Fiscal Policy Flashcards
What is fiscal policy?
When the government makes a change to spending, legislation or taxes in an attempt to better the economy (in particular, close the output gap).
If there is a decrease in exogenous consumption (|C) by 10 units which results in a contractionary gap of 50 units, what can the government do to close this gap?
It’s implicitly stated that there is a multiplier of 5 (i.e. MPS = 1/5) but that’s just in the back of your head.
The government can simply increase its expenditure by 10 units (say national defense or road construction) to close the gap. The multiplier will close the gap by 50 units.
If people are feeling more confident about their wealth i.e. exogenous consumption increases, what kind of fiscal policy can the government use to reduce the expansionary output gap?
To reduce the expansionary output gap, the government can increase taxes (which lowers wealth and thus consumption).
By what means can fiscal policy be used to eliminate an output gap?
For contractionary output gaps, the government can increase expenditure (stimulus packages, infrastructure, etc).
For expansionary output gaps, the government can increase taxes.
This is to ensure the most efficient economic growth by ensuring real GDP is as close to potential GDP as possible.
What is the difference between the macroeconomic effects of changes to government expenditure vs changes to tax and transfer payments?
Changes in government expenditure affect Planned Aggregate Expenditure directly (+delta G).
Changes in tax and transfer payments affect PAE indirectly via affecting the wealth on the demand side i.e. the consumers, or the disposable income of the private sector (Y-T).
Why is there a difference between the macroeconomic effects of changes to government expenditure vs changes to tax and transfer payments?
Government expenditure affects PAE directly.
Tax reduction reduction inccreases marginal propensity to consume (people have more wealth so they spend more) and thus there is an increase in expenditure overall. Graphically, a reduction in tax rate is equivalent to make the slope of PAE steeper abd thus changing where it intersects potential GDP line.
What is the balanced budget multiplier?
It is the change in GDP for an extra doller by the effects of both government expenditure and changes in tax.
An increase in government purchases increases ___________ by an equal amount
exogenous expenditure
An exogenous reduction in taxes or an increase in transfer payments increases exogenous expenditure by an amount equal to _________________.
The MPCx(tax reductions) or MPCx(increase in transfers).
What are three limitations on the ability of the fiscal policy to stabilise the economy?
- Effects on the supply side that might lead to undesirable long term consequences
- Expansionary fiscal policies (closing recessionary gaps) may lead to large budget deficits that reduce national savings
- Fiscal policies are relatively inflexible as the government cannot quickly change legislations on expenditure and taxes.
What are the long term effects of fiscal policies on the supply side?
Basically, it reduces the power of the government. The government can’t intervene as much to improve social factors such as pollution. There would be less money for national defense, etc.
What are automatic stabilisers?
Policies put in place that would naturally affect the economy without the government need to intervene via parliament.
More specifically, they are automatic increases in government spending or decreases in taxes when real output declines e.g. GDP falls, income tax collection falls (because taxible income decreases) and also more people would be entitled to welfare benefits.
How would fiscal policies be considered an important stabilising force.
Two reasons:
- Introduction of automatic stabilisers
- Useful for prolonged periods of recession e.g. the great depression (even if they can’t respond immediately).
What is the effect of fiscal policy on the distribution of income?
It reduces income inequality via a income progresssive tax system where the more you earn, the more tax you pay.
Therefore it can be seen that it is important in influencing the distribution of disposable income across households.
What effect will demographic change have on fiscal policy?
The particular consideration of changes in demographics is an aging population. There will be more elderly people to take care of, and proportionally less income-tax payers. The particular effects are increased expenditure on health, aged care and age pensions,
