Fiscal Policy Flashcards
Fiscal Policy =
Changes in taxes (T), transfer payments (TR) and government purchases (G) that are specifically intended to achieve macroeconomic policy objectives, such as full employment, price stability, and sustainable economic growth.
- These policies can have effects through aggregate demand in the short run, but also through aggregate supply (ie “supply side” policies) in the long run.
Automatic stabilisers =
Government transfers and taxes that automatically increase or decrease along with the business cycle.
- For example, the revenue from income taxes naturally increases in booms and decreases in recessions. This is true even when the tax rates are constant.
- This stabilizes the economy because it “leans against the wind”: when times are bad, taxes are reduced (leading to a partial recovery of AD) and, when times are good, taxes are increased (leading to a partial restraint on AD).
Discretionary fiscal policy =
When the government is takes deliberate actions to change public consumption, public investment, transfer payments or taxes to achieve its economic objectives.
- For example, the government changes tax rates or increases expenditure to achieve these objectives.
Recall the components of aggregate demand:
AD = Y = C + I + G + NX
Expansionary Fiscal Policy:
- It involves
- increasing government purchases (G), or
- increasing transfer payments (TR), or
- decreasing taxes (T).
- An increase in G will increase AD directly.
- An increase in TR or a reduction in T has an indirect effect by increasing disposable income and, thereby, consumption – which is a component of AD .
- The aim is to shift the AD curve further to the right than it would have been without policy
Overall Effects of Expansionary Fiscal Policy in the Short Run and the Long Run (if the economy is initially in Long Run Equilibrium):
In the short run:
- Prices increase and output increases.
In the long run:
- Prices increase even further but output is unchanged.
Thus, in the log run, expansionary fiscal policy does not affect output but causes inflation.
Using Expansionary Fiscal Policy to Offset a Negative AD Shock:
- Suppose, instead, that the economy was not initially in a long‐run equilibrium but was experiencing a potential recession from a negative AD shock.
- In this case, expansionary fiscal policy can be used to bring the economy back to full‐ employment equilibrium – potentially more quickly than through the automatic adjustment mechanism.
Expansionary fiscal policy in the very long run:
Contractionary Fiscal Policy:
- It involves
- decreasing government purchase (G), or
- decreasing transfer payments (TR), or
- increasing taxes (T)
- A decrease in G will reduce AD directly.
- A decrease in TR or an increase in T will have an indirect effect by reducing disposable income and thus AD.
- Appropriate when the economy is above full-employment equilibrium and the inflation rate is high.
Overall Effects of Contractionary Fiscal Policy in the Short Run and the Long Run (if Initially in LR Equilibrium):
In the short run:
- Prices fall and output falls.
In the long run:
- Prices fall even further but output is unchanged overall.
Thus, in the long run, contractionary fiscal policy has no effect on output but reduces prices (or inflation).
Using Contractionary Fiscal Policy to Offset a Positive AD Shock:
- Suppose, instead, that the economy was not initially in a long‐run equilibrium but was experiencing a overheating from a positive AD shock.
- In this case, contractionary fiscal policy can be used to bring the economy back to full‐ employment equilibrium – potentially more quickly than through the automatic adjustment mechanism.
Contractionary fiscal policy in the very long run:
Fiscal policy summary:
Multiplier effect:
The process by which an increase in autonomous expenditure leads to a larger increase in real GDP.
The government purchases multiplier:
An increase in government purchases will increase aggregate demand by more than the initial amount of the increase in purchases.
The tax multiplier:
Tax changes also have a multiplier effect.
- The higher the tax rate the smaller the multiplier effect, because each increment in income has more taken away as taxes – reducing the impact on disposable income and, thus, consumption.
- A cut in the tax rate increases the size of the multiplier effect, for completely analogous reasons.
Cyclically adjusted budget deficit or surplus:
The deficit or surplus in the federal government’s budget if the economy were at potential GDP.
- It is also known as structural deficit or surplus.
- It provides a more accurate indicator of whether the federal government’s budget is expansionary or contractionary.
