Transcript Nickling`s Guide to Fiscal Policy

Nickling’s Guide to
Fiscal Policy
DECLASSIFIED
Stabilization Policy
 Stabilization policy is a government policy
designed to lessen the effects of the
business cycle. It can be either
contractionary or expansionary.
 Expansionary policy attempts to reduce
unemployment and stimulate output.
 Contractionary policy attempts to stabilize
prices and reduce output.
 Stabilization policy can take the form of either
fiscal policy or monetary policy.
 Fiscal policy uses taxes and government purchases.
 Expansionary fiscal policy involves more government
purchases and/or lower taxes to shift AD rightward.
 Contractionary fiscal policy involves fewer government
purchases and/or increased taxes to shift AD leftward.
 Monetary policy uses interest rates and the money
supply.
 Discretionary policy is intentional government
intervention in the economy.
 Automatic stabilizers are built-in measures such
as taxes and transfer payments to lessen the
effects of the business cycle.
Benefits and Drawbacks
to Fiscal Policy
 Fiscal policy has two main benefits:
 It can be focused on particular regions.
 It has a relatively direct impact on spending.
 Fiscal policy has two main drawbacks
 It is subject to delays: recognition lag,
decision lag, and impact lag.
 It is closely related to public debt.
Nickling’s Road to Success in
Understanding Fiscal Policies:
 In the following cases, would policy-makers raise
or reduce government purchases? Why?
 Real output is less than potential level.
[Raise] because this economy is facing a
recessionary gap; AD curve shifts right
 Unemployment is below its natural rate.
[Reduce] because this economy is facing an
inflationary gap, so reduce to stabilize prices; AD
curve shifts left
 Real output equals its potential level and
unemployment is at its natural rate.
[Neither] because there’s no inflationary or
recessionary gap
 Explain how automatic stabilizers work during the
following periods.
 The economy is experiencing a recession, with shrinking
incomes and spending.
Since incomes/spending is decreasing, taxes
revenues fall, however government
transfers/subsidies is increasing. Therefore,
spending will increase as result and apply an
expansionary effect on the economy.
 The economy is in an expansionary phase, with rising
incomes and spending.
Since incomes/spending is increasing, taxes
revenues rise, however government
transfers/subsidies is decreasing. Therefore,
spending will decrease as result and apply a
contractionary effect on the economy.
The Multiplier Effect
 The multiplier effect is the magnified impact of a
spending change on AD.
 An initial spending change produces income and part of this new
income becomes new spending.
 This process is repeated with each spending round smaller than
the last.
 Each new spending round is determined by the marginal
propensity to consume (MPC) which measures the effect of an
income change on domestic consumption.
 Each new spending round is also determined by the marginal
propensity to withdraw (MPW) which measures the effect of an
income change on withdrawals.
 MPC and MPW always summing to one.
The spending multiplier:
 The value by which an initial spending change is
multiplied to give the total shift in the AD curve.
 Equals (1/MPW).
 The actual change in equilibrium output is less
than the change in AD found using the spending
multiplier because of price changes.
Nickling’s Road to Success in
Understanding Fiscal Policies:
A)
If an economy is initially in equilibrium and injections rise by $1 million,
then by how much will withdrawals have to rise in order to bring
injections and withdrawals back in balance?
Withdrawals will have to rise by the same amount of $1
million to bring injections and withdrawals back into
balance.
B)
If the economy’s MPW is 0.67 then by how much will incomes and
output have to rise to create the required additional expenditures?
Incomes and output must rise by $1.5 million, since each
$1.50 in extra income will create $1 [=(0.67 x 1.50)] in
additional withdrawals.
C)
Explain how your answer to part B. is based on the formula for the
spending multiplier.
The 1.5 million found in part b can be derived by multiplying
the initial $1 million increase in injection
 For each of the following cases, calculate the
spending multiplier and state the direction and
size of the shift in the AD curve.
 Government purchases fall by $10 billion in an
economy with an MPW of 0.60.
Left, 16.67 billion
 A tax cut causes an initial $25 billion rise in spending
in an economy with an MPW of 0.80.
Right, 6.25 billion
 Government purchases rise by $15 billion in an
economy with an MPC of 0.25.
Right, 20 billion
 A $30 billion tax rise occurs in an economy with an
MPC of 0.45.

Left, 22.5 billion