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Unit 3: Macroeconomics. Chapter 9: An Introduction to Macroeconomics Chapter 10: The Business Cycle and Fiscal Policy Chapter 11: Money and Banking. Chapter 10: The Business Cycle and Fiscal Policy. Overview The macroeconomy and aggregate demand and supply analysis

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unit 3 macroeconomics

Unit 3: Macroeconomics

Chapter 9: An Introduction to Macroeconomics

Chapter 10: The Business Cycle and Fiscal Policy

Chapter 11: Money and Banking

chapter 10 the business cycle and fiscal policy
Chapter 10: The Business Cycle and Fiscal Policy
  • Overview
    • The macroeconomy and aggregate demand and supply analysis
    • The fluctuations of the economy as explained by the business cycle
    • How the Great Depression led to the development of the Keynesian view of government in economic intervention
    • The use of fiscal policy to influence the business cycle
    • The limitations and drawbacks of using fiscal policy to mange the economy
introduction to fiscal policy
Introduction to Fiscal Policy
  • Chapter 9 introduced critical macroeconomic indicators such as:
    • Unemployment rate
    • Inflation rate (measured as an annual percentage change in the CPI)
    • Economic growth (measured as an annual percentage change in the GDP)
  • In Chapter 1, we examined:
    • How the production possibilities curve helps to describe the choices that an economy faces
    • The potential that exists if all its resources are used to maximum efficiency
introduction to fiscal policy1
Introduction to Fiscal Policy
  • In other chapters we also explored how equilibrium is determined in the product, labour, and capital markets
  • These concepts for the foundation necessary to understand how the macroeconomy works and to examine a long-standing economic debate:
  • What is the best way to ensure the economic well-being of our society?
aggregate demand and supply
Aggregate Demand and Supply
  • In previous chapters, we looked at supply and demand as a way to explain how equilibrium is established in individual markets
  • Our explanation of equilibrium at the macro level begins with a similar analysis
aggregate demand and supply1
Aggregate Demand and Supply
  • In theory, if we could add up all consumer demand, at all various price levels, for all markets, we could determin the total demand schedule for an economy
  • Similarly, if we could add up all of what producers are willing to supply, at all various price levels, for all markets, we could determine the total supply schedule for an economy
  • When we combine all markets for individual goods and services in society, we are looking at the aggregate, or total, for the entire economy
aggregate demand
Aggregate Demand
  • Aggregate demand (AD) is the total demand for all goods and services produced in a society
  • Table 10.1 shows the total amount of goods and services purchased at each price level, as measured by the chain Fisher volume index, in a particular economy
  • Figure 10.2 is a graph of its aggregate demand curve
    • Looks very similar to the market demand curve studied in Unit 2
    • As price rises, the total real output (or aggregate quantity demanded) falls
slide8

Table 10.1: Example of total amount of goods and services purchased at each

Particular price level in an economy (aggregate demand)

aggregate demand2
Aggregate Demand
  • It should be pointed out that the aggregate demand at each of the price levels is really equivalent to the GDP that would occur at that price level
    • i.e. The sum of all consumption, investment, government spending, and net exports in the economy
  • In the last chapter, we defined this by the formula:

GDP = C + I + G + (X – M)

aggregate demand3
Aggregate Demand
  • For real economic growth to occur, the real GDP must grow
    • In other words, the aggregate quantity demanded must increase at each of the price levels
    • This means one or more of the variable in the GDP formula must increase in value
aggregate supply
Aggregate Supply
  • Aggregate supply (AS) is the total supply of all goods and services produced in a society
  • The aggregate supply curve shows the total amount of goods and services that would be supplied at each price level, as measured by the chain Fisher volume index, in an economy
  • Table 10.3 is an aggregate supply schedule for a particular economy
  • Figure 10.4 is a graph of the aggregate supply curve
slide13

