Demand Side Policies Fiscal Policy -1

Learning Outcomes -Explain the Government primarily earns revenue from taxes (direct & indirect). -Explain Government Spending can be classified into 3 categories: -Current Expenditures, Capital Expenditures and Transfer Payments -Distinguish between a budget deficit, budget surplus and balanced budget. -Explain the relationship between budget deficits/surpluses and Government debt.

Demand Side Policies Demand side policies focus on shifting Aggregate Demand to achieve the goal of price stability. Purposeful Government Intervention in the economy in order to influence AD is called Discretionary Policy. ● Two Categories: -Fiscal Policy and -Monetary Policy

Automatic Stabilizers Automatic Stabilizers are introduced into an economy with the aim to reduce economic fluctuations in the Business Cycle. ● Considered Non-discretionary Policies ● If automatic stabilizers work, the Potential Output of the economy would be very close to the actual output. ● Examples: 1.Progressive Taxes in an Inflationary Gap 2.Unemployment Benefits in a Recessionar y Gap

Sources of Government Revenue 1.Taxes: Both Direct and Indirect Taxes 2.Sale of Government’s goods and Services ● Transportation ● Electricity ● Water 3. Sale of Government -owned enterprises or property.

Government Expenditures 1.Current Expenditures a.Wages & Salaries for Government Employees b.Spending on supplies for day to day activities c.Public Schools d.Public Health care. e.Interest on Government loans 2.Capital Expenditures a.Public Investments b.Building roads, airports, schools and hospitals 3.Transfer Payments a.Unemployment Benefits b.Redistribution of Income

Budget Outcomes Balanced Budget: if tax revenues are equal to Government Expenditures over a specific period of time. Budget Deficit: If Tax Revenues are less than Government Expenditures Budget Surplus: If Tax Revenues are greater than Government Expenditures

Fiscal Policy -2 Learning outcomes: ● Explain how changes in the level of government expenditure &/or taxes can influence the level of Aggregate Demand. ● Describe the mechanism through which expansionary fiscal policy can help an economy close a recessionary gap. ● Construct a diagram to show the potential effects of expansionary fiscal policy, outlining the importance of the Aggregate Supply curve. ● Describe the mechanism through which contractionary fiscal policy can help an economy close an inflationary gap. ● Construct a diagram to show the potential effects of contractionary fiscal policy, outlining the importance of the Aggregate Supply curve.

Macro Economic Objective The Macroeconomic Objective of an economy is to: 1.Stable Price Levels 2.Full Employment 3.Economic Growth Where: ● Actual output = Potential output ● Unemployment = Natural Rate of Unemployment Tragakes, pg. 253

Fiscal Policy Manipulation by the government of its expenditures and taxes in order to influence Aggregate Demand. Fiscal Policy can influence 3 of the 4 components of Aggregate Demand: 1.Government Spending - G 2.Consumption Spending - C- changes in taxes 3.Investment Spending - I - changes in taxes

Expansionary Fiscal Policy Economy is experiencing a Recessionary Gap : ● Actual Output < Potential Output ● Unemployment > Natural Rate of Unemployment Expansionary Fiscal Policy ● Goal is increase Aggregate Demand in order to achieve Full Employment : ○Actual Output = Potential Output ○Unemployment = Natural Rate of Unemployment Policies may consist of: 1.Increasing Government Spending 2.Decreasing Personal Income Taxes 3.Combination of both Tragakes, pg. 322

Contractionary Fiscal Policy Economy is experiencing an Inflationary Gap ● Actual Output > Potential Output ● Unemployment < Natural Rate of Unemployment Contractionary Fiscal Policy Goal is to decrease Aggregate Demand in order to reach Full Employment ● Actual Output = Potential Output ● Unemployment = Natural Rate of Unemployment Policies may consist of: 1.Decreasing Government Spending 2.Increasing Taxes 3.Combination of both Tragakes, pg. 324

Ratchet Effect ● Price Levels increase when there is an increase in AD and economy experiences an Inflationary Gap. ● Though when there is a decrease in AD, Price Levels will remain the same and Real GDP will decrease. This is a more realistic representation of What happens in the real world. Tragakes, pg. 324

Fiscal Policy - 3 (Automatic Stabilizers and Spending Multiplier) Learning outcomes: ● Explain how factors including progressive tax system and unemployment benefits, which are influenced by the level of economic activity automatically help to stabilize short-term fluctuations. ● Explain how Government spending can be further influenced by the Multiplier. ● Evaluate the effectiveness of Fiscal Policy through consideration of factors including the ability to target sectors of the economy, the direct impact on Aggregate Demand, the effectiveness of promoting economic activity in a recession, time-lags, political constraints, crowding out effect, and the inability to deal with Supply-side causes of instability.

