Transcript Fiscal Policy

EOCT Review Question #1
During what stage of the business
cycle would unemployment be the
largest?
A.
B.
C.
D.
Peak
Recession
Trough
recovery
EOCT Review Question #2
If we have progressive tax system and
Billy pays $1.000.00 on his $10,000
income, what is true of Sue’s tax
liability if she earns $40,000.00?
A.
B.
C.
It is exactly $4,000.00
It is less than $4,000.00
It is more than $4,000.00
EOCT Review Question #3
Which of the following would cause
cost-push inflation?
A.
B.
C.
D.
20%
20%
20%
20%
increase in natural gas prices
growth in the stock market
cut in federal income tax
increase in grain production
EOCT Review Question #4
Which group is most likely to suffer
from higher rates of unemployment
and poverty than most others?
A.
B.
C.
D.
Minorities
People with limited education
Single parents
Two-parent families
Fiscal Policy
Chapter 15
Fiscal “Tools”
1. Government Purchases/Spending
2. Transfer Payments
3. Taxes
…and how these three affect
macroeconomic variables such as real
GDP, employment, the price level, and
economic growth
Points to Remember
 Prior
to the Great Depression
economists believed that the best
way to stabilize the economy was
through the natural market forces
– Adam Smith and supply side economics
After the Great Depression
 Remember:
– Keynes
– government needs
to aid the economy
– demand side
economics
What is Fiscal Policy



Government taxing and spending used to
move the economy toward full
employment with price stabiltiy
Potential output- the maximum
sustainable output in the long run given
the supply of resources, technology and
“rules of the game” that nurture
production and exchange
AKA- full employment output
How just a little Fiscal Policy can
effect our economy in a BIG way.
$150
$400
$150
$200
$50 (already in
his pocket)
$200 already in
his pocket)
Multiplier Effect
For every dollar spent by the
federal government, GDP will
increase by more than that 1
dollar.
This could also be effected by
business invention or change in
consumption- but Keynes focused
on the government’s role in his
book General Theory
Fiscal Policy and Taxes
 An
increase in tax rates decreased
disposable income– consumption & real GDP decrease
A
decrease in taxes increases
disposable income– consumption & real GDP increase
 What
is disposable income?
Disposable Income
 This
is the income available after
taxes
 This
is the money consumers have to
spend
 Less
taxes = more money to spend
Government Use of Fiscal Policy
1.
When the economy is in a slump
(recession or depression) the economy
has contracted.

The government will enact an
Expansionary fiscal policy to help
boost the economy.
Closing a Contractionary Gap
using Fiscal Policy
Potential
output
So unemployment exceeds
the natural rate (4%-5%)!
Price level
Begin with a aggregate supply curve
(AS130 ) - if the price level turns out
to be 130, the economy will produce
its potential output at e*
Suppose instead that AD
intersects AS at point e,
therefore a Contractionary Gap
of $0.5 trillion
This is where
we should be!
AS 130
e*
130
e
125
AD
0
9.5
10.0
Contractionary gap
Real GDP
(trillions of dollars)
Closing a Contractionary Gap
using Fiscal Policy
This is where
we should be!
Potential
output
A $0.2 trillion decrease in taxes
reflects an expansionary fiscal policy
that increases AD, as shown by the
AS 130
Price level
rightward shift from AD to AD*
e*
130
e
e'
125
Also, a $0.2 trillion increase in
transfer payments reflects an
expansionary fiscal policy that
increases AD, as shown by the
rightward shift from AD to AD*
AD*
AD
0
Transfer payments are those payments
given to help the needy and unemployed.
9.5
10.0
Contractionary gap
10.5 Real GDP
(trillions of dollars)
Closing an contractionary gap through
fiscal policy results in a higher price
level and lower unemployment .
Government Use of Fiscal Policy
2.
When the economy has picked up
the pace (an economic boom) the
economy has expanded.
 The government will enact an
Contractionary fiscal policy to help
slow down the economy.
Closing an Expansionary Gap using
Contractionary Fiscal Policy
Potential
output
AS 130
Price level
Suppose that aggregate
demand exceeds
potential output and
inflation results (we
could be in an economic
boom).
135
e'
AD
As a result, output is
$10.5 trillion and an
expansionary gap of
$0.5 trillion exists.
0
10.0 10.5
Expansionary gap
Real GDP
(trillions
of dollars)
Closing an Expansionary Gap using
Contractionary Fiscal Policy
AS 130
Price level
If left alone, this gap
could be closed by a
leftward shift of the AS
curve, returning the
economy to the
potential level of output
but at a higher price
level, shown by point e"
Potential
output
By decreasing government
purchases, increasing taxes,
or decreasing transfer
payments, the government
can implement a
Contractionary Fiscal
Policy designed to reduce
AD
e*
135
125
AD
e
AD*
0
10.0 10.5
Expansionary gap
Closing an expansionary gap through
fiscal policy results in a lower price level,
but higher unemployment .
Real GDP
(trillions
of dollars)
Difficulty in Calculating Effects
 Remember
 It
the multiplier effect.
is difficult to judge how large of an
expansion or contraction a change in
any single fiscal policy (taxes,
transfer payments, etc) will produce
in the economy
Two categories of Fiscal Policy:
1)Discretionary fiscal policy- requires
congressional action (This is what
we have been talking about…)
1)Automatic Stabilizers- usually the
results of these actions in the
future (unemployment insurance)
that become part of the federal
budget
How automatic stabilizers work






These change automatically with the ups and
downs of the economy by stabilizing disposable
income and smoothing fluctuations in
consumption and aggregate demand throughout
the business cycle
Boost aggregate demand during recession
Dampen aggregate demand during expansion
Unemployment insurance
Welfare spending
Tax rates
Problems with Fiscal Policy
 Doesn’t
work during periods of
stagflation- can’t fight
unemployment and inflation at the
same time
 It is difficult to estimate the natural
rate of unemployment- people lie!
 Time’s effect on discretionary fiscal
policy- these changes don’t happen
quickly!
Lags = time for the policy to take
effect on the economy
Recognition- time it takes to identify a
problem (typical recession lasts 11
months, but can take 6 to recognize)
 Decision making- once recognized policy
makers need to agree on what to do to fix
it
 Implementation- after decided upon it
takes time to get things done
 Effectiveness- may take 9 – 18 months to
meet the full effect

Fiscal policy and supply
 Unintentional
on supply
 Example-
– negative externality
transfer payments fewer
people want to work, negative effect
on the supply of labor (this will shift
aggregate supply to the left)