Table 10.3: Example of total amount of goods and services supplied at each

Particular price level in an economy (aggregate supply)

aggregate supply2
Aggregate Supply
  • While similar in shape to the supply curve from microeconomic supply analysis, the aggregate supply curve does feature important differences
  • The first is the very elastic portion that occurs at low output levels (first part of graph)
    • At very low outputs, most of a society’s resources are sitting idle
    • Ex: When there are many unemployed workers, there is too little competition for workers among producers to force the price of wage labour higher (surpluses force prices down)
aggregate supply3
Aggregate Supply
  • Therefore, there is little increase in the average costs of production when new workers are hired and output is increased
  • Price levels would consequently stay fairly low even as output increases
  • As more output is produced, more competition occurs among producers for limited amounts of land, labour, and capital inputs
  • As these resources become scarcer, their prices go up and put upward pressure on the prices of all goods and services
aggregate supply4
Aggregate Supply
  • At higher output levels, prices tend to rise much more rapidly
  • At some point, the economy would run out of resources altogether
    • Any attempted increase in output would simply result in producers “bidding up” input prices to higher levels without actually producing any more output
aggregate supply5
Aggregate Supply
  • In theory, an economy producing that level of output is producing at a point on its production possibilities curve
    • It can’t physically produce more output without improvements in technology or the discovery of new physical inputs
equilibrium output and price level
Equilibrium Output and Price Level
  • The point at which the AD curve intersects the AS curve is the equilibrium level of price and output for the economy
equilibrium output and price level1
Equilibrium Output and Price Level
  • When the economy is at full-employment equilibrium the two curves intersect at a point on the AS curve where prices start to rise more rapidly, but the curve is not yet vertical
  • As the economy approached full employment, competition for scarce resources starts to push price levels up
  • The economy still has room for further increases in real GDP because of frictional unemployment and the possibility of increasing output beyond the full-employment level (ex: having employees work overtime)
equilibrium output and price level2
Equilibrium Output and Price Level
  • At some point, the curve would become vertical as an absolute capacity is reached
  • Full-employment equilibrium is the point at which price levels start to rise more quickly, but below the absolute capacity of the economy
equilibrium output and price level3
Equilibrium Output and Price Level
  • Two other possibilities exist for an economy
  • Below full employment equilibrium occurs when the AD curve intersects AS to the left of full-employment equilibrium
    • At this point, real GDP is lower and price levels are rising very lowly
    • The low level of output leads to higher unemployment levels and what is known as a recessionary gap
    • This situation is characterized by high unemployment, low inflation, and low GDP growth
equilibrium output and price level4
Equilibrium Output and Price Level
  • Above full employment, equilibrium occurs when the AD curve intersects AS to the right of full-employment equilibrium
    • At this point, real GDP and employment levels are both very high
    • Price levels, however, are rising very rapidly
    • This is known as an inflationary gap
    • High inflation, high employment levels, and high levels of GDP growth are characteristics of inflationary periods
changes in aggregate demand
Changes in Aggregate Demand
  • Just as the demand curve might shift in microeconomic analysis, the aggregate demand curve will shift as changes in economic activity are considered
  • Shifts in the aggregate demand curve can be attributed directly to changes in the variables that make up GDP
    • Consumption (C)
    • Investment (I)
    • Government spending (G)
    • The balance of foreign trade (X – M)
changes in aggregate demand1
Changes in Aggregate Demand

Changes in consumption

  • Consumer income can be divided into four possible uses
    • Consumption
    • Go to government through taxes
    • Be saved for future use
    • Be spent on imports
  • In terms of impact on aggregate demand (AG) we are most concerned with consumption
    • Makes up 60% of GDP
changes in aggregate demand2
Changes in Aggregate Demand
  • The amount available for consumption is whatever is left over after the other three components are considered
    • As a result, an increase in AD will occur when consumption increases
  • May be the result of either:
    • An increase in the level of income
    • A decrease in one or more of savings, taxes, and import spending
  • An increase in consumption results in a right shift in the AD curve
    • The result is an increase in the equilibirum level of prices, real GDP, and employment
  • A decrease in consumption results in a left shift in the AD curve
    • Decrease in equilibirum level of prices, real GDP, and employment
changes in aggregate demand3
Changes in Aggregate Demand

