Week 21 - Spending and Output Pt2 Flashcards
What does the income-expenditure multiplier measure?
It measures the change in short-run equilibrium output resulting from a one-unit change in autonomous expenditure.
income-expenditure multiplier example
Initial planned expenditure = 960 + 0.8Y
New planned expenditure = 950 + 0.8Y
The 10-unit drop in C implied a 10 unit drop in autonomous expenditure
Equilibrium changed from $4,800 to $4,750
A $10 change in autonomous expenditures caused a $50 change in output
Multiplier = 5
The larger the mpc, the greater the multiplier
What are stabilisation policies?
Government policies designed to influence planned aggregate expenditure in order to eliminate output gaps.
What is the goal of stabilisation policy?
To close recessionary or inflationary gaps and stabilise the economy around its potential output.
What are expansionary stabilisation policies?
Policies that increase planned aggregate expenditure to boost output and close a recessionary gap.
What are contractionary stabilisation policies?
Policies that decrease planned aggregate expenditure to reduce inflationary pressure and close an inflationary gap.
What tools are used in fiscal policy for stabilisation?
Changes in government spending, transfers (like unemployment benefits), and taxes.
How does expansionary fiscal policy work?
By increasing government spending or transfers, or by cutting taxes to raise aggregate demand.
How does contractionary fiscal policy work?
By reducing government spending or transfers, or by raising taxes to lower aggregate demand.
What is monetary policy in the context of stabilisation?
It involves changing the money supply to influence interest rates and aggregate expenditure.
How does expansionary monetary policy affect the economy?
It increases the money supply, lowers interest rates, and encourages more spending and investment.
How does contractionary monetary policy work?
It reduces the money supply, raises interest rates, and slows down spending and investment to control inflation.
What is the primary goal of fiscal policy in stabilising the economy?
To influence planned aggregate expenditure (PAE) to close output gaps and stabilise economic fluctuations.
What are the three main tools of fiscal policy?
Government spending, taxation, and transfer payments.
How does government spending affect PAE?
Directly—an increase in government spending raises PAE, while a decrease lowers it.
How does taxation affect PAE?
Indirectly—lower taxes increase disposable income and consumption, raising PAE; higher taxes reduce it.
How do transfer payments affect PAE?
Indirectly—higher transfers (like unemployment benefits or social security) increase household income and consumption, boosting PAE.
What is discretionary fiscal policy?
Policy actions that involve deliberate changes in government spending (G) or net taxes (T) to influence the economy.
What is the direct effect of changing government spending (G)?
It changes PAE immediately, since G is a component of total expenditure.
What is the indirect effect of changing net taxes (T)?
It changes households’ disposable income, affecting their consumption and thus PAE
How do changes in G and T affect the government budget?
They alter the government deficit or surplus, since the deficit is calculated as G – T.
What’s the difference between discretionary fiscal policy and automatic stabilisers?
Discretionary fiscal policy requires active decisions, while automatic stabilisers (like income taxes and welfare) adjust naturally with economic conditions.
Is government spending part of planned aggregate expenditure (PAE)?
Yes, it is a direct component of PAE.
How do changes in government spending affect PAE?
Directly—an increase in government spending raises PAE, while a decrease lowers it.
government spending example
Suppose planned spending decreases $10 from
Y = 960 + 0.8Y to Y = 950 + 0.8Y
Equilibrium Y decreases from $4,800 to $4,750
* Recessionary gap is $50
* Stabilisation policy indicates a $10 increase in government spending will restore the economy to Y* at $4,800
The multiplier is 5, since a $10 change in spending leads to a $50 change in output.
Because it enters PAE directly, creating an immediate and amplified impact on output through the multiplier effect.
By increasing G during a downturn, the government raises total spending to close the recessionary gap.
How did U.S. military spending change after World War II?
Military spending as a share of GDP decreased sharply after WWII.
When did military spending peak after WWII?
Military spending peaked during major wars (like the Korean War, Vietnam War) and the Reagan military buildup in the 1980s.
How did military spending contribute to ending the Great Depression?
Increased military spending during World War II helped stimulate demand and pull the economy out of the Great Depression.
What is the relationship between military spending and recessions?
Recessions tend to occur when military spending declines, as it is a significant component of aggregate demand.
How can increases in government spending (G) stimulate the economy?
Increases in government spending, such as on military, can boost aggregate demand and help reduce recessions or stimulate economic growth.
What role does military spending play in stabilisation policy?
Military spending can serve as an expansionary tool to stimulate demand, especially when the economy faces a downturn or recession.
How did military spending affect the U.S. economy during the Reagan era?
The Reagan military buildup increased military spending significantly, contributing to higher aggregate demand and economic growth in the 1980s.
What impact does a decline in military spending have on the economy?
A decline in military spending can lead to reduced demand, potentially contributing to economic slowdowns or recessions.
What is the crowding-out effect?
The crowding-out effect refers to the tendency of an increase in government expenditure to raise interest rates, which in turn reduces private sector consumption and investment.
