Econ 105 Ch 16

• Fiscal policy


  The setting of the level of government spending and taxes
• Fiscal expansion


  An increase in G and/or a decrease in T, shifting AD right to prevent or reduce a recession
• Fiscal contraction


  A decrease in G and/or an increase in T, shifting AD left to prevent or reduce an inflationary boom
• How fiscal policy influences aggregate demand

  1. Fiscal expansion shifts AD right

  2. Fiscal contraction shifts AD left
• Multiplier effect


  Expansionary fiscal policy leads to an increase in Y, which leads to an increase in household income, which leads to an increase in consumption, which leads to a further increase in AD
• Marginal Propensity to Consume (MPC)


  The fraction of extra income that a household spends
• Marginal Propensity to Import (MPI)


  The fraction of extra income that a household spends on foreign goods
• Increase in government spending

  Leads to a larger increase in AD depending on the relative size of the multiplier and crowding-out effects
• Crowding-out effect


  Expansionary fiscal policy leads to an increase in public savings, which leads to an increase in the interest rate, which leads to a decrease in investment, which leads to a decrease in AD
• Exercise 1: Ending a recession


  1. If MPC = 0.8 and no crowding out, government should increase G by an amount to shift AD by $20

  2. If there is crowding out, government needs to increase G by more than this amount
• Taxes


  The other important instrument of fiscal policy besides government spending
• Tax changes


  Affect households' disposable income, thus affecting consumer spending and shifting AD
• Exercise 2: Comparing tax cut vs spending increase

  In a closed economy with MPC = 0.75, a $5 increase in G would affect AD more strongly than a $5 tax cut
• Permanent vs temporary tax cut

  A permanent tax cut causes a bigger increase in C and a bigger shift in AD than a temporary tax cut
• Arguments for active stabilization policy

  • Economies tend to fluctuate if left on their own, leading to costs in the form of unemployment, inflation, and uncertainty
  • Fiscal policy can stabilize aggregate demand, production, and employment, leading to a more stable economy that benefits everyone
• Arguments against active stabilization policy

  • Tax rates and spending programs should be chosen to achieve long-term goals like economic growth and income distribution
  • Fiscal policies affect the economy with long policy lags, so by the time a policy is implemented the economy's condition may have changed
• Policy lags


  The time it takes for a policy change to affect the economy
• Automatic stabilizers


  Changes in fiscal policy that stimulate aggregate demand without policymakers having to take any deliberate action when the economy goes into recession
• How automatic stabilizers work

  1. In a recession, GDP falls, leading to a decrease in households' disposable income, which leads to an automatic decrease in income tax rates, which leads to an increase in AD, reducing the magnitude of the downturn

  2. In a recession, GDP falls and unemployment rises, leading to an increase in the number of households applying for income support benefits, which leads to an increase in disposable income, which leads to an increase in AD, reducing the magnitude of the downturn