Chapter 13: Fiscal Policy Flashcards
At the Canadian federal level, which taxes generate the greatest revenue?
Income taxes (both personal income and corporate profits) and social insurance taxes
What is social insurance?
Government programs intended to protect families against economic hardship (mainly pension plans and social assistance benefits).
What is fiscal policy?
Changes in government spending, taxes, and transfers designed to affect overall spending.
How do you calculate disposable income?
Disposable income = Income - Taxes + Transfers
What does the government use fiscal policy for?
To shift the aggregate demand curve, and close a recessionary or inflationary gap.
What is expansionary fiscal policy?
Fiscal policy that increases aggregate demand by increasing government purchases, decreasing taxes, or increasing transfers.
What are the three forms of expansionary fiscal policy?
An increase in government purchases of goods and services, a cut in taxes, and an increase in government transfers.
What is contractionary fiscal policy?
Fiscal policy that reduces aggregate demand by decreasing government purchases, increasing taxes, or decreasing transfers.
What are the three forms of contractionary fiscal policy?
A reduction in government purchases of goods and services, an increase in taxes, and a reduction in government transfers.
What are the three main arguments against expansionary fiscal policy?
Government spending always crowds out private spending; Government borrowing always crowds out private investment, and; Government budget deficits lead to reduced private spending.
What is the counter-argument against the claim that government spending always crowds out private spending?
The claim assumes that resources in the economy are always fully employed, which they’re not. Expansionary fiscal policy during recessionary gaps puts unemployed resources to work and generates higher spending and higher income. Government spending only crowds out private spending when the economy is operating at full employment.
What is the counter-argument against the claim that government borrowing always crowds out private investment?
Crowding out depends on whether the economy is depressed or not. Government borrowing crowds out private investment spending only when the economy is operating at full employment (which is why most economists do not recommend a fiscal expansion at such times).
What is the counter-argument against the claim that government budget deficits lead to reduced private spending?
The claim is based on the assumption that expansionary fiscal policy will have no effect on the economy because far-sighted consumers will undo any attempts at expansion by the government (Ricardian equivalence). In reality, most consumers, when provided with extra cash (generated by fiscal expansion), will spend at least some of it. So even fiscal policy that takes the form of temporary tax cuts or transfers of cash to consumers probably does have an expansionary effect.
Even with Ricardian equivalence, a temporary rise in government spending that involves direct purchases of goods and services (i.e., road construction), will still lead to a boost in total spending in the near term.
What is a key reason for caution in the case of fiscal policy?
Time lags between when the policy is decided upon and when it is implemented. Because of these lags, an attempt to increase spending to fight a recessionary gap may take so long to get going that the economy has already recovered on its own. In fact, the recessionary gap may have turned into an inflationary gap by the time expansionary fiscal policy takes effect. In that case, expansionary fiscal policy will make things worse, not better.
What causes time lags in fiscal policy?
The government has to realize a recessionary or expansionary gap exists; The government has to develop a spending plan, and; It takes time to spend money.
Consider whether this situation is expansionary or contractionary fiscal policy: several military bases around the country, which together employ tens of thousands of people, are closed.
Contractionary fiscal policy (decrease in government spending).
Consider whether this situation is expansionary or contractionary fiscal policy: the number of weeks an unemployed person is eligible for unemployment benefits is increased.
Expansionary fiscal policy (increase in government transfers).
Consider whether this situation is expansionary or contractionary fiscal policy: the federal tax on gasoline is increased.
Contractionary fiscal policy (increase in government taxes).
Explain why federal disaster relief, which quickly disburses funds to victims of natural disasters such as hurricanes, floods, and large-scale crop failures, will stabilize the economy more effectively after a disaster than relief that must be legislated.
Because federal disaster relief is not impacted by time lags. It takes time for policy to be decided upon, legislated, and implemented. By the time relief that must be legislated has been distributed, the economy may be in a worse-off position, and it may take more time and resources to restore it to a stabilized form than quick disaster relief.
Is the following statement true or false? Explain. “When the government expands, the private sector shrinks; when the government shrinks, the private sector expands.”
This statement implies that expansionary fiscal policy will result in crowding out of the private sector, and that the opposite, contractionary fiscal policy, will lead the private sector to grow. Whether this statement is true or not depends upon whether the economy is at full employment; it is only then that we should expect expansionary fiscal policy to lead to crowding out. If, instead, the economy has a recessionary gap, then we should expect instead that the private sector grows along with the fiscal expansion, and contracts along with a fiscal contraction.
Why do changes in government taxes or transfers shift the AD curve by less than an equal-sized change in government purchases?
Because government spending directly contribute X amount to real GDP. Through taxes and transfers, households will only spend some amount of X (recall the MPC), and the rest will “leak” out into savings.
How do you calculate total effects of the multiplier on government purchases?
ΔY = ΔG * (1/(1-MPC))
How do you calculate the total effects of the multiplier on government transfers?
ΔY = ΔTR * MPC * (1/(1-MPC))
When expansionary fiscal policy takes the form of a rise in transfer payments, real GDP may rise…
By either more or less than the initial government outlay. That is, the multiplier may either be more or less than 1 depending on the size of the MPC.