# Fiscal Policy by yaofenji

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```									Fiscal Policy
How the government uses
discretionary fiscal policy to influence
the economies performance
Discretionary Fiscal Policy
The deliberate use of changes in government spending or
taxes to alter aggregate demand

Examples of Expansionary Fiscal Policy
• Increase government spending
• Decrease taxes
• increase government spending and taxes equally
Examples of Contractionary Fiscal Policy
• Decrease government spending
• Increase taxes
• Decrease government spending and taxes equally
Government Fiscal Policy to Combat a Recession
• Increase Government
Price                  AS             Spending
Level                               • Decrease Tax

155

150

\$6   \$6.1         \$6.2
full
employment    Real GDP
Increase in the
price level and
the real GDP

Increase in the
aggregate
demand curve

Increase in
government
spending
Spending Multiplier
Any initial change in spending leads to a chain reaction of
more spending which causes a greater change in demand

Calculating the Spending Multiplier
The ratio of the change in real GDP to an initial change
in aggregate expenditure

Marginal Propensity to Consume (MPC)
The change in consumption resulting from a change in
income
C
MPC =
Y
Spending Multiplier
1
1 – MPC
MPC = 0.75
1
=4
1 – 0.75
Real GDP increases with an increase in
government spending of \$50 billion
M x ΔG = ΔQ
4 x \$50 billion = \$200 billion
Tax Multiplier
The change in aggregate demand (total spending) resulting
from an initial change in taxes
When government cuts taxes by \$50 billion
The multiplier process is less because initial spending
increases only by \$38 billion instead of \$50 billion
The tax cut has a smaller multiplier effect on aggregate
demand than an equal increase in government spending
Tax Multiplier Formula
1 – spending multiplier
With spending multiplier of 4 the tax multiplier is
1 – spending multiplier = -3

Real GDP increases by \$150 billion with a cut in
taxes of \$50 billion 3 x \$50 billion = \$150 billion
The MPC can change from one time
period to another
Fiscal policy be used to combat
inflation when the economy is
operating in the intermediate range of
the aggregate supply curve
Fiscal Policy to Combat Inflation
• Reduce Government Spending
• Increase Tax
AS

\$160

\$6   \$6.1                   Real GDP
full
employment
Decrease in the
price level

Decrease in the
aggregate demand
curve

Decrease in
government spending
or increase in taxes
What happens to Aggregate Demand (AD)
with a cut in Government (G) spending of
25 billion?

ΔG x GM = ΔAD        GM = Government Spending Multiplier

-\$25 billion x 4 = -\$100 billion

What will happen to AD with a cut in
taxes of 33.3 billion?
ΔT x TM = ΔAD         TM = Tax Multiplier

\$33.3 x -3 = -\$100 billion
Balanced Budget Multiplier
An equal change in government spending and taxes, will
change aggregate demand by the amount of the change in
government spending

Automatic Stabilizer
Federal expenditures and tax revenues that automatically
change levels in order to stabilize an economic expansion or
contraction

Examples of Automatic Stabilizers
• Transfer payments
• Unemployment compensation
• Welfare
Budget Surplus
A budget in which government revenues exceed
government expenditures in a given time period
Budget Deficit
A budget in which government expenditures exceed
government revenues in a given time period
Automatic Stabilizers
\$1,250
Government Spending and Taxes

T
\$1,000

Budget
deficit
\$750

\$500

\$250                                   G

\$4 bil      \$6 bil    \$8 bil
Real GDP
Budget surplus
offsets inflation

Tax collections rise and
government transfer
payments fall

Increase in
real GDP
Budget deficit
offsets recession

Tax collections fall and
government transfer
payments rise

Decrease in
real GDP
Supply-side Fiscal Policy
A fiscal policy that emphasizes government policies that
increase aggregate supply
Purpose: to achieve long-run growth in real output, full
employment, and a lower price level
Demand-Side Fiscal Policy

AS
\$250

\$200

\$100

2   4      6         8        10   12
full
employment             Real GDP
Increase in the aggregate
demand curve

Increase in
government spending;
decrease in net taxes
Supply-Side Fiscal Policy

AS1
\$250
AS2
\$200

\$150

\$100

0    2   4      6         8      10    12
full
employment           Real GDP
Increase in the aggregate
supply curve

Decrease in resource
prices; technological
decrease in regulations
Supply-Side Policies Affect Labor Markets
Wage rate
Before tax-cut   After tax-cut
labor supply     labor supply

W1

W2
Labor
Demand

L1       L2      Q of Labor
Tax rate cuts                        Supply-side
policy
Higher disposable income
boosts worker’s incentives to
work harder and produce
more

Firms invest more and
create new ventures, which
increase jobs and output

Aggregate supply
curve increase

Economy expands,
employment rises, and
inflation is reduced
Tax rate cuts                             Keynesian
policy
Higher disposable income
increases money for
spending

People spend extra income
on more goods and services

Aggregate demand
curve increase

Economy expands,
employment rises, but
inflation rate rises
Laffer Curve
Puts forth the idea that increasing taxes from zero will
increase tax revenues up to a certain point

Taxes increases may lead to higher
government revenues
Depends on where the economy is on the Laffer Curve

When taxes increase beyond a certain
point tax revenues begin to decline as the economic pie
begins to shrink

Economic pie begins to shrink as Workers
have less incentive to work and investors have less of an
incentive to invest as their taxes increase beyond a
certain level
The Laffer Curve

Rmax
Federal Tax Revenue

R

0   Tmax   T   100%
Federal Tax Rate

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