Automatic Stabilizers Automatic Stabilizer are Non-Discretionary Policies Benefit because there is no time lag from Political disagreement on bestway to implement. Two important Automatic Stabilizers: 1.Progressive Income Taxes 2.Unemployment Benefits

Progressive Income Tax Progressive Income Taxes: If the economy is experiencing an Inflationary Gap ● Actual Output > Potential Output ● Unemployment < Natural Rate of Unemployment As Real GDP and Incomes rise so does the tax revenues of the Government because of the progressive tax. Reduces the disposable income of the citizens and dampens (decreasing) Aggregate Demand Tragakes, pg. 324

Progressive Income Tax Progressive Income Taxes: If the economy is experiencing a Recessionary Gap ● Actual Output < Potential Output ● Unemployment > Natural Rate of Unemployment As Real GDP and Incomes decrease so does the Tax revenues of the Government because of the progressive tax. People pay less taxes. The after tax disposable income of the Citizens increases and increases Aggregate Demand Tragakes, pg. 322

Unemployment Benefits Unemployment Benefits in a Recessionary Gap ● Actual Output < Potential Output ● Unemployment > Natural Rate of Unemployment So, unemployment benefits help: 1.Allows the unemployed worker to continue to consume thus supporting Aggregate Demand 2.Increases Government Spending which supports Aggregate Demand With no Unemployment Benefits, the economy would experience a much greater decrease in AD. Tragakes, pg. 322

Unemployment Benefits Unemployment benefits If the economy is experiencing an Inflationary Gap ● Actual Output > Potential Output ● Unemployment < Natural Rate of Unemployment So, unemployment benefits help: 1.Less unemployed individuals so Government does not need to spend as much on Unemployment Benefits thus decreasing Government Spending and influencing Aggregate Demand. With no Unemployment Benefits, the economy would experience a much greater decrease in Aggregate Demand. Tragakes, pg. 324

Multiplier-Discretionary Fiscal Policy Effect of Government Spending is related to the value of the Multiplier ● Increase in Government Spending as a part of Expansionary Fiscal Policy. ● The influence on AD depends on the size of the Multiplier which depends on the MPC (Marginal Propensity to Consume). ● Larger the size of the MPC (meaning a smaller amount of leakages),the greater impact the Expansionary Fiscal Policy will have on Aggregate Demand. Effect of a change in tax rate is also related to the value of the Multiplier

Examples Assume: ● Government spends $8 million ● Marginal Propensity to Consume is 0.75 or 3/4 ● Multiplier = 1 divided by ( ) ○Multiplier = 4 The effect of Discretionary Fiscal Policy will be $32million. ($8 million X 4) The greater the Marginal Propensity to Consume, the larger the impact of the Discretionary Fiscal Policy on the Economy. Tragakes, pg. 322

Fiscal Policy and long term growth Fiscal Policy focuses mostly on short-term stabilization of an economy.Does contribute to long term expansion of Potential Output both directly and indirectly. Directly ●Allocate resources to the development of physical capital goods (roads, bridges). ●Allocate resources to the development of human capital(training, education). ●Incentivize firms to invest by lowering the business taxes. Indirectly ● Creating a stable Macroeconomic environment allows firms to be more confident and can lead to more investment by those firms thus impacting the Potential Output of an economy.

Evaluating Fiscal Policy Learning outcomes: ● Evaluate the effectiveness of Fiscal Policy through consideration off actors including the ability to target sectors of the economy, the direct impact on Aggregate Demand, the effectiveness of promoting economic activity in a recession, time-lags, political constraints,crowding out effect, and the inability to deal with Supply-side causes of instability.

Strengths of Fiscal Policy ● Ability to pull an economy out of a deep recession. ● Dealing with rapidly escalating inflation through contractionary fiscal policy. ● Ability to target specific areas of an economy by directing money to those areas. (Examples include: education, health care). ● Ability to influence Potential Output of an economy.

Weaknesses of Fiscal Policy ● Time lags ● Recognising the economic problem. ● Reaching an appropriate deal with politicians. ● Action influencing the Aggregate Demand. ● Political constraints. ● Crowding out Effect. ● Inability to address Supply-side issues. ● Inability to fine-tune the economy.