USC ECON 205 - Taxes and Fiscal Policy

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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 PolicyCurrent LectureChanges 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 ADFiscal 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 endthe 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 ADFiscal 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 curveUsing 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 rateCase 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 inflationAutomatic 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 SpendingIn recession, more people apply for assistanceGovernment spending on these programs automatically increasesstimulates

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