1. Principles of Macroeconomics Lecture 3b FISCAL POLICY

2.  What fiscal policy is and what it is used for  What discretionary fiscal policy is and its function  About the economy’s built-in stabilizers  What a cyclically adjusted budget is  The problems, criticisms, and complications of fiscal policy In this chapter you will learn

3.  Legislative Mandates  Fiscal Policy & the AD-AS Model  Built-In Stabilization  Evaluating Fiscal Policy  Problems, Criticisms & Complications Topics

4.  Great Depression  need for stabilization role  Unemployment Insurance introduced during World War II  Governments regularly use fiscal policy to stabilize the economy Legislative Mandates

5. Definition:  Deliberate changes of  government expenditures  taxes  Dependent upon deliberate decisions in Parliament Discretionary Fiscal Policy

6. Expansionary Fiscal Policy  Recessionary Gap Options:  Increase Government Spending  Decrease Taxes  Some Combination of the Two Discretionary Fiscal Policy

7. AS AD 0 Price level Real GDP (billions) PL 0 GDP f GDP 0 recessionarygap Expansionary Fiscal Policy Figure 10-1

8. AS AD 0 Price level Real GDP (billions) PL 0 GDP f GDP 0 PL 1 AD 1 Figure 10-1 Expansionary Fiscal Policy

9. Contractionary Fiscal Policy  Inflationary Gap Options:  Decrease Government Spending  Increase Taxes  Some Combination of the Two Discretionary Fiscal Policy

10. Real GDP (billions) AS GDP f AD 3 PL 3 Price level GDP 3inflationarygap Figure 10-2 Contractionary Fiscal Policy

11. Real GDP (billions) AS GDP f AD 3 PL 2 AD 2 Price level Figure 10-2 Contractionary Fiscal Policy PL 3

12.  depends on political views about size of government Policy Options: G or T?

13.  A tax or government expenditure which automatically:  increases the deficit during recession phase  decreases the surplus during inflation phase Automatic or Built-In Stabilizers Government establishes tax rates, but does not set total taxes

14. G,T T = Net Taxes G (assumed constant) GDP 0 GDP 1 T1T1 Automatic or Built-In Stabilizers Figure 10-3 Deficit {

15. G,T T G GDP 0 GDP 2 Surplus T2T2 Automatic or Built-In Stabilizers Figure 10-3

16.  the stabilizers will automatically generate an expansionary budget deficit when GDP is low  and a contractionary surplus when GDP is high Automatic or Built-In Stabilizers

17. The built-in stability depends on:  Tax Progressivity  Progressive  Proportional  Regressive  The more progressive the tax system, the greater the automatic stabilization Automatic or Built-In Stabilizers

18.  automatic stabilizers can mask the direction of discretionary fiscal policy  the cyclically adjusted budget shows what the budget balance would be if the economy were operating at full employment Cyclically Adjusted Budget

19. 500 real GDP G, T T G GDP 1 (year 1) 450 GDP 2 (year 2) Figure 10-4 full-employment GDP the cyclically adjusted deficit is zero in year 1 at GDP 1 the cyclically adjusted deficit is zero in year 1 at GDP 1 it is also zero in year 2 at GDP 2 Cyclically Adjusted Budget the deficit is a by- product of the recession

20. 500 475 450 425 G, T real GDP G T1T1T1T1 T2T2T2T2 GDP 3 (year 3) GDP 4 (year 4) the cyclically adjusted deficit is zero in year 3 the cyclically adjusted deficit is zero in year 3 taxes are reduced full-employment GDP Figure 10-4 Cyclically Adjusted Budget $50 billion deficit due to recession $50 billion deficit due to recession $25 billion deficit due to expansionary fiscal policy $25 billion deficit due to expansionary fiscal policy economy enters a recession in year 4

21.  Problems of Timing  Recognition Lag  Administration Lag  Operational Lag  A Political Business Cycle?  Offsetting Provincial & Municipal Finance Problems, Criticisms, & Complications

22. Crowding-Out Effect expansionary fiscal policy Ü higher interest rates Ü reduction in interest-sensitive spending may not be significant in a recession fiscal policy can be accommodated by increases in money supply Problems, Criticisms, and Complications

23.  some portion of the potential effect of expansionary fiscal policy may be dissipated in the form of inflation illustrated… Problems, Criticisms, and Complications

24. AD 0 AS PL 1 Price level Figure 10-5 Fiscal Policy, AS & Inflation Real GDP (billions) AD 1 GDP 0 GDP f PL 2 GDP 1

25. AD 0 AS PL 1 Price level Figure 10-5 Fiscal Policy, AS & Inflation Real GDP (billions) AD 1 GDP 0 GDP f PL 2 GDP 1 n price level rises n GDP increases only to GDP 1

26.  Shocks Originating from Abroad  Net Export Effect… Fiscal Policy in the Open Economy

27. recession expansionary fiscal policy higher domestic interest rates increased foreign demand for C$ C$ appreciates net exports fall partial offset to expansionary fiscal policy 27 Table 10-1

28. 28 inflation contractionary fiscal policy lower domestic interest rates decreased foreign demand for C$ C$ depreciates net exports rise partial offset to contractionary fiscal policy Table 10-1

29.  tax changes may alter aggregate supply & affect the results of fiscal policy  saving & investment  work incentives  risk-taking  examine the effects of a tax cut… Supply-Side Fiscal Policy

30. AS 1 AD 1 Price level Real GDP (billions) PL 1 GDP 1 Figure 10-6 PL 2 AD 2 GDP 2 AS 2 PL 3 GDP 3

31.  most economists are skeptical about the supply-side effects of tax cuts  weak effects  timing Supply-Side Fiscal Policy