

  • New Orders for Consumer Goods


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Forecasting the Future

The leading indicators....

  • Average Workweek

  • Initial Claims for Unemployment Insurance

  • New Orders for Consumer Goods

  • Vendor Performance


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Forecasting the Future

The leading indicators....

  • Average Workweek

  • Initial Claims for Unemployment Insurance

  • New Orders for Consumer Goods

  • Vendor Performance

  • New Orders for Capital Goods


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Forecasting the Future

The leading indicators....

  • Average Workweek

  • Initial Claims for Unemployment Insurance

  • New Orders for Consumer Goods

  • Vendor Performance

  • New Orders for Capital Goods

  • Building Permits for Houses


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Forecasting the Future

The leading indicators....

  • Average Workweek

  • Initial Claims for Unemployment Insurance

  • New Orders for Consumer Goods

  • Vendor Performance

  • New Orders for Capital Goods

  • Building Permits for Houses

  • Stock Prices


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Forecasting the Future

The leading indicators....

  • Average Workweek

  • Initial Claims for Unemployment Insurance

  • New Orders for Consumer Goods

  • Vendor Performance

  • New Orders for Capital Goods

  • Building Permits for Houses

  • Stock Prices

  • Money Supply


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Forecasting the Future

The leading indicators....

  • Average Workweek

  • Initial Claims for Unemployment Insurance

  • New Orders for Consumer Goods

  • Vendor Performance

  • New Orders for Capital Goods

  • Building Permits for Houses

  • Stock Prices

  • Money Supply

  • Interest-Rate Spread


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Forecasting the Future

The leading indicators....

  • Average Workweek

  • Initial Claims for Unemployment Insurance

  • New Orders for Consumer Goods

  • Vendor Performance

  • New Orders for Capital Goods

  • Building Permits for Houses

  • Stock Prices

  • Money Supply

  • Interest-Rate Spread

  • Consumer Confidence

January 2006 grew .1%


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ANY

QUESTIONS?

Forecasting the Future

The leading indicators....

  • Average Workweek

  • Initial Claims for Unemployment Insurance

  • New Orders for Consumer Goods

  • Vendor Performance

  • New Orders for Capital Goods

  • Building Permits for Houses

  • Stock Prices

  • Money Supply

  • Interest-Rate Spread

  • Consumer Confidence


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Employment Act of 1946

Council of Economic Advisers

discretionary fiscal policy

expansionary fiscal policy

budget deficit

contractionary fiscal policy

budget surplus

built-in stabilizer

progressive tax system

proportional tax system

regressive tax system

actual budget

cyclical budget

full-employment budget

structural budget

political business cycle

crowding-out effect

net export effect

supply-side fiscal policy


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Chapter 13

Money

and

Banking

Next...


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