Government Intervention in the Free Market? Fiscal Policy Government Intervention in the Free Market?

Fiscal Policy Fiscal Policy is Government’s attempt to moderate the “ups & downs” of business cycle by changing taxes & spending policies If the Economy is too slow => Gov’t tries to “speed it up” If the Economy is too fast => Gov’t tries to “slow it down”

Inflationary Gap Recessionary Gap Economy above full output Economy below full output LRAS1 Price Level Real GDP SRAS1 LRAS1 Price Level Real GDP SRAS1 AD1 AD1 P1 Y1 ----------------- -------------- E1 P1 Y1 ----------- --------- E1 Y* Y* Unemployment high, real output low Below PPF, idle resources Unemployment very low, output high Above PPF, no idle resources

Fiscal Policy Handout Introductory Reading

2 Types of Fiscal Policy Expansionary Policy Goal: Contractionary Policy Goal: AD Increase Gov’t Spending Decrease Taxes AD Decrease Gov’t Spending Increase Taxes

FISCAL POLICY Economy in recession, Unemployment = 9.1% AD2 Expansionary Fiscal Policy needed -------------- P2 E2 Y2 Lower Taxes & ↑ Gov’t spending C ↑ & G ↑ => AD shifts right End result: higher GDP, more Jobs & slightly higher inflation

Sample Problem: GDP = +5.0% Unemployment 4.0% Economy growing “too fast” Contractionary Fiscal Policy needed AD2 Raise Taxes & ↓Gov’t spending C ↓ & G ↓ => AD shifts left End result: lower GDP, less Jobs & slightly lower inflation