Chapter 13: Fiscal Policy Flashcards
Discretionary fiscal policy (that which is direct result of policy action taken by policymakers)
Refers to the use of govt spending or tax policy to stimulate or contract aggregate demand (AD); used to shift the ADC (aggregate demand curve)
GDP= C + I + G + X – IM
Lags in Fiscal Policy
Reason for caution:
*realize recesssionary/inflationary gap by collecting and analyzing economic date
*Govt develops a spending plan
*Implementation of action plan (spending the $)
All 3 take time
Fiscal policy and the multiplier
- Fiscal policy has a multiplier effect on the economy
- Expansionary fiscal policy leads to an increase in real GDP > the initial rise in aggregate spending caused by the policy
- Conversely, contractionary fiscal policy leads to a fall in real GDP > the initial reduction in aggregate spending caused by the policy.
Fiscal policy and the multiplier (continued)
- The size of the shift of the ADC depends on the type of fiscal policy.
- The multiplier on changes in govt purchases, 1/(1-MPC), is > the multiplier on changes in taxes or transfers, MPC/(1-MPC), because part of any change in taxes or transfers is absorbed by savings.
- Changes in govt purchases have more powerful effect on economy than equal-changes in taxes or transfers.
Taxes and the multiplier
- Taxes, unemployment ins benefits, Medicaid and food stamps, and transfer programs act as “automatic stabilizers”, reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle.
- in contrast, discretionary fiscal policy arises from deliberate actions by policy makers rather than the business cycle.
Expansionary fiscal policies
Make a budget surplus smaller or a budget deficit larger
Contractionary fiscal policies (smaller govt purchases or goods/services, smaller govt transfers, or higher taxes)
- Increase the budget balance for that year, making a budget surplus bigger or a deficit smaller
- Some of fluctuations in the budget balance are due to the effects of the business cycle
- To separate the effects of business cycle from those of discretionary fiscal policy, govts estimate the “cyclically adjusted budget balance”, an estimate if economy were at potential output.
Relationship between budget balance & business cycle
- Recession–> balance towards deficit
- Expansion–>balance towards surplus
- Higher unemployment rate, higher budget deficit
Cyclically adjusted budget deficit
Fluctuates less than the actual budget deficit, because years of large budget deficits also tend to be years when the economy has a large recessionary gap.
Problems posed by Rising Govt Debt
- Public debt may crowd out investment spending and reduce long-run economic growth
- Rising debt may lead to govt default, resulting in econ and financial turmoil
- IF a govt that has trouble borrowing prints more money to pay it’s bills–>inflation
Norway as an example
Norway has large negative public debt due to it’s oil exports. Instead of spending its oil revenues immediately, Norway uses them to build investment fund for future needs and thus has large govt assets rather than debt.
Most expensive transfer programs
Soc Security, Medicare and Medicaid
Social insurance
govt programs aimed at protecting families against econ hardship
GDP= C+I+G+X–IM
Govt purchases of goods/services (G) has direct impact on total spending in economy.
Also affects C through change in taxes and transfers, and may affect I through govt policy.
debt-GDP ratio
government debt as a % of GDP, frequently used as a measure of a govt’s ability to pay it’s debts