Week 21 - Spending and Output Pt3 Flashcards
What are automatic stabilisers in fiscal policy?
Policies that automatically increase government spending or decrease taxes when real output declines, without the need for new legislation.
What are examples of automatic stabilisers?
Unemployment compensation and the progressive income tax system.
How do automatic stabilisers work during a recession?
They help sustain household income and consumption by increasing government transfers and reducing tax burdens automatically.
Why don’t automatic stabilisers require new decisions or legislation?
Because they are built into existing laws and respond automatically to changes in economic conditions.
When is fiscal policy especially useful?
During prolonged periods of recession when automatic stabilisers and monetary policy may not be enough.
What type of policy is more commonly used for short-run economic stabilisation?
Monetary policy is more often used due to its flexibility and quicker implementation.
What are automatic stabilisers?
Automatic stabilisers are automatic changes in the government budget deficit that help dampen fluctuations in economic activity.
How do automatic stabilisers function during a recession?
They increase the budget deficit by reducing taxes and/or increasing transfer payments automatically, helping to support aggregate demand.
How do automatic stabilisers respond during an expansion?
They reduce the budget deficit by increasing tax revenues and reducing transfer payments, helping to cool down the economy.
What is discretionary fiscal policy?
It refers to deliberate government decisions to increase or decrease government purchases, transfer payments, and taxation to influence the economy.
What is the formula for the government deficit?
Government Deficit = G – T, where T is net taxes (tax revenue minus transfer payments).
How do net taxes (T) behave over the business cycle?
Net taxes tend to rise during expansions (as incomes and tax revenues increase) and fall during recessions (due to lower income and higher transfer payments).
What happens to incomes, consumption, and profits during a recession?
They decline, which leads to lower tax revenues and higher transfer payments.
How do automatic stabilisers operate during a recession?
Tax revenues fall, transfer payments (like unemployment benefits) rise, and net taxes decrease—automatically increasing the government deficit (G – T).
What causes net taxes to fall during recessions?
A decline in income, consumption, and profits reduces tax revenues, while more people claim unemployment and other benefits.
What happens during economic expansions to income, consumption, and profits?
They increase, leading to higher tax revenues and lower transfer payments.
How do automatic stabilisers function during an expansion?
Net taxes automatically increase as tax revenues rise and transfer payments fall, reducing the government deficit.
What is the automatic effect of the business cycle on the government deficit (G – T)?
The deficit increases during recessions and decreases during expansions without new policy decisions.
What was the purpose of the American Recovery and Reinvestment Act of 2009?
To stimulate the economy during the Great Recession through tax cuts and increased government spending.
How much was allocated to tax cuts and government spending in the 2009 stimulus?
$200 billion in tax cuts and $600 billion in increased government spending.
What was the effect of the 2009 stimulus package?
It raised consumption spending and real GDP was higher than it would have been otherwise.
What was the CARES Act of 2020?
A $2.2 trillion economic stimulus package in response to the economic impact of COVID-19.
What were some key components of the CARES Act?
$300 billion in one-time payments to individuals
$260 billion in enhanced unemployment benefits
$669 billion in small business funding (e.g., Paycheck Protection Program)
$500 billion in aid for large corporations
$339.8 billion to support state and local governments
Why was urgent fiscal intervention needed in March 2020?
It was predicted that most airlines could go bankrupt without immediate support, highlighting the severe economic fallout.
What were the goals of the COVID-19 stimulus package?
To restore planned aggregate expenditure (PAE), offset losses in investment (physical and human capital), and maintain valuable employment relationships.
What is the key assumption in the basic Keynesian model?
Producers meet demand at preset (fixed) prices in the short run.
What defines short-run equilibrium in the Keynesian model?
Short-run equilibrium occurs when output
Y= planned aggregate expenditure (PAE).
What does short-run equilibrium output represent?
It is the level of output that prevails when prices are predetermined and firms simply meet the level of demand.
Why are prices considered fixed in the short run in the Keynesian model?
Because firms cannot immediately adjust prices in response to changes in demand due to contracts, menu costs, and market frictions.
What happens if PAE is less than output in the Keynesian model?
Firms accumulate unintended inventories, leading them to reduce production.
What happens if PAE is greater than output?
Firms draw down inventories and increase production to meet demand.
