Chapter 17 Fiscal Policy.

Chapter 17 Fiscal Policy

Learning Objectives Define fiscal policy.
Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilise the economy. Explain how the multiplier process works with respect to fiscal policy.

Learning Objectives Discuss the difficulties that can arise in implementing fiscal policy. Explain how the federal budget can serve as an automatic stabiliser. Discuss the long-run effects of fiscal policy.

Stimulus policies bring booms for retailers?
The 2008 and 2009 cash payments given to most people by the federal government were designed to stimulate consumer spending during a time of economic downturn. Retail spending increased, but critics argued that much was saved, or spent on imported goods. The Baby Bonus, which began in 2004, is another policy which impacts on retail spending.

LEARNING OBJECTIVE 1 Fiscal Policy Fiscal Policy: Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as full employment, price stability, and healthy rates of economic growth. Fiscal policy refers to the actions of the federal government, and not state, territory or local governments.

LEARNING OBJECTIVE 1 Fiscal Policy Automatic stabilisers versus discretionary fiscal policy. Automatic stabilisers: Government spending and taxes that automatically increase or decrease along with the business cycle. Discretionary fiscal policy: When the government is taking actions to change spending or taxes to achieve its economic objectives.

Fiscal Policy An overview of government spending and taxes.
LEARNING OBJECTIVE 1 Fiscal Policy An overview of government spending and taxes. Government expenditure includes government purchases and government spending. Between 1960 and 2008, government spending fluctuated between 19% and 25% as a proportion of GDP. Government spending as a proportion of GDP is forecast to rise to 29% of GDP by 2009/10.

Government expenditure as a percentage of GDP, 1960–2008: Figure 17.1
Figure 17.1: Government expenditure as a percentage of GDP, 1960 – 2008. Source: Reserve Bank of Australia (2009), Statistics, Gross Domestic Product Expenditure Components, Table G11, viewed 2 June 2009, at < Government expenditure as a proportion of GDP fluctuated quite significantly during the 1960s, and then trended upwards until Government expenditure as a proportion of GDP peaked in 1986 at almost 25%. Throughout the 1990s there was a downward trend – a result of the microeconomic reform policies of governments during this time. By 2008 government expenditure as a proportion of GDP had begun to rise again. Source: Reserve Bank of Australia (2009), Statistics, Gross Domestic Product Expenditure Components, Table G11, viewed 2 June 2009, at < Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Government expenditure as a percentage of GDP, 2007/08 to 2012/13: Figure 17.2
Figure 17.2: Government expenditure as a percentage of GDP, 2007/08 to 2012/13. Source: Australian Government (2009), Budget , Budget Overview, Appendix A, Australian Government Budget Aggregates, viewed 2 June 2009, at < The Federal Government ‘stimulus package’ during the global financial crisis contained significant projected increases in government spending as a proportion of GDP – the highest in over 50 years. Government expenditure as a proportion of GDP is expected to be 29% in 2009/10. Source: Australian Government (2009), Budget , Budget Overview, Appendix A, Australian Government Budget Aggregates, viewed 2 June 2009, at < Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Fiscal Policy An overview of government spending and taxes.
LEARNING OBJECTIVE 1 Fiscal Policy An overview of government spending and taxes. The largest single source of federal government revenue is from personal income taxation receipts – almost half of government revenue.

Government revenue by source, 2007/08: Figure 17.3
Figure 17.3: Government revenue by source, 2007/08. Source: Source: Australian Government (2007), Budget , Appendix D, Australian Government Taxation and Spending, viewed 5 May 2008, at < The largest proportion of government revenue comes from personal income taxation. For the financial year 2007/08, almost half of the federal government revenue came from personal income taxation. The second largest source of revenue was from from company and petroleum tax , at 27% of total revenue in 2007/08. Source: Australian Government (2007), Budget , Appendix D, Australian Government Taxation and Spending, viewed 5 May 2008, at < Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Using fiscal policy to influence aggregate demand
LEARNING OBJECTIVE 2 Using fiscal policy to influence aggregate demand Expansionary fiscal policy: Involves increasing government purchases and/or decreasing taxes. An increase in government purchases will increase aggregate demand directly. A reduction in taxes has an indirect effect on aggregate demand through the effect on disposable income.

