Fiscal policy Flashcards
what is discretionary fiscal policy
When the government is taking actions to change spending or taxes to achieve its economic objectives (fiscal policy)
automatic stabilisers
Transfer payments and taxes that automatically increase or decrease along with the business cycle.
draw the diagram of an expansionary fiscal policy
describe this diagram
Economy begins at equilibrium at $1200 real GDP and price level of 100
Year 2: LRAS1 shifts to LRAS2, AD1 shifts to AD2(w/o policy) which is below potential GDP (recession, workers sacked, profits fall) SRAS1 shifts to SRAS2. economy will be at short-run equilibrium
increasing gov expenditure and/or reduce taxes will shift AD1 to AD2(w policy). Equilibrium at C, which is at potential GDP
draw diagram of the effect a contractionary fiscal policy would have on the economy
explain the diagram
The economy begins in equilibrium at point A, at potential GDP of $1200 billion and a price level of 100.
LRAS increases to $1400 billion in the second year.
The shift in aggregate demand from AD1 to AD2(without policy) results in a short-run macroeconomic equilibrium beyond potential GDP of $1450 billion (point B).
The economy will experience a rising inflation rate, with the price level rising from 100 to 104.
Decreasing government purchases or increasing taxes will shift AD1 to AD2(with policy) and keep real GDP from moving beyond its potential level. The inflation rate is 3 per cent rather than 4 per cent, and real GDP is at its potential level of $1400 billion
Multiplier effect
process by which an increase in autonomous expenditure leads to a larger increase in real GDP.
spending and real GDP increase over a number of periods
draw a diagram to show the multiplier effect from an increase in gov purchase
The shift to the right from AD1 to AD2 shows
the initial increase in government purchases raises incomes and leads to further increases in consumption spending, the aggregate demand curve will ultimately shift further to the right, to AD3.
The multiplier effect will continue over a number of periods, with
the additional consumption spending in each period being half of the income increase from the previous period. Eventually, the process will be complete,
what is the government purchases multiplier:
ratio of the change in equilibrium real GDP to the initial change in government purchases
describe how tax cuts have a multiplier effect
an inital tax cut increases disposable income –> increases consumption –> set off further increases in real GDP and income
tax multiplier equation
tax multiplier = change in equilibrium GDP/ change in taxes
is tax multiplier a negative no?
yes
if the tax multiplier is –1.6, a $10 billion cut in taxes
how much will it increase real GDP
will increase real GDP by –1.6 × –10 billion = $16 billion.
why may there be a smaller increase in aggregate demand when there is an increase in government purchases
a portion will be saved or a portion might be spent on imports
what effect does a change in tax rates have on equilibrium real GDP?
The higher the tax rate –> the smaller the amount of any increase in income that households have available to spend –> reduces the size of the multiplier effect
a cut in tax rates affects equilibrium real GDP through two channels
(1) a cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending, and
(2) a cut in tax rates increases the size of the multiplier effect.
multiplier effect and aggregate supply
draw diagram
describe this diagram
The economy is initially at point A.
An increase in government purchases causes the aggregate demand curve to shift to the right, from AD1 to AD2.
The multiplier effect results in the aggregate demand curve shifting further to the right, to AD3 (point B).
Because of the upward-sloping supply curve the shift in aggregate demand results in a higher price level.
new equilibrium at point C, both real GDP and the price level have increased. The increase in real GDP is less than indicated by the multiplier effect with a constant price level
describe the multiplier effect of decreases in gov purchases and increases in taxes
an increase in taxes –> reduce household disposable income –> reduce consumption spending –> reduced sales –> firms cut back on production –> lay off workers –> fall income –> reduced consumption
Real GDP is currently $1200 billion, and potential GDP is $1250 billion. If the government increased government purchases by $50 billion or cut taxes by $50 billion, the economy could be brought to equilibrium at potential GDP.’
true or false?f
false, multiplier effect not considered.