Changes in investment

  • The overall level of investment spending is related to the expectation of future profits
  • If business profits are expected to increase and the economic climate looks strong, investment will increase and the AD curve will shift to the right
  • If businesses foresee a downturn in economic profits, investment will decrease and the AD curve will shift to the left
changes in aggregate demand4
Changes in Aggregate Demand
  • These movements are also closely tied to interest rate
  • Any investment is likely to necessitate the borrowing of funds
    • If the interest rate goes up, the costs associated with the investment also go up
    • This would reduce the potential for profit
  • Increases in interest rates also tend to reduce investment spending, shifting the AD curve to the left
  • Decreases in interest rates have the opposite effect
changes in aggregate demand5
Changes in Aggregate Demand

Changes in government spending

  • If a government increases its spending or transfer payments, the AD curve will shift right
  • If a government reduces spending, the AD curve will shift left
  • These changes are at the heart of fiscal policy and will be discussed later in the chapter
changes in aggregate demand6
Changes in Aggregate Demand

Changes in export demand (foreign trade)

  • There are three major factors influencing demand for Canadian-produced exports:
    • The domestic rate of inflation
    • The relative levels of income in other countries
    • The value of the Canadian dollar
changes in aggregate demand7
Changes in Aggregate Demand
  • Inflation (or a general increase in the level of prices) affects only domestic and not foreign goods and services
    • A general increase in the price of Canadian goods and services makes them more expensive than foreign-made goods and services
  • A rapid rise in inflation will reduce export demand
    • Foreign consumers will buy fewer Canadian products
  • A decline in the rate of inflation will make Canadian goods less expensive and increase export demand
changes in aggregate demand8
Changes in Aggregate Demand
  • A similar effect will occur as the income levels rise for consumers in countries that are trading partners
  • Their demand for goods will increase and Canadian exports to these countries will rise
  • The opposite will occur for a decrease in the level of foreign incomes
changes in aggregate demand9
Changes in Aggregate Demand
  • Increases in the value of the Canadian dollar will increase the cost of Canadian products for foreign consumers
    • An increase in the value of the Canadian dollar can translate into a decrease in AD because we are selling fewer exports
  • Decreases in the value of the collar make the relative price of Canadian products cheaper for foreign consumers, thus increasing AD
changes in aggregate supply
Changes in Aggregate Supply
  • Just as events in the marketplace can shift the AD curve, the AS curve is subject to shifts as well
  • There are three reasons why the AS curve might shift:
    • A change in the price of any of the basic inputs (land labour, and capital)
    • A change in the amount of basic inputs available
    • A change in the efficiency of the production process
changes in aggregate supply1
Changes in Aggregate Supply

Changes in price of inputs

  • If the prices for land, labour, or capital increase, firms will produce less at each price level
    • The AS curve will shift upward and to the left at all points to the left of its perfectly inelastic section
    • The perfectly inelastic section will not move because, while prices are higher, the same amount of inputs are available
      • Therefore, the maximum real GDP possible is the same as it was before the price increases
  • Decreases in the price of inputs will shift the AS curve downward
changes in aggregate supply2
Changes in Aggregate Supply

Changes in the amount of inputs available

  • If new resources are discovered, more capital goods are made available, or the workspace grows, there are more inputs available for use
  • Just as these changes would shift the production possibilities curve outward, they would increase the maximum capacity of the economy
  • The availability of more resources also reduced competition for them, pushing down the costs of basic inputs
changes in aggregate supply3
Changes in Aggregate Supply
  • The effect of the AS curve is:
    • To shift the relatively elastic, horizontal portion downward, reflecting decreases input prices
    • To shift the vertical portion to the right, reflecting the increased capacity of the economy
changes in aggregate supply4
Changes in Aggregate Supply

