Transcript Fiscal Policy Practice What type of gap?

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685-694 and
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fiscal policy
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FISCAL
POLICY
THE CAR ANALOGY
The economy is like a car…
 You can drive 120mph but it is not sustainable.
(Extremely Low unemployment)
 Driving 20mph is too slow. The car can easily
go faster. (High unemployment)
 70mph is sustainable. (Full employment)
 Some cars have the capacity to drive faster
than others. (industrial nations vs. 3rd world
nations)
 If the engine (technology) or the gas mileage
(productivity) increase then the car can drive
at even higher speeds. (Increase LRAS)
The government often speeds up or slows down
the economy by using fiscal and/or monetary
policy.
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How does the Government Stabilizes the
Economy?
The Government has
two different tool
boxes it can use:
1. Fiscal PolicyActions by Congress to
stabilize the economy.
OR
2. Monetary PolicyActions by the
Federal Reserve Bank
to stabilize the
economy.
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For now we will only focus on Fiscal Policy.
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Contractionary Fiscal Policy (The BRAKE)
Laws that reduce inflation, decrease
GDP (Close a Inflationary Gap)
• Decrease Government Spending
• Increase Taxes (Decreasing disposable income)
• Combinations of the Two
Expansionary Fiscal Policy (The GAS)
Laws that reduce unemployment and
increase GDP (Close a Recessionary Gap)
• Increase Government Spending
• Decrease Taxes (Increasing disposable income)
• Combinations of the Two
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Discretionary vs Non-Discretionary
Discretionary Fiscal Policy
• Congress creates a new bill that is designed to
change AD through government spending or
taxation.
• Ex: In a recession, Congress increase spending.
•Why might this be a difficult way to fix the
economy?
•Recognition Lag – Takes time to identify a
recession rather than just natural fluctuations
•Administrative Lag - Takes time for Congress to
act.
•Operational Lag – Govt. spending usually spread
over a period of time
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Discretionary vs Non-Discretionary
Non-Discretionary Fiscal
Policy
•AKA: Automatic Stabilizers
•Permanent spending or taxation laws
enacted to work counter cyclically to
stabilize the economy
•Ex: Welfare, Unemployment, Min. Wage,
Tax progressivity
The more progressive the tax system, the
greater the economy’s built-in stability.
Why?
Three Types of Taxes
1. Progressive Taxes -takes a larger percent of
income from high income groups (takes more
from rich people). Example?
Ex: Current Federal Income Tax system
2. Proportional Taxes (flat rate) –takes the same
percent of income from all income groups.
Example?
Ex: 20% flat income tax on all income groups
3. Regressive Taxes –takes a larger percentage
from low income groups (takes more from poor
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people). Example?
Ex: Sales tax; any consumption tax.
THE MORE PROGRESSIVE THE TAX
SYSTEM, THE STEEPER THE TAX CURVE,
AND THE MORE BUILT IN STABILITY
Do you see
any
problems
with this
model in
regard to
the real
world?
Government Expenses, G
and Tax Revenues, T
T
Surplus
G
Deficit
GDP1 GDP2
GDP3
Real Domestic Output, GDP
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Price level
• What type of gap and what type of policy is best?
• What should the government do to spending? Why?
• How much should the government spend?
The government should
increase spending which
LRAS
would increase AD
AS How much?
They should NOT spend
$100 billion!!!!!!!!!!
If they spend $100 billion,
AD would look like this:
P1
AD2
AD1
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$400 $500
FE
Real GDP (billions)
WHY?
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The Multiplier Effect
Let’s practice calculating the spending multiplier
Spending
Multiplier
OR
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Fiscal Policy Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .8)
Price level
LRAS
1. What type of gap?
AS
2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
4. What is the least
amount of initial
government spending
AD1
AD2 to close gap?
P1
$50
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$100
Real GDP (billions)
$10 Billion
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Fiscal Policy Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .5)
LRAS
Price level
AS
P1
AD2
1. What type of gap?
2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
4. How much needed to
close gap?
AD1
$80 $100
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Real GDP (billions)
-$10 Billion
What about taxing?
•The multiplier effect also applies when the government
cuts or increases taxes.
•But, changing taxes has less of an impact then
government spending. Why?
Expansionary Policy (Cutting Taxes)
•Assume the MPC is .75 so the multiplier is 4
•If the government cuts taxes by $4 million how much
will consumer spending increase?
•NOT 16 Million!!
•When they get the tax cut, consumers will save $1
million and spend $3 million.
•The $3 million is the amount magnified in the
economy.
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•$3 x 4 = $12 Million increase in consumer spending
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Calculating the Tax Multiplier
If the MPC is .75 how much is the tax multiplier?
Simple Tax
Multiplier
MPC x
OR
MPC
MPS
•If the spending multiplier is 4, then the tax
multiplier is only 3
•But remember that an increase in taxes
decreases GDP so the tax multiplier is negative.
Total change = Tax Multiplier
in GDP
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x
Initial Change
in Taxes
Cutting Tax Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .5)
LRAS
Price level
AS
1. What to options does
the government have?
2. How much should they
increase government
spending?
P1
$10 Billion
AD1
$80
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3. How much should they
cut taxes?
AD2
-$20 Billion
$100
Real GDP (billions)
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FISCAL POLICY
 Which
is preferable in response to a
recessionary gap?
 Govt. Spending?
 Taxes?
 Which is preferable in response to an
inflationary gap?
 Govt. Spending?
 Taxes?
 Why?
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