What is the formula for planned aggregate expenditure (PAE) in the Keynesian model?
PAE = C + I + G + NX
In the Keynesian model, what do the components of PAE stand for?
C = Consumption
I = Investment
G = Government spending
NX = Net exports (exports – imports)
How is consumption (C) expressed in terms of income and taxes in the Keynesian model?
C = C̅ + c(Y – T)
Where:
C̅ = Autonomous consumption
c = Marginal propensity to consume (mpc)
Y = Income
T = Net taxes
How do we incorporate the consumption function into the PAE equation?
PAE = [C̅ + c(Y – T)] + I + G + NX
What is the role of the marginal propensity to consume (mpc or c)?
It determines how much consumption changes in response to a change in disposable income (Y – T).
Why do we assume I, G, and NX are fixed in the short-run Keynesian model?
To simplify analysis and focus on how changes in income affect consumption and overall output.
What is the expression for PAE in terms of the marginal propensity to consume (c)?
PAE = (C + cT + I + G + NX) + cY
What is the short-run equilibrium condition in the Keynesian model?
Y = PAE
How do you express short-run equilibrium output using the PAE formula?
Y = (C + cT + I + G + NX) + cY
How do you solve for Y in the Keynesian model?
Y - cY = C + cT + I + G + NX
Y(1-c) = C + cT + I + G + NX
Y = (C + cT + I + G + NX)/ (1-c)
What does the denominator 1−c represent in the Keynesian equation for output?
It reflects the income-expenditure multiplier. The larger the mpc (c), the larger the multiplier.
Why is this model useful for fiscal policy analysis?
It shows how changes in autonomous spending (C, I, G, NX, T) affect total output via the multiplier effect.
What is the income-expenditure multiplier?
It measures the effect of a 1-unit change in autonomous expenditure on short-run equilibrium output.
What does a multiplier of 5 mean?
A 1-unit increase in autonomous spending increases output by 5 units; a 10-unit decrease reduces output by 50 units.
What determines the size of the multiplier in the Keynesian model?
The marginal propensity to consume (mpc)
What is the formula for the multiplier?
Multiplier = 1/ (1-c)
Where c is the marginal propensity to consume.
How does a higher mpc affect the multiplier?
A higher mpc leads to a larger multiplier, meaning changes in spending have a stronger impact on output.
Is the multiplier effect immediate?
No, it occurs over time as increased spending leads to income, which leads to more spending, and so on.
How is the multiplier used to calculate the change in output?
Change in output (ΔY) = Multiplier × Change in autonomous expenditure (ΔA)
In the example: PAE = 960 + 0.8Y → Y = 4,800; then PAE = 950 + 0.8Y → Y = 4,750. What is the multiplier?
Change in A = –10
Change in Y = –50
Multiplier = ΔY / ΔA = 50 / 10 = 5
If MPC (c) = 0.8, what is the multiplier?
Multiplier = 1/ 1-0.8
= 5
If MPC (c) = 0.6, what is the multiplier?
Multiplier = 1/ 1-0.6
= 2.5
What happens to the multiplier when MPC increases?
The multiplier increases, making the economy more responsive to changes in autonomous spending.
What does the multiplier imply for fiscal policy?
Small changes in government spending or taxes can lead to larger changes in output due to the multiplier effect.
What is the tax multiplier?
It measures the effect of a change in net taxes on short-run equilibrium output.
What is the formula for the tax multiplier?
Tax Multiplier = -c/(1-c)
Where c is the marginal propensity to consume (MPC).
Why is the tax multiplier negative?
Because an increase in taxes reduces disposable income, which reduces consumption and output.
If c = 0.8, what is the tax multiplier?
Tax multiplier = -0.8/ 1-0.8
= -0.8/0.2
= -4
How does the tax multiplier compare to the spending multiplier?
The tax multiplier is smaller in absolute value because only a portion (c) of the tax change affects spending.
How does a tax cut affect output?
A tax cut increases disposable income → increases consumption → increases output.
What is the effect of a $10 tax cut if c = 0.75?
Tax multiplier = -0.75/ 1-0.75
= -3
Change in Y = –3 × (–10) = +30 increase in output.
What happens when taxes are a function of income (T = tY)?
Taxes increase with income, reducing the marginal impact of changes in income on consumption. This stabilises the economy.