Changes in efficiency

  • Improvements in technology make the workforce more productive
    • As the workforce becomes more efficient, it can produce more output with the same resources
  • The resulting effect on the AS curve is the same as increasing the amount of resources available
  • The curve shits downward, with the vertical portion moving farther to the right
the business cycle aggregate supply and demand
The Business Cycle & Aggregate Supply and Demand
  • A business cycle covers periods of alternating economic growth and recession (or negative economic growth) as measured by changes in the real GDP
    • In other words, business cycles are the ups and downs of the economy
  • The duration in time of a business cycle and its size (in loss or gain of real GDP) vary from one cycle to the next
the business cycle aggregate supply and demand1
The Business Cycle & Aggregate Supply and Demand
  • A business cycle occurs because of the fluctuations that economies experience over time
    • Result from changes in economic growth and patterns of consumption
    • In the previous section, we explained these changes as shifts of the AD and AS curves
the business cycle aggregate supply and demand2
The Business Cycle & Aggregate Supply and Demand
  • Business cycles are the heart of macroeconomics
    • Economists try to determine how well the economy is doing and where it is heading
  • Forecasting the coming economic climate allows economists to advise political and business leaders on how to deal with possible future economic events
  • When the economy is heading in an undesirable direction, economists can advise a nation’s leaders to apply fiscal or monetary policy tools to try to change the course of the economy
the dynamics of the business cycle
The Dynamics of the Business Cycle
  • The causes of these fluctuations in economic activity are varied
  • The cyclical nature of the marketplace is dynamic
    • It’s not possible to detail all the reasons for cyclical fluctuations in the economy
  • We will now go through how a simple macroeconomic model works
the dynamics of the business cycle1
The Dynamics of the Business Cycle
  • An expansion period begins when consumer spending increases and production increases
    • Represented by an upward trend in the business cycle
  • Let’s assume the Canadian economy is on an upswing
    • Unemployment is declining
    • Business activity is increasing
    • Increased production
  • Increased production leads to new workers being hired
    • New employment leads to a general rise in consumer incomes
    • Generates increased levels of consumption
the dynamics of the business cycle2
The Dynamics of the Business Cycle
  • Consumer psychology that is influenced by positive economic news can also contribute to increased spending
  • Increased spending translates into an increase in aggregate demand for goods and services
    • This leads to an higher levels of output and employment as well as higher prices
  • This higher demand leads to increased production, more workers being hired, and the cycle starts again
    • This prosperity cycle is the result of aggregate demand feeding itself
the dynamics of the business cycle4
The Dynamics of the Business Cycle
  • It looks like, as long as resources are available, this trend of greater and greater economic expansion should continue
  • However, at some point the economy will peak, and then the trend will begin to reverse
the dynamics of the business cycle5
The Dynamics of the Business Cycle
  • The reasons for the turn-around at the peak of a business cycle are varied
  • Consumers may exhaust the purchasing patterns that pushed up aggregate demand
    • Many of the expensive durable goods (ex: cars, appliances, new homes) that drive a booming economy don’t need to be replaced very often
    • Demand begins to decrease when many consumers’ wants are satisfied
the dynamics of the business cycle6
The Dynamics of the Business Cycle
  • Sometimes the turnaround is linked to an event
    • Ex: the stock market crash of 28 Oct 1929
    • Combined with restrictive trade policies, the dependence of the resource, and reduced government and investment spending, the result was a huge drop in aggregate demand
the dynamics of the business cycle7
The Dynamics of the Business Cycle
  • The increase in producers competing for capital funds to support business expansion puts upward pressure on interest rates
    • As interest rates increase, consumers are less likely to buy goods for which they need to borrow money
      • The durable goods that make up 10% of GDP
    • If demand shifts too far to the right, it will exceed the economy’s capacity to produce
the dynamics of the business cycle8
