Unit 3: Chapters 13, 14, 15 Flashcards
Fiscal policy
changing the levels of government spending and taxes to stabilize the economy, i.e., achieve potential real GDP, the natural rate of unemployment, and price stability.
Should be counter-cyclical
Objective of Expansionary fiscal policy
to close a recessionary gap (recession) by increasing aggregate demand
Objective of Contractionary fiscal policy’s
to close an inflationary gap (boom) by decreasing aggregate demand
Fiscal policy can be either….
Discretionary or non discretionary
Discretionary or active fiscal policy
means that Congress actually meets to implement changes in government expenditures and/or taxes to close an output gap
Negative GDP gap or recession characteristics & solution
1.High unemployment (cyclical) inflation
- Actual GDP < potential real GDP
- Unemployment rate > natural rate
Solution: increase aggregate demand
Positive GDP gap or economic boom characteristics and solution
- Demand-pull inflation
- Actual GDP > potential real GDP
- Unemployment rate < natural rate
Solution:
Decrease aggregate demand
Expansionary fiscal policy—
Policy options/anticipated effect/final result
Policy options for Congress:
- Increase government spending
- Increase investment tax credit
- Reduce corporate income tax rate
- Reduce personal income taxes
- Increase transfer payments
- Incur a budget deficit
Anticipated effect:
Aggregate demand increases
Final result: 1.Unemployment falls 2.Negative GDP gap closed 3.Actual GDP = potential real GDP 4.Unemployment rate = natural rate
Contractionary fiscal policy–
Policy options/anticipated effect/final result
Policy options for Congress:
- Reduce government spending
- Reduce investment tax credit
- Increase corporate income tax rate
- Increase personal income taxes
- Decrease transfer payments
- Incur a budget surplus
Anticipated impact on the economy:
Aggregate demand decreases
Final result:
- Demand-pull inflationary pressures fall
- Positive GDP gap closed
- Actual GDP = potential real GDP
- Unemployment rate = natural rate
Level of taxes increase
1.TX ↑ Income ↓ C ↓ (S ↓) GDP ↓
2.If taxes increase by $x,then disposable income decreases by $x
3.If disposable income decreases by $x,then C decreases (and S decreases)
4.If C decreases,then real GDP decreases
Level of taxes decrease
1.TX ↓ Income ↑ C ↑ (S ↑) GDP ↑
2.If taxes decrease by $x,then disposable income increases by $x
3.If disposable income increases by $x,then C increases (and S increases)
4.If C increases, then real GDP increases
Non-discretionary fiscal policy
(automatic stabilizers, built-in stability) passively manipulates aggregate demand
built-in stabilizer
1.Increases the government’s budget deficit (or reduces its budget surplus) during a recession
both of which are expansionary
2.Increases the government’s budget surplus (or reduces its budget deficit) during an expansion both of which are contractionary
automatic stabilizer examples
1.Personal income tax, corporate income tax, sales tax, payroll tax revenues
2.Unemployment compensation
3.Welfare payments
Advantages of the automatic stabilizers
1.The automatic stabilizers are “built-in” to federal government programs, therefore the dollar amounts change with no explicit action taken by Congress
2.The automatic stabilizers do not suffer from some of the timing problems of discretionary fiscal policy. No recognition lag and no administrative lag
Problems with state and local government fiscal policies offsetting federal fiscal policy
State fiscal policy is pro-cyclical or destabilizing because state governments have legal requirements to annually balance their budgets
Problem of the crowding-out effect
An expansionary fiscal policy designed to increase aggregate demand will increase the budget deficit. If the deficit is financed by an increase in government borrowing, interest rates will increase causing private-sector investment spending (IG) to fall. The “crowding out” of investment reduces aggregate demand and, thus, weakens the impact of an expansionary fiscal policy.
Problems with implementing fiscal policy in an open economy (foreign sector)
Net export effect arises because international flows of financial capital are seeking the best interest rate. Net export effect weakens the impact of fiscal policy
Budget deficit (G > Tx)
Amount by which government expenditures exceed tax collections in a given year.
Budget surplus (G < Tx)
Amount by which tax collections exceed government expenditures in a given year
Public (national) debt
Accumulation of federal budget deficits and surpluses over time
Public debt consists of
Treasury bills, Treasury notes, Treasury bonds, and U.S. savings bonds.
Sources or causes of budget deficits and thus a large public debt
1.Wars
2.Recessions
3.Lack of fiscal discipline by Congress
Federal government can meet its financial obligations by:
1.Refinancing maturing Treasury securities
2.Increasing taxes
3.Creating money (through the Federal Reserve in a national emergency)
Externally-held debt
is an economic burden to Americans
Interest payments and repayment of principal transfers funds to foreign lenders
Crowding-out of private investment
is an economic burden to future generations
Barter
refers to the exchanging of one good for another good
Problems associated with barter
- Trade requires a double coincidence of wants
- No common unit of account to measure relative value
- Opportunity cost of making a transaction is high
The only requirement for anything to serve as money is that it must be
Socially acceptable
Money promotes economic efficiency because it…
1.Overcomes the problems associated with barter
2.Promotes specialization and trade
3.Increases real output and standard of living
Three functions of money
1.Medium of exchange
2.Unit of account: Allows people to measure relative value; the “price” of something.
3.Store of value: Allows people to transfer purchasing power from the present to the future.
Commodity money
Intrinsic value: the value of the physical material
If intrinsic value exceeds the face value, then
It takes out of circulation; ceases to function as money
Fiat money
1.No intrinsic value
2.Token money: Government makes sure that the face value exceeds its intrinsic value
3.Not backed by any commodity
4.Social acceptability of what is no more than a fiction or belief
5.Legal tender means that Federal Reserve Notes and coins must be accepted as payment for all debts, public and private
