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Chapter 13 Fiscal Policy

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Chapter 13 Fiscal Policy Democracy will defeat the economist at every turn at its own game Harold Innis, Canadian Economist and Historian – PowerPoint PPT presentation

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Title: Chapter 13 Fiscal Policy


1
Chapter 13Fiscal Policy
  • Democracy will defeat the economist at every
    turn at its own game Harold Innis, Canadian
    Economist and Historian

2
Governments can do plenty to stabilize the
economy not only during downturns when
unemployment is high, but also during
inflationary upswings. Governments can use
certain policies to achieve economic stability
for example, they can spend more money or reduce
taxes to cause changes in total spending and
aggregate demand. This chapter examines the
theory behind such policies and their outcomes.
3
Stabilization Policy
  • Government policy designed to lessen the effects
    of the business cycle, particularly unemployment
    and inflation
  • Goal
  • Keep the economy as close as possible to its
    potential output
  • To smooth out business cycle
  • - the closer the economy stays to the long-run
    trend of potential output, the lower will be the
    social costs of unemployment and inflation to the
    countrys citizens

4
Business Cycle
5
2 Types of Stabilization Policy
  • Expansionary policies government policies
    designed to reduce unemployment and stimulate
    output
  • when output is below its potential
  • Injections gt withdrawal
  • Contractionary policies government policies
    designed to stabilize prices and reduce output
  • when the economy is booming
  • Withdrawal gt injections

6
2 Categories of Stabilization Policy
  • Fiscal policy government stabilization policy
    that uses taxes and government purchases as its
    tools
  • also known as budgetary policy
  • Usually applied to a fiscal year the 12 month
    period to which a budget applies
  • Monetary Policy government stabilization policy
    that uses interest rates and the money supply as
    its tools

7
Types of Stabilization Policy
8
Two methods used on Fiscal Policy
  • The government makes changes on 2 factors to
    influence aggregate demand, thus the equilibrium
    price and quantity
  • Government Spending
  • Immediate effect on aggregate demand (direct
    injection/withdrawal)
  • Tax Rate
  • Less immediate effect on aggregate demand
    (Indirect injection/withdrawal)

9
Expansionary Fiscal Policy
  • Government
  • Spending
  • Increases
  • Tax Rate
  • Decreases
  • Encourage households and business spending
  • Consumption investment increase

10
Contractionary Fiscal Policy
  • Government
  • spending
  • Decreases
  • Tax rate
  • Increases
  • Reduce households disposable income and
    businesses profits
  • Consumption investment decrease

11
Discretionary Policy vs. Automatic Stabilizers
  • Discretionary policy intentional government
    intervention in the economy
  • i.e.budgeted changes in spending/ taxation
  • Automatic stabilizers built-in measures that
    lessen the effect of the business cycle
  • i.e. Taxation transfer programs ? progressive
    income taxes, unemployment insurance, welfare
    payments

12
Net Tax Revenues
  • taxes collected transfers subsidies
  • During a period of expansion
  • Net tax revenues increase (leakage)
  • Spending and aggregate demand decrease
  • During a period of contraction
  • Net tax revenues decrease
  • Spending and aggregate demand increase

13
How Does Automatic Stabilizer work?
  • Contracting Economy
  • 1. Household incomes business profits fall
  • 2. Taxes collected by government fall
  • 3. Government transfer payments subsidies
    increase (job lost business suffers)
  • 4. Decline in net tax revenues ? spending
    aggregate demand increase
  • 5. Economy pushed towards its potential output

14
How Does Automatic Stabilizer work?
  • Expanding Economy
  • 1. Personal incomes business profits increase
  • 2. Governments collect more taxes
  • 3. Government transfer payments subsidies
    reduced (high employment, businesses prosper)
  • 4. Spending aggregate demand decrease
  • 5. Economy pushed back down to its potential
    output

15
The Spending Multiplier
  • Used to estimate the impact of government
    policies on the economy in terms of dollar values
  • The Multiplier Effect the magnified impact of a
    spending change on AD
  • Assumes price level stays constant
  • The Spending Effect value by which an initial
    spending change is multiplied to give the total
    change in outputs shift in the AD curve

