Download The Spending Multiplier

Chapter 12: Fiscal Policy
Shauna Delaney, Jennifer Doyle, Su-Ann Khaw, Ronnie Wu
The Goal of Stabilization

To lessen the effects of the ups and downs of the business cycle. A
stabilization policy attempts to influence the amounts ________ and
________ in an economy. The goal is to keep the economy as close as
possible to its ___________.

Expansionary policies: used when total output is below its potential output,
policy makers want to eliminate the recessionary gap, which will reduce
__________ and stimulate ____________.

Contractionary policies: used when the economy is booming, in order to
reduce _________. This will stabilize _______ and bring the economy back
down to its __________________.

Fiscal Policy: Government stabilization policy that uses taxes and government
purchases as its tools; budgetary policy. Since governments have an
extensive impact on the economy through __________ and government
________, the government’s budget becomes an instrument of stabilization
policy, (fiscal policy.)
Use of Fiscal Policy

Expansionary fiscal policy: involves increasing government purchases,
decreasing taxes, or both. This is used when the business cycle is in a
___________
.
o

When governments increase their ______
__ it raises injections to the
circular flow. Injections rise relative to withdrawals, and total flow ___
_____. Reducing taxes has the same effect.
Contractionary fiscal policy: involves decreasing government spending and
increasing taxes, or both. This is used when the business cycle is in a
_________ boom. Increasing taxes has the same effect.
Injections and Withdrawals

Expansionary fiscal policy: When governments increase their ______
__
it raises injections to the circular flow. Injections rise relative to withdrawals,
and total flow ______
__. Reducing taxes has the same effect. As the total
flow rises, the equilibrium point is pushed ________ ___.

Contractionary fiscal policy: When governments decrease their ______
__
it reduces injections to the circular flow. Injections fall relative to withdrawals,
and total flow _____
___. Reducing taxes has the same effect. As the total
flow reduces, the equilibrium point is pushed _____ ______.
Aggregate Demand

To increase aggregate demand so the economy expands to its potential
output, government __
______ increases, __
____ are cut, or both.
Increasing government purchase has an __
______ effect on aggregate
demand since government purchases are a component of ____
___
________ ___. Tax cut effects are less ___________ because there is no
guarantee that households and businesses will alter spending in response.

To decrease aggregate demand so the economy contracts to its potential
output, government ____
____ decreases, ______ are increased, or both.
Decreasing government purchase has an ________ effect on aggregate
demand since government purchases are a component of ___
____
_______ ____. Tax increase effects are less ___________ because there is
no guarantee that households and businesses will alter spending in response.
Automatic Stabilizers

built in measures that do not involve the direct involvement of government
decision makers. These measures include progressive income taxes,
Employment Insurance, and welfare payments.
The Spending Multiplier
Multiplier Effect

multiplier effect: the magnified impact of a __________ change on aggregate
__________ .

marginal propensity to consume: the effect on domestic ___________ of a
change in income.
o
MPC = change in consumption on domestic items
Change in income

marginal propensity to withdraw: the effect on withdrawals (i.e. _________,
__________, and ________) of a change in income.
o
MPW =
change in total withdrawals
Change in income

MPC + MPW = 1 because income is ALWAYS either spent or _________ as
savings, imports or taxes.

The multiplier effect will continue until the initial
______________ ___________ = ____________
Spending Multiplier

spending multiplier: the value by which an _________ spending change is
multiplied to give the total change in ______ _________.
o
Total
output = initial
o
Spending Multiplier =
spending x spending multiplier
1
MPW
Effect of a Tax Cut

The initial change in spending on domestic items from a change in ________
(T) is found by multiplying the economy’s ____ by the size of the ____
________ multiplied by the spending multiplier.

