Chapter 12 - Fiscal Policy Flashcards
What is aggregate demand?
The total quantity of output demanded at alternative price levels in a given time period
What are the 4 major components of aggregate demand?
Consumption
Investment
Government spending
Net exports (exports-imports)
State the aggregate demand formula
AD=C+I+G+NE
Name some characteristics of C (consumption)
C is…..
The largest portion of AD
The most unpredictable portion of AD
Describe what I means in the formula
Investment (businesses). Includes items on the shelf in a store
What is consumption?
Expenditures by consumers on final goods and services
Consumption accounts for approximately ______ of total spending in the US economy
2/3
What is investment?
Expenditures on (production of) new plant and equipment in a given time period, plus changes in business inventories
I represents spending by…..
Business firms on capital goods like machinery, tools, and equipment
What do businesses want to do?
Expand the production possibilities curve
What is government spending?
Expenditures on all goods and services provided by the public sector
Are income transfers included in government spending? Why or why not?
NO because they are payments to individuals for which no services are exchanged
What is net exports?
Difference between export spending and import spending (exports-imports)
Are US net exports positive or negative? Explain
Negative because we buy more goods from abroad than foreigners buy from us
Define fiscal policy
The use of government taxes and spending to alter alter macroeconomic outcomes. It can be used to STIMULATE or DEPRESS aggregate demand
Is fiscal policy used to shift the AS curve?
No——ONLY AD
Does C+I+G+NE usually add up to the right amount of aggregate demand?
NO- gov spending and taxes is used to adjust aggregate demand (fiscal policy)
Fiscal policy works principally through…..
SHIFTS of the AD curve
What results when AD is too high? (Rightward shift)
Inflation
What happens when AD is too low? (Leftward shift)
Unemployment
What is the GDP gap?
The difference between full employment output and the amount of output demanded at current price levels (equilibrium output)
What is the goal of fiscal policy in relation to the GDP gap?
To close it as much as possible
What is another word for after-tax income?
Disposable income
What is fiscal stimulus?
Increased government spending and lower taxes intended to shift (increase) aggregate demand
Fiscal stimulus is intended to _____ incomes and _____ consumer spending
Increase incomes and increase consumer spending
What is the term used to describe the fact that money gets spent and respent in a circular flow?
The multiplier effect
With the multiplier effect, ____ initially increases AD. Then, AD increases indirectly by ___ and____
Initially - G
Indirectly - C and I
All income is either ____ or ____
Spent or saved
How to calculate savings?
Income - consumption
Describe a scenario that depicts the multiplier effect
Someone makes $100 a week. They get a 10% raise, therefore their disposable income is now $110. They spend that extra $5 buying coffee. The $5 is in the hands of the coffee shop, and they can use some/all of that to buy more ingredients/machines and pay their workers. This money is now in the hands of a coffee shop worker who will then spend it at another store
The key to the multiplier effect is that….
100% is not spent every time!!!
What does MPC stand for?
Marginal propensity to consume
What does marginal propensity to consume mean?
Fraction of each additional dollar of disposable income spent on consumption
(Fraction of income consumed)
What does MPS stand for?
Marginal propensity to save
What does marginal propensity to save mean?
Fraction of each additional dollar of disposable income NOT spent on consumption
MPC+MPS=
1
FORMULA FOR MPC
CHANGE IN CONSUMPTION/CHANGE IN DI
FORMULA FOR MPS (2 potential)
1-MPC
Or
MPS=change in saving/change in Di
Used to make $100 and spent $25. Now, you make $200 and spend $100
Calculate MPC and MPS
100-25/200-100
75/100 = 0.75MPC
100-75/200-100 = 0.25MPS
THE MPC IS 0.75. Explain what this means
For every additional dollar earned, 0.75 cents is spent
Multiplier tells us…..
How much total spending will change in response to an initial spending stimulus
Formula for multiplier
1/(1-MPC)
If MPC = 0.75, what is the multiplier?
1/1-0.75
1/0.25 = 4
The multiplier is 4. Explain what this means?
Total spending increased x4
Or…
For every 1$ of gov spending, AD will increase by $4
How is the change of spending determined?
Multiplier * initial change in gov spending
How is the GDP gap closed?
By the DIRECT impact of gov spending followed by subsequent increases in consumer spending
For the GDP gap to be closed, AD curve shifts to the…..
Right
Besides government spending, how else can the government increase consumption/investment?
Tax cuts
A tax cut directly increases……..
Disposable income
What is disposable income?
The after tax income of consumers
A tax cut will stimulate more consumer spending as long as….
MPC is greater than zero
When fiscal stimulus closes the GDP gap, it will also cause…
Inflation
Explain why fiscal stimulus will also cause inflation
The AS curve is upward sloping. Therefore, any increase in AD will raise output and price levels
What is fiscal restraint?
Bring prices down my moving the AD curve to the left
Fiscal restraint is _____ or _____ intended to reduce (shift) aggregate demand
Tax hikes or spending cuts
When inflation threatens, _______ is used
Fiscal restraint
If excessive aggregate demand is causing prices to rise, what will the goal of fiscal policy be?
To reduce aggregate demand, not stimulate it
Fiscal restraint is achieved in 2 ways:
Budget cuts (decreased government spending ) or tax hikes
Cutbacks in gov spending _____ reduce aggregate demand
DIRECTLY
The impact of spending cuts is magnified by…..
The multiplier
Government cutbacks have a ____ effect on aggregate demand
Multiplied
Tax increases _____ disposable income, thereby _____ consumption and shifting the AD curve to the _______
Tax increases LOWER disposable income, thereby REDUCING consumption and shifting the AD curve to the LEFT
What is budget deficit?
The amount by which government expenditures exceeds government revenue in a given time period.
GOV SPENDING > TAX REVENUES
What is budget surplus?
An excess of government revenues over government expenditures in a given time period
GOVERNMENT SPENDING < TAX REVENUES
PROBLEM: unemployment is too high. What do we want to do to the AD curve and what tools do we have to accomplish this???
Shift AD curve to the right. Increased gov spending and tax cuts
PROBLEM: inflation. What do we want to do to the AD curve to solve this problem and what tools do we have to accomplish this?
Lower AD (shift to the left) decreased gov spending and raise taxes
