Topic 15- Fiscal Policy Flashcards
What is the main determinant of C (consumption)
disposable inclome (Yd)
what is disposable income
the income remaining to housheolds after they have paid taxes and revied government transfer payments
Yd= Y+ TR -T
and if we assume no transfer payments
Yd=Y-T
Consumption Function
consumption is a function of disposable income
C=C(Yd)
THIS IS A POSITIVE RELATIONSHIP!
Increase in disposable income means?
Increase in consumption function
C= co + c1Yd
co= autonomous consumption, what households consume if their disposable income is equal to zero
c1= marginal propensity to consume, the slope of the consumption function
What is MPC
the amount by which consumption spending changes when disposabel income changes
MPC= change in C/ Change in Yd
Can marginal propensity to consume MPC be greater than 1
NO!!! ALWAYS BETWEEN 0 AND 1
0<c1<1
consumption has both an autonomus component and a induced component
independant vbl
dependant vbl
What is net taxes?
Taxes- Transfer Payments
How does higher income (Y) affect consumption (C)
POSITIVE relationship, they both go up
How does higher taxes affect consumption
INVERSE RELATIONSHIP!! taxes go up then consumption goes down
autonomous spending
is independnat of Y, it is equal to
c0-c1T+I+G
y= 1/ (1-c1) * (c0-c1T+I+G)
In the Y formula, does a change in Taxes, c0, or Investment have the same impact as a change in Y?
YES! because all terms are multiplied by the same multiplier!
How does fiscal policy affect output and price level
throguh changes in govt spending and taxes
what is Expansionary fiscal policy used for
increasing employment
what are exxamples of expansionary fiscal policy
increasing govt spending (AD curve shifts to the right bc Gmoves up)
decreases individual income taxes, increasing disponable income (shifts AD curve riht bc consumption spending nicrease)
decreases business taxes (shifts AD right, because more investment)
what are two examples of contractionary fiscal policy
decreasing government spending (G lower means AD shift left)
increasing taxes (decreases disposable income, C and I both go down, AD shift left)
when would a government employ contractionary fiscal policy
just to decrease inflation/high price level
Why is fiscal policy less effective?
because getting the timing right is HARD!!! (getting approved from parliament is hard, and it takes time to increase govt spending too)
crowding out effect! (govt spending will decrease the supply of loanable funds - decrease the AD curve- and make higher interest rate)
IMPORTANT NOTE FOR THE FINALLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLL
IF THE QUESTION ABOUT FISCAL/MONETARY POLICY SAYS THAT HOLDING ALL OTHER FACTORS CONSTANT!!!
IT MEANS THAT THERE IS NO CROWDING OUT EFFECT
What is dispobsable income
the money houses have left after they paid Taxes (T) and recieved transfer payments from government!
Yd= Y+ TR-T
if no transfer paymnets
Yd=Y-T
How are consumption and disposbale income related (2)
1) Disposable income is the main part of Consumption
and
2) C=C(YD) Consumption is a function of disposabel income (it is determine by it Disposable income!)
an increase in disposabe income?
increase consumption
A general consumption function
C=Co+C1Yd
Consumption= Autonomus consumpion+marginal propesnisty ot consume(Disposable income)
C=Co+C1(YD)
explain each
Consumption
Co: autonomous consumption [how much the ohsue will consume even when disposable income is equal to zero! NECESSITIES)
c1: MPC, the slope of consumption function (the amount of which consumption changes when disposable income changes)
c1-> change in consumption/change in disposable income
Yd= disposabel income
MPC formula
change in consumption/Change in disposable income
C1- non-autonomous or induced consumption component
component that depends on disposable income! produces the upward slope line because as disposable income increases, consumption increases too!
IF disposable income increases
consumption will increase
what happens when you sub in Yd formula for the Consumption function
Yd=Y-T
C=Co+C1(Yd)
C=Co+C1(Y-T)
C=Co+C1Y-C1T
CONSUMPTION CAN BE EXPRESSED AS A FUNCTION OF GDP AND TAXES!! NOT JUS DISPOSABLE INCOME1!!!!!
C=Co+C1Y-C1T
MEANING
CONSUMPTION CAN BE EXPRESSED AS A FUNCTION OF GDP AND TAXES!! NOT JUS DISPOSABLE INCOME1!!!!!
C=Co+C1Y-C1T
relation between consumption, gdp, and taxes
as gdp goes up, consumption will go up, BUT LESS THAN ONE FOR ONE
as taxes go up, consumption will decreases, BUT LESS THAT ONE FOR ONE
What happens if you plug in new consumtpion function to Y=C+I+G (closed econ)
Y=C+I+G
Y=Co+CIY-C1T+I+G
Y(1-C1)=Co-C1T+I+G
Y= 1/(1-C1) *(Co-C1T +I+G)
THIS GIVES YOU FISCAL MULTIPLIER AND AUTONOMOUS SPENDING
FISCAL MULTIPLIER
1/(1-C1)
in the final formula for Y, what is fiscal multiplier, and waht is the autonomous spending
Y= 1/(1-c1) * (co-c1T+I+G)
Fiscal Mult Authonous spending
Does I G and T depend on income
NO THESE ARE FIXED AMOUNTS!!!! AUTONOMOUS
What is the restriction on the multiplier
MPC always has to be 0<MPC<1!!!
SO! 1/(1-c1) = 1/(1-MPC) RIGHT
AND IF MPC 0<C<1 , then 1/(1-c1) >1
What does the fiscal multiplier final equation imply
Y= (1/1-MPC)*(C0-C1T+I+G)
any increase in G, I, or Autonoomous consumption, AND ANY DECREASE IN TAXES, will increase OUTPUT more than the amount of increase in G,I, OR AUTONOMOUS (MORE THAN 1 FOR 1)
WHere does the multiplier effect even come from
Y= (1/1-MPC)*(Co+G+I+T)
Increase in G, will increase AD, which iwll increase production, which will increase income, which will increase consumption, which will increase AD…
How large is total increase in Real GDP (Y) as a result of the intiatl increase in G?