LEARNING OBJECTIVE 2 Using fiscal policy to influence aggregate demand Expansionary fiscal policy. The goal of expansionary fiscal policy is to increase aggregate demand by more than it would have increased without policy. The aim is to shift the AD curve further to the right. Appropriate when the economy is in equilibrium below full-employment, eg: a recession.

Expansionary fiscal policy
Price level LRAS1 LRAS2 Expansionary fiscal policy causes the AD curve to shift further to the right. SRAS1 SRAS2 103 C 102 B A 100 AD3(with policy) Expansionary fiscal policy. The economy begins in equilibrium at point A, at potential real GDP of $1200 billion and a price level of Without expansionary policy, aggregate demand will shift from AD1 to AD2(without policy), which is not enough to keep the economy at potential GDP, because long-run aggregate supply has shifted from LRAS1 to LRAS2. The economy will be in short-run equilibrium at point B, with real GDP of $1350 billion and a price level of Increasing government purchases or cutting taxes will shift aggregate demand to AD3(with policy). The economy will be in equilibrium at point C with real GDP of $1400 billion, which is its potential level, and a price level of The price level is higher than it would have been if expansionary fiscal policy had not been used. AD2(without policy) AD1 $1200 1350 1400 Real GDP (billions of dollars) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 2 Using fiscal policy to influence aggregate demand Contractionary fiscal policy: Involves decreasing government purchases and/or increasing taxes. A decrease in government purchases or an increase in taxes will reduce the rate of increase in aggregate demand, to reduce the inflation rate. Appropriate when the economy is above full- employment equilibrium and the inflation rate is high.

Contractionary fiscal policy
Price level LRAS1 LRAS2 Contractionary fiscal policy causes the AD curve to shift to the right by less than it would have without policy. SRAS1 SRAS2 104 B 103 C A 100 Contractionary fiscal policy. The economy begins in equilibrium at point A, at potential real GDP of $1200 billion and a price level of Without contractionary policy, aggregate demand will shift from AD1 to AD2(without policy), which results in a short-run equilibrium beyond potential GDP at point B, with real GDP at $1450 billion and a price level of Decreasing government purchases or increasing taxes will shift aggregate demand to AD3(with policy). The economy will be in equilibrium at point C with real GDP of $1400 billion, which is its potential level, and a price level of The inflation rate will be 3% as opposed to the 4% it would have been without the contractionary fiscal policy. AD2(without policy) AD3(with policy) AD1 $1200 1400 1450 Real GDP (billions of dollars) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Countercyclical fiscal policy
Problem Type of Policy Actions by the Government Result Recession or slow economic growth Expansionary Increase government spending or cut taxes Real GDP and the price level rise by more than they would have without policy Table 17.1: Countercyclical fiscal policy. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Countercyclical fiscal policy
Problem Type of Policy Actions by the Government Result Recession or slow economic growth Expansionary Increase government spending or cut taxes Real GDP and the price level rise by more than they would have without policy Rising inflation Contractionary Decrease government spending or raise taxes Real GDP and the price level do not rise by as much as they would have without policy Table 17.1: Countercyclical fiscal policy. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

The multiplier effect and government purchases and tax multipliers
LEARNING OBJECTIVE 3 The multiplier effect and government purchases and tax multipliers The government purchases multiplier. An increase in government purchases will increase aggregate demand by more than the initial amount of increase in purchases. Autonomous expenditure: Expenditure that does not depend in the level of GDP. Induced expenditure: Expenditure that does depend in the level of GDP.

LEARNING OBJECTIVE 3 The multiplier effect and government purchases and tax multipliers The government purchases multiplier. Multiplier: The increase in equilibrium real GDP divided by the increase in autonomous expenditure. The multiplier effect: The series of induced increases in consumption spending that results from an initial increase in autonomous expenditure.

LEARNING OBJECTIVE 3 The multiplier effect and government purchases and tax multipliers An initial increase in autonomous government spending, such as building new railway lines, will increase aggregate demand by an amount that is more than the initial amount of new spending.