Why does the crowding-out effect occur?
It occurs because increased government spending raises the demand for money, driving up interest rates. Higher interest rates then discourage private investment and consumption.
How does an increase in government spending (G) influence interest rates?
Increased government spending increases the demand for funds, pushing up interest rates.
How do higher interest rates affect private consumption (C) and investment (I)?
Higher interest rates make borrowing more expensive, leading to lower private sector consumption (C) and investment (I).
How does the crowding-out effect impact Planned Aggregate Expenditure (PAE)?
The increase in government spending might be offset by the reduction in private sector spending, meaning the overall effect on PAE could be smaller than expected.
In what context does the crowding-out effect become significant?
It becomes particularly significant when the economy is near full employment, and government spending competes for scarce financial resources with private investment.
How can the crowding-out effect be mitigated?
It can be reduced if the economy has a low level of private sector investment or when the central bank reduces interest rates through monetary policy.
What factors determine the size of the crowding-out effect?
The sensitivity of investment and consumption to interest rates, the level of unused capacity in the economy, and the effectiveness of monetary policy.
What is the relationship between government spending (G) and interest rates (i)?
An increase in government spending (G) raises interest rates (i), which may then reduce private investment (I) and consumption (C), partially offsetting the expansionary effect.
What determines the strength of the crowding-out effect?
The strength of the crowding-out effect depends on:
1) the responsiveness of consumption and investment to interest rate changes, and
2) the responsiveness of the demand for money to interest rate changes.
How does the responsiveness of consumption and investment to interest rates affect the crowding-out effect?
The greater the decline in consumption and investment in response to higher interest rates, the stronger the crowding-out effect will be.
What happens if consumption and investment are highly sensitive to interest rates?
A small increase in interest rates can lead to a large reduction in private sector spending, resulting in a stronger crowding-out effect.
What is meant by the “responsiveness of the demand for money to interest rate changes”?
It refers to how much people and businesses will demand money as interest rates change. The higher the sensitivity of money demand to interest rates, the stronger the crowding-out effect.
How does the demand for money affect the crowding-out effect?
If the demand for money is highly responsive to interest rates, an increase in government spending will raise interest rates significantly, which then leads to a larger reduction in private consumption and investment.
What happens if the demand for money is less responsive to interest rates?
If demand for money is less responsive, the crowding-out effect will be weaker because the increase in interest rates will be smaller, resulting in less reduction in private sector spending.
In summary, what two factors influence the magnitude of crowding-out?
1) The sensitivity of consumption and investment to interest rates, and
2) the sensitivity of the demand for money to interest rates.
What can policymakers do to reduce the crowding-out effect?
Policymakers can use monetary policy to reduce interest rates or target fiscal policies that don’t rely too heavily on borrowing, thus reducing the crowding-out effect.
How is net tax (T) defined?
Net tax (T) = total taxes – transfer payments – government interest payments.
How do changes in taxes and transfer payments affect planned aggregate expenditure (PAE)?
Changes in taxes and/or transfer payments affect PAE indirectly, by altering disposable income.
How does a decrease in taxes affect disposable income?
Lower taxes increase disposable income, as households have more income available for spending.
How do higher transfer payments affect disposable income?
Higher transfer payments, such as unemployment benefits or welfare, increase disposable income, allowing households to spend more.
What effect does an increase in disposable income have on consumption (C)?
Higher disposable income leads to an increase in consumption, as people tend to spend a portion of the additional income.
How does the change in disposable income affect aggregate demand?
Increases in disposable income boost consumption, which increases aggregate demand and planned aggregate expenditure (PAE).
How do taxes and transfers indirectly affect PAE?
By changing disposable income, which then affects consumption (C), which is a key component of PAE.
What is the relationship between taxes, transfers, and the multiplier?
Lower taxes or higher transfers lead to higher disposable income, increasing consumption and output, with the total effect amplified by the multiplier.
Using Tax Cuts to Close a
Recessionary Gap – An Example
Original planned spending Y = 960 + 0.8Y
* Autonomous spending decreases Y = 950 + 0.8Y
* Recessionary gap is $50
* Tax cut to close the gap must be bigger than $10
– Increase disposable income to cause initial
increase in spending to be $10
* Taxes will have to go down by $12.50
Because of the marginal propensity to consume (MPC), a tax cut of $12.50 will increase disposable income, leading to a $10 increase in spending (C).
The decrease in taxes increases disposable income, which then leads to increased consumption (C), helping close the recessionary gap.
The MPC determines how much of the additional disposable income is spent. In this case, an MPC of 0.8 means that for every $1 increase in disposable income, consumption rises by $0.80.
Why did the U.S. federal government issue tax rebates in 2001?
The economy showed signs of slowing in early 2001, prompting the government to issue rebates as a stimulus measure.
How much were the individual tax rebates in 2001?
The federal government rebated $300 to individuals and $600 to couples.
What was the total value of the rebates issued in 2001?
The total rebates amounted to about $38 billion.
