Download Fiscal Policy

Aim: What can the
government do to bring
stability to the
economy?
Two Views of Government Policy
Classical – “government is best
that governs least”
Keynesian – government role is to
safeguard the economy – “in the
long-run we are all dead”
Classical Economic Theory
• Adam Smith – laissez-faire
– competitive markets, flexible
prices
– limited role of govt
– demand is more influential than
price
–supply in the short-run is fixed
Great Depression
- foundation for an activist
government
Pre 1945 ￫ booms and busts for
“natural” economic reasons
Post 1945 ￫ managed government
John Maynard Keynes
The General Theory of
Employment, Interest and
Money
Keynesians look to demand to
manage the economy
Safeguarding the economy
Fiscal Policy
- govt uses taxes and spending to
achieve macroeconomic goals
Expansionary Fiscal Policy
• used in recessionary economy
• decrease taxes
• increase spending
Contractionary Fiscal Policy
• used in demand side inflation
• increase taxes
• decrease spending
Role of govt is to provide for the
public good – protect quality of life
-
persuasion
regulation
subsidies
taxation
services
transfer payments
Key Terms
Consumption – refers to the
willingness of people to purchase
goods and services
Disposable income – is the income
available to consumers, after taxes
to spend
Savings – is money not used for
consumption
Planned investment – which equals
savings in equilibrium, is the
amount firms intend to spend on
investment in capital goods for
future production
Actual investment – is the money
spent, in reality, on investment
goods
Inventories – represent the
difference between planned
investment and actual investment
National Income – in equilibrium,
represents Real GDP
Transfer payments – are monies
spent by the government without
corresponding provisions of goods
and services
Consumption function – the
relationship between expenditure
and income
Determinants of Consumer
Spending
• the past/the lag
• wealth
• price level
• inflation rate
• expectations about the future
Aim:
How is equilibrium in the
market for goods and services
analyzed graphically?
What is the role of savings,
consumption and investment?
Do Now
(1) If the economy is
expanding too quickly and
prices are rising, how should
government officials adjust
taxes?
(2) If there is growing
unemployment and business
inventories, how should
government officials adjust
taxes?
Income-Expenditure Diagram
• 45° line marks all the points at
which output and spending are
equal – all the points at which
the economy can possibly be in
equilibrium
Reaction to price levels
• higher prices lead to lower
consumer spending
• a rise in price level leads to a
reduction in the consumption
function
The effect of the price level on
the expenditure schedule
• a rise in price level leads to a
lower equilibrium level of real
aggregate quantity demanded
• a fall in prices leads to a higher
equilibrium aggregate quantity
demanded
• When
equilibrium
GDP falls
above full
employment,
the economy
will probably
be plagued by
inflation.
• When
equilibrium
falls below full
employment,
there will be
unemployment
and recession
Recessionary Gap – amount at
which the equilibirum level of
GDP fall short of potential GDP
Inflationary Gap – the amount
by which equilibrium level of
GDP exceeds the full
employment level of GDP
Aim:
How will consumers respond
to a tax cut – a $1 increase in
disposable income?
The primary tool that the govt
can use to stabilize the
economy is the personal
income tax – personal
consumption makes up 65% 75% of GDP
Marginal Propensity to Consume
• Basis for Keynesian Expenditure
Analysis
• MPC states that consumers will
spend a fraction of each additional
dollar of income on goods and
services and save the rest
GDP = Y
Aggregate output = real GDP
Y = savings + consumption
Y=S+C
MPC = Change in Consumption
Change in disposable income
MPC = ∆C
∆Y
MPS = Change in Savings
Change in disposable income
MPS = ∆S
∆Y
MPC + MPS = 1
Expenditure Multiplier
1/MPS = 1/1-MPC
the greater the MPC the
greater the multiplier
Aim:
How has the Keynesian
model been modified to
include aggregate price
levels?
• Keynesian model could not
accurately forecast GDP,
employment & price levels in
an inflationary environment.
• AD/AS Model
Aggregate Demand
• accounts for the purchases of
all consumers, businesses,
governments and foreign trade
in the entire domestic economy
Reasons for negative slope of the
Aggregate Demand Curve
• Interest rate effect – increased
prices lead to an increasing
demand for money – this increased
demand for money leads to higher
interest rates which leads to a
decrease in output
• Real Wealth Effect - as prices
increase, the value of consumer
wealth falls – this fall leads to a
decrease in consumption, which
leads to a decrease in output
• Foreign sector substitution – as
prices for domestic goods rise,
consumers begin to substitute with
foreign sector goods which are less
expensive – this results in less
consumption of domestic goods
which leads to a decrease in
production
Aggregate Supply
• Relationship between the quantity
of output supplied by all firms in
an economy and the overall price
level
Along the AS Curve
• Horizontal range – unused
capacity, supply can increase
without increasing the price – this
can occur when there is excess
capacity in terms of raw materials
or labor
• Mid-range – illustrates tightening
of resource availability and
therefore impacts price level as
more products are demanded –
occurs when demand for the
product increases and the resources
needed to produce more products
are scarce and thus more costly
• Vertical range – situation where all
resources are being used and no
more products can be produced –
the only thing that can happen is
that suppliers raise their prices – it
is the Long Run AS Curve
Graphs