Chapter 13: Unemployment and fiscal policy

Question 1

Drivers of private investment spending within the capitalist economy

Answer 1

Expectations about future post-tax profits.

Question 2

Marginal propensity to consume

Answer 2

The change in consumption when disposable income changes by one unit.

Question 3

Aggregate demand equation

Answer 3

Aggregate demand = consumption + investment

Question 4

How government spending and tax can dampen the economy

Answer 4

• Size of government: Larger the government the generally more stable the government.
• Government provides unemployment benefits: Smooths out fluctuations in income
• Government intervention: Use fiscal policy to stabilise aggregate demand.

Question 5

Government budget surplus

Answer 5

When the government budget balance is positive. See also: Government budget balance.

Budget in balance: G = T
Budget deficit: G > T
Budget surplus: G < T

Question 6

Austerity policy

Answer 6

A policy where a government tries to improve its budgetary position in a recession by increasing its saving. See also: Paradox of thrift.

Question 7

Primary budget deficit meaning

Answer 7

The government deficit (its revenue minus its expenditure) excluding interest payments on its debt. See also: Government debt.

Question 8

Multiplier mechanism

Answer 8

The total (direct and indirect) change in output caused by an initial change in government spending.

Question 9

Aggregate consumption

Answer 9

An equation that shows how consumption spending in the economy as a whole depends on other variables: for example, in the multiplier model, the other variables are current disposable income and autonomous consumption. See also: Disposable income, Autonomous consumption.

Question 10

Investment function

Answer 10

An equation that shows how investment spending in the economy as a whole depends on other variables, namely, the interest rate and profit expectations. See also: Interest rate, Profit.

Question 11

Goods market equilibrium

Answer 11

The point at which output equals the aggregate demand for goods produced in the home economy. The economy will continue producing at this output level unless something changes spending behaviour. See also: Aggregate demand.

Question 12

Autonomous consumption

Answer 12

Consumption that is independent of income.

Question 13

Autonomous demand

Answer 13

Components of aggregate demand that are independent of current income.

Question 14

Target wealth

Answer 14

Target wealth is the level of wealth that the household aims to hold, based on its economic goals (or preferences) and expectations. We assume that households try to maintain this level of wealth in the face of changes in their economic situation, as long as it is possible to do so.

Question 15

Household balance sheet

Answer 15

A record of the assets, liabilities and net worth of an economic actor such as a household, bank, firm or government.

Question 16

Financial accelerator

Answer 16

The mechanism through which firms’ and households’ ability to borrow increases when the value of the collateral they have pledged to the lender (often a bank) goes up.

Question 17

Automatic stabilisers

Answer 17

Characteristics of the tax and transfer system in an economy that have the effect of offsetting an expansion or contraction of the economy.

Question 18

Fiscal stimulus

Answer 18

The use by the government of fiscal policy (via a combination of tax cuts and spending increases) with the intention of increasing aggregate demand. See also: Fiscal multiplier, Aggregate demand.

Question 19

Paradox of thrift

Answer 19

The paradox is that if a single individual consumes less, her savings will increase; but if everyone consumes less, the result may be lower rather than higher savings overall. The attempt to increase saving is thwarted if an increase in the saving rate is unmatched by an increase in investment (or other source of aggregate demand such as government spending on goods and services). The outcome is a reduction in aggregate demand and lower output so that actual levels of saving do not increase.

Question 20

Government budget balance

Answer 20

The excess of government purchases of goods and services plus interest payments and transfers including pensions over tax and other forms of revenue. See also: Government budget deficit, Government budget surplus.

Question 21

Government budget deficit

Answer 21

When the government budget balance is negative. See also: Government budget balance.

Question 22

Government budget surplus

Answer 22

When the government budget balance is positive. See also: Government budget balance.

Question 23

Government debt

Answer 23

Thesum of all the bonds the government has sold over the years to finance its deficits, minus the ones that have matured.

