Chapter 12 - Fiscal Policy Flashcards
Definition of Fiscal Policy
Refers to government decisions about the level of taxation or government spending.
Affects economy by shifting Aggregate Demand (directly affects spending)
Two channels to affect AD with fiscal policy
government spending and tax policy
Definition of Expansionary Fiscal Policy
When the overall effect of decisions about taxation and spending is to increase aggregate demand.
Characterized by:
increasing government spending and lowering taxes
Shift AD curve to the right
Increased output, increased prices
Definition of Contractionary Fiscal Policy
When the overall effect of decisions about taxation and spending is to reduce aggregate demand.
Decreased government spending and higher taxes both
What is the main reason for policy makers to use fiscal policy?
to smooth fluctuations in the economy
Keynesian economic policy
Using expansionary policy responses (such as increasd government spending and decreased taxes) to counteract a decreasing AD.
This leads to output and price levels rising.
3 Different kinds of lag between policy choice and implementation
Information Lag
Formulation Lag
Implementation Lag
Definition of Information Lag
There’s a lack of understanding in the current economy
Definition of Formulation Lag
A discrepancy in deciding on and passing legislation
Definition of Implementation Lag
The literal time it takes the economy to adjust
Definition of Automatic Stabilizers
Are taxes and gov’t spending that affects fiscal policy without actual action from policy makers.
Example of automatic stabilizers and why
Taxes because we have a progressive tax system. Ie) as your earnings rise, higher tax rates apply - affect Tax revenues
These take less time to implement.
Definition of Discretionary Fiscal Policy
Self explanatory - when the government takes discretion when looking at the economy
ex) expansionary, contractionary fiscal policy
Limitations of fiscal policy
Politicians often cut taxes in response to recessions; wealth effect - increasing consumption
Tax cuts aren’t free because the government must find a way to make up for lost tax revenue (most likely in the future).
Definition of ‘Ricardian Equivalence’
Predicts that if there are tax cuts but no decrease in spending, people will not change their behaviour
This happens because the public knows they’ll have to pay later eventually.
Definition of the Multiplier Effect
the increase in consumer spending that occurs when spending by one person causes others to spend more too. This amplifies the impact of the initial government policy on the economy.
Things we need to do before deriving the multiplier
1) look at after tax income because that is each household’s consumption
2) people spend only a portion of their income
Definition of Marginal Propensity to Consume
the amount by which consumption increases when after-tax income increases by $1
MPC is also a value between 0 and 1 - indicates the fraction of an additional dollar that gets spent.
Example of MPC value of 0.8
MPS = 0.2
Multiplier = 1/MPS = 5
With an MPC of 0.8, we’re indicating that consumers spend 80% of their income and save 20%. This is key to know when indicating how much gov’ts need to put into the economy when trying to use expansionary fiscal policy to shift Aggregate Demand
Definition of Taxation Multiplier
Indicates how much GDP changes when taxes increase by $1
Taxation multiplier = 1 less than Multiplier effect
Definition of Transfer Payments
Refers to payments from gov’t accounts to individuals for programs like social insurance
Definition of the Budget Deficit
the amount of money a government spends beyond the revenue it brings in. ie) spending more than than we earned.
ex) Running a deficit means we’re in the red fam
Definition of the Budget surplus
The amount of revenue a government brings in beyond what it spends.
What is the difference between debt and deficit?
Deficits tell us how much the government revenues have fallen short of spending each years.
Debt is the total amount that the government owes. Or, Debt is the cumulative sum of all deficits and surpluses.
2 Main Benefits of Debt
1) allows the government to be flexible if something unexpected happens
2) Can pay for investments that lead to economic growth and prosperity
Direct costs of debt
the interest governmenthas to pay to the people borrowed from
There’s a vicious cycle of debt - high interest rates
Indrect costs of debt
distorts credit markets because everyone out here borrowing from everyone
