Transcript Fiscal Policy, Deficits, and Debt

30
Fiscal Policy, Deficits, and Debt
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Fiscal Policy
Recall;
• AD = C + I + G + X - M
• Changes in AD will have significant
effects on the economy.
• Economic problems such as inflation
and unemployment
• Changes in AD components leads to
changes in AD
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Fiscal Policy
• Recall that the government sector
purchase goods and services (G) and
collect taxes (T)
• The government can use: G and T to
affect AD
• Fiscal policy:
deliberate changes in G and/or T to
achieve full employment, price stability,
and economic growth.
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Fiscal Policy
How to use fiscal policy?
• Performed by the government via its tools:
G and/or T
• Note that G has a direct effect on AD while
T has indirect effect (through C and S)
• Two different fiscal policies: Expansionary
Fiscal Policy and Contractionary Fiscal
Policy
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Expansionary Fiscal Policy
•
•
•
•
Used to face a recession
When: GDP (or Y) < AE
Need to increase the level of AE
Increase level of G, and / or Reduce
level of T
• Both will increase the level of Y
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Expansionary Fiscal Policy
Price level
AS
increase in
aggregate demand
P1
AD1
AD2
$510
Real GDP (billions)
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Expansionary Fiscal Policy
Example;
• Assume we have a sharp decline in I from I0 to
I1. (show the graph? )
• Result: what will happen to AD(show the graph?)
• This may cause a problem .……….
• What is the solution? Use …………..fiscal policy.
• What are the tools of such fiscal Policy to use?
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Expansionary Fiscal Policy
• Assume that GDP0=$505,
• When I falls, GDP1=$485
• This is accompanied by an increase
unemployment.
• How much we need ∆G, ∆ T, or both?
Recall that MPC=75%, and Gm=4, Tm=3
• ∆G:
• ∆T:
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∆Y = ∆G . M
20 = ∆G . 4
∆G = $5
∆Y = - ∆T . M
20 = - ∆T . 3
∆T = - $6.67
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Expansionary Fiscal Policy
Therefore;
∆C = MPC.T=(0.75)(6.67) = +5
∆S = MPS.T=(0.25)(6.67) = +1.67
• What if we used both?
∆Y= ∆ G mg + ∆T mt
20 = ∆G(4)+ ∆T(3)
20 = 1.25(4)+ 5(3)
20 = 2(4)+ 4(3)
20 = 2.75(4)+ 3(3)
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Contractionary Fiscal Policy
•
•
•
•
Used to face a demand-pull inflation
When: GDP (or Y) > AE
Need to reduce the level of AE
Reduce level of G, or/ and Increase
level of T
• Both will reduce the level of Y
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Contractionary Fiscal Policy
Price level
AS
P1
decrease in
aggregate demand
a
P2
b
AD1
AD2
$522
Real GDP (billions)
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Contractionary Fiscal Policy
Example;
• Assume we have a increase in I from I0 to I1.
(show the graph? )
• Result: what will happen to AD(show the graph?)
• This may cause a problem .……….
• What is the solution? Use …………..fiscal policy.
• What are the tools of such fiscal Policy to use?
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Contractionary Fiscal Policy
•
•
•
•
Assume that GDP0=$505,
When I falls, GDP1=$515
This is accompanied by an increase prices.
How much we need ∆G, ∆ T, or both?
Recall that MPC=75%, and Gm=4, Tm=3
• ∆G:
• ∆T:
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∆Y = ∆G . M
-10 = ∆G . 4
∆G = $2.5
∆Y = - ∆T . M
-10 = - ∆T . 3
∆T = - $3.34
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Contractionary Fiscal Policy
Therefore;
∆C = MPC.T=(0.75)(3.34) = -2.505
∆S = MPS.T=(0.25)(6.67) = -0.835
• What if we used both?
∆Y= ∆ G mg + ∆T mt
10 = ∆G(4)+ ∆T(3)
10 = 1 (4)+ 2(3)
10 = 1.75(4)+ 1(3)
10 = 0.25(4)+ 3(3)
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Policy Options: G or T?
• To expand the size of government
(if they are concerned about unmet social needs or
infrastructure)
• If recession, then increase government
•
spending
If inflation, then increase taxes
• To reduce the size of government
(when they think government is too large and inefficient)
• If recession, then decrease taxes
• If inflation, then decrease government
spending
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Other Considerations
The crowding-out effect
 The crowding-out effect may be caused by fiscal policy.
 “Crowding-out” may occur with government deficit
spending. It may increase the interest rate and reduce
private spending (Private Investment Spending) which
weakens or cancels the stimulus of fiscal policy.
Standardized Budget (Full-Employment Budget)
 Public Budget = Total Revenue – Government Spending
 Total Revenue is coming usually from Tax Revenue
 Total Revenue >Government Spending…Budget Surplus
 Total Revenue < Government Spending….Budget Deficit
 If the budget was initially balanced, expansionary fiscal
policy creates a budget deficit..How??
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