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Published byVincent Allen Modified over 8 years ago
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What can governments do when the there is a downturn or upturn in the economy? They can stabilize the economy Example: they can spend more money or reduce taxes to cause changes in total spending and aggregate demand 11.1 - Fiscal Policy
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A Stabilization Policy attempts to influence the amounts spent and produced in an economy 2 Categories: 1. Expansionary Policies: When total output is below its potential, there is unemployment and a recessionary gap Governments need to reduce unemployment and increase total output 2. Contractionary Policies: When economy is booming, governments want to stabilize prices and bring economy back to its potential output The Goal of Stabilization
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Recall: Governments can affect spending and purchases through taxation and government purchases Gov’t has an annual budget which sets out what the government will tax and spend This budget is a stabilization policy AKA Fiscal Policy (“fiscal” = budgetary) Fiscal Year: 12-month period to which the budget applies Monetary Policy: when governments exert their influence on interest rates and the economy’s money supply Stabilizing the Business Cycle
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Effective stabilization policy minimizes the severity of the peaks and troughs in the business cycle Differences between actual output and the long-run trend of potential output are, therefore, smaller, thus reducing recessionary and inflationary gaps Stabilization Policy and the Business Cycle
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Fiscal policy can be applied to any part of the business cycle Expansionary Fiscal Policy Occurs during a recession or depression Involves increasing government purchases and/or decreasing taxes Contractionary Fiscal Policy Occurs during an inflationary period Policy-makers focus on restraining output and spending Involves decreasing government spending and/or increasing taxes Use of Fiscal Policy
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A rise in government purchases or a cut in taxes increases aggregate demand, shifting the aggregate demand curve from AD to AD’ This causes a rise in the equilibrium price level, and output rises to its potential level (from left point to right point) This eliminates economy’s recessionary gap Expansionary Fiscal Policy
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Fiscal Policy involves adjusting government purchases or taxes Since it’s a government’s choice to pass these laws and create these budgets, fiscal policy is known as discretionary policy i.e. these are not automatic Automatic stabilizers in the business cycle include income taxes, employment insurance, welfare and some agricultural subsidies Automatic Stabilizers
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A fall in government purchases or a rise in taxes decreases aggregate demand, shifting the aggregate demand curve to the left from AD 1 to AD 2 This causes a fall in the equilibrium price level, and output falls to its potential level (from right point to left point) Result: economy’s inflationary gap is eliminated Contractionary Fiscal Policy
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