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Fiscal Policy Key Concepts Summary ©2005 South-Western College Publishing What does this chapter cover? You will study demand-side and supply-side fiscal policies. What is a discretionary fiscal policy?

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fiscal policy
Fiscal Policy
  • Key Concepts
  • Summary

©2005 South-Western College Publishing

what does this chapter cover
What does this chapter cover?

You will study demand-side and supply-side fiscal policies.

what is a discretionary fiscal policy
What is a discretionary fiscal policy?

The deliberate use of changes in government spending or taxes to alter aggregate demand and stabilize the economy

what are examples of expansionary fiscal policy
What are examples of expansionary fiscal policy?
  • Increase government spending
  • Decrease taxes
  • increase government spending and taxes equally
what are examples of contractionary fiscal policy
What are examples of contractionary fiscal policy?
  • Decrease government spending
  • Increase taxes
  • Decrease government spending and taxes equally
slide6

Government Spending to Combat a Recession

AS

E2

155

155

Price Level

E1

X

150

AD2

AD1

full employment

Real GDP

0

$6

$6.1

$6.2

slide7

Increase in the price level and the real GDP

Increase in the aggregate demand curve

Increase in government spending

how much will real gdp increase by with an increase in government spending of 50 bil
How much will real GDP increase by with an increase in government spending of $50 bil?

4 x $50 bil = $200 bil

what is the tax multiplier
What is thetax multiplier?

The change in aggregate demand (total spending) resulting from an initial change in taxes

what happens when government cuts taxes by 50 bil
What happens when government cuts taxes by $50 bil?

The multiplier process is less because initial spending increases only by $38 bil instead of $50 bil

can we assume that the mpc will remain fixed
Can we assume that the MPC will remain fixed?

No, it can change from one time period to another

can fiscal policy be used to combat inflation
Can fiscal policy be used to combat inflation?

Yes, this would happen when the economy is operating in the Classical or Intermediate range of the aggregate supply curve

slide17

Using Fiscal Policy to Combat Inflation

AS

Price Level

E1

160

155

AD1

E2

full employment

AD2

0

$6

$6.1

Real GDP

slide18

Decrease in the price level

Decrease in the aggregate demand curve

Decrease in government spending

what is the balanced budget multiplier
What is the balanced budget multiplier?

An equal change in government spending and taxes, which changes aggregate demand by the amount of the change in government spending

what is an automatic stabilizer
What is anautomatic stabilizer?

Federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction

what are examples of automatic stabilizers
What are examples of automatic stabilizers?
  • Transfer payments
  • Unemployment compensation
  • Welfare
what is a budget surplus
What is abudget surplus?

A budget in which government revenues exceed government expenditures in a given time period

what is a budget deficit
What is abudget deficit?

A budget in which government expenditures exceed government revenues in a given time period

slide25

Automatic Stabilizers

$2,500

T

$1,000

Budget deficit

Budget surplus

$750

Government Spending and Taxes

$500

G

$250

Real GDP

$4

$6

$8

slide26

Budget offsets inflation

Tax collections fall and government transfer payments rise

Increase in real GDP

slide27

Budget offsets recession

Tax collections fall and government transfer payments rise

Decrease in real GDP

what is supply side fiscal policy
What is supply-side fiscal policy?

A fiscal policy that emphasizes government policies that increase aggregate supply

what is the purpose of supply side fiscal policies
What is the purpose of supply-side fiscal policies?

To achieve long-run growth in real output, full employment, and a lower price level

slide30

Demand-Side Fiscal Policy

AS

250

Price Level

E2

full employment

200

E1

150

AD2

100

AD1

Real GDP

6

0

2

4

8

10

12

slide31

Increase in the aggregate demand curve

Increase in government spending; decrease in net taxes

slide32

Supply-Side Fiscal Policy

AS1

250

Price Level

AS2

200

E1

150

full employment

E2

100

AD

Real GDP

6

0

2

4

8

10

12

slide33

Increase in the aggregate supply curve

Decrease in resource prices; technological advances; subsidies; decrease in regulations

slide34

Supply-Side Policies Affect Labor Markets

Before tax-cut labor supply

After tax-cut labor supply

E1

W1

Wage rate

E2

W2

Labor Demand

Q of Labor

0

L1

L2

will an increase in taxes lead to higher government revenues
Will an increase in taxes lead to higher government revenues?

