Chapter 13: Fiscal Policy Flashcards
What is fiscal policy (discretionary fiscal policy)?
This refers to changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability and healthy rates of economic growth. Do not mix this up with automatic stabilisers.
What is fiscal policy usually referred to by economists?
They typically use the term to refer only to the actions of the federal government, even though state and local governments also have responsibility for taxing and spending.
Are all federal government tax and spending decisions fiscal policy actions?
No, they because they are not all intended to achieve macroeconomic policy goals.
e.g. a decision to cut the taxes of people who take out private health insurance is a health policy action, not a fiscal policy action.
What are automatic stabilisers?
Transfer payments and taxes that automatically increase or decrease along with the business cycle. As a result, these changes in these types of spending and taxes happen without actions by the government.
e. g. when the economy is expanding and employment is increasing, government transfers for unemployment benefit payments to workers who were previously unemployed will automatically decrease and vice versa.
e. g. when the economy is expanding or experiencing an economic boom and incomes are rising, the amount the government collects in taxes will increase as people pay additional taxes on their higher incomes and vice versa.
Is there a difference between government purchases and government expenditures?
Yes.
Purchases example: the federal government funds the building of a motorway or purchases the services of a university, it receives goods and services in return
Expenditures example: federal government expenditures include purchases plus all other federal government spending.
Can fiscal policy be used to influence aggregate demand?
Yes, the federal government can use it to offset the effect of the business cycle or an economic shock in the economy. When the economy is experiencing an economic contract or recession, increases in government purchases or decreases in taxes will increase AD. The inflation rate may also increase of AD increases faster than AS. However, decreasing government purchases or raising taxes can slow the growth of AD and reduce the inflation rate.
What is expansionary fiscal policy?
Increases in government purchases or decreases in taxes in order to increase AD.
How does an increase in government purchases increase AD?
An increase in government purchases will increase AD directly because government purchases are a component of AD.
How does a decrease in taxes increase AD?
Because it increases the amount of disposable income (income after tax) households have. This will lead to an increase in consumption spending. Similarly, tax cuts on business income can increase AD by increasing business investment.
Explain the effect of expansionary fiscal policy on the dynamic AD and AS model.
Overtime potential GDP increases – shown by the LRAS curve shifting to the right
The factors that also cause the LRAS to shift also cause firms to supply more goods and services at any given price level in the short run = SRAS curve shift to the right
Finally, during most years, the AD curve also shifts to the right, indicating that aggregate expenditure is higher at every price point (this indicates the use of expansionary fiscal policy to meet LRAS and SRAS at an equilibrium).
This results in the equilibrium price level increasing = inflation rate is higher than it would have been if expansionary fiscal policy had not been used.
What is contractionary fiscal policy?
This refers to decreases in government purchases or increases in taxes in order to reduce the increases in AD (as these are likely to increase the rate of inflation without intervention).
Explain the effect of contractionary fiscal policy on the dynamic AD and AS model.
Y axis = price level X axis = real GDP LRAS1 = vertical line intersecting with AD1 and SRAS1 (equilibrium A) AD1 = diagonal downward sloping line SRAS1 = diagonal upward sloping line
LRAS2 = shifts to right of LRAS1
AD2(without policy) = shifts to the right of AD1 (due to LRAS increasing)
SRAS2 = shifts to right of SRAS1 (this results in a short-run macroeconomic equilibrium beyond potential GDP – point B)
Point B = intersection between SRAS2 and AD2(without policy) (higher price level and higher GDP than point A and C)
= increase in price level
Decreasing government purchases or increasing taxes will shift AD1 and/or AD2(without policy) to AD2(with policy) and keeps real GDP from moving beyond its potential level.
AD2(with policy) = downward sloping line in between AD1 and AD2(without policy). It intersects with LRAS2 and SRAS2 to create equilibrium point C.
Point C = price level and GDP level in between point A and B.
Summarise countercyclical fiscal policy.
Problem – Type of Police – Actions by the Government - Result
Economic contraction or recession = expansionary = increase gov spending or cut taxes = real GDP and price level rise by more than they would have without policy.
Rising inflation rate = contractionary = decrease government spending or raise taxes = real GDP and the price level does not rise by as much as they would have without policy.
What is the multiplier effect?
The process by which an increase in autonomous expenditure leads to a larger increase in real GDP.
What is autonomous expenditure?
Economists refer to the initial increase in government purchases as autonomous because it was the result of a decision by the government and does not directly depend on the level of real GDP. The increases in consumption spending are induced by the initial increase in autonomous spending.
Explain the multiplier’s effect on AD.
An initial increase in government purchases causes the AD curve to shift from the right from AD1 to AD2 and represents the impact of the initial increase in $x billion government purchases. Because this initial billion raises incomes and leads to further increases in consumption spending, the AD curve will shift further to the right, to AD3.
What is the government purchases multiplier?
The ratio of change in equilibrium real GDP to the initial change in government purchases.
Government purchases multiplier = change in equilibrium real GDP/change in government purchases
Although we cannot say precisely how many periods it will take, we simply label the final period, n, rather than giving it a specific number.
Is the multiplier a short-run or long-run effect?
The multiplier has a short-run effect that assumes that the economy is below the level of potential GDP. In the long-run, the economy is at potential GDP, so an increase in government purchases causes a decline in the non-government components of real GDP, but it leaves the level of real GDP unchanged.
Do tax cuts have a multiplier effect?
Yes. Cutting personal income taxes increases the disposable income of households. When household disposable income rises, so will consumption spending, depending on the size of the MPC. These increase in consumption spending will set off further increases in real GDP and income, just as increases in government purchases do.
What is the tax multiplier expression?
Tax multiplier = change in equilibrium real GDP/changes in taxes.
The tax multiplier effect is a negative number because changes in taxes and changes in real GDP move in opposite directions: an increase in taxes reduces disposable income, consumption and real GDP. And a decrease in taxes raises disposable income, consumption and real GDP.
Therefore, the first period of the multiplier process will lead to a smaller increase in AD than what occurs when there is an increase in government purchases, and the total increase in equilibrium real GDP will be smaller.
What is the effect of changes in tax rates?
A change in tax rates has a more complicated effect on equilibrium real GDP than does a tax cut of a fixed amount. To begin with, the value of the tax rate affects the size of the multiplier effect. The higher the tax rate, the smaller the multiplier effect. This is because a higher tax rate causes a smaller amount of increase in income which households have available to spend, which reduces the size of the multiplier effect.
What are the 2 channels in which a cut to tax rates affects equilibrium real GDP?
- A cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending and
- A cut in tax rates increases the size of the multiplier effect.