EOCT Review Question #1 During what stage of the business cycle would unemployment be the largest? A. Peak B. Recession C. Trough D. recovery

EOCT Review Question #2 If we have progressive tax system and Billy pays $ on his $10,000 income, what is true of Sue’s tax liability if she earns $40,000.00? A. It is exactly $4, B. It is less than $4, C. It is more than $4,000.00

EOCT Review Question #3 Which of the following would cause cost-push inflation? A. 20% increase in natural gas prices B. 20% growth in the stock market C. 20% cut in federal income tax D. 20% increase in grain production

EOCT Review Question #4 Which group is most likely to suffer from higher rates of unemployment and poverty than most others? A. Minorities B. People with limited education C. Single parents D. Two-parent families

Fiscal Policy Chapter 15

Fiscal “Tools” 1.Government Purchases/Spending 2.Transfer Payments 3.Taxes …and how these three affect macroeconomic variables such as real GDP, employment, the price level, and economic growth

Points to Remember  Prior to the Great Depression economists believed that the best way to stabilize the economy was through the natural market forces –Adam Smith and supply side economics

After the Great Depression  Remember: –Keynes –government needs to aid the economy to aid the economy –demand side economics

What is Fiscal Policy  Government taxing and spending used to move the economy toward full employment with price stabiltiy  Potential output- the maximum sustainable output in the long run given the supply of resources, technology and “rules of the game” that nurture production and exchange  AKA- full employment output

$200 How just a little Fiscal Policy can effect our economy in a BIG way. $150 $150 $50 (already in his pocket) $200 already in his pocket) $400

Multiplier Effect For every dollar spent by the federal government, GDP will increase by more than that 1 dollar. This could also be effected by business invention or change in consumption- but Keynes focused on the government’s role in his book General Theory

Fiscal Policy and Taxes  An increase in tax rates decreased disposable income- – consumption & real GDP decrease  A decrease in taxes increases disposable income- – consumption & real GDP increase  What is disposable income?

Disposable Income  This is the income available after taxes  This is the money consumers have to spend  Less taxes = more money to spend

Government Use of Fiscal Policy 1. When the economy is in a slump ( recession or depression ) the economy has contracted.  The government will enact an Expansionary fiscal policy to help boost the economy.

Closing a Contractionary Gap using Fiscal PolicyP r i c e l e v e l 130 Potential output 0 Real GDP (trillions of dollars) AS 130 Contractionary gap e* 10.0 e 125 AD 9.5 Begin with a aggregate supply curve (AS 130 ) - if the price level turns out to be 130, the economy will produce its potential output at e* Suppose instead that AD intersects AS at point e, therefore a Contractionary Gap of $0.5 trillion So unemployment exceeds the natural rate (4%-5%)! This is where we should be!

P r i c e l e v e l 130 Potential output 0 Real GDP (trillions of dollars) AS 130 Contractionary gap e* 10.0 e 125 AD 9.5 AD* e' 10.5 A $0.2 trillion decrease in taxes reflects an expansionary fiscal policy that increases AD, as shown by the rightward shift from AD to AD* Also, a $0.2 trillion increase in transfer payments reflects an expansionary fiscal policy that increases AD, as shown by the rightward shift from AD to AD* Transfer payments are those payments given to help the needy and unemployed. Closing aContractionary Gap using Fiscal Policy Closing a Contractionary Gap using Fiscal Policy This is where we should be! Closing an contractionary gap through fiscal policy results in a higher price level and lower unemployment.

Government Use of Fiscal Policy 2. When the economy has picked up the pace ( an economic boom ) the economy has expanded.  The government will enact an Contractionary fiscal policy to help slow down the economy.

Closing an Expansionary Gap using Contractionary Fiscal Policy Closing an Expansionary Gap using Contractionary Fiscal Policy 0 Potential output 10.0 Real GDP (trillions of dollars) P r i c e l e v e l AS 130 AD e' Suppose that aggregate demand exceeds potential output and inflation results (we could be in an economic boom). As a result, output is $10.5 trillion and an expansionary gap of $0.5 trillion exists. Expansionary gap 

Closing an Expansionary Gap using Contractionary Fiscal Policy Closing an Expansionary Gap using Contractionary Fiscal Policy 0 Potential output 10.0 Real GDP (trillions of dollars) P r i c e l e v e l AS 130 AD e* Expansionary gap  AD* If left alone, this gap could be closed by a leftward shift of the AS curve, returning the economy to the potential level of output but at a higher price level, shown by point e" By decreasing government purchases, increasing taxes, or decreasing transfer payments, the government can implement a Contractionary Fiscal Policy designed to reduce AD e Closing an expansionary gap through fiscal policy results in a lower price level, but higher unemployment. 125

Difficulty in Calculating Effects  Remember the multiplier effect.  It is difficult to judge how large of an expansion or contraction a change in any single fiscal policy (taxes, transfer payments, etc) will produce in the economy

Two categories of Fiscal Policy: 1)Discretionary fiscal policy- requires congressional action (This is what we have been talking about…) 1)Automatic Stabilizers- usually the results of these actions in the future (unemployment insurance) that become part of the federal budget

How automatic stabilizers work  These change automatically with the ups and downs of the economy by stabilizing disposable income and smoothing fluctuations in consumption and aggregate demand throughout the business cycle  Boost aggregate demand during recession  Dampen aggregate demand during expansion  Unemployment insurance  Welfare spending  Tax rates

Problems with Fiscal Policy  Doesn’t work during periods of stagflation- can’t fight unemployment and inflation at the same time  It is difficult to estimate the natural rate of unemployment- people lie!  Time’s effect on discretionary fiscal policy- these changes don’t happen quickly!

Lags = time for the policy to take effect on the economy  Recognition- time it takes to identify a problem (typical recession lasts 11 months, but can take 6 to recognize)  Decision making- once recognized policy makers need to agree on what to do to fix it  Implementation- after decided upon it takes time to get things done  Effectiveness- may take 9 – 18 months to meet the full effect

Fiscal policy and supply  Unintentional – negative externality on supply  Example- transfer payments fewer people want to work, negative effect on the supply of labor (this will shift aggregate supply to the left)