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CHAPTER 12 Fiscal Policy. present by : Ivy, Yi Lin, Mamie, Mon, Chris. In this chapter. you will: learn about expansionary and contractionary fiscal policies, which are used by governments seeking economic stability

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chapter 12 fiscal policy

CHAPTER 12Fiscal Policy

present by: Ivy, Yi Lin, Mamie, Mon, Chris

in this chapter
In this chapter......

you will:

  • learn about expansionary and contractionary fiscal policies, which are used by governments seeking economic stability
  • analyze the multiplier effect of fiscal policy, as determined by the marginal propensities to consumer and withdraw
  • consider budget surpluses and deficits and their impact on public debt and public debt charges
the goal of stabilization
The Goal of Stabilization
  • Stabilization policy is government policy designed to lessen the effects of the business cycle which can be either expansionary policies or contractionary policies.
  • expansionary policies attempt to reduce unemployment and stimulate total output
  • contractionary policies attempt to stabilize prices and bring the economy back down to its potential output.
stabilizing the business cycle

Without stabilization policy

With stabilization policy

Real GDP


Stabilizing The Business Cycle



Long-Run Trend

of Potential Output



stabilizing the business cycle1
Stabilizing the Business Cycle
  • Governments have an extensive impact on the economy through texation and government purchases.
stabilizing the business cycle2
Stabilizing The Business Cycle
  • Fiscal Policy uses taxes and government purchases as its tools
  • Fiscal Year is the 12-month period to which a budget applies
  • Monetary policy uses interest rates and the money supply as its tool.
use of fiscal policy
Use of Fiscal Policy
  • Expansionary fiscal policy involves increasing government purchases, decreasing taxes, or both to stimulate spending and output.
  • Contractionary fiscal policy involves decreasing government purchases, increasing taxes, or both to restrain spending and output.
expansionary fiscal policy





Price Level (GDP deflator,

1997 = 100)





Real GDP (1997 $ billions)

Expansionary fiscal policy
  • expansionary fiscal policy involves more government purchases and/or lower taxes to shift AD rightward






Potential Output

contractionary fiscal policy

Initial Inflationary Gap


Price Level (GDP deflator,

1997 = 100)





Real GDP (1997 $ billions)

Contractionary Fiscal policy
  • contractionary fiscal policy involves fewer government purchases and/or increased taxes to shift AD leftward






Potential Output

automatic stabilizers
Automatic Stabilizers
  • Discretionary Policy is international government intervention in the economy such as bedgeted changes in spending or texation.
  • Automatic stabilizers: built-in measures, such as texation&transfer payment programs, that lessen the effects of the business cycle.
  • Net tax revenues = taxes collected —— transfers&subsidies
the multiplier effect
The Multiplier Effect
  • The magnified impact of a spending change on aggregate demand
  • an initial spending change produces income and part of this new income becomes new spending
  • The process is repeated with each spending round smaller than the last
  • Each new spending round are determined by the marginal propensity to consumer(MPC) and marginal propensity
the multiplier effect1
The Multiplier Effect

Marginal propensity to consumer (MPC)

the effect on domestic consumption of a change in income

MPC = change in consumption on domestic items

change in income

Marginal propensity to withdraw (MPW)

the effect on withdrawals—saving, imports, and taxes—of a change in income

MPW = change in total withdrawals

change in income

*MPC + MPW = 1

income is always either spend or withdrawn

the multiplier effect2
The Multiplier Effect

Exercise: A $100 increase in a person's income causes him to increase his saving by $5, his imports by $35, and his tax payments by $20. In this case, the marginal propensity to withdraw is:

Change in total withdrawals(saving/ import/ taxes)

Change in income

5 + 35 + 20 = 60 = 0.6

100 100

the effect of a rise in government purchases
The Effect of a Rise in Government Purchases

The multiplier effect will continue until withdrawals equal to the initial discretionary injection

the spending multiplier

The spending multiplier is the value by which the initial spending change is multiplied to give the total change in real output.

The Spending Multiplier

In other words, the shift in the aggregate demand curve

Total change in output = initial change x spending

(shift in AD curve) in spending multiplier



Find the spending multiplier when initial spend has rose by $1000 and the total output increased by $2000.

Spending multiplier= total change in output

Initial change in spending





Relationship between the marginal propensity to withdraw and the spending multiplier

The spending multiplier is the reciprocal of the marginal propensity to withdraw.


If MPW (marginal propensity to withdraw) is 0.5 what is the spending multiplier?

Spending Multiplier =__1__






Effect of a Tax Cut

  • The multiplier effect can be applied to tax cuts
  • Tax cuts can be used to expand the economy
  • Lower tax cuts can leave households and businesses with more funds to spend and invest
  • The initial spending stimulus of the tax cut is multiplied by the spending multiplier (or reciprocal of MPW). This results in an increase in total output
  • a shift in the aggregate demand curve

The initial change in spending on domestic items from a change in taxes (T) is found by multiplying the economy’s marginal propensity to consume by the size of the tax change, then it is multiplied by the spending multiplier (1/MPA)

Total change in output = initial change x spending

(shift in AD curve) in spending multiplier

Total change in output = - (MPC X change in T) x (1/MPA)

-(MPC X T) has a minus sign because the spending change is in the opposite direction to the tax change


Relevance of the Spending Multiplier

  • When the economy is close to its potential level, the increase in aggregate demand translates into higher price levels more than into expanded production
  • When the stated goal being a stable economy and expanded output, expansionary fiscal policy is less effective the closer the economy is to its potential
  • Similarly, for the contractionary fiscal policy, when the economy is above its potential, a decrease in aggregate demand means both price level and total output will fall
  • Based on the possible changes in the price level, the multiplier effect is less definite than the use of simple formula would indicate
benefits of fiscal policy
Benefits of fiscal policy

Two benefits as stabilization tool:

regional focus and impact on spending

  • Regional focus:(it can be focused on particular regions)

During a recession, new government purchases and program to reduce the amount of tax paid can be targeted to regions where unemployment rate are highest.( Net income revenue drop hit by unemployment and falling output.)

