Fiscal Policy Flashcards
What are the two ways the government can manipulate the economy through fiscal policy?
Fiscal policy is the way by which the government can manipulate the nation’s economy. They do this in two ways:
Through government spending
Through taxation
What are the two types of fiscal policies? Explain them.
There are two types of fiscal policy and they include expansionary fiscal policy and contractionary fiscal policy. Expansionary fiscal policy refers to laws that increase output by either increasing government spending or decreasing taxes. Contractionary fiscal policy refers to laws that decrease inflation by decreasing government spending or increasing taxes.
What is discretionary?
Fiscal policy can be both discretionary and non-discretionary. Discretionary fiscal policy occurs when Congress creates a new bill that is designed to change AD through government spending or taxation. A great example in today’s economy of discretionary fiscal policy was the stimulus checks that were issued to Americans after many faced job loss due to the temporary shut down of our country due to the COVID-19.
Short Run Effects.
What can occur with discretionary policy? What does non discretionary policy refer to?
Lags or delays can sometimes occur with the discretionary fiscal policy because it takes time to decide on and implement a policy that will help the economy. Non-discretionary fiscal policy refers to permanent spending or taxation laws already on the books that help regulate the economy. This includes things like social security, welfare, and unemployment compensations.
How is fiscal policy used to correct recessionary gap and inflationary gap?
Fiscal policy is mainly used to correct the economy when it is either in a recessionary gap or an inflationary gap situation The government has to decide whether to use government spending or taxation to correct the situation. This depends on the difference between where the economy is currently producing and what its potential output is. This will also be affected by the multipliers which are impacted by the marginal propensity to save and the marginal propensity to consume
Explain Expansionary Fiscal Policy. Draw the Graph.
As stated, expansionary fiscal policy is the government’s way of getting out of a recession by increasing spending and cutting taxes. In a recession, real GDP is low while unemployment is high. To fix this problem, the government cuts taxes and increases spending. This shifts the AD curve to the right, bringing the equilibrium back. However, a bad side effect is an increase in price levels. LRAS stays the same so real GDP does not change, but because LRAS, SRAS and AD all intersect higher than before, a price level increase is inevitable. Also, because tax multipliers are smaller, it’ll have to be greater to make an impact on real GDP. Therefore, the size of tax cut must be greater to match an increase in government spending.
You’ll see that AD1 and SRAS intersect much lower and to the left of LRAS. This signifies a recession. Then, the government enacts a fiscal policy. Now AD will shift right to become AD2 because consumers will likely spend more (less taxes, more money circulating). This brings the equilibrium to where it should be (LRAS), but now the price level higher than before.
Explain Contractionary Fiscal Policy. Draw a Graph
Instead of a recession, we have an economy operating perhaps too well. Inflation is rising quickly and becoming a problem, so the government has to contract the economy a little so people spend less. This is done by decreasing government spending and increasing taxes. This causes AD to shift left this time and brings the price level down. This can, unfortunately cause real GDP to decrease a little, but a substantial decrease in inflation (which is a good thing).
Look at the graph. This time, SRAS and AD1 are intersecting on the right side of LRAS. The government implements a contractionary fiscal policy this time. Now, because people will have less money to spend due to taxes and becaues there’s less money circulating, the equilibrium will be at a lower price level.
What happens when there is large government debt?
When there is an existence of a large national debt, it will affect government spending in the future. Future spending will fall. Since a government must pay interest on its accumulated debt, this means that the government will not have those funds for alternative uses.
What is surplus/defecit? What does this mean?
A government surplus happens when the difference between tax revenues and government spending is positive. Meaning, we spent less than we received. When this phenomenon happens, the excess tax revenue is used to pay off the debt borrowed during recessionary times and the interest.
Deficit happens when the government spends more than it received as revenue.
Government has three areas in which it is required to spend a certain amount of money every year. This is called mandatory spending. After that, everything else is part of the discretionary spending
when the government is in deficit, it’ll borrow more, adding to the already enormous debt. On top of that, the government has to pay interest on top of the debt, so national debt just continues to increase no matter what.
What happens to recessionary gaps and expansionary gaps, with state local debts?
The US is operating in a recessionary gap, where tax revenues are low and spending is high, leading to a deficit.
The US is operating in a expansionary gap, where tax revenues are high and spending low, leading to a surplus.
If the Constitution required the state government to balance the budget to exactly zero here’s what would happen?
Government implements higher taxes and less spending, but this is a recipe for a recession!
Government implements lower taxes and more spending, but this is a recipe for an inflation!
If we actually had to balance our budget, we would be in a vicious cycle of recession and inflation. Sometimes, we gotta go into deficit (or surplus) in order to save the sinking economy.
Many state and local governments are required to balance the budget. This means during a recession, while the national government is cutting taxes to motivate its citizens to spend more and close the recessionary gap, the state government is increasing taxes and cutting programs (less spending) to balance the budget to make up for the deficit caused by the recession
Explain Crowding Out. Draw all three graphs.
The crowding-out effect is the economic theory that public sector spending can lessen or eliminate private sector spending. It’s where the government’s budget deficit increases demand for loanable funds, but it reduces the amount of available loanable funds for private investors. It increases demand but also increases interest rates. Less investment happening by the private sector means the national economic growth is not happening. This reduces demand and brings the economy back to where it started: a recessionary gap.
The graph on the left shows an economy in a recessionary gap. The graph in the middle shows the rightward shift of aggregate demand (AD) that can correct a recessionary gap when the government increases its spending in order to get the economy moving again.The graph on the right shows what can happen when crowding out occurs. Instead of government spending correcting the economy, they choose to spend money on a good or service that will decrease or eliminate private spending, causing the economy to move only from AD to AD2. When crowding out occurs, the economy does not quite get back to long-run equilibrium.
What is the Long-Run Impact of Crowding Out?
Economy: If this crowding out prolongs for a longer time, we will essentially come into a situation where economic growth is severely reduced. Our economy might start going downhill and widen the recessionary gap because more people are saving instead of saving, thus decreasing demand. This can cause the government to enact an expansionary fiscal policy, only to have it canceled by crowding out. This can lead to a vicious cycle where the final destination is economic doom.
What is the Long-Run Impact of Crowding Out?
Economy: If this crowding out prolongs for a longer time, we will essentially come into a situation where economic growth is severely reduced. Our economy might start going downhill and widen the recessionary gap because more people are saving instead of saving, thus decreasing demand. This can cause the government to enact an expansionary fiscal policy, only to have it canceled by crowding out. This can lead to a vicious cycle where the final destination is economic doom.Infrastructure: Crowding out can have a serious impact on infrastructure too. If private investments decrease due to crowding out, more and more private firms will be discouraged from participating in infrastructure building because of low investment or because of its unprofitable nature. This can lead to a decrease or inefficiency in building things like roads, bridges and hospitals. It can also decrease the quality of the infrastructure as well.
Infrastructure: Crowding out can have a serious impact on infrastructure too. If private investments decrease due to crowding out, more and more private firms will be discouraged from participating in infrastructure building because of low investment
