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CHAPTER 12 Fiscal Policy


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Title: CHAPTER 12 Fiscal Policy

CHAPTER 12Fiscal Policy
  • present by Ivy, Yi Lin, Mamie, Mon, Chris

In this chapter......
  • you will
  • learn about expansionary and contractionary
    fiscal policies, which are used by governments
    seeking economic stability
  • analyze the multiplier effect of fiscal policy,
    as determined by the marginal propensities to
    consumer and withdraw
  • consider budget surpluses and deficits and their
    impact on public debt and public debt charges

The Goal of Stabilization
  • Stabilization policy is government policy
    designed to lessen the effects of the business
    cycle which can be either expansionary policies
    or contractionary policies.
  • expansionary policies attempt to reduce
    unemployment and stimulate total output
  • contractionary policies attempt to stabilize
    prices and bring the economy back down to its
    potential output.

Stabilizing The Business Cycle
Long-Run Trend of Potential Output
Stabilizing the Business Cycle
  • Governments have an extensive impact on the
    economy through texation and government

Stabilizing The Business Cycle
  • Fiscal Policy uses taxes and government purchases
    as its tools
  • Fiscal Year is the 12-month period to which a
    budget applies
  • Monetary policy uses interest rates and the money
    supply as its tool.

Use of Fiscal Policy
  • Expansionary fiscal policy involves increasing
    government purchases, decreasing taxes, or both
    to stimulate spending and output.
  • Contractionary fiscal policy involves decreasing
    government purchases, increasing taxes, or both
    to restrain spending and output.

Expansionary fiscal policy
  • expansionary fiscal policy involves more
    government purchases and/or lower taxes to shift
    AD rightward

Potential Output
Contractionary Fiscal policy
  • contractionary fiscal policy involves fewer
    government purchases and/or increased taxes to
    shift AD leftward

Potential Output
Automatic Stabilizers
  • Discretionary Policy is international government
    intervention in the economy such as bedgeted
    changes in spending or texation.
  • Automatic stabilizers built-in measures, such as
    texationtransfer payment programs, that lessen
    the effects of the business cycle.
  • Net tax revenues taxes collected

The Multiplier Effect
  • The magnified impact of a spending change on
    aggregate demand
  • an initial spending change produces income and
    part of this new income becomes new spending
  • The process is repeated with each spending round
    smaller than the last
  • Each new spending round are determined by the
    marginal propensity to consumer(MPC) and marginal

The Multiplier Effect
  • Marginal propensity to consumer (MPC)
  • the effect on domestic consumption of a
    change in income
  • MPC change in consumption on domestic items
  • change in income
  • Marginal propensity to withdraw (MPW)
  • the effect on withdrawalssaving, imports,
    and taxesof a change in income
  • MPW change in total withdrawals
  • change in
  • MPC MPW 1
  • income is always either spend or

The Multiplier Effect
  • Exercise A 100 increase in a person's income
    causes him to increase his saving by 5, his
    imports by 35, and his tax payments by 20. In
    this case, the marginal propensity to withdraw
  • Change in total withdrawals(saving/ import/
  • Change in income
  • 5 35 20 60 0.6
  • 100 100

The Effect of a Rise in Government Purchases
The multiplier effect will continue until
withdrawals equal to the initial discretionary
The Spending Multiplier
The spending multiplier is the value by which the
initial spending change is multiplied to give the
total change in real output.
In other words, the shift in the aggregate demand
Total change in output initial change x
spending (shift in AD curve) in
spending multiplier
Find the spending multiplier when initial spend
has rose by 1000 and the total output increased
by 2000.
Spending multiplier total change in output
Initial change in
spending 2000 1000 2
Relationship between the marginal propensity to
withdraw and the spending multiplier
The spending multiplier is the reciprocal of the
marginal propensity to withdraw.
Example If MPW (marginal propensity to withdraw)
is 0.5 what is the spending multiplier?
Spending Multiplier __1__
_1_ 0.5 2
Effect of a Tax Cut
  • The multiplier effect can be applied to tax cuts
  • Tax cuts can be used to expand the economy
  • Lower tax cuts can leave households and
    businesses with more funds to spend and invest
  • The initial spending stimulus of the tax cut is
    multiplied by the spending multiplier (or
    reciprocal of MPW). This results in an increase
    in total output
  • a shift in the aggregate demand curve

The initial change in spending on domestic items
from a change in taxes (T) is found by
multiplying the economys marginal propensity to
consume by the size of the tax change, then it is
multiplied by the spending multiplier (1/MPA)
Total change in output initial change x
spending (shift in AD curve) in
spending multiplier
Total change in output - (MPC X change in T)
x (1/MPA)
-(MPC X T) has a minus sign because the spending
change is in the opposite direction to the tax
Relevance of the Spending Multiplier
  • When the economy is close to its potential level,
    the increase in aggregate demand translates into
    higher price levels more than into expanded
  • When the stated goal being a stable economy and
    expanded output, expansionary fiscal policy is
    less effective the closer the economy is to its
  • Similarly, for the contractionary fiscal policy,
    when the economy is above its potential, a
    decrease in aggregate demand means both price
    level and total output will fall
  • Based on the possible changes in the price level,
    the multiplier effect is less definite than the
    use of simple formula would indicate

Benefits of fiscal policy
  • Two benefits as stabilization tool
  • regional focus and impact on spending
  • Regional focus(it can be focused on particular
  • During a recession, new government purchases and
    program to reduce the amount of tax paid can be
    targeted to regions where unemployment rate are
    highest.( Net income revenue drop hit by
    unemployment and falling output.)
  • In a boom, spending cuts and tax hikes can be
    concentrated on the regions where inflation is at
    its worst.( Larger increase in net tax revenue in
    regional where the economy is most over-heated.)

