chapter 12 Flashcards
def
Fiscal policy
is about the changes governments make to purchases, transfers, and taxes in trying to achieve the key macroeconomic outcomes of steady growth, full employment, and stable prices
Fiscal policy works through
aggregate demand, speeding up or slowing down an economy facing recessionary or inflationary gaps
def
Injection
spending in the circular flow that does not start with consumers: government spending (G), business investment spending (I), exports (X)
def
Leakage
spending that leaks out of the circular flow through taxes, savings, and imports
def
Multiplier effect
a spending injection has a multiplied effect on aggregate demand
How do you get a smaller multiplier effect
More leakages
How do you get a larger multiplier effect
Fewer leakages
formula
Size of Multiplier Effect
1/% of leakages from additional income
Changes in government spending on products and services or in net taxes have multiplied effects on
aggregate demand and real GDP
Effects of a tax cut or an increase in transfer payments in leakages
reduces leakages, leaving consumers with more money to spend
The new spending has a multiplied effect, increasing aggregate demand
Effect of an increase in taxes or decrease in transfers
increase in leakages, leaving consumers with less money to spend
The reduced spending has a multiplied effect, decreasing aggregate demand
what type of shock
An increase in government spending or a decrease in taxes is a
positive aggregate demand shock, shifting the aggregate demand curve rightward
what type of shock
A decrease in government spending or an increase in taxes is a
negative aggregate demand shock, shifting the aggregate demand curve leftward by the multiplied effect of the initial decrease in income
most volatile part of aggregate demand
Business investment spending as it fluctuates up and down with changes in interest rates and expectations of future profits
def
Export-Led growth
Economic growth driven by the multiplied effects of increasing exports
def
Expansionary fiscal policy
increases aggregate demand by increasing government spending, decreasing taxes, or increasing transfers; shifts the aggregate demand curve rightward, a positive demand shock
Fiscal policies to increase government spending, cut taxes, or increase transfers are positive aggregate demand shocks for countering a recessionary gap
def
Contractionary fiscal policy
decreases aggregate demand by decreasing government spending, increasing taxes, or decreasing transfers; shifts the aggregate demand curve leftward, a negative aggregate demand shock
To decrease aggregate demand, governments can decrease spending, raise taxes, or decrease transfer payments
Any change in injections has a multiplied effect of
aggregate demand
what direction
Injections increasing causes a shift
rightward
what direction
Injections decreasing causes a shift
leftward
When the economy is in recession and far below potential GDP, more of the increase in aggregate demand increases
real GDP
When the economy is at or above potential GDP, more of the increase in aggregate demand increases
prices
Beliefs
Hands-Off Demand-Side Fiscal Policies
- The government should keep its hands off the economy whenever possible
- If fiscal policy is necessary to accelerate the economy, tax cuts are favored instead of increased government spending; This puts more money in the hands of private individuals and businesses
- Government spending is subject to political influence and is not always spent where it is needed
- If fiscal policy is necessary to slow down the economy, government spending is favored over tax increases; This keeps money in the hands of private individuals and businesses
Beliefs
Hands-On Demand-Side Fiscal Policies
- Essential hands-on role for government to correct failures
- All forms of fiscal policy are acceptable, especially when monetary policy is ineffective due to transmission breakdowns
- Favors government spending over taxes; More effective, since consumers and businesses may save the money from tax cuts
- If fiscal policy is necessary to slow the economy down the hand-on position favors tax increases over reduced government spending; This preserves the government’s ability to stabilize the economy
Policies for Economic Growth
- Stimulate saving and capital investment
- Encourage Research and Development
- Improve Education and Training
Stimulate saving and capital investment
- Tax incentives can stimulate saving, increase the quantity of capital, and promote economic growth
- Governments uses tax incentives as a fiscal policy tool to stimulate saving and increase the quantity of capital available
Government tax exemptions for interest earned in Tax-Free Savings Accounts (TFSAs) and Registered Retirement Savings Plans (RRSPs) reward saving and increase the supply of loanable funds, making it easier and cheaper for businesses to borrow to finance new factories or new machinery and promote economic growth
Encourage Research and Development
- Government spending and tax incentives for research and development promote economic growth
- Government uses targeted government spending and tax incentives as fiscal policy to encourage research and development
- Government also provides tax incentives to businesses to encourage research and development
Improve Education and Training
- Government-financed education and training that increase human capital promote economic growth
Human capital increases through education and training - Businesses are willing to pay higher wages to workers with more human capital because they are more productive
- Government can spend to directly provide education and it can provide subsidies to schools and students
Hands-off Save
- Strongly supports fiscal policies to encourage saving and capital investment
- Believe that as saving flows into the loanable funds market, interest rates quickly fall, encouraging more consumer spending and business borrowing to finance more investment spending (I)
- These spending increases offset the additional saving, restoring aggregate demand to match aggregate supply
- Outweigh any short-run mismatches between aggregate demand and aggregate supply
Hands-On: Spend
- Worried that when businesses see reduced consumer spending, they will postpone investment spending
- Even if saving causes interest rates to fall in the loanable funds market, more pessimistic expectations about sales and profits outweigh the lower costs of borrowing
