Chapter 16 Flashcards
What is fiscal policy?
The setting of the level of government spending and taxation by government policymakers to influence the economy.
How does an increase in government purchases shift the AD curve?
It increases aggregate demand directly, shifting the AD curve to the right.
What are the two macroeconomic effects that influence the size of a fiscal policy’s impact on AD?
Multiplier effect
Crowding-out effect
What is the multiplier effect?
Additional shifts in AD that result when expansionary fiscal policy increases income and consumer spending.
What is the formula for the spending multiplier in a closed economy?
Multiplier = 1 / (1 - MPC)
How does the multiplier change in an open economy?
Multiplier = 1 / (1 - MPC + MPI)
where MPI = marginal propensity to import.
What is the crowding-out effect on investment?
The offset in AD that occurs when expansionary fiscal policy raises interest rates, reducing private investment.
What is the crowding-out effect on net exports?
In a small open economy with flexible exchange rates, expansionary fiscal policy raises the real exchange rate, reducing net exports and offsetting gains in AD.
What is an automatic stabilizer?
A feature of fiscal policy that automatically adjusts to economic fluctuations, like the tax system or EI benefits, without deliberate action.
How does a tax cut affect AD?
Increases disposable income → increases consumption → shifts AD right. The effect depends on whether households view the cut as permanent or temporary.
Why does a temporary tax cut have a smaller effect on AD than a permanent one?
Households save more if they view it as temporary, reducing the immediate impact on consumption.
What is the investment accelerator?
A mechanism by which higher demand leads firms to invest more, reinforcing the multiplier effect.
What happens when expansionary fiscal policy is implemented in a small open economy with flexible exchange rates?
Interest rate rises
Capital inflows increase
Dollar appreciates
Net exports fall
AD returns to original level (no lasting effect)
What happens under a fixed exchange rate when the government uses expansionary fiscal policy?
The BOC intervenes to keep the exchange rate fixed by expanding money supply → prevents crowding-out → larger effect on AD.
What is the case for active fiscal stabilization policy?
It can offset demand shocks, reduce the severity of recessions, and maintain full employment in the short run.
What is the case against active fiscal stabilization policy?
Long implementation lags
Risk of poor timing
May destabilize rather than stabilize
Why is the tax system an automatic stabilizer?
When incomes fall, tax revenues fall, leaving more disposable income; when incomes rise, taxes increase, slowing demand.
How does the government’s use of EI and transfer payments stabilize the economy?
These payments increase automatically during downturns, supporting incomes and preventing larger drops in AD.
What is the difference in impact between government purchases and tax cuts?
Government purchases affect AD directly, while tax cuts depend on household consumption (some of which is saved), so the impact is smaller.
What happens if fiscal policy raises demand, but the Bank of Canada keeps interest rates fixed?
The BOC increases the money supply to keep interest rates constant → no crowding-out → full multiplier effect on AD.
