9.4 Fiscal Stabilization Policy Flashcards
Is fiscal stabilzation policy fundamentally a short or long run policy?
Fiscal stabilization policy is fundamentally a short-run policy. In response to various shocks that cause changes in real GDP, the government may use various fiscal tools in an attempt to push real GDP back toward potential output.
What are the alternatives to using fiscal stabilization policy?
The alternatives to using fiscal stabilization policy are to wait for the recovery of private-sector demand (a shift in the AD curve) or to wait for the economy’s adjustment process (a shift in the AS curve) to bring real GDP back to potential. The slower these processes are, the stronger is the justification for government to use its fiscal tools.
Example of Canadian fiscal stabilization policy.
Canadian federal expenditure during the Second World War rose from 12.2 percent of GDP in 1939 to 41.8 percent in 1944. At the same time, the unemployment rate fell from 11.4 percent to 1.4 percent as the economy boomed.
More recently, the Canadian government dramatically increased spending in an effort to dampen the effects of the major global recession that began in late 2008. Most economists agree that this “fiscal stimulus” contributed significantly to real GDP growth in the 2009–2012 period.
What effect does a reduction in tax rates or an increase in government purchases or transfers do the the AD curve and real GDP?
In our macroeconomic model, a reduction in tax rates or an increase in government purchases or transfers will shift the AD curve to the right, causing an increase in real GDP.
What does an increase in tax rates or a cut in government spending do to the AD curve?
An increase in tax rates or a cut in government spending will shift the AD curve to the left, causing a decrease in real GDP.
In the absence of a recovery in private-sector demand, such a recessionary gap can be closed in two ways. Whats the first?
The first involves the economy’s adjustment process that we saw previously in this chapter. The excess supply of factors at will eventually cause wages and other factor prices to fall, shifting the AS curve downward and restoring output to , as shown in part (i) of the figure.
However, because of the downward stickiness of wages, this process may take a long time. Policymakers may not be prepared to wait the time necessary for the recessionary gap to correct itself.
In the absence of a recovery in private-sector demand, such a recessionary gap can be closed in two ways. Whats the second way?
The second way to close the recessionary gap involves an active policy choice. The government can use expansionary fiscal policy to shift the AD curve to the right, as shown in part (ii) of the figure. It would do this by reducing tax rates, increasing transfers, or increasing the level of government purchases.
What does the closing of a ressesionary gap look like graphically?
What are ways a recessionary gap may be closed?
A recessionary gap may be closed by a (slow) downward shift of the AS curve or an increase in aggregate demand.
What is the advantage of using fiscal policy to fix a recession?
The advantage of using fiscal policy rather than allowing the economy to recover naturally is that it may substantially shorten what might otherwise be a long recession.
What is a potential disadvantage of the use of fiscal policy?
One disadvantage is that the use of fiscal policy may stimulate the economy just before private-sector spending recovers on its own. As a result, the economy may overshoot its potential output, and an inflationary gap may open up. In this case, fiscal policy that is intended to promote economic stability can actually cause instability.
In the absence of a downward adjustment of private-sector demand, there are two ways such an inflationary gap may be closed. What is the first one?
Again, the first involves the economy’s adjustment process. Excess demand for factors will cause wages and other factor prices to rise, shifting the AS curve upward and gradually restoring output to Y* , as shown in part (i) of the figure.
In the absence of a downward adjustment of private-sector demand, there are two ways such an inflationary gap may be closed. What is the second one?
Alternatively, the government can use a contractionary fiscal policy to shift the AD curve to the left and close the inflationary gap, as shown in part (ii). The government would do this by increasing tax rates, reducing transfers, or reducing its level of purchases.
What does the closing if an inflationary gap look like grapically?
How can an inflationary gap potentially be removed?
An inflationary gap may be removed by an upward shift of the AS curve or by a leftward shift of the AD curve.
What is the advantage of using contractionary fiscal policy to close an inflationary gap?
The advantage of using a contractionary fiscal policy to close the inflationary gap is that it avoids the rising wages and prices that would otherwise occur.
What is a disadvantage of using fiscal policy to close an inflationary gap?
One disadvantage is that if private-sector expenditures fall for some unrelated reason, the fiscal contraction may end up being too large and real GDP may be pushed below potential, thus opening up a recessionary gap.
When is the case for using discal policy to stabilize real GDP stronger?
The case for using fiscal policy to stabilize real GDP is stronger when the economy’s adjustment process is slow to operate.
What would happen if many people decided to start puting a greater ratio of their disposable income into savings as opposed to consumption?
What is the Paradox of thrift?
In our macro model, an increase in the country’s total desired saving would shift the AD curve to the left and reduce the equilibrium level of real GDP in the short run.
Thus, frugality on the part of individuals, which may seem to be prudent behaviour for each individual taken separately, ends up causing an economic recession.
This phenomenon is known as the paradox of thrift—the paradox being that what may be good for any individual when viewed in isolation ends up being undesirable for the economy as a whole.
What are the policy implications of the paradox of thrift?
The policy implication of this phenomenon is that a major and persistent recession can be battled by encouraging governments, firms, and households to reduce their saving and increase their spending. In times of unemployment and recession, a greater desire to save will only make things worse for the overall economy. This result goes directly against the idea that we should “tighten our belts” when times are tough.
Why does the paradox of thrift only apply in the short run?
The paradox of thrift applies to shifts in aggregate demand that have been caused by changes in saving and spending behaviour. That is why it applies only in the short run, when the AD curve plays an important role in the determination of real GDP.
What are the short-run and long run implications of the paradox of thrift?
The paradox of thrift—the idea that an increase in desired saving reduces the level of real GDP—is true only in the short run.
In the long run, the path of real GDP is determined by the path of potential output. The increase in saving has the long-run effect of increasing investment and therefore increasing potential output.
Why are the fiscal policies that we have been discussing referred to as discretionary?
The fiscal policies that we have been discussing are referred to as discretionary because the government uses its discretion in changing its taxation or its spending in an attempt to change the level of real GDP. However, even if the government makes no active decisions regarding changes in spending or taxation, the mere existence of the government’s tax-and-transfer system will act as an automatic stabilizer for the economy.
Definition of an Automatic stabilizer
Automatic stabilizer
Elements of the tax-and-transfer system that reduce the responsiveness of real GDP to changes in autonomous expenditure.