fiscal policy, deficits, and debt 30 mcgraw-hill/irwin copyright © 2012 by the mcgraw-hill...
DESCRIPTION
Fiscal Policy Recall that the government sector purchase goods and services (G) and collect taxes (T) The government can use: G and T to affect AD Fiscal policy: deliberate changes in G and/or T to achieve full employment, price stability, and economic growth. LO1 30-3TRANSCRIPT
Fiscal Policy, Deficits, and Debt
30
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Fiscal Policy
Recall;• AD = C + I + G + X - M• Changes in AD will have significant
effects on the economy.• Economic problems such as inflation and
unemployment• Changes in AD components leads to
changes in AD
LO1 30-2
Fiscal Policy• Recall that the government sector purchase
goods and services (G) and collect taxes (T)
• The government can use: G and T to affect AD
• Fiscal policy: deliberate changes in G and/or T to achieve full employment, price stability, and economic growth.
LO1 30-3
Fiscal Policy
How to use fiscal policy?• Performed by the government via its tools: G
and/or T
• Note that G has a direct effect on AD while T has indirect effect (through C and S)
• Two different fiscal policies: Expansionary Fiscal Policy and Contractionary Fiscal Policy
LO1 30-4
Expansionary Fiscal Policy
• Used to face a recession• When: GDP (or Y) < AE• Need to increase the level of AE• Increase level of G, and / or Reduce
level of T• Both will increase the level of Y
LO1 30-5
Expansionary Fiscal Policy
Real GDP (billions)
Pric
e le
vel
AD2
AD1
increase inaggregate demand
AS
$510
P1
LO1 30-6
Expansionary Fiscal PolicyExample;• Assume we have a sharp decline in I from I0 to I1. (show the
graph? )
• Result: what will happen to AD(show the graph?)
• This may cause a problem .……….• What is the solution? Use …………..fiscal policy.• What are the tools of such fiscal Policy to use?
LO1 30-7
Expansionary Fiscal Policy
• Assume that GDP0=$505,
• When I falls, GDP1=$485• This is accompanied by an increase
unemployment.• How much we need ∆G, ∆ T, or both?
Recall that MPC=75%, and Gm=4, Tm=3• ∆G: ∆Y = ∆G . M
20 = ∆G . 4 ∆G = $5• ∆T: ∆Y = - ∆T . M
20 = - ∆T . 3 ∆T = - $6.67
LO1 30-8
Expansionary Fiscal PolicyTherefore; ∆C = MPC.T=(0.75)(6.67) = +5∆S = MPS.T=(0.25)(6.67) = +1.67
• What if we used both?∆Y= ∆ G mg + ∆T mt
20 = ∆G(4)+ ∆T(3)20 = 1.25(4)+ 5(3)20 = 2(4)+ 4(3)20 = 2.75(4)+ 3(3)
LO1 30-9
Contractionary Fiscal Policy
• Used to face a demand-pull inflation• When: GDP (or Y) > AE• Need to reduce the level of AE• Reduce level of G, or/ and Increase
level of T• Both will reduce the level of Y
LO1 30-10
Contractionary Fiscal Policy
Real GDP (billions)
Pric
e le
vel
AD2
AD1
decrease inaggregate demand
AS
$522
P2a
bP1
LO1 30-11
Contractionary Fiscal PolicyExample;• Assume we have a increase in I from I0 to I1. (show the graph? )
• Result: what will happen to AD(show the graph?)
• This may cause a problem .……….• What is the solution? Use …………..fiscal policy.• What are the tools of such fiscal Policy to use?
LO1 30-12
Contractionary Fiscal Policy
• Assume that GDP0=$505,
• When I falls, GDP1=$515• This is accompanied by an increase prices.• How much we need ∆G, ∆ T, or both?
Recall that MPC=75%, and Gm=4, Tm=3• ∆G: ∆Y = ∆G . M
-10 = ∆G . 4 ∆G = $2.5• ∆T: ∆Y = - ∆T . M
-10 = - ∆T . 3 ∆T = - $3.34
LO1 30-13
Contractionary Fiscal PolicyTherefore;
∆C = MPC.T=(0.75)(3.34) = -2.505∆S = MPS.T=(0.25)(6.67) = -0.835
• What if we used both?∆Y= ∆ G mg + ∆T mt
10 = ∆G(4)+ ∆T(3)10 = 1 (4)+ 2(3)10 = 1.75(4)+ 1(3)10 = 0.25(4)+ 3(3)
LO1 30-14
Policy Options: G or T?• To expand the size of government (if they are concerned about unmet social needs or
infrastructure)
• If recession, then increase government spending• If inflation, then increase taxes
• To reduce the size of government(when they think government is too large and inefficient)
• If recession, then decrease taxes• If inflation, then decrease government spending
LO1 30-15
Other ConsiderationsThe crowding‑out effect The crowding‑out effect may be caused by fiscal policy.“Crowding‑out” may occur with government deficit spending. It may increase the interest rate and reduce private spending (Private Investment Spending) which weakens or cancels the stimulus of fiscal policy.
Standardized Budget (Full-Employment Budget)Public Budget = Total Revenue – Government SpendingTotal Revenue is coming usually from Tax RevenueTotal Revenue >Government Spending…Budget SurplusTotal Revenue < Government Spending….Budget DeficitIf the budget was initially balanced, expansionary fiscal policy creates a budget deficit..How??
LO1 30-16