The multiplier effect and aggregate demand: Figure 17.6
Price level 2. … and the multiplier effect results in a further shift. 100 1. An initial $10 billion increase in government purchases shifts the aggregate demand curve to the right by $10 billion … Figure 17.6:The multiplier effect and aggregate demand. An initial increase in government purchases of $10 billion causes the aggregate demand curve to shift to the right from AD1 to AD2 and represents the impact of the initial increase of $10 billion in government purchases. Because this initial increase raises incomes and leads to further increases in consumption spending, the aggregate demand curve will shift further to the right to AD3. AD3 AD2 AD1 Real GDP Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 3 The multiplier effect and government purchases and tax multipliers The government purchases multiplier.

The multiplier effect of an increase in government purchases: Figure 17.7
Figure 17.7: The multiplier effect of an increase in government purchases. Following an initial increase in government purchases, spending and real GDP increase over a number of periods due to the multiplier effect. The new spending and increased real GDP in each period is shown in green, the level of spending from the previous period is shown in orange, so the sum of the orange and green areas represents the cumulative increase in spending and real GDP. In total, equilibrium real GDP will increase by $20 billion as a result of an initial increase of $10 billion in government purchases. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 3 The multiplier effect and government purchases and tax multipliers A simple formula for the multiplier. Marginal propensity to consume (MPC): The amount by which consumption spending increases when disposable income increases.

LEARNING OBJECTIVE 3 The multiplier effect and government purchases and tax multipliers Summarising the multiplier effect. The multiplier effect occurs when autonomous expenditure increases or decreases. The larger the MPC, the larger the value of the multiplier. The formula for the multiplier is oversimplified because it ignores the effect that an increasing GDP can have on imports, inflation and interest rates.

LEARNING OBJECTIVE 3 The multiplier effect and government purchases and tax multipliers The tax multiplier. Tax cuts also have a multiplier effect.

LEARNING OBJECTIVE 3 The multiplier effect and government purchases and tax multipliers Taking into account the effects of aggregate supply. The upward sloping aggregate supply curve causes the price level to rise as aggregate demand increases. As a result, the multiplier effect will not be as great as it would be if prices were constant.

The multiplier effect and aggregate supply: Figure 17.8
Price level LRAS SRAS 2. Because the SRAS curve is upward sloping, real GDP and the price level are both higher in the new equilibrium. C 103 A B 100 1. An initial increase in government purchases combined with the multiplier effect shifts the aggregate demand curve to the right. Figure 17.8: The multiplier effect and aggregate supply. The economy is initially at point A. An increase in government purchases causes the aggregate demand to shift to the right from AD1 to AD2. The multiplier effect results in the aggregate demand curve shifting further to the right to AD3 (point B). Because of the upward-sloping supply curve, the shift in aggregate demand results in a higher price level. In the new equilibrium at point C, both real GDP and the price level have increased. The increase in real GDP is less than indicated by the multiplier effect with a constant price level. AD3 AD2 AD1 $1100 $1120 $1225 Real GDP Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 3 The multiplier effect and government purchases and tax multipliers The multipliers works in both directions. Both expansionary and contractionary fiscal policy have a multiplier effect.

The multiplier in reverse, the Great Depression of the 1930s.
MAKING THE CONNECTION 17.1 The multiplier in reverse, the Great Depression of the 1930s. More than 1000 unemployed men marched from the Esplanade to the Treasury Building in Perth, Western Australia, to see premier James Mitchell. The multiplier effect had contributed to the very high levels of unemployment during the Great Depression. The multiplier effect contributed to the very high levels of unemployment during the Great Depression.

Fiscal policy multipliers
LEARNING OBJECTIVE 3 Fiscal policy multipliers Suppose the Australian economy is currently in equilibrium at a position where actual GDP exceeds potential GDP by $100 million. The Federal Treasurer announces a decision to reduce government spending by $50 million and increase taxes by $50 million in order to return the economy to full employment. Is the Treasurer’s economic policy sound?