16
Multiplier Effect
  • 1. Marginal propensity to consume (MPC) effect
    on domestic consumption of a change in income
  • Explains if income increase x amount, how much
    extra will be spent on domestic goods and
    services?
  • Applies to individual households and the economy
    as a whole

17
Multiplier Effect
  • 2. Marginal propensity to withdraw (MPW)
  • Effect of withdrawing saving, imports and
    taxes of a change in income
  • MPC MPW 1
  • Always!! Because income is either spent on
    domestic consumption or withdrawn from the
    circular flow

18
Spending Multiplier formulas
19
How does the Multiplier Effect work?
20
Multiplier Effect
21
Effect of a Tax Cut
  • Tax adjustment has a smaller initial effect on
    spending compared to government purchases
  • i.e. assume MPC 0.5
  • Tax cut increases Spender As income by 1000
    (after tax) ? initial change in spending on
    domestic items 500
  • Government purchases ? initial change in spending
    on domestic items 1000

22
What if Price Levels Vary?
  • Recall slope of the aggregate supply curve is
    steeper as it reaches or surpasses the potential
    output level
  • If AD curve shifts from AD0 to AD1 the price
    level rises proportionally more than the output
    does
  • Expansionary fiscal policy is less effective when
    the economy is close to its potential
  • If AD curve shifts to the left, the price level
    falls proportionally more than the output does

23
What if Price Levels Vary?
24
  • !! Multiplier Effect is just a theory, it is not
    definite because of possible changes in price
    level, However, it is still useful to indicate
    the Maximum change in equilibrium output
    following a certain fiscal policy !!

25
Benefits of Fiscal Policy
  • 1. Regional Focus
  • Discretionary fiscal policy can be targeted on
    particular regions to balance out regional
    differences in economy situations
  • During a recession, new government purchases or
    tax cuts can be targeted to regions where
    unemployment rates are highest
  • In a boom, spending cuts and tax hikes can be
    concentrated on the regions where inflation is at
    its worst

26
Benefits of Fiscal Policy
  • 2. Impact on Spending
  • Fiscal policy has a more straightforward impact
    than monetary policy
  • The first spending adjustment is assured since
    the government itself initiates the change

27
Drawbacks of Fiscal Policy
  • 1. Delays through 3 time lags
  • Recognition lag the amount of time it takes
    policy-makers to realize that a policy is needed
  • Decision lag the amount of time needed to
    formulate and implement an appropriate policy
  • Impact lag the amount of time between a policys
    implementation and its having an effect on the
    economy

28
Drawbacks of Fiscal Policy
  • 2. Political Visibility
  • Highly visible and therefore often affected by
    political as well as economic considerations
  • Voters and political parties are likely to
    respond more favourably to expansionary policies
    regardless of the appropriateness of these
    policies for the economy

29
Drawbacks of Fiscal Policy
  • 3. Public Debt
  • The total amount owed by the federal government
    as a result of its past borrowing
  • The government has to pay public debt charges
    each year and has not been able to reduce the
    public debt just by paying only the interest

30
Impact of Fiscal Policy
  • Budget Surpluses and Deficits
  • Balanced Budget
  • Expenditures revenues
  • Budget Surplus
  • Revenues gt expenditures
  • Surplus amount revenue expenditures
  • Budget Deficit
  • Expenditures gt Revenues
  • Deficit amount expenditures revenue

31
Impact of Fiscal Policy
  • Budget Surplus and Deficit's impact on Public
    Debt
  • Amount of deficit amount increase in public
    debt
  • Amount of surplus amount reduced in public debt

32
Fiscal Policy Guidelines
  • Annually Balanced Budget
  • Revenues and expenditures should balance each
    year
  • Cyclically Balanced Budget
  • Government revenues and expenditures should
    balance over the course of one business cycle
  • Functional Finance
  • Government budgets should be geared to the
    yearly needs of the economy

33
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