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Fiscal Policy. By: Johnny, Faisal, Nish, Bianca, & Kalam . Welcome to Day 1!. Fiscal Policy . The Goal of Stabilization: Influence the amount spent and produced in an economy Meant to meet potential output To have less movements in the business cycle. Use of Fiscal Policy:

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Fiscal Policy

By: Johnny, Faisal, Nish, Bianca, & Kalam


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Welcome to Day 1!

Fiscal Policy

The Goal of Stabilization:

  • Influence the amount spent and produced in an economy

  • Meant to meet potential output

  • To have less movements in the business cycle


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Use of Fiscal Policy:

  • Two Policies : Expansionary Policies and Contractionary Policiesare used to control output

  • Injections and withdrawals helps or takes away from the circular flow

  • Governments effects aggregate demand and aggregate supply

  • Government purchases have immediate effect on aggregate demand while tax cuts are less immediate

    Automatic Stabilizers:

  • Discretionary policies are intentional government intervention in the economy

  • Automatic stabilizers are built-in measures that lessen the effects of the business cycle

  • Examples are taxation and transfer payment programs


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  • Introduction to The Spending Multiplier:

  • The impact policies have on the economy is like a ripple effect

  • Assuming that price is constant, multiplier effect is the magnified impact of a spending change on aggregate demand

  • Marginal Propensity to Consume answers the question: “If income increases this amount, how much extra will be spent on domestic goods and services?”

  • MPC = change in consumption on domestic items

  • change in income

  • Marginal Propensity to Withdraw is the effect on withdrawals of a change in income

  • MPW = change in total withdraws

  • change in income


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END OF DAY 1!

Have a fabulous day



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The Multiplier Effect

  • Government decision-makers estimate the impact of their policies on the economy by using the multiplier effect

  • Multiplier Effect: the magnified impact of a spending change on aggregate demand

    500 250

    Spender A ------> Spender B ------> Spender C ------>

    Increase in Income: (1000) (500) (250)


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  • Marginal Propensity to Consume (MPC): the effect on domestic consumption of a change in income

  • MPC answers the question: “If income increases this amount, how much extra will be spent on domestic goods and services?”

    MPC= change in consumption on domestic items

    ------------------------------------------------------

    change in income

  • Marginal Propensity to Withdraw (MPW): the effect on withdrawals of a change in income

  • 3 types of withdrawals: savings, taxes, and imports

    MPW= change in total withdrawals

    ------------------------------------

    change in income

  • 1.0 = MPC + MPW


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Multiplier Effect in Detail

1st Round: Government pays Spender A $1000 Real Output: 1000

(not only income, but also economy’s output)

2nd Round: MPC is 0.5 (500/1000) MPW is also (500/1000)

MPC=$500 MPW=$500 Real Output: 1500

3rd Round: Spender B

MPC=$250 MPW=$250 Real Output: 1750

Later Spending Rounds:

Total MPC Total MPW Real Output: 2000 for later spending rounds for later spending rounds

=$250 =$250

  • Expansion continues until withdrawals equal initial discretionary injection

    • Injections and withdrawals are both $1000 higher than they were before government purchases were increased


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The Spending Multiplier

Spending multiplier is the value by which the initial spending change is multiplied to give the total change in output

Total Change = initial change X spending

in spending in spending multiplier

recall that the economy’s total output expands until new withdrawals equal the initial government purchase

There is an inverse relationship between MPW and the spending multiplier ( if MPW is ½, then the multiplier equals 2) therefore spending multiplier is the reciprocal of the MPW


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  • The multiplier effect can also be applied to tax cuts

  • Lower taxes allow others to have more funds to spend and invest and therefore in this case the spending multiplier is multiplied with the initial spending from the tax cut

  • Increases the total output and shifts aggregate demand curve

  • Tax adjustment has a small initial effect on spending

  • Since aggregate supply curve gets steeper as it reaches the potential output level, an increase in equilibrium makes the price level rise proportionally more than output


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Benefits of Fiscal Policy total output falls; price will fall proportionally more than output