That depends on where the economy is on the Laffer Curve

what is the laffer curve
What is theLaffer Curve?

Puts forth the idea that increasing taxes from zero will increase tax revenues up to a certain point

what happens beyond a certain point
What happens beyond a certain point?

Tax revenues begin to decline as the economic pie begins to shrink

why does the economic pie begin to shrink
Why does the economic pie begin to shrink?

Workers have less incentive to work and investors have less of an incentive to invest

slide39

The Laffer Curve

B

Rmax

C

Federal Tax Revenue

R

D

A

Federal Tax Rate

0

Tmax

T

100%

slide41
What is a discretionary fiscal policy?
  • What are examples of expansionary fiscal policy?
  • What are examples of contractionary fiscal policy?
  • With an MPC of 0.75, what is the multiplier?
  • How much will real GDP increase by with an increase in government spending of $50 bil?
  • What is the tax multiplier?
  • What is the formula for the tax multiplier?
  • Can fiscal policy be used to combat inflation?
slide42
What will happen to ad with a cut in g spending of 25 bil?
  • What is the balanced budget multiplier?
  • What is an automatic stabilizer?
  • What is a budget surplus?
  • What is a budget deficit?
  • What is supply side fiscal policy?
  • What is the Laffer Curve?
slide44

Fiscal policy is the use of government spending, taxes, and transfer payments for the purpose of stabilizing the economy.

slide45

Discretionary fiscal policy follows the Keynesian argument that the federal government should manipulate aggregate demand in order to influence the output, employment, and price levels in the economy.

slide46

Discretionary fiscal policy requires either new legislation to change government spending or taxes in order to stabilize the economy.

slide47

Expansionary fiscal policy is a deliberate increase in government spending, a deliberate decrease in taxes, or some combination of these two options.

slide48

Contractionary fiscal policy is a deliberate decrease in government spending, a deliberate increase in taxes, or some combination of these two options.

slide49

Using either expansionary or contractionary fiscal policy, the government can shift the aggregate demand curve in order to combat recession, cool inflation, or achieve other macroeconomic goals.

slide50

Discretionary Fiscal Policies

Expansionary Contractionary

  • Increase government spending
  • Decrease taxes
  • Increase government spending and taxes equally
  • Decrease government spending
  • Increase taxes
  • Decrease government spending and taxes equally
slide51

The tax multiplier is the multiplier by which an initial change in taxes changes aggregate demand (total spending) after an infinite number of spending cycles.

slide53

A balanced budget multiplier is not neutral. A dollar of government spending increases real GDP more than a dollar cut in taxes. Thus, even though the government does not spend more than it collects in taxes, it is still stimulating the economy.

slide54

Combating recession and inflation can be accomplished by changing government spending or taxes.

slide55

The total change in aggregate demand from a change in government spending is equal to the change in government spending times the spending multiplier. The total change in aggregate demand from a change in taxes is equal to the change in taxes times the tax multiplier.

slide56

Increase in the price level and the real GDP

Increase in the aggregate demand curve

Increase in government spending

slide57

Decrease in the price level

Decrease in the aggregate demand curve

Decrease in government spending

slide60

Automatic stabilizers are changes in taxes and government spending that occur automatically in response to changes in the level of real GDP.

slide61

The business cycle creates braking power. A budget surplus slows down an expanding economy. A budget deficit reverses a downturn in the economy.

slide62

Automatic Stabilizers

$2,500

T

$1,000

Budget deficit

Budget surplus

$750

Government Spending and Taxes

$500

G

$250

Real GDP

$4

$6

$8

slide63

According to supply-side fiscal policy, lower taxes encourage work, saving, and investment, which shift the aggregate supply curve rightward. As a result, output and employment increase without inflation.

slide64

The Laffer curve represents the relationship between the income tax rate and the amount of income tax revenue collected by the government.