Fiscal Policy – Monetarist Assumptions Due to the upward sloping supply curve in the M/NC model: Fiscal policy will always affect prices In the short run, the size of the changes in price and real output depend on the slope of the SRAS curve In the long run, price changes will lead the economy back to Y P Recessionary Gap Inflationary Gap

Fiscal Policy – Keynesian Assumptions The effect of fiscal policy depends on the position of AD on the AS curve: Below full employment, expansionary policy can increase output with no inflation Around full employment (Y P ), labor and supply shortages lead to diminishing returns – output/inflation trade-off Above full employment, expansionary policies are purely inflationary; contractionary policies can reduce inflation without reducing output

Fiscal Policy – Keynesian Assumptions The effect of fiscal policy depends on the position of AD on the AS curve: Below full employment, expansionary policy can increase output with no inflation Around full employment (Y P ), labor and supply shortages lead to diminishing returns – output/inflation trade-off Above full employment, expansionary policies are purely inflationary; contractionary policies can reduce inflation without reducing output Keynesians believe governments can “choose from a menu” of possible inflation/real output combinations

Government Policies Supply-Side Policies Demand- Side Policies Demand- Side Policies Automatic Stabilizers Discretionary Policy Fiscal Policy Market-Based Interventionist Monetary Policy Automatic Stabilizers: factors that automatically, without any action by the government, work towards stabilizing the economy by reducing short-term fluctuations in the business cycle

Automatic Stabilizers Automatic Stabilizers: factors that automatically, without any action by the government, work towards stabilizing the economy by reducing short-term fluctuations in the business cycle Try to identify some automatic stabilizers in the economy. (There are two main ones.)

Automatic Stabilizers Automatic Stabilizers: factors that automatically, without any action by the government, work towards stabilizing the economy by reducing short-term fluctuations in the business cycle Try to identify some automatic stabilizers in the economy. (There are two main ones.) Hint: a stabilizer will add to household/firm cash in bad times and reduce household/firm cash in good times

Automatic Stabilizers

Fiscal Policy Effects on Long Term Growth So far, we’ve only talked about short run effects. How can fiscal policy affect long run growth?

What are the different factors of production? How would you invest in them to improve their productivity? Review - Capital and Investment Natural Capital (Land / Natural Resources) Human Capital (Labor) Physical Capital (Manmade) Exploiting marketable commodities (lumber, oil, etc.) Protecting/improving ecological & common access resources Investment Education & training Health care, nutrition, sanitation & clean water, etc. Culture / recreation Investment Buying new machinery, roads, airports, broadband, etc. Technological advances

Fiscal Policy Effects on Long Term Growth Indirect Effects Direct Effects Stability makes consumers and firms more confident of the future: Consumers more likely to make large purchases Businesses can more easily forecast the future and are more likely to invest in: -R&D -New plant & equipment Governments can allocate a portion of spending to: Infrastructure projects and R&D Training and education Incentives to encourage business investment => Increased physical and human capital, and higher labor productivity

Effectiveness of Fiscal Policy Strengths Weaknesses & Limitations Correcting a serious, demand-driven recession Correcting rapid inflation Can target specific economic sectors Direct impact on aggregate demand (predictable) Can improve long-term growth Time lags (recognize problem then decide on response then implement response) Political constraints and priorities Blunt instrument (can’t “fine-tune” the economy) Crowding out Cannot address supply-side problems (i.e., stagflation) Tax cuts may not increase demand in a recession (if people are worried and instead increase saving)