The Dynamics of the Business Cycle
  • If demand shifts too far to the right, it will exceed the economy’s capacity to produce
    • This will cause more severe inflation
    • As prices rise, higher inflation levels have the effect of reducing the real income of consumers
    • Demand begins to decline
the dynamics of the business cycle9
The Dynamics of the Business Cycle
  • Together, these factors have the effect of reversing the direction of shift in the aggregate demand curve
    • Instead of moving to the right, as it did while the economy was expanding, it now begins to shift to the left
    • This trend is reflected in the recessionary part of the business cycle, which slopes downward
the dynamics of the business cycle10
The Dynamics of the Business Cycle
  • The prosperity cycle begins to reverse as we move past the peak of the business cycle
  • Reduced demand for domestic goods leads to firms being overstocked with goods
    • An increase in good surplus indicates to firms that they should cut back production
  • Production cutbacks lead to worker layoffs, which lead to lower incomes
  • Decreased incomes lead to a decrease in consumer demand for goods and services, shifting aggregate demand to the left
the dynamics of the business cycle11
The Dynamics of the Business Cycle
  • If this occurs, the revenues of firms will tend to decline
  • Some firms will be forced to cut back production in order to control costs, others may lay off workers, and still other firms that can’t reduce their costs may go out of business
  • When this type of downward spiral in economic activity occurs, it is called a recessionary trend
the dynamics of the business cycle12
The Dynamics of the Business Cycle
  • Officially, a recession occurs when real GDP growth is negative, or declines for two consecutive quarters (three-month periods)
  • The recessionary, or contractionary, part of the business cycle is characterized by:
    • Increasing unemployment
    • Low (or negative) levels of real GDP growth
    • Low levels of inflation or even falling prices (deflation)
the dynamics of the business cycle13
The Dynamics of the Business Cycle
  • The recessionary period is influenced heavily by consumer psychology
  • Media reports of layoffs (and the threat of more layoffs) cause people who still have jobs to decrease their consumption spending
  • Sometimes people begin to save in order to provide a “cushion” in case they are laid off
  • Others may cut back on the purchase of “big ticket” durable goods, fearing to increase their debt load when wage increases are unlikely and loss of income is possible
the dynamics of the business cycle14
The Dynamics of the Business Cycle
  • These changes in the level of consumption spending make the recessionary period worse
    • They tend to pull aggregate demand farther to the left
  • If the recessionary period becomes prolonged, with very high unemployment and very low output levels, it is known as a depression
the dynamics of the business cycle15
The Dynamics of the Business Cycle
  • At some point, events will occur that will stop the downturn in economic activity and will generate increases in consumer spending
    • Prices may fall to a point where consumers start to spend again, and the upward movement of the business cycle resumes
  • Consumers can postpone the purchase of some items only for a certain length of time
    • A new car or fridge is bought when it is no longer worthwhile to repair it
    • Clothes wear out
  • As these purchases occur, inventories of firms begin to dwindle and firms increase production again
the dynamics of the business cycle16
The Dynamics of the Business Cycle
  • While these regular fluctuations of economic activity occur over varying durations and to varying degrees, over time the level of business activity in an economy tends to increase steadily
leakages and injections
Leakages and Injections
  • Another explanation of the business cycle centers on the money payments that flow through the economy
  • This circular flow of income sees the GDP as a total of all money payments in the economy
    • Businesses hire individuals from households to work for them and pay them a wage in exchange
    • Businesses also pay individuals money through interest payments on the capital that they borrow for expansion
    • Individuals, in turn, spend the money that they earn on goods and service that the businesses produce
    • This simplified circular flow model can be seen highlighted in green in Figure 10.11
leakages and injections2
Leakages and Injections
  • Leakages are any uses of income that cause money to be taken out of the income-expenditure stream of the economy
