Chapter 12 | Fiscal Policy, Deficits, National Debt Flashcards
Demand Policies for Stabilization
Fiscal policies – changes in government spending, taxes, and transfers – act as aggregate demand shocks, have multiplied impact on aggregate demand, and can counter output gaps
Fiscal policy
changes in government purchases, taxes, transfers to achieve macroeconomic outcomes of steady growth, full employment, and stable prices
Circular flow transmits the effects of fiscal policy
Circular flow transmits the effects of fiscal policy
Injection
spending in the circular flow not starting with consumers: G (government spending), I (business investment spending), X (exports)
Leakage
spending leaking out of the circular flow through taxes, saving, imports
Multiplier effect
spending injection has multiplied effect on aggregate demand
Multiplied increase in aggregate demand from
Increased government spending
Tax cuts
Increased transfers
Multiplied decrease in aggregate demand from
Decreased government spending
Tax increases
Decreased transfers
Demand-Side Fiscal Policy
Size of multiplier effects depends on leakages out of circular flow
Size of Multiplier Effect Formula
Size of Multiplier Effect = 1 / % of leakages from additional income
More leakages = smaller multiplier
Fewer leakages = larger multiplier
Changes in injections
G, I, X – is aggregate demand shock, shifting AD rightward (↑ injections) or leftward (↓ injections) by multiplied effect of initial rejection
Expansionary fiscal policy
increases aggregate demand by increasing government spending, decreasing taxes, or increasing transfers
- Shifts the aggregate demand curve rightward – positive aggregate demand shock
- Counters a recessionary gap
Contractionary fiscal policy
decreases aggregate demand by decreasing government spending, increasing taxes, or decreasing transfers
- Shifts the aggregate demand curve leftward – negative aggregate demand shock
- Counters an inflationary gap
Injections multiplier effects on equilibrium real GDP depend on how close economy is to potential GDP
When economy below potential GDP, more of increase in aggregate demand increases real GDP
When economy at or above potential GDP, more of increase in aggregate demand drives up prices
Disagreements About Demand-Side Fiscal Policy
Hands-off camp favours tax cuts to accelerate economy; spending reductions to slow economy
Hands-on camp favours government spending to accelerate economy; tax increases to slow economy
Supply-Side Fiscal Policy
Fiscal policies targeting aggregate supply – tax incentives, support for R&D, education, training – promote economic growth, but hands-off and hands-on camp differ in emphasizing long-run or short-run effects.
Government policies to promote economic growth include spending and tax incentives
To stimulate saving and increase quantity of capital
For research and development
For education and training increasing human capital
Fiscal spending and tax policies can increase quantity and quality of inputs, increasing (long-run and short-run) aggregate supply and potential GDP per person
Fiscal spending and tax policies can increase quantity and quality of inputs, increasing (long-run and short-run) aggregate supply and potential GDP per person
Supply-side effects
incentive effects of taxes on aggregate supply
Supply-siders believe
tax cuts have powerful incentive effects and will increase, not decrease, government tax revenues
Laffer Curve
graph showing that as tax rate increases, tax revenues increase, reach a maximum, then decrease
Evidence shows that tax cuts reduce revenue
Supply-sider arguments appeal to politicians
promise tax cuts – which voters like – without reducing government services or going into debt
Fiscal policies that encourage saving can decrease aggregate demand in the present
Hands-off camp believes long-run benefits of increased aggregate supply outweigh short-run mismatches between reduced aggregate demand and aggregate supply
Hands-on camp worries that short-run costs of decreased aggregate demand and recession outweigh long-run benefits of economic growth
Deficits and Surpluses
Automatic stabilizers create cyclical budget deficits and surpluses while keeping the economy close to potential GDP. Structural deficits and surpluses at potential GDP are more problematic
Government budget scenarios
Balanced budget – revenues = spending
Budget deficit revenues – < spending
Budget surplus revenues – > spending
Automatic stabilizers
tax and transfer adjustments counteracting changes to real GDP, without explicit government decisions
During contractions
tax revenues fall, transfer payments increase, supporting spending and aggregate demand, but causing automatic budget deficit
During expansions
tax revenues rise, transfer payments decrease reducing spending and aggregate demand, but causing automatic budget surplus
Automatic stabilizers work like a thermostat, keeping economy close to potential GDP
Since automatic stabilizers introduced after Great Depression, business cycles are less frequent, contractions less severe
Cyclical deficits and surpluses
created only as a result of automatic stabilizers counteracting business cycles
With automatic stabilizers, government attempts to balance the budget during
Recessions – decrease aggregate demand, make recessions worse
Expansions – increase aggregate demand, increase risk of inflation
With a balanced budget over the business cycle, cyclical surpluses during expansions offset cyclical deficits during contractions
With a balanced budget over the business cycle, cyclical surpluses during expansions offset cyclical deficits during contractions
Economists are concerned with
structural deficits and surpluses
structural deficits and surpluses
budget deficits and surpluses at potential GDP
National Debt
Deficits are a flow while debit is a stock. Of five common arguments about national debt, some are myths, some are potential problems.
Deficits and debt have different time dimensions
Deficits and surpluses are flows
Debt is a stock
National debt (public debt)
total amount owed by government = (sum of past deficits) - (sum of past surpluses)
Five arguments about national debt
- Will Canada go bankrupt?
- Burden for future generations?
- Debt is always bad
- Interest payments create self-perpetuating debt
- Crowding out and crowding in
- Will Canada go bankrupt?
a) Largely a myth
b)Government of Canada never has to pay back national debt – can simply refinance it
c) Governments that do not pay debts find it difficult/expensive to borrow on bond market
- Burden for future generations?
a) Depends on who receives interest payments on national debt – Canadians or non-Canadians
- Debt is always bad
a) Myth – consumers and businesses make smart choices to go into debt
b) Government debt can be smart choice if positive impact on economy of spending financed by debt is greater interest cost
c) Government debt can be not-smart choice if spending financed by debt for consumption only
d) Yes – Hands-Off camp opposes, No – Hands On camp supports, debt financed government spending to prevent recession
- Interest payments create self-perpetuating debt
a) Potential problem of the national debt
b) Canada’s yearly deficits between mid-1970s and mid-1990’s increased national debt and interest payments -> increasing yearly deficits
c) Vicious cycle broke in 1996
- Crowding out and crowding in
a) Potential problem and benefit of the national debt
b) Crowding out - when government debt-financed fiscal policy decreases private investment by raising interest rates
c) Crowding in - when government debt-financed fiscal policy increases private investment by improving expectations
Politics & Economics
Sort out economic arguments from political arguments so that you can make informed choices as a citizen about hands-off and hands-on roles for government fiscal policy and your own future
Political philosophies differ among countries
United States – created through a revolution against British government’s interference – has hands-off origins
Canada – created by an act of government – has hands-on origins
Words about proper role for government often reveal speaker’s point of view
Hands-off words used with government: intervene, interfere, mistake
Hands-on words used with government: act, participate, responsibility
Arguments about fiscal policy, deficits, and debt often mix up politics and economics
- Policies that make economic sense (balance budget over business cycle) might not make political sense; when recession over, hard to stop spending, to raise taxes
- Political hands-off arguments against government are often disguised as arguments against national debt
- Sort out economic from political arguments to make informed choices about hands-off and hands-on role for government