Because of the multiplier effect, an increase in government purchases or a decrease in taxes of less than $50 billion is necessary to increase equilibrium real GDP by $50 billion. For instance, assume that the government purchases multiplier is 2 and the tax multiplier is –1.6
Gov purchases multiplier = change in equilibrium real GDP/ change in gov purchases
2= 50/ change in gov purchases
change in gov purchaes = 25
Tax multiplier = change in equilibrium real GDP/ change in taxes
-1.6 = 50/change in taxes
change in taxes= -31.25
Getting the timing right can be more difficult with fiscal policy than with monetary policy for two main reasons.
- reserve bank can change monetary policy monthly at montly meetings or any time by calling a special meeting
- change in fiscal policy made through budget in May annually. Must pass through Lower and Upper House which can take many months
describe why it may take a while to implement fiscal policy
e.g. $10b to construct railway lines –> months for detailed construction plans –> state gov asks for bids from private construction companies –> winnings bidders selected –> several months before project begins
it takes time for policy-makers to collect statistics and identify changes in the economy. It can also take a substantial amount of time for the government to
formulate policy and get it passed through parliament.
the size of the multiplier effect may be limited if
if gov expenditure causes crowding out
what is crowding out
A decline in private expenditure as a result of an increase in government purchases.
explain the crowding out effect (financial crowding out specifically)
gov spends w/o increasing taxation –>
most likely operating with budget deficit –>
borrows money by issuing cth bonds and securities –>
borrow from domsetic market, demand for loanable funds increase and real interest rate increases –>
reduced consumption and investment and net exports
if government borrowing occurs on global financial markets, ( by selling securities and bonds) what effect does it have on domestic interest rates
no effect
what is another way gov borrowing can cause interest rates to rise?
give an example
if government borrowing for spending programs increases aggregate demand by an amount that puts upward pressure on inflation
Australian government was borrowing around $1 million each day to fund stimulus infrastructure programs that were continuing even though the rate of economic growth was returning to a healthier level.
inflationary pressures that led the RBA to increase interest rates 4 times during 2010.
when might crowding out not be a problem
In a deep recession when many firms are very pessimistic about the future where investment spending falls to very low levels and is unlikely to fall much further even if interest rates rise.
If the economy is close to potential GDP, will crowding out be a problem
an increase in interest rates may result in a significant decline in investment spending
how does the GDP level affect the cyclically adjusted budget deficit?
if real GDP is above potential GDP, budget will be in surplus (increase in taxes, reduction in transfer payments)
if real GDP is below potential GDP, budget will be in deficit (fall in taxes, rise in revenue)
if real GDP = potential GDP, budget will be balanced
draw the supply side effects of a tax change
explain this diagram
equilibrium is at point A
No tax change, shifts from LRAS1 to LRAS2 new equilibrium at B
With tax reductions and simplifications the long-run aggregate supply curve shifts further to the right to LRAS3 and equilibrium moves to point C (further increasing real GDP and lowering price)
draw the phillip’s curve
what does it show
short-run relationship between unemployment rate and inflation
describe the following diagram
if aggregate demand was strong
and draw the corresponding phillip’s curve
In year 2, if the AD curve shifts to the right by the same amount as the LRAS curve, then macroeconomic equilibrium occurs at real GDP of $1450 billion, which is the new higher level of potential GDP (point B).
The price level rises from 100 to 104, so the inflation rate remains at 4 per cent. Point B on the Phillips curve is the same as point A because the inflation and unemployment rates haven’t changed.
describe the following diagram
if aggregate demand was weak
and draw the corresponding phillip’s curve
Year 2: macroeconomic equilibrium occurs below potential GDP. Inflation falls to 2% and unemployment rises to 6%
draw the long-run phillip’s curve and LRAS curve according to Friedman and Phelps
impact of unexpected price level changes on the real wage
company’s managers and the unions agree on a wage of $31.50 per hour to be paid during 2015. Both the company and the unions expect that the price level will increase from 100 in 2014 to 105 in 2015, so the inflation rate will be 5 per cent.
If inflation rate was 2% during 2015?
if the inflation rate was 8% during 2015?