  • The income generated by production is subject to three leakages as it is returning to generate more production:
    • Taxes (T)
    • Savings (S)
    • Imports (M)
  • The amount of each of these leakages will rise and fall with the level of production
leakages and injections3
Leakages and Injections
  • “Leaked” money often ends up getting re-spent in the economy
    • The problem is where and how
  • Governments might spend the money they take in taxes
    • But they might also spend more or less than the amount they actually receive in tax revenues
  • Other countries’ export earnings might be used to purchase imports
    • But there is no guarantee that trade will be balanced, or that they will purchase Canadian goods
  • The money we save might be borrowed for business investment inside Canada
    • But then again, it might not
leakages and injections4
Leakages and Injections
  • An injection is any expenditure that causes money to be put into the income-expenditure stream
  • The three major injections into the economy are:
    • Government spending (G)
    • Investment spending (I)
    • Exports (X)
  • Consumption is NOT an injection
    • Consumer incomes are disposed of through consumption, taxes, savings, and import spending
    • If leakages are going up, they reduce consumption spending
    • If leakages are going down, they help increase such spending
leakages and injections5
Leakages and Injections
  • The relationships between the three leakages and three injections determine whether the overall demand is growing or shrinking
  • If leakages > injections = aggregate demand will shrink
    • But as production falls, consumers will pay fewer taxes, save less, and buy fewer imported goods, causing leakages to fall
  • When the leakages falls to the level of the injections, the economy generally stops shrinking
    • The economy is in equilibirum
leakages and injections6
Leakages and Injections
  • The equilibrium may be:
    • Below full employment (a recessionary gap)
    • At full employment
    • Above full employment (a inflationary gap)
leakages and injections7
Leakages and Injections
  • If injections > leakages = aggregate demand will grow
    • But as production and incomes rise, so do taxes, savings and imports, causing leakages to grow
  • When leakages are as large as injections, growth will stop
    • Once again, this may be at, above, or below full-employment equilibrium
leakages and injections8
Leakages and Injections
  • Some have compared this model to filling a bathtub
    • If the amount of water coming in (injection) is greater than the amount going down the drain (leakage), the bathtub fills up (the GDP gets bigger)
    • If the amount of water coming in is less than the amount leaking out, the bathtub empties (the GDP shrinks)
    • If the water coming in and the water leaking out are equal, the amount of water in the tub remains the same (equilibrium)
leakages and injections9
Leakages and Injections
  • This model can be expressed as a formula (see board)
fiscal policy
Fiscal Policy
  • Most mixed economies go through upheavals caused by the ups and downs of the business cycle
  • Should we as a society do anything about these economic booms and recessions, or should we let the market make its own adjustments?
fiscal policy1
Fiscal Policy
  • John Maynard Keynes believed that the business cycle should be managed
    • Advocated government intervention
  • Governments intervene in the economy through the use of stabilization policies
    • One way that a government can intervene is through applying the tools of fiscal policy
keynes s ideas
Keynes’s Ideas
  • By examining the relationships between demand and income, Keynes was able to explain the Great Depression in a way that classical economists could not
  • A collapse of investment spending brought consumer spending down with it
    • With low levels of consumer spending, it was unlikely investment spending would recover
    • Ex: An auto company that is running at only 50% capacity has no reason to build new factories
keynes s ideas1
Keynes’s Ideas
  • But Keynes’s ideas went far beyond simply explaining depressions and recessions
  • If government policy could affect the sizes of leakages (taxes, savings, and imports) and injections (investment spending, government spending, and exports), aggregate demand could be managed
keynes s ideas2
Keynes’s Ideas
  • Aggregate demand could be purposely increased in a recession or depression and purposely reduced when excessive demand was leading to inflation
  • This was a revolutionary way of thinking that would influence economic thought for the rest of the 20th century
    • Ex: the stock market fell in 1987 much more rapidly than it did in 1929, but the rate of economic growth was not greatly affected, partly because governments applied Keynesian theory