What other fiscal measures were taken in 2001 alongside the tax rebates?
The federal government also made cuts in tax rates as part of the fiscal stimulus.
How did households respond to the rebates?
Two-thirds of the rebates were spent by households within six months, boosting consumption.
Why was the 2001 federal tax rebate considered a successful policy?
It successfully stimulated the economy by increasing household spending and boosting aggregate demand.
What role did the rebates play in stabilising the economy?
By increasing disposable income, the rebates helped counteract the economic slowdown, providing an immediate boost to consumption.
What was the American Recovery and Reinvestment Act (ARRA) of 2009?
ARRA was a fiscal policy package aimed at addressing the 2007-2009 recession, which included tax cuts and government spending increases.
How much in tax cuts were included in the ARRA of 2009?
The ARRA included $288 billion in tax cuts.
How much did government spending increase as part of the ARRA?
The ARRA included a $600 billion increase in government spending.
What was the effect of these fiscal measures on consumption spending?
Both the tax cuts and government spending increases were effective at raising consumption spending, stimulating aggregate demand.
How did the ARRA impact real GDP?
The ARRA helped raise real GDP, making it higher than it would have been without the fiscal stimulus.
What was the main objective of the ARRA during the recession?
The main objective was to stimulate economic activity, increase consumption, and mitigate the effects of the recession.
When was the CARES Act signed into law?
The CARES Act was signed into law in March 2020.
What is the total value of the CARES Act economic relief bill?
The CARES Act totalled $2.2 trillion, making it the largest economic relief bill to date.
What were some of the key provisions of the CARES Act?
The CARES Act included hundreds of billions of dollars in tax relief, stimulus checks for individuals, and payroll credits for employers.
What was the purpose of the stimulus checks in the CARES Act?
The stimulus checks were designed to provide immediate financial relief to individuals affected by the economic downturn due to the COVID-19 pandemic.
What role did payroll credits play in the CARES Act?
Payroll credits helped employers retain employees by providing financial assistance to cover wages and keep businesses operating during the pandemic.
How did the CARES Act aim to stimulate the economy?
By providing direct financial relief to individuals and businesses, the CARES Act sought to boost consumption, support businesses, and reduce the economic impact of the COVID-19 crisis.
Besides planned spending, what else can fiscal policy affect?
Fiscal policy can also affect potential output (Y), not just planned aggregate expenditure.*
How can investment in infrastructure influence potential output (Y)?*
Infrastructure investment improves productivity and capacity, which increases potential output (Y).*
How do taxes and transfers affect potential output?
Taxes and transfers influence incentives to work, save, and invest—changes in these incentives can shift potential output (Y).*
What do supply-side economists focus on in fiscal policy?
Supply-side economists emphasise how fiscal policy affects the economy’s ability to produce (Y), focusing on long-term growth and incentives.*
What is the modern view of fiscal policy’s impact?
Current thinking is more balanced—acknowledging both demand-side effects (short-run impact on spending) and supply-side effects (long-run impact on output).
Give an example of a supply-side fiscal policy.
A tax cut that encourages business investment or work effort, potentially increasing the economy’s productive capacity.
Why do supply-side effects matter for long-run economic growth?
Because they influence the economy’s potential output by affecting labor supply, capital investment, and productivity.
What is the government budget deficit?
The government deficit is the difference between government spending (G) and net taxes (T), or Deficit = G-T
What is the effect of large and persistent budget deficits on national saving?
They reduce national saving, which limits the funds available for private investment.
How does reduced national saving affect economic growth?
Less saving leads to less investment, which in turn slows down long-run economic growth.
How can deficits limit the government’s ability to use fiscal policy?
Large deficits constrain future fiscal stimulus options, as expanding government spending or cutting taxes further could worsen the deficit.
Why is it difficult to implement contractionary fiscal policy?
Political considerations often make tax increases or spending cuts unpopular, even if they are economically necessary.
What is the long-run consequence of chronic deficit spending without adjustments?
It can lead to higher interest rates, lower investment, higher debt burdens, and slower economic growth.
How does deficit spending relate to the crowding-out effect?
Deficit spending can increase interest rates, which crowds out private investment by making borrowing more expensive.
What are the two main limits to fiscal policy flexibility?
The time-consuming legislative process and (2) competing political objectives.
Why does the legislative process limit fiscal policy flexibility?
Because passing changes to spending or taxes takes time due to debate, negotiation, and approval requirements
What are examples of competing political objectives that limit fiscal policy?
Spending priorities like national defence, Medicare, and income support (entitlements) can limit the ability to shift resources quickly.
How do entitlement programs limit fiscal flexibility?
Entitlements are mandatory expenditures, leaving less room in the budget for discretionary fiscal changes.
How does national defence spending influence fiscal policy flexibility?
High or rigid defence budgets can crowd out other spending priorities or limit fiscal stimulus options.
Why is speed important for effective fiscal policy?
Because delays in implementing policy can reduce its effectiveness in addressing recessions or overheating.
