Macro Chapter 11

Fiscal Policy

Quick Review #1

• Answer: E

Quick Review #2

• Which of the following transactions would represent an addition to a nation’s current gross domestic product?

• A. Ms. Smith purchases a share of stock in an automobile company

• B. A retailer increases her stock of imported shoes• C. The government increases its domestic purchases

of food for use by the military• D. A corporation sells shoes from last year’s inventory• E. A mother sells her car to her daughter• Answer: C

Quick Check #3

• Goods and services that are purchased for resale or for further processing or manufacturing

• Intermediate Goods

Quick Check #4

• When unemployed people lack the skills or education, or geographically are misplaced to find work

• Structural Unemployment

Council of Economic Advisors (CEA)

• Group of 3 economists appointed by the President to advise him on economic policy- mostly professors of economics

• Obama and former

Chr. Austin Goolsbee

Fiscal Policy

• Fiscal = “Financial”

• Changes in government spending and taxation designed to achieve full employment, control inflation, and encourage economic growth

Expansionary Fiscal Policy

• Used during a recession to stimulate the economy

Government has 3 Choices:

1. Increase government spending

2. Reduce taxes

3. Combo of both

1. Increased Gov’t Spending

• Ceteris Paribus, an increase in govt spending will shift the AD to the right

• New spending on highways, schools, etc. will lead to more GDP

• ***the multiplier leads to an even greater increase in demand

Fiscal Policy and theAD-AS Model

Real Domestic Output, GDP

Pri

ce L

evel

AD1

RecessionsDecreaseAggregateDemand

AD2

$5 Billion AdditionalSpending

Full $20 Billion Increase in

Aggregate Demand

AS

$490 $510

P1

Expansionary Fiscal Policy

2. Reduce Taxes

• Reducing taxes will also shift the AD curve to the right

• ***Tax cuts must be greater than the increase in govt spending to achieve the same shift in GDP due to people saving part of a tax cut

Tax Cuts and Real GDP

• 1. Change in GDP = tax cut (MPC) x multiplier

• 2. Tax Multiplier = -MPC/MPS

Reduced Taxes Example

• If the govt cuts taxes by $6.67 Billion and the MPC is .75, what is the total change in GDP?

• 6.67 x .75 = $5 billion consumed, and $1.67 B saved

• $5 B x 4 (multiplier 1/.25) = increase of $20 B in GDP

3. Combo of Govt Spending and Tax Cuts

• Ex- $1.25 B in increased government spending and $5 B tax cut with an MPC of .75

• Govt spending = 1.25 x 4 = $5 B• Tax Cut = 5 x .75 = $3.75 B increase x 4 = $15 • $5 B + $15 B = $20 B increase in GDP

Contractionary (Restrictive) Fiscal Policy

• Used to fight inflation

• 3 Options:

• 1. decrease govt spending

• 2. raise taxes

• 3. combo of the two

1. Decreased Govt Spending

• Decreased spending shifts the AD curve to the left

• If prices are inflexible downwards, this policy will stop the inflation rather than return to original price level

2. Increased Taxes

• Reduces consumption spending since people will have less disposable income

3. Combo Reduced Spending and Tax Increase

• Ex- $2 B decline in spending coupled with a $4 B increase in taxes (MPC of .75)

• Spending = 2 x 4 (multiplier) = $8 B

• Taxes = 4 x .75 = 3 x 4 (multiplier) = $12 B

• $8 B + $12B = decrease of $20 B in GDP

Fiscal Policy and theAD-AS Model

Real Domestic Output, GDP

Pri

ce L

evel

AD3

RecessionsDecreaseAggregateDemand

AD4

$5 Billion Initial Decrease

In Spending

Full $20 Billion Decrease in

Aggregate Demand

AS

$510 $530

P1

Contractionary Fiscal Policy