keynes s ideas3
Keynes’s Ideas
  • Government policies to mange aggregate demand fall into three areas
    • Fiscal policy
    • Monetary policy
    • Trade policy
the basics of fiscal policy
The Basics of Fiscal Policy
  • Fiscal policy is the use by a government of its powers of expenditure, taxation, and borrowing to alter the size of the circular flow of income in the economy so as to bring about:
    • Greater consumer demand
    • More employment
    • Inflationary restraint
    • Other economic goals
the basics of fiscal policy1
The Basics of Fiscal Policy
  • If private spending is too small…
    • Government can increase aggregate demand by increasing its own spending or by encouraging private spending
  • If private spending is too large…
    • Government can reduce aggregate demand by decreasing its own spending or by discouraging private spending
  • When the government takes deliberate actions through legislation to alter spending or taxation policies in order to influence the level of spending and employment, it is called discretionary fiscal policy
expansionary policy
Expansionary Policy
  • When the economy is in a recession:
    • Aggregate demand is low
    • Unemployment is high
    • There is little, or negative, growth in output
  • The government may wish to increase aggregate demand by using an expansionary fiscal policy
    • This would entail a tax cut, an increase in government spending, or both, to stimulate economic growth and lower unemployment rates
expansionary policy1
Expansionary Policy
  • If the government cut taxes, it would increase the disposable income of consumers
    • Assuming the consumers didn’t save this increase or spend it on imports, they would increase the aggregate demand in the economy through consumption
  • The shift in aggregate demand would lead to both an increase in employment and an increase in the growth of GDP as the equilibrium moved closer to full-employment output
    • As long as the equilibrium remained below full-employment equilibrium, there would be little increase in the general level of prices
expansionary policy2
Expansionary Policy
  • The same stimulation of aggregate demand would occur (but for different reasons) if the government used increased government spending as their expansionary policy
  • Government spending is one of the four components of GDP, and therefore, of aggregate demand
  • An increase in government spending would directly shift the aggregate demand curve to the right through the G portion of the GDP equation
expansionary policy3
Expansionary Policy
  • The influence of government spending on aggregate demand is direct
  • A reduction in taxes requires consumers to follow through by spending their increase in income, which they may choose not to do
    • If they choose not to increase consumption, aggregate demand will not increase
  • Because an increase in government spending acts directly on aggregate demand, there is no risk that the policy will not have the desired effect
expansionary policy4
Expansionary Policy
  • If the government wanted to maximize the effect of its expansionary policy, it could use both a tax cut and a spending increase in order to stimulate aggregate demand as much as possible
contractionary policy
Contractionary Policy
  • When the economy is suffering from inflation:
    • Aggregate demand is too high
    • Employment is high
    • There is high growth in output
  • The government may wish to decrease aggregate demand by using contractionary fiscal policy
    • This would entail a tax increase, a decrease in government spending, or both to reduce upward pressure on prices
contractionary policy1
Contractionary Policy
  • If the government increased taxes…
    • This would effectively decrease the disposable income of consumers
    • In turn, this would decrease the aggregate demand in the economy through the C (consumption) portion of the GDP equation
  • The shift in aggregate demand would lead to a decrease in the inflation rate
  • However, the decrease would also have the trade-off of lowering GDP and employment levels as equilibrium moved back toward full-employment equilibrium
contractionary policy2
Contractionary Policy
  • The government could also address the problem by altering its spending
    • A reduction in government spending would reduce aggregate demand
  • As in expansionary policy, using both would increase the overall effect
  • The overall goal of expansionary and contractionary fiscal policy (known as fiscal stabilization policy) is to smooth out the ups and downs of the business cycle
tools of fiscal policy
Tools of Fiscal Policy