LEARNING OBJECTIVE 3 Fiscal policy multipliers STEP 1: Review the material. This problem is about the multiplier impact of government fiscal policy, which is explained in the section in the text book, ‘The multiplier effect and government purchases and tax multipliers’. STEP 2: Answer the question by showing that the Treasurer has overlooked the multiplier effect in his policy decision, which means the economy is likely to move to a below full employment equilibrium.

LEARNING OBJECTIVE 3 Fiscal policy multipliers STEP 3: Assume the government purchases multiplier is 2, and the tax multiplier is STEP 4: Use this assumption to calculate the impact of a $50 million decrease in government expenditure of GDP.

LEARNING OBJECTIVE 1 Fiscal policy multipliers Recall the government purchases multiplier is: Therefore:

LEARNING OBJECTIVE 3 Fiscal policy multipliers STEP 5: Now calculate the impact of the increase in taxes. Recall the tax multiplier is:

LEARNING OBJECTIVE 3 Fiscal policy multipliers Therefore

LEARNING OBJECTIVE 3 Fiscal policy multipliers STEP 6: The total decrease in GDP is $100 million from the government expenditure effect plus $83 million from the tax effect. GDP decreases by a total of $183 million, much more than is necessary to return the economy to full employment equilibrium.

The limits of using fiscal policy to stabilise the economy
LEARNING OBJECTIVE 4 The limits of using fiscal policy to stabilise the economy There are two main problems associated with fiscal policy effectiveness: Timing lags Crowding out

LEARNING OBJECTIVE 4 The limits of using fiscal policy to stabilise the economy Timing lags Recognition lag: the time it takes policy makers to ascertain there is a problem to be addressed. Legislative lag: the time it takes to have policy approved by both Houses of Federal Parliament. Implementation lag: the time it takes to implement the policy, and for the policy to take effect.

LEARNING OBJECTIVE 4 The limits of using fiscal policy to stabilise the economy Crowding Out: A decline in private expenditures as a result of an increase in government purchases. An increase in government purchases diverts money and resources away from the private sector. Most economists agree that there is partial crowding out in the short run, and complete crowding out in the long run.

LEARNING OBJECTIVE 4 The limits of using fiscal policy to stabilise the economy Crowding out. Financial crowding out: To finance a budget deficit, the government will sell more bonds and securities, which will increase the real rate of interest. Higher interest rates will reduce private investment spending and consumption spending. Higher interest rates may also cause net exports to decline.

LEARNING OBJECTIVE 4 The limits of using fiscal policy to stabilise the economy Crowding out. Resource crowding out: The government competes with the private sector for labour and other resources, putting upward pressure on prices. Occurs when the economy is close to full capacity.

LEARNING OBJECTIVE 4 The limits of using fiscal policy to stabilise the economy Crowding out in the long run. Most economists agree that there is no long run effect on GDP from a permanent increase in government spending. The increase in government purchases is offset by a decrease in private investment, consumption spending and net exports.

Limits to fiscal policy: Japan in the late 1990s.
MAKING THE CONNECTION 17.2 Limits to fiscal policy: Japan in the late 1990s. Fiscal policy in Japan has not been effective in expanding real GDP and reducing unemployment.

Deficits, surpluses and federal government debt
LEARNING OBJECTIVE 5 Deficits, surpluses and federal government debt Budget deficit: The situation in which the government’s spending is greater than its tax revenue. Budget surplus: The situation in which the government’s expenditures are less than its tax revenue.

Commonwealth government budget – surpluses and deficits, Australia, 1974/75 to 2009/10: Figure 17.9
Figure 17.9: Commonwealth government budget – surpluses and deficits, Australia, 1974/75 to 2009/10. Source: Australian Government (2007), Budget Overview, Appendix G, Historical budget and net debt data, viewed 5 May 2008, at Australian Government (2009), Budget , Budget Overview, Appendix I, Historical budget and net financial worth data, viewed 26 May 2009, at < The figure shows the Commonwealth government budget position from 1974/75 to 2009/10. The budget was generally in deficit throughout the 1970s and 1980s, and was generally in surplus between since 1997/98 and 2007/08. The budget surplus in 2007/08 was around 1.1% of GDP, or over $19 billion, but moved into a large deficit in 2008/09. Source: Australian Government (2007), Budget Overview, Appendix G, Historical budget and net debt data, viewed 5 May 2008, at Australian Government (2009), Budget , Budget Overview, Appendix I, Historical budget and net financial worth data, viewed 26 May 2009, at < Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 5 Deficits, surpluses and federal government debt If the government has a budget deficit, this has to be financed by borrowing, which contributes to net debt.

