ECON 205 1st Edition Lecture 20 Outline of Last Lecture How does interest rate effect help explain slope of AD How can central bank use monetary policy to shift the AD curve In what way does fiscal policy affect AD What are arguments for and against using policy to smooth out cycles Outline of Current Lecture Continuation of Liquidity Traps and Fiscal Policy Current Lecture Changes in Taxes Tax cut increases household s take home pay Households respond by spending portion of extra income AD shifts right Size of shift affected by multiplier and crowding out Households sometimes perceive the tax cut to be temporary Permanent cut larger increase in C and larger shift in AD Fiscal Policy Examples Econ in recession shifting AD curve rightward by 200 billion would end recession A If MPC 8 and no crowding out how much should congress increase G to end the recession Multiplier 1 1 8 5 200 5 40 increase G by 40 billion B If there is crowding out Congress should increase G by a larger amount because crowding out decreases the impact of G on AD Fiscal Policy and Aggregate Supply Most economists believe the short run effects of fiscal policy mainly work through AD But fiscal policy might also affect AS Key to economics people respond to incentives Cut in tax rate gives workers incentives to work more so increase efficiency output and GDP Government purchases might affect AS If government increases spending on roads better roads increases business productivity increased quantity of goods and services provided AS shifts to right This effect happens more to LRAS curve Using Policy to stabilize the economy Since Employment Act of 1946 economic stabilization is the goal of US policy How active of a role should the government have Case for active stabilization Policy Keynes Animal Spirits wave of pessimism and optimism shifting AD Other factors fluctuations Booms and recessions abroad stock market booms and crashes Gov should use policy to decrease fluctuations When GDP falls below natural rate use expansionary monetary or fiscal policy to prevent or decrease a recession Prevent inflation when GDP rises above natural rate Case Against active stabilization Policy monetary policy affects economy with long lag firms make investment plans in advance so Investment takes time to respond to challenges of r Most economists believe it takes at least 6 months for policy to have any effect Due to long lags such policies may destabilize econ Econ s conditions may have changed by the time the policies are influential Policymakers should focus on long run goals like economic growth and low inflation Automatic Stabilizers Automatic Stabilizers Economic policies and programs designed to offset fluctuations without intervention by the government or polcymakers Tax system is one In recession taxes fall automatically falling to a lower tax bracket stimulates AD Government Spending In recession more people apply for assistance Government spending on these programs automatically increases stimulates AD