1/1-MPC
Tax multiplier
so this is a negative number because changes in taces and changes in real gdp move in opp direction
(more taxes, less real gdp)
-MPC/1-MPC
AN INCREASE IN TAXES…
LOWERS SPEDNIN, INVESTMENT, AND GDP IN ECON
AN INCIREASE IN GOVT SPENIDNG/PURCHASES
INCREASES INCOME SPENDING AND GDP
so what has more impact, tax multiplier or fiscal mulitplier
FISCAL MULTIPLIER!!!
MPC/1-MPC < 1/1-MPC
Why does fiscal multiplier have more impact than tax multiplier
increase in govt purchases affects Y DIRECTLY!!!the first round gdp changes in multiplier process are equal to this change in sepnding
change in taxation will affect income first, adn then spending, the first round gdp change in multiplier process will be equal to smaller change in spending
A change in taxes affects income first and then spending. For example,
a tax cut will increase income, but not all of that income will be spent
(some of it is saved). The fraction of income that is spent is the MPC
times the income change. The first round GDP change in the multiplier
process will be equal to this smaller change in spending.
A change in taxes affects income first and then spending. For example,
a tax cut will increase income, but not all of that income will be spent
(some of it is saved). The fraction of income that is spent is the MPC
times the income change. The first round GDP change in the multiplier
process will be equal to this smaller change in spending.
multiplier effect
increase in autonomous spending, increases real gdp
Multiplier formula
change in real gdp/change in autonomous spending
The larger the MPC (all else equal), the larger the value of the
multiplier
The larger the MPC (all else equal), the larger the value of the
multiplier
does multipler make eocnomy more senestivies to change
YES! decline in one sector causes declines in spending and production of other sectors
Fiscal policy
GOVERNMENTS actions to make sure price level is stable and unemployment is low
mainly through tax or changing their level of spending
two types of fiscal policy
1) automatic stabilizer: govt spending and taxes that automaticaly increase or decrease in the business cycle
2) discretionary fiscal policy: intential actions of govt, like chanignig spenidng or taxes
Expansionary fiscal policy
GOAL: MOVE AD RIGHT
increase govt spending OR decreasing taxes
1) increase govt sepnding (G goes up) so AD automatically goes up
2) Decreaseing income TAXES, indirectly affects AD by increasing disposable income of people, and increasing (C)
3) Decreasing business taxes, incretly increase business investments
What does exapnsionary fiscal policy fo for emplyment
increases it
Contractionary fiscal policy
GOAL: move ad curve left
decrease govt sepnding or increase taxes
1) Gecrease govt spending (Decreases GD, AD CURVE LEFT)
2) Increase personal tax (less disposabel income so less C, AD LEFT)
3) INcrease bsniess taxes (less investments, AD LEFT)
GENERAL GOAL OF EXPANSIONARY POLICY
CONTRACTIONARY POLICY
INCREASE EMPLOYMENT
COOL INFLATION
What 2 effects make the size of shift in AD curve differetn from the change in govt spending (make it so its not a1 to 1 change)
multiplier effect
crowding out effect
Multiplier effect
-background of why
-WHAT IS IT
1) inital increase in govt spenidng is autonomous (result of a decision by the govt and doesnt depend on elvel of REAL GDP)
lets say govt increase spending
2) but increase in consumption spending thas a result form intial autonoomus increaseis an INDUCED change
so MULT EFFECT IS
THE ADDITIAONL SHIFT N AD THAT IS A REUSLT OF EXPANSIONARY FISCAL POLICY!!
basically w multiplier effect
you move ad curve a lil
and it moves inself omre because of ad effect
is fiscal policy better or monetary 3 reasons
monetary!
fiscal policy is slow and beuraeucratic, and hard to implement
and govt spending might CROWD OUT private spending
Crowding out
decline in private spedning bc govt spending
Crowding-out effect is the offset in aggregate demand that results
when expansionary fiscal policy raises the interest rate and thereby
reduces private spending
Crowding-out effect is the offset in aggregate demand that results
when expansionary fiscal policy raises the interest rate and thereby
reduces private spending
Can crowding out potentially reduce how effective expansionary fiscal policy is?
YES!!!!
govt spending increase, AD right, income and real gdp right
income and real gdp right, money demand increases, money demand curve right, interest rate UP
higher INTEREST RATE!!!!!! c + i + nX alll decrease, ad shift left
in the short run, waht does govt spenidg result in
partial/but not complete crowding out
crowding out effect visualized
shift to the right ad curve (Gincrease), and then shift back to the left (Crowding out!)
In the long run, what does a permanent increase of govt spending do? BASICALLY WHAT DOES A CROWDIGN OUT EFFECT DO IN THE LONG RUN
the decline in investment, consumption, and nx is OFFSET by the increase in govt pruchases, and AD IS UNCHANGED!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
in th elong run an increase in govt spenidng resultsin complete crowdin gout!
The economy is in recession. Shifting the AD curve
rightward by $20b would end the recession.
If MPC = 0.8 and there is no crowding out, how
much should the government increase G to end the
recession?
multiplier: 1/1-0.8 = 5
wanna shift ad right, increase govt spending
INcrease govt sepdning by 4! and then multiplier will do its thang!!!
Crowding out may cause
an expansionary fiscal policy to fail to meet its goal of keeping the
economy at potential GDP
Crowding out may cause
an expansionary fiscal policy to fail to meet its goal of keeping the
economy at potential GDP