- While they see the long-run benefits of increased saving for aggregate supply and economic growth they are concerned that short-run decreases in aggregate demand may cause a recession because markets fail to quickly adjust
Who said “In the long run we are all dead”
KEYNES
Supply-side effects
the incentive effects of taxes on aggregate supply
Why do tax cuts have supply-side effects
- if the government cuts taxes on labor as well as on capital investments, the quantities of labor and capital inputs supplied to markets could increase, increasing aggregate supply
- Tax cuts can increase aggregate supply and potential GDP through supply-side effects
What do all economists believe about tax cuts
- that have incentive effects causing a small increase in aggregate supply → shifting both the LAS and SAS curves rightward
- Supply-side effects are small because most people already work as many hours as they can and don’t get much choice from their bosses over how long to work
def
Supply-Siders
believe that tax cuts have powerful incentive effects and claim that tax cuts will increase government tax revenues
Who mainly supports supply-sider argument to argue for tax cuts
Politicians who favor a hands-off role for government, no empirical evidence to support the claim
Argument: tax cuts will increase, not decrease government tax revenues
Balanced budget
income and spending match
Deficit
amount by which your spending exceeds income for the month
Debt
borrowing from student loans, credit cards, or family
Surplus
amount by which your income exceeds your spending for the month
Government revenue comes from what sources
personal income taxes, corporate taxes, employment insurance premiums, GST/HST
def
Automatic stabilizers
tax and transfer adjustments that counteract changes to real GDP without explicit government decisions
What happens to tax revenues and transfer payments when a positive demand shock causes the economy to expand beyond potential GDP
tax revenues increase and transfer payments decrease
When were automatic stabilizers introduced
after the Great Depression; since then, business cycles in Canada have been less frequent, and contractions have been less severe
Opportunity cost of automatic stabilizers
Increases in government budget deficits and accumulated debt since the Global Financial Crisis
Automatic stbailizers in a negative demand shock
As automatic stabilizers start working, tax revenues decrease and spending on transfer payments increases, creating an automatic budget deficit
Automatic stbailizers in a positive demand shock
As automatic stabilizers start working, tax revenues increase and spending on transfer payments decrease, automatically creating a budget surplus
Cyclical deficits and surpluses
created only as a result of automatic stabilizers counteracting business cycles
What can happen due to government’s attempt to balance the budget during an expansion
increases aggregate demand, increasing the risk of inflation
Good Balanced Budgets over the Business Cycle
With a balanced budget over the business cycles, cyclical surpluses during expansions offset cyclical deficits during contractions
A good balanced budget will have a surplus during the expansion and a deficit during the contraction
How to know if the budget is balanced over the business cycle
the positive amount of the surplus equals the negative amount of the deficit
def
Structural deficits and surpluses
budget deficits and surpluses occurring at potential GDP
When does a structural deficit occur
when governments spend more than their revenues even while the economy is at potential GDP and growing steadily
Not caused by business cycles, they are built into the structure of government taxes, transfers and spending programs
When does a structural surplus occur
when there is a government budget surplus even while the economy is at potential GDP and growing steadily
Problems with structural deficits
- Structural deficits are ongoing; even when the economy is at full employment, the government has to borrow money
- There are no offsetting surpluses; as deficits accumulate, the government must go deeper into debt
Problems with structural surpluses
Accumulate over time, raising the question of why government keeps collecting taxpayers’ money that it is not spending
Deficits are a
flow because they must be measured for a specified time dimension
Debt is a
stock, fixed amount at a moment in time
National debt
total amount owed by government
* = (sum of past deficits) - (sum of past surpluses)
How is the national debt measured?
measured in the nominal prices of that year
The most meaningful measure of the national debt
national debt as a percentage of GDP
Myths and Problems about the National Debt
- Canada will not go bankrupt bc of debt: The Government of Canada never has to pay back the national debt, it can simply refinance it
- Burden for Future Generations: Whether or not the national debt is a burden for future generations depends on who receives interest payments on the national debt (canadians or non-canadians)
- Debt is always bad: Debt is a smart choice if the expected future profits or benefits from spending the borrowed money are greater than the interest costs on the loan
- Interest payments create self-perpetuating debt: There is a vicious cycle when yearly deficits increase national debt, increasing interest payments, increasing yearly deficits, etc.
Crowding out
tendency for government debt-financed fiscal policy to decrease private investment spending by raising interest rates
High government borrowing raises interest rates, which in turn reduced some private investment
Crowding in
tendency for government debt-financed fiscal policy to increase private investment spending by improving expectations
The improvement in business expectations of profitability may increase private investment
United States origin
- created through a revolution against British government interference, has hands-off political origins
- Focus was on the individual’s right to pursue their own destiny, free from government restrictions
- Hands-off: government should not intervene, interfere, mistake
Canada Origin
- created by an act of government, has hands-on origins
- Stresses government’s responsibility to promote and protect the public good
- Hands-on: “government needs to act, responsibility, participation”
Normative statements
involve value judgements or opinions, “should”
Positive statements
can be evaluated as true or false, facts
Politicians decide on
government tax, transfer and spending programs
Political hands-off arguments against government are often disguised as
arguments against the national debt