Commonwealth government net debt, Australia, 1974/75 to 2009/10: Figure 17.10
Figure 17.10: Commonwealth government net debt, Australia, 1974/75 to 2009/10. Source: Australian Government (2007), Budget Overview, Appendix G, Historical budget and net debt data, viewed 5 May 2008, at Australian Government (2009), Budget , Statement 7: Asset and Liability Management, Table 2, viewed 26 May 2009, at < In Australia, the net debt of the Commonwealth government was generally increasing from the second half of the 1970s, accelerating in the 1980s through to 1986/87. Decreases in net debt between 1987/88 and 1990/91 were followed by substantial increases in net debt over the period 1991/92 to 1995/96,(after a serious recession), during which the net debt peaked at 18.2% of GDP in 1996/97, or $96.2 billion. The Coalition government consistently reduced the net debt of the Commonwealth government throughout the period after 1995/96 and by 2005/06 the government had no net debt. This means that the government had become a net saver. However, government borrowing in 2009/10 by the Labour Government to finance the budget deficit meant that the federal government again moved into a position of debt. Source: Australian Government (2007), Budget Overview, Appendix G, Historical budget and net debt data, viewed 5 May 2008, at Australian Government (2009), Budget , Statement 7: Asset and Liability Management, Table 2, viewed 26 May 2009, at < Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 5 Deficits, surpluses and federal government debt How the federal budget can serve as an automatic stabiliser. Federal government deficits increase automatically during recessions because: Tax revenues fall. Unemployment benefit payments increase.

LEARNING OBJECTIVE 5 Deficits, surpluses and federal government debt How the federal budget can serve as an automatic stabiliser. Federal government deficits decrease or surpluses increase automatically during expansions because: Tax revenues increase. Unemployment benefit payments decrease.

LEARNING OBJECTIVE 5 Deficits, surpluses and federal government debt The cyclically adjusted budget deficit or surplus: The deficit or surplus in the federal government’s budget if the economy were at potential GDP. May provide a more accurate measure of the impact on the economy of government expenditure and taxation policies.

How the level of GDP affects the cyclically adjusted budget deficit: Figure 17.11
Figure 17.11: How the level of GDP affects the cyclically adjusted budget deficit. Suppose the federal budget is balanced at potential real GDP of $1200 billion. If GDP is above $1200 billion, there will be a budget surplus. If GDP is below $1200 billion, there will be a budget deficit. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 5 Deficits, surpluses and federal government debt Should the federal budget always be balanced? When the economy is in a recession, tax revenues fall and government spending rises, moving the budget into a deficit. When GDP is above its potential level during a boom, the budget automatically moves into a surplus – tax revenues rise. To maintain a balanced budget every year could involve destabilising policies.

LEARNING OBJECTIVE 5 Deficits, surpluses and federal government debt Is government debt a problem? At times, government debt may be necessary, eg: during a recession. Economists examine the debt level, and the interest repayments on the debt relative to GDP, to determine if it is a problem. Debt servicing (interest repayments) involves an opportunity cost. Government borrowing also leads to crowding out.

Do you agree with this statement?
LEARNING OBJECTIVE 5 Debts and deficits During the 1990s the Australian Federal government operated successive government deficits of over $10 billion dollars. Clearly the government of the day was engaging in vigorous expansionary policy. Do you agree with this statement?

STEP 2: Answering the question.
LEARNING OBJECTIVE 5 Debts and deficits STEP 1: Review the material. This problem is about government deficits, so you may like to read the section in the text book, ‘Deficits, surpluses and federal government debt’. STEP 2: Answering the question. The Australian economy experienced a major recession in 1990, due to high interest rates. As a result businesses were less profitable than had previously been the case, and many more people were unemployed. As a consequence, tax revenues decreased and transfer payments in the form of unemployment and other benefits increased. These factors contributed to the successive budget deficits which followed.