Changes in spending

  • The government can stimulate the economy by increasing general spending in all areas of its programs
    • Health and welfare
    • Culture
    • Education
    • Etc.
tools of fiscal policy1
Tools of Fiscal Policy
  • It can also undertake infrastructure programs
    • Infrastructure is the underlying economic foundation of goods and services that allows a society to operate
  • These programs might include building:
    • Roads
    • Hospitals
    • Schools
    • Communications systems (Ex: laying fiber-optic cable)
  • The added advantage of that they add to the stock of capital goods and
    • Promote the outward shift of the production possibilities curve
tools of fiscal policy2
Tools of Fiscal Policy

Changes in taxation

  • To restrain or stimulate economic activity, the government can change the amount of tax it collects
  • This can be accomplished through a number of options:
    • Raise or lower personal and corporate income taxes and/or sales and excise taxes
    • Alter tax exemptions or tax credits
    • Provide special tax incentives for investments, such as larger capital cost allowances on new buildings and equipment
      • This would influence aggregate demand through the I portion of the GDP equation
tools of fiscal policy3
Tools of Fiscal Policy

Automatic stabilizers

  • We have looked at discretionary fiscal policies, which require the government to make specific decisions to implements necessary changes to its spending and taxation policies
  • Automatic stabilizers already exist and are acting on aggregate demand before a recession or inflationary trend takes hold
    • Mechanisms built into the economy that automatically increase or decrease aggregate demand when needed
    • Require absolutely no direct actions or legislation by policy markers because they are already legislated
tools of fiscal policy4
Tools of Fiscal Policy
  • Employment insurance and welfare are automatic stabilizers
  • During periods of economic downturn, Employment Insurance payments increase as more people become unemployed
    • Since unemployment increases during recessionary periods, Employment Insurance payments help to maintain incomes and, thus, the consumption portion of GDP
  • If the recessionary period is prolonged, the number of people on welfare rolls also increases
    • The purpose of welfare is to ensure people a level of income so that they can survive
    • But these payments also help to increase consumption
    • This either slows the leftward shift of the AD curve or begin to increase AD
tools of fiscal policy5
Tools of Fiscal Policy
  • Another common type of automatic stabilizer is tax rates that vary with levels of income
  • A progressive tax acts as a stabilizer in that:
    • It rises as incomes rise
    • It has the effect of increasing a leakage as incomes grow
  • At lower levels of income, the tax rate may be 20%
    • But as a person’s income rises, it may start to be taxed at 30%
  • These increases in tax slow down the increase in consumption
    • Stop the aggregate demand curve from shifting too quickly to the right, which could lead to inflation
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Tools of Fiscal Policy
  • It is important to note that these is also a discretionary element to automatic stabilizers
  • At any time, the government may make a decision to change the level of spending or taxation
  • When these changes are made, they are considered discretionary fiscal measures
government budget options
Government Budget Options
  • Governments in Canada usually announce their changes in revenue and spending plans in the spring by outlining the coming year’s budget
  • In establishing their budget, the government can end up in one of three situations:
government budget options1
Government Budget Options
  • Deficit budget
    • Occurs when the government spends more than it collects in tax revenue
    • It must borrow they money to cover the shortfall
  • Surplus budget
    • Occurs when the government collects more in tax revenue than it spends
    • Consequently, it has money left over
  • Balanced budget
    • Results when the government spends an amount equal to what it has collected in tax revenue
government budget options2
Government Budget Options
  • The debt is the total amount that a government owes on money it has borrowed to fund deficit budgets
  • Ex: A government spends $150 billion in year 1 but takes in only $130 billion in revenues
    • It has a shortfall, or budget deficit, of $20 billion
    • It must borrow $20 billion
    • In year 2, the government spends $150 billion (including interest on the debt from Year 1) and takes in $140 billion in revenues
    • It has a deficit of $10 billion and an accumulated debt of $30 billion ($20 billion from year 1 and $10 billion from year 2)
drawbacks and limitations of fiscal policy
Drawbacks and Limitations of Fiscal Policy
  • The time lags that exist in utilizing fiscal policy are significant
    • Recognition lag = The time the government takes to recognize a problem in the economy
    • Decision lag = The time required for the government to determine the most appropriate policy
    • Implementation lag = Once the decision has been made, various government departments have to figure out just how to implement the new directives regarding spending and taxation
    • Impact lag = Once the policy is in place, time is required before its full effects can be felt through the multiplier effect
drawbacks and limitations of fiscal policy1
Drawbacks and Limitations of Fiscal Policy
  • The government might have difficulty changing spending and taxation policies
    • Raising taxes is often unpopular
    • Cutting spending may be impossible if there are long-term contracts or the programs are very popular with citizens
    • The timing of government elections may also influence spending and taxation policies
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Drawbacks and Limitations of Fiscal Policy
  • Conflict between the various levels of government regarding the appropriate fiscal policy might limit effectiveness
    • If the federal government is reducing spending and increasing taxes in an effort to slow down economic growth and a powerful provincial government is increasing spending and cutting taxes in order to gain political support, the two policies may offset each other
drawbacks and limitations of fiscal policy3
Drawbacks and Limitations of Fiscal Policy
  • Regional variations may exist that interfere with the implementation of fiscal policy
    • If part of the country is doing well while another region is suffering from a slowdown, what policy should be used?
    • An expansionary policy would likely cause inflation in the region doing well, yet a contradictory policy would make the recession worse in the part of the country suffering a slowdown
drawbacks and limitations of fiscal policy4
Drawbacks and Limitations of Fiscal Policy
  • The size of the debt can also limit the use of fiscal policy as an effective tool
    • In recent years, the federal debt in Canada has grown so large that there is much political pressure not to increase it further
    • If expansionary policy were desired, the government would have little room to increase spending and cut taxes without increasing the debt
    • The federal government and most provincial governments made deficit reduction the primary focus of fiscal policy during the late 1990s
drawbacks and limitations of fiscal policy5
Drawbacks and Limitations of Fiscal Policy
  • Some economists believe that a crowding out of private investment occurs when the government competes with the private sector to borrow funds to finance the debt
    • Argue that this policy drives up interest rates and reduces the amount available for private investment
    • As a result, investment in capital goods decreases and the rate of economic growth slows