Question 24

Supply side (aggregate economy)

Answer 24

How labour and capital are used to produce goods and services. It uses the labour market model (also referred to as the wage curve and profit curve model). See also: Demand side (aggregate economy).

Question 25

Demand side (aggregate economy)

Answer 25

How spending decisions generate demand for goods and services, and as a result, employment and output. It uses the multiplier model. See also: Supply side (aggregate economy).

Question 26

Business cycle

Answer 26

Alternating periods of positive and negative growth rates. The economy goes from boom to recession and back to boom. See also: Short-run equilibrium.

Question 27

Long run (model)

Answer 27

The term does not refer to a period of time, but instead to what is exogenous. A long-run cost curve, for example, refers to costs when the firm can fully adjust all of the inputs including its capital goods; but technology and the economy’s institutions are exogenous. See also: Technology, Institutions, Short run, Medium run.

Question 28

Medium run (model)

Answer 28

The term does not refer to a period of time, but instead to what is exogenous: capital stock, technology and institutions are exogenous in the medium run. See also: Capital, Technology, Institutions, Short run, Long run.

Question 29

Short run (model)

Answer 29

The term does not refer to a period of time, but instead to what is exogenous: prices, wages, capital stock, technology and institutions are exogenous. See also: Price, Wages, Capital, Technology, Institutions, Medium run, Long run.

Question 30

What is the ‘multiplier’? and what does it do?

Answer 30

A change in aggregate demand will change output more than one-for-one when households use some portion of any increase in income they receive to purchase goods and services. Because the multiplier is typically greater than one, positive or negative shocks to aggregate demand are amplified.

Question 31

How do government transfers act as stabilisers?

Answer 31

Transfers such as unemployment benefits typically increase in a recession and tax revenues tend to fall. These automatic stabilisers help to dampen the business cycle.

Dampening mechanisms offset shocks (stabilising):
(PRIVATE SECTOR) consumption smoothing,
(GOVERNMENT AND CENTRAL BANK) automatic stabilisers (e.g. unemployment benefit) or stabilisation policy (e.g. fiscal or monetary)

Amplifying mechanisms reinforce shocks (may be destabilising):
(PRIVATE SECTOR) Credit constraints limit consumption smoothing, Rising value of collateral (house prices) can increase wealth above the target level and raise consumption, Rising capacity utilisation in a boom encourages investment spending, adding to the boom.
(GOVERNMENT AND CENTRAL BANK) Policy mistakes, such as limiting the scope of automatic stabilisers in a recession or running deficits during low demand periods, while not running surpluses during booms.

Question 32

Who uses fiscal and monetary policy? And what do they do?

Answer 32

The government and central bank can use fiscal policy (changes in taxes or spending) or monetary policy to stabilise the economy. Fiscal policy affects aggregate demand directly, whereas monetary policy affects aggregate demand indirectly by altering interest rates.

Question 33

How can fiscal stimulus stabilise an economy?

Answer 33

This can be used when private investment or consumption falls, or when the private sector increases its saving. It needs to be reversed once private spending recovers and the economy is growing again in order to avoid government debt rising unsustainably.

(GOVERNMENT AND CENTRAL BANK ONLY)

Dampening mechanisms offset shocks (stabilising): Automatic stabilisers (e.g. unemployment benefit), Stabilisation policy (fiscal or monetary)

Amplifying mechanisms reinforce shocks (may be destabilising): Policy mistakes, such as limiting the scope of automatic stabilisers in a recession or running low demand periods, while not running surpluses in booms.

Question 34

What can affect debt to GDP ratios?

Answer 34

Wars, recessions and financial crises increase government debt relative to GDP. Growth of the economy, low interest rates and inflation reduce it.

Question 35

Effects of trade with the rest of the world.

Answer 35

This is a source of good and bad shocks to aggregate demand, such as export booms or the collapse of demand in another country’s market. Trade with the rest of the world reduces the size of the multiplier.