Only the amount used to buy ___________ __________ represents the
initial spending increase. (initial government purchase doesn’t increase real
output because spender A’s disposable income would increase from a tax cut,
therefore more money would be withdrawn before the first effect on real
output)
o
Total
output = - (MPC X
T) x spending multiplier
NOTE: Total change in output = maximum shift in AD curve
-(MPC X
T) has a minus sign because the change in spending is in the opposite
direction.
o
i.e. if there is a $3 billion tax rise, consumers will spend less, therefore
change in spending will go down: -(MPC x $3 billion). If there’s a $3 billion
tax cut, consumers will spend more, increasing spending: -(MPC x -$3
billion)  two negatives cancel out to become positive
Benefits of the Fiscal Policy
Regional Focus
 Business cycles can effect different parts of Canada differently

can focus on particular regions

have the greatest effect in regions that need
them the most.
o During a recession, new government purchases or programs to reduce
the amount of tax paid can be targeted to regions where
unemployment rates are _____________
o During a recession, net tax revenue drop _______ in regions hardest
hit by ______________ and ___________ output.
o During a boom, net tax revenue increase where the economy is most
___________________.
o During a boom, increase revenues from personal income tax _______
most quickly in areas where
and __________ are
most buoyant.
o During a boom, spending cuts and tax hikes can be concentrated on
regions where ____________ is at its ________.
Impact on Spending
 Fiscal policies have
impact on spending.
o Tax cuts, lower taxes
leave and
with
more funds to spend and invest, and the result would be an increase.
(increase in spending multiplied by the spending multiplier would equal
increase in output)
Drawbacks of the Fiscal Policy
Delays
 Discretionary policies are sometimes delayed due to the “three times lag”
 Three times lag
o
- the amount of time it takes policy makers to
realize that a policy is needed
o
- the amount of time needed to formulate and
implement an appropriate policy
o
- the amount of time between a policy’s
implementation and its having an effect on the economy
 Due to the lag
pass between the
and the
of a fiscal policy, the economy may already have
moved to a different point in the business cycle
Political Visibility
 Discretionary fiscal policies are highly visible elements in government activity,
therefore it is often affected by both
and
considerations
o Ex. Tax hikes and decrease government spending sometimes are the
appropriate action for the economy; however citizens do not favour
these actions regardless of the appropriateness. As a result political
parties would choose other options over this.
Public Debt
 The total amount by
the federal government as a result of its
past borrowing
 The amount of
may influence the government’s
to impose fiscal policies. Due to the fact that money is needed to pay public
debt charges

- the amounts paid out each year by the
federal government to cover the interest charges on its public debt
o Ex. During a recession, if the government has a high public debt, then
they cannot decrease taxes, or increase government spending, if they
do they will not have the money to pay public debt charges
Impact of Fiscal Policy
Budget Surpluses and Deficits


When a government’s ___________ and ____________ are equal, the
government is running a ___________ ____________
When a government’s revenues exceed its ____________, there is a budget
_____________
Budget surplus = __________ ___________ – government expenditures
3.0 billion = _____________ - 175.8 billion

When a government’s expenditures exceed its revenues, there is a
__________ ___________
Budget deficit = government expenditures - __________ __________
8.9 billion = 149.8 billion - _____________



The use of a government’s deficit or surplus in relation to the economy’s overall
_____ gives an indication of what type of discretionary ________ _________ is in
operation, as well as the effects of ________ _________
A government’s deficit should not be confused with its debt! A budget deficit
occurs when a government’s expenditures exceed its _________ during a given
period, whereas the government’s debt represents the sum of all its ________
_________ deficits minus budget surpluses.
When the federal government has a budget deficit, the public debt increases by the
_________ __________
Fiscal Policy Guidelines






There are _______ principles that guide government fiscal policy: annually
balanced budgets, __________ balanced budgets, and __________
__________
Annually balanced budget is the principle that government _________ and
___________ should balance each year
Although an annually balanced budget may make sense for a _________, it is
not necessarily appropriate for __________ as a whole
A ___________ ____________ _____________ is the principle that
government revenues and expenditures should balance over the course of one
__________ __________
___________ finance is the principle that government budgets should be geared
to the yearly needs of the economy.
Governments should base a year’s ________ _________ on the needs of the
economy.
Recent Fiscal Policy



During the 1970’s and 80’s _________ _________ was the guiding principle
behind fiscal policy in Canada. Since then, there have been attempts to move
towards a _________ _________ __________
The large federal deficits in Canada’s history were due to _________
__________ and the use of discretionary __________ policy. The federal
government __________ purchases of goods and services to counteract the
effects of sagging output and incomes.
During the mid to late 1990’s, the impact of automatic stabilizers, __________
interest rates, and spending cuts by all levels of government led to a budget
_________