The effects of fiscal policy in the long-run
LEARNING OBJECTIVE 6 The effects of fiscal policy in the long-run Supply side policies: Fiscal policies that have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. These policy actions primarily affect aggregate supply rather than aggregate demand, shifting the long-run aggregate supply curve to the right.

LEARNING OBJECTIVE 6 The effects of fiscal policy in the long-run The long-run effects of tax policy. Tax Wedge: The difference between the pre-tax and post-tax return to economic activity. Lowering taxes can increase the incentive to work, and encourage investment. Reducing each of the following taxes can increase aggregate supply. Personal income tax Company income tax Taxes on capital gains

LEARNING OBJECTIVE 6 The effects of fiscal policy in the long-run Tax simplification. There are also potential gains to be derived from simplifying the tax law. Resources diverted to tax compliance and tax minimisation can be put to more productive uses. Tax simplification may improve the efficiency of firm and household decision making.

LEARNING OBJECTIVE 6 The effects of fiscal policy in the long-run The economic effect of tax reform. Tax reform can increase the labour force, capital stock and technological change by more than would have occurred without tax reform. The LRAS curve will shift to the right by more than it otherwise would have.

The supply-side effects of a tax change: Figure 17.12
Price level Increase in LRAS without tax changes LRAS1 LRAS2 LRAS3 Additional increase in LRAS because of tax changes P1 A P2 B P3 C Figure 17.12: The supply-side effects of a tax change. The economy’s initial equilibrium is at point A. With no tax change, long-run aggregate supply shifts to the right from LRAS1 to LRAS2. Equilibrium moves to point B, with the price level falling from P1 to P2 and real GDP increasing from Y1 to Y2. With tax reductions and simplifications, long-run aggregate supply shifts further to the right to LRAS3 and equilibrium moves to point C, with the price level falling to P3 and real GDP increasing to Y3. AD1 Y1 Y2 Y3 Real GDP Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

An Inside Look Figure 1 Supply-side policies can increase long-run aggregate supply, thereby reducing the upward pressure on prices following an increase in aggregate demand Insert Figure 1 from page 567: As large as possible while maintaining clarity. Supply side policies can increase long run aggregate supply, thereby reducing the upward pressure on prices following an increase in aggregate demand.

Key Terms Automatic stabilisers Autonomous expenditure Budget deficit
Budget surplus Contractionary fiscal policy Crowding out Cyclically adjusted budget deficit or surplus Discretionary fiscal policy Expansionary fiscal policy Fiscal policy Induced expenditure Marginal propensity to consumer (MPC) Multiplier Multiplier effect Supply side policies Tax wedge

Get Thinking! The opening case study for Chapter 17 describes the Baby Bonus introduced in 2004 at $4000 and increased over the following years to $5000. Is the Baby Bonus fiscal policy? Given the evidence cited in the text book that the Australian economy was at or near full employment in the mid 2000s, why do you think this policy was introduced? What effect do you think it may have had on the price level? Strictly speaking, the Baby Bonus was not fiscal policy, as it was not a policy used to achieve macroeconomic objectives. It was advocated as a way to increase the birth rate, to deal with projected declines in labour force participation rates and an aging population. However, a policy that increases spending when the economy is already at full employment may have an inflationary effect.

Check Your Knowledge Q1. When the economy is in a recession the government can: Reduce expenditures and leave taxes constant in order to stimulate aggregate demand. Increase government purchases or decrease taxes in order to increase aggregate demand. Decrease government purchases or increase taxes in order to decrease aggregate supply. Change spending and taxation but not aggregate demand or aggregate supply.

Check Your Knowledge Q2. By how much will equilibrium real GDP increase as a result of a $100 billion increase in government purchases? By more than $100 billion. By less than $100 billion. By exactly $100 billion. None of the above. Equilibrium real GDP will not change as a result of an increase in government purchases.

Check Your Knowledge Q3. Which of these policies can result in ‘crowding out’? Fiscal policy. Monetary policy. Environmental policy. None of the above.

Chapter 17 Fiscal Policy.

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