UB ECO 181 - Chapter 9 - Fiscal Policy (12 pages)

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Chapter 9 - Fiscal Policy



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Chapter 9 - Fiscal Policy

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Pages:
12
School:
University at Buffalo-SUNY
Course:
Eco 181 - Intro To Macroeconomics
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Macroeconomic Stabilization Policy Government s attempt to change AD demand and thus the level of real GDP unemployment and price level 1 Discretionary 2 Automatic stabilzer action must be taken N0 action needed Fiscal Policy Monetary Policy Done by president and congress Done by the fed reserve Goals 1 Steady sustainable growth long run 2 Low unemployment 4 6 3 Low inflation 2 Expansionary Policy Contractionary Policy Intentional increase in AD Intentional decrease in AD Should be done if Y Less than YN U UN Inflation is should be done if Y YN U UN Inflation is Policy is much more complicated when we have 3 Discretionary Fiscal Policy Tools 1 Changes in Govt spending such as spending on infrastructure defense edu Health care will Directly affect AD 2 Changes in taxes will affect disposable income which will in turn affect consumption and thus AD 3 Changes in transfer payments will also affect income and affect consumption and AD For example voting to extend unemployment Compensation beyond 6 months Expansionary Fiscal An increase in G and or TP or a decrease in taxes Will Shift AD out Contractionary Fiscal An decrease in G and or TP or a increase in Taxes will shift AD inward Obama s Fiscal Policy 2010 737Billion Recovery Act Fiscal policy has three affects I Direct Expenditure effect If Government spending changes AD changes as much as the change in G If Taxes or Transfer Payments change AD changes less since people don t spend all of the extra income II Multiplier Effect Increases in Government spending or other types of spending will lead to increases in RGDP that are greater than the initial Change in Spending Due to additional increases in income and thus consumption If the government spend 100 B on planes from Boing Boeing revenue increases by 100 B This is distributed to Boeing s workers as wages and owners as profits or stock dividends This extra consumption causes increases in AD Increase in G by 100 shifts the AD curve out by 1 T to AD1 However the increase in Income causes C to increase which shifts the AD curve out more to AD2 The size of the additional shift is determined by the multiplier How big is the multiplier effect It depends on how much consumer s respond to changes in income Marginal propensity to consume MPC the fraction of extra income that households consume rather than save E g if MPC 0 8 and income rises 100 C rises 8 100 80 As C increases rise and C would rise MPC Change in C Change in RGDP Change in C MPC Change in RGDP Marginal Propensity to save MPS 1 MPC This process would continue with each additional increase in C getting smaller Thus above the initial increase in 100B causes C to increase by a total of 400 causing a total increase in Y of 500 Thus in this case the multiplier would be 5 Change in Y multiplier Initial Change in Spending Example 1 If G increases by 100B and the MPC 8 What is the total change in GDP due to the multiplier effect Chang in y 1 1 8 10 500 Multiplier holds for any change in spending Example 2 Suppose that due to a change in tax laws investment spending falls by 50 billion What will be the total impact resulting from the multiplier if the mpc is 75 1 75 4 50 200 Multiplier works in reverse too 3nd Effect of an Expansionary policy The Crowding out Effect Increases in government spending reduce private spending Crowd out A fiscal expansion usually requires government borrows In order to entice people to lend them money there will be upward pressure on interest rate This will increase the cost of borrowing by firms which will decrease Investment spending Thus the AD shift may be less than predicted by the multiplier Thus if G increases by 100B AD will shift out by 1 T to AD If the MPC is 8 the multiplier effect would shift it out by 500 But the higher interest rates will shift AD inward Thus to close a gap of 500B the government would have to increase spending by more than 100B if there is crowding out Other possible Effects of Increasing G Direct Expenditure Offsets Some people argue that if the government increases spending then private spending will fall since they are substitutes This is an argument for why the government should spend money on goods and services that would not be provided by the private market Defense infrastructure education Positive Externalities of Government spending Much of the spending done by the government on programs such as infrastructure education health care create positive externalities and result in greater growth from smarter healthier workers Changes in Taxes or Transfer Payments A cut in taxes will increase after tax income Households respond by spending a portion of this extra income Change in spending MPC Change in taxes But since not all of it is spent a 1 00 tax cut or increase in transfer payments will have a smaller effect on AD then a 1 00 increase in Government spending Direct Expenditure affect Change in C and AD MPC the change in taxes Spending Multiplier Change in RGP change in spending 1 1 mpc Tax Multiplier Change in RGP Tax Multiplier is smaller than the Spending Multiplier Example 14 9 15 4 15 7 Suppose that the economy is in a recession and shifting the AD curve rightward by 800b would end the recession a If mpc 75 and there is no crowding out how much should Congress increase G to end the recession b Would the government need to cut taxes by more or less than in a c If there is crowding out will Congress need to increase G more or less than in a 3 tools taxes transfer govt spending Of fiscal policy Aimed at changing AD and real GDP Fiscal policy and Aggregate Supply Most economists believe that the short run effects of Fiscal policy work through changing AD However some economists also believe that there can be short run effects on Supply SRAS A cut in taxes give households a greater incentive to supply resources Thus shifting SRAS out These economists are called supply siders Most economists believe that supply effects are more likely to be in the long runs Spending on education infrastructure can increase productivity and shift LRAS and SRAS in the Arguments against Active Stabilization policy Fiscal and Monetary policy affect the economy with long 1 Lag time it takes to recognize the problem for both policies 2 Lag time it takes to implement the policy This is much longer for policy due to government 3 Lag time it takes for policy to This is longer for policy because it takes time for changes in to effect After a shock happens Economy is already self adjusting If a


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