Benefits of fiscal policy
  • Impact on spending
  • it has a relatively direct impact on spending
  • (compare with monetary policy--Fiscal policy is
    easy to control the trend of economy, making it
    closer the potential output and achieve the goal
    of stabilization)
  • influences of a stabilization is tied to its
    initial effect on spending
  • During recession, government increase the
    government purchases, it decrease the spending
  • In contrast, government decreases the government
    purchases which increase the spendingalter the
    government purchases to make economy stability.

 Drawbacks of fiscal policy
  • a)Delays? while automatic stabilizers to
    stabilize the economy, the discretionary measure
    are sometimes delayed.
  • Recognition lag the amount of time it takes
    policy-makers to realize that a policy needed.(
    decided and realized the economy need adjusted )
  • Decision lag the amount of time needed to
    formulate and implement an appropriate
    policy.(how to adjust)
  • Impact lag the amount of time between a policys
    implementation and its having an effect on the
    economy.(already have move to a different point
    in the business cycle )

Drawbacks of fiscal policy
  • b)Political visibility
  • Discretionary is highly visible element of
    government activity, therefore, it is often
    affected by political and economic
  • E.G vote increases in government purchases and
    reduce the taxes, regardless of the
    appropriateness of these policies for the
    economy.(election is coming up)

Drawbacks of fiscal policy
  • c)Public debt
  • Public debt the total amount owned by the
    federal government as a result of its past
  • Total government include the debts of
    individuals provinces and territories and
    incorporates local government and hospital.
  • Public debt charges the amounts paid out each
    year by the federal government to cover the
    interest charges on its public debt.
  • E.G. the federal governments public charge
    were37.2billion, the government should pay 507.7
    to bondholders. What is the average interest?
  • Average interest ratepublic debt charge/public

12.3 The Impact of Fiscal Policy
Balanced budget
  • Balanced budget mean governments expenditures
    and revenues are equal
  • This situation is so uncommon.

Budget surplus
  • Budget surplus is the governments revenues
    exceed its expenditures
  • government revenues- government expenditures
    Budget surplus
  • For example, government will cut defence spending
    and raising income taxes during the economic boom
    to suppress the inflationary.

Budget deficit
  • Budget deficit is the governments expenditures
    exceed its revenues
  • government expenditure government
    revenueBudget deficit
  • For example, government will increase the
    spending on road and bridges, or institute a
    temporary sales-tax cut to stimulate household
    spending, during the downturn.

Impact on public debt
  • The governments debt represents the sum of all
    its past budget deficits minus any budget
  • Budget deficits- Budget surpluses governments
  • When the government has a budget surplus, the the
    public debt reduced by the same amount.
  • When the government has a budget deficit, the
    public debt increases by the same amount.

Fiscal Policy Guidelines
  • There are 3 principles that guide government
    fiscal policy
  • 1)Annually balanced budgets
  • 2)Cyclically balanced budgets
  • 3)Functional Finance
  • Critics of fiscal policy suggest that any fiscal
    policy that is used must be guided by the
    principle of an annually balanced budget. In
    other words, revenues and expenditures should be
    balanced every year.
  • Critics also say that an annually balanced budget
    is not necessarily appropriate for society and
    state it is flawed reasoning.
  • Cyclically balanced budget is the principle that
    government revenues and expenditures should
    balance over the course of one business cycle.

Recent Fiscal Policy
  • Functional Finance is the principle that
    government budgets should be geared to the yearly
    needs of the economy.
  • The choice of fiscal policy guidelines depends on
    the governments belief in fiscal policy as an
    effective tool for stabilizing the economy.
  • Defenders of functional finance are those who see
    functional finance as a powerful stabilizing
    tool, while economist who support cyclically or
    annually balanced budget tend to be less
    convinced of fiscal policys effectiveness.

Recent Fiscal Policy
  • In the 1970s and early 1980s, Canada believed in
    functional finance but recently had made
    unsuccessful attempts to move towards cyclically
    balanced budgets.
  • This change in view came from constant budget
    deficits and their impact on the economy as a
  • Total government deficits were highest during the
    recessions in early 1980s and 1990s.
  • The 1980s deficits were largely optional, while
    the 1990s deficits were related to automatic

Keynes and His Influence
  • Neoclassical theory is the view of economy that
    economic slow-downs such as the great depression
    were self correcting and is based on two
    assumptions flexible labour markets and Says
  • Flexible labour markets Neoclassical economists
    suggest that both the demand and supply of labour
    depend on real wage rate, or wages expressed in
    constant base-year dollars, rather than the
    nominal wage rate, which is valued in current
  • There are two types of unemployment
  • 1)Voluntary unemployment
  • 2)Involuntary unemployment
  • Voluntary unemployment exists whenever workers
    decide that real wages are not high enough to
    make work worthwhile.
  • Involuntary unemployment is when someone wants to
    work at the current real wage rate but cannot
    find a job. Involuntary occurs when the market
    demand and supply creates a surplus.

Says Law
  • Say argued that supply automatically creates its
    own demand.
  • An example would be a tailor supplies clothes in
    order to have funds needed to purchase other
  • Keyness theory challenged both assumptions made
    by the neoclassical economists. Keynes believed
    that workers are influenced by nominal wages
    rather than real wages and purchasing power.

Thank you !
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