  • Two benefits as a stabilization tool: its regional focus, and the direct impact it has on spending

  • Regional Focus:

    • Parts of Canada may be more affected than others by the business cycle

    • Discretionary fiscal policy can focus on particular regions where, for example, unemployment rates are the highest or inflation is at its worst

    • Automatic stabilizers have the greatest effect in regions that need them the most

  • Impact on Spending:

    • Fiscal policy has a more straightforward impact when altering government purchases than monetary policy, since the government itself initiates the change


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Drawbacks of Fiscal Policy total output falls; price will fall proportionally more than output

  • Delays:

    • Recognition Lag – the amount of time it takes policy-makers to realize that a policy is needed

    • Decision Lag – the amount of time needed to formulate and implement an appropriate policy

    • Impact Lag – the amount of time between a policy’s implementation and its having an effect on the economy

  • Political Visibility:

    • Voters are likely to respond more favourably to increases in government purchases and cuts in taxes

  • Public Debt:

    • Public Debt - the total amount owed by the federal government as a result of its past borrowing

    • Public Debt Charges – are the amounts paid out each year by the federal government to cover the interest charges on its public debt


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End of Day 2 total output falls; price will fall proportionally more than output


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Day 3: Impact of Fiscal Policy total output falls; price will fall proportionally more than output


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Impact of Fiscal Policy total output falls; price will fall proportionally more than output

  • Balanced budget is the situation where a government’s expenditure and revenues are equal

  • A budget surplus is when a government’s revenues exceed expenditures

  • A budget deficit is when a government’s expenditure exceeds revenues

  • Size of a government’s surplus or deficit in relation to the economy’s overall GDP gives clues to what type of discretionary fiscal policy in operation, as well as the automatic stabilizers


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Budget Surpluses and Deficits total output falls; price will fall proportionally more than output

  • Rarely does budget surpluses relate to discretionary fiscal policy. (Example of such would be the government deciding to suppress the inflationary effects of an economic boom by raising income taxes and cutting defense spending

  • Budget surpluses are more likely because of built in factors (rising tax revenues might outweigh transfer payment can show a surplus during economic booms)

  • Budget deficits may indicate active expansionary policies that increase government expenditures and reduce revenues

  • Budget deficits occur often as a result of automatic stabilizers (example: les jobs and spending during a recession leads to rising Unemployment Insurance and sagging income tax revenues)


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Fiscal Policy Guidelines total output falls; price will fall proportionally more than output

  • 3 principles that guide government fiscal policy:

    1) Annually balanced budgets

    2) Cyclically balanced budgets

    3) Functional finance

  • Annually balanced budget is the principle that government revenues and expenditures should balanced each year

  • Critics of fiscal policy say annually balanced budget are not necessary for the society and state it as faulty reasoning

  • Cyclically balanced budget is the principle that government revenues and expenditures should balanced over the course of one business cycle


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Recent Fiscal Policy total output falls; price will fall proportionally more than output

  • Government revenues and expenditures don’t need to balance every year but over one business cycle

  • Function finance is the principle that government budgets should be geared to the yearly needs of the economy

  • Defenders of functional finance are those who believe fiscal policy is a powerful stabilization took

  • The choice of fiscal policy guideline depends on the government’s belief in fiscal policy as an effective took for stabilizing the economy

  • 1970s and 1980s Canada believed in functional finance but recently has made unsuccessful attempts to move toward cyclically balanced budgets

  • Canada’s change of view came from constant budget deficits and its impact on the economy as a whole


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  • Government deficits were highest during recessions during the early 1980s and early 1990s

  • Tax revenues fell with slumping incomes during that time as a result of the automatic stabilizers

  • Discretionary expansionary policy also contributed since federal government increased purchases of goods and services to counteract the effects of sagging outputs and incomes

  • Canada experienced a period of economic growth, noticeably during 1988 where unemployment was under 8%, the economy was at or above potential output but still budgets didn’t show a surplus

  • 1990s downturn caused a concern over increased public debt and lowered confidence in discretionary fiscal policies to counteract a recession


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End of Day 3 the early 1980s and early 1990s