In a boom, spending cuts and tax hikes can be concentrated on the regions where inflation is at its worst.( Larger increase in net tax revenue in regional where the economy is most over-heated.)

benefits of fiscal policy1
Benefits of fiscal policy
  • Impact on spending
  • it has a relatively direct impact on spending

(compare with monetary policy--Fiscal policy is easy to control the trend of economy, making it closer the potential output and achieve the goal of stabilization)

    • influences of a stabilization is tied to its initial effect on spending
  • During recession, government increase the government purchases, it decrease the spending
  • In contrast, government decreases the government purchases which increase the spending—alter the government purchases to make economy stability.
drawbacks of fiscal policy
Drawbacks of fiscal policy

a)Delays while automatic stabilizers to stabilize the economy, the discretionary measure are sometimes delayed.

  • Recognition lag: the amount of time it takes policy-makers to realize that a policy needed.( decided and realized the economy need adjusted )
  • Decision lag: the amount of time needed to formulate and implement an appropriate policy.(how to adjust)
  • Impact lag: the amount of time between a policy’s implementation and its having an effect on the economy.(already have move to a different point in the business cycle )
drawbacks of fiscal policy1
Drawbacks of fiscal policy

b)Political visibility

  • Discretionary is highly visible element of government activity, therefore, it is often affected by political and economic considerations.
  • E.G vote: increases in government purchases and reduce the taxes, regardless of the appropriateness of these policies for the economy.(election is coming up)
drawbacks of fiscal policy2
Drawbacks of fiscal policy

c)Public debt

  • Public debt: the total amount owned by the federal government as a result of its past borrowing.
  • Total government: include the debts of individuals’ provinces and territories and incorporates local government and hospital.
  • Public debt charges: the amounts paid out each year by the federal government to cover the interest charges on its public debt.
  • E.G. the federal government’s public charge were37.2billion, the government should pay 507.7 to bondholders. What is the average interest?

Average interest rate=public debt charge/public debt

12 3 the impact of fiscal policy
12.3 The Impact of Fiscal Policy
  • Balanced budget mean government’s expenditures and revenues are equal
      • This situation is so uncommon.

Balanced budget

budget surplus
Budget surplus
  • Budget surplus is the government’s revenues exceed its expenditures
  • government revenues- government expenditures = Budget surplus
  • For example, government will cut defence spending and raising income taxes during the economic boom to suppress the inflationary.
budget deficit
Budget deficit
    • Budget deficit is the government’s expenditures exceed its revenues
  • government expenditure – government revenue=Budget deficit
  • For example, government will increase the spending on road and bridges, or institute a temporary sales-tax cut to stimulate household spending, during the downturn.
impact on public debt
Impact on public debt
  • The government’s debt represents the sum of all its past budget deficits minus any budget surpluses.
    • Budget deficits- Budget surpluses= government’s debt
    • When the government has a budget surplus, the the public debt reduced by the same amount.
    • When the government has a budget deficit, the public debt increases by the same amount.
fiscal policy guidelines
Fiscal Policy Guidelines
  • There are 3 principles that guide government fiscal policy:

1)Annually balanced budgets

2)Cyclically balanced budgets

3)Functional Finance

  • Critics of fiscal policy suggest that any fiscal policy that is used must be guided by the principle of an annually balanced budget. In other words, revenues and expenditures should be balanced every year.
  • Critics also say that an annually balanced budget is not necessarily appropriate for society and state it is flawed reasoning.
  • Cyclically balanced budget is the principle that government revenues and expenditures should balance over the course of one business cycle.
recent fiscal policy
Recent Fiscal Policy
  • Functional Finance is the principle that government budgets should be geared to the yearly needs of the economy.
  • The choice of fiscal policy guidelines depends on the government’s belief in fiscal policy as an effective tool for stabilizing the economy.
  • Defenders of functional finance are those who see functional finance as a powerful stabilizing tool, while economist who support cyclically or annually balanced budget tend to be less convinced of fiscal policy’s effectiveness.
recent fiscal policy1
Recent Fiscal Policy
  • In the 1970s and early 1980s, Canada believed in functional finance but recently had made unsuccessful attempts to move towards cyclically balanced budgets.
  • This change in view came from constant budget deficits and their impact on the economy as a whole.
  • Total government deficits were highest during the recessions in early 1980s and 1990s.
  • The 1980s deficits were largely optional, while the 1990s deficits were related to automatic stabilizers.
keynes and his influence
Keynes and His Influence
  • Neoclassical theory is the view of economy that economic slow-downs such as the great depression were self correcting and is based on two assumptions: flexible labour markets and Say’s law.
  • Flexible labour markets: Neoclassical economists suggest that both the demand and supply of labour depend on real wage rate, or wages expressed in constant base-year dollars, rather than the nominal wage rate, which is valued in current dollars.
  • There are two types of unemployment:

1)Voluntary unemployment

2)Involuntary unemployment

  • Voluntary unemployment exists whenever workers decide that real wages are not high enough to make work worthwhile.
  • Involuntary unemployment is when someone wants to work at the current real wage rate but cannot find a job. Involuntary occurs when the market demand and supply creates a surplus.
say s law
Say’s Law
  • Say argued that supply automatically creates its own demand.
  • An example would be a tailor supplies clothes in order to have funds needed to purchase other products.
  • Keynes’s theory challenged both assumptions made by the neoclassical economists. Keynes believed that workers are influenced by nominal wages rather than real wages and purchasing power.