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Fiscal Policy Wrap-up

Fiscal Policy Wrap-up. Multiplier Effect, Policy Lag & Automatic Stabilizers. Consumption vs. Savings. In the short run => consumption (C) is more powerful than savings ↑ C => ↑ AD => ↑ R-GDP Larger MPC leads to an ↑ Multiplier In the short run , savings is leakage from GDP

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Fiscal Policy Wrap-up

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  1. Fiscal Policy Wrap-up Multiplier Effect, Policy Lag & Automatic Stabilizers

  2. Consumption vs. Savings • In the short run => consumption (C) is more powerful than savings • ↑ C => ↑ AD => ↑ R-GDP • Larger MPC leads to an ↑ Multiplier • In the short run, savings is leakagefrom GDP • overtime savings ends up in the loanable funds market (supply curve!) • turns into Investment (I) => ↑ I => ↑ AD => ↑ R-GDP

  3. GDP Leakage • Leakages - Income not passed on by consumers in the circular flow • GDP =Y = C + I + G + (X – M) • Leakage to GDP: S + T + M (S = Savings T= taxes M = Imports) • Injections to GDP: I + G + X (Investment, Gov’t, Exports) • In equilibrium:Leakage = Injections

  4. Fiscal Policy with Multiplier

  5. Net impact of Fiscal Policy • End result of fiscal policy on AD & Real GDP is difficult to forecast • Tax cuts & ↑ Gov’t Spending => push AD to the right • However, other factors => push AD to the left • The exact net impact is uncertain

  6. AD2 Opposing forces of Fiscal Policy • Multiplier Effect (helps) • Automatic Stabilizers (helps) • Policy Lag • Crowding Out (hurts) • Net Export Effect (hurts) • State & Local Tax Laws (hurts) Make fiscal policy more effective Make fiscal policy less effective These 4 opposing forces make predicting final effect of FISCAL POLICY Difficult!

  7. Helps:Automatic Stabilizers • Considered anything which automatically: • Increases deficit during recessionary periods • Increases surplus during inflationary periods During Recessions Gov’t collects less taxes Pays more unemployment & welfare benefits, food stamps, (transfer payments) During Booms Collects more taxes (progressive tax system) Pays less unemployment & welfare benefits, food stamps, (transfer payments)

  8. The CONFLICT between 2-theories: Crowding Out (hurts) Multiplier Effect (helps) When Government Spending increases or Taxes are cut: →Multiplier argues for a larger increase in R-GDP → Crowding out argues for a smaller increase in R-GDP We ASSUME the multiplieralways overpowers crowding out! (AD shifts right!)

  9. Hurts:Policy Lag & Net Export Effect • All fiscal policy have long “policy lag” • Changes in Taxes & Gov’t Spending take time to occur • Makes fiscal policy less effective • Net Export Effect hurts. • expansionary fiscal policy => leads to higher price level • Exports are now more expensive => Less exports (NX ↓) => AD ↓ Exports Expensive If Price Level ↑ NX ↓ => AD↓

  10. Hurts: State & Local Taxes • States & Local Governments are required to balance budget • California was in a budget crisis in 2010! • State Deficits can only exist in short run! • Therefore, states often raise taxes as federal government cuts taxes • This partially offsets expansionary fiscal policy

  11. Sample Free Response

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