present by: Ivy, Yi Lin, Mamie, Mon, Chris

you will:1. learn about expansionary and contractionar

y fiscal policies, which are used by governments seeking economic stability

2. analyze the multiplier effect of fiscal policy, as determined by the marginal propensities to consumer and withdraw

3. consider budget surpluses and deficits and their impact on public debt and public debt charges

Stabilization policy is government policy designed to lessen the effects of the business cycle which can be either expansionary policies or contractionary policies.

expansionary policies attempt to reduce unemployment and stimulate total output

contractionary policies attempt to stabilize prices and bring the economy back down to its potential output.

CONTRACTION EXPANSION

Peak

Trough

Long-Run Trendof Potential Output

Without stabilization policy

With stabilization policy

Real

GDP

Time

Governments have an extensive impact on the economy through texation and government purchases.

Fiscal Policy uses taxes and government purchases as its tools

Fiscal Year is the 12-month period to which a budget applies

Monetary policy uses interest rates and the money supply as its tool.

Expansionary fiscal policy involves increasing government purchases, decreasing taxes, or both to stimulate spending and output.

Contractionary fiscal policy involves decreasing government purchases, increasing taxes, or both to restrain spending and output.

expansionary fiscal policy involves more government purchases and/or lower taxes to shift AD rightward

AS

AD0 AD1

b

a

Potential Output

InitialRecessionaryGap

Real GDP (1997 $ billions)8007800

170

160

Pric

e Le

vel (

GDP

defla

tor,

1997

= 1

00)

contractionary fiscal policy involves fewer government purchases and/or increased taxes to shift AD leftward

8108000

190

170

Real GDP (1997 $ billions)

Pric

e Le

vel (

GDP

defla

tor,

1997

= 1

00)

AS

AD0

AD1Potential Output

Initial Inflationary Gap

d

c

Discretionary Policy is international government intervention in the economy such as bedgeted changes in spending or texation.

Automatic stabilizers: built-in measures, such as texation&transfer payment programs, that lessen the effects of the business cycle.

Net tax revenues = taxes collected —— transfers&subsidies

The magnified impact of a spending change on aggregate demand

an initial spending change produces income and part of this new income becomes new spending

The process is repeated with each spending round smaller than the last

Each new spending round are determined by the marginal propensity to consumer(MPC) and marginal propensity

Marginal propensity to consumer (MPC) the effect on domestic consumption of a change in

income MPC = change in consumption on domestic items change in income

Marginal propensity to withdraw (MPW) the effect on withdrawals—saving, imports, and

taxes—of a change in income MPW = change in total withdrawals change in income

*MPC + MPW = 1 income is always either spend or withdrawn

Exercise: A $100 increase in a person's income causes him to increase his saving by $5, his imports by $35, and his tax payments by $20. In this case, the marginal propensity to withdraw is:

Change in total withdrawals(saving/ import/ taxes) Change in income 5 + 35 + 20 = 60 = 0.6 100 100

The multiplier effect will continue until withdrawals equal to the initial discretionary injection

The spending multiplier is the value by which the initial spending change is multiplied to give the total change in real

output.

In other words, the shift in the aggregate demand curve

Total change in output = initial change x spending (shift in AD curve) in spending multiplier

Example:

Find the spending multiplier when initial spend has rose by $1000 and the total output increased by $2000.

Spending multiplier= total change in output Initial change in spending

=$2000 $1000

=2

Relationship between the marginal propensity to withdraw and the spending multiplier

The spending multiplier is the reciprocal of the marginal propensity to withdraw.

Example:If MPW (marginal propensity to withdraw) is 0.5 what is the spending multiplier?

Spending Multiplier =__1__ MPW

=_1_ 0.5

=2

Effect of a Tax CutThe multiplier effect can be applied to tax cuts

Tax cuts can be used to expand the economy

Lower tax cuts can leave households and businesses with

more funds to spend and invest

The initial spending stimulus of the tax cut is multiplied by

the spending multiplier (or reciprocal of MPW). This results

in an increase in total output

a shift in the aggregate demand curve

The initial change in spending on domestic items from a change in taxes (T) is found by multiplying the economy’s marginal propensity to consume by the size of the tax change, then it is multiplied by the spending multiplier (1/

MPA)

Total change in output = initial change x spending (shift in AD curve) in spending multiplier

-(MPC X T) has a minus sign because the spending change is in the opposite direction to the tax change

Total change in output = - (MPC X change in T) x (1/MPA)

Relevance of the Spending Multiplier

When the economy is close to its potential level, the increase in

aggregate demand translates into higher price levels more than into

expanded production

When the stated goal being a stable economy and expanded output,

expansionary fiscal policy is less effective the closer the economy is to its

potential

Similarly, for the contractionary fiscal policy, when the economy is

above its potential, a decrease in aggregate demand means both price

level and total output will fall

Based on the possible changes in the price level, the multiplier effect is

less definite than the use of simple formula would indicate

Two benefits as stabilization tool:regional focus and impact on spending

• Regional focus ：（ it can be focused on particular regions ）

During a recession, new government purchases and program to reduce the amount of tax paid can be targeted to regions where unemployment rate are highest. （ Net income revenue drop hit by unemployment and falling output. ）

In a boom, spending cuts and tax hikes can be concentrated on the regions where inflation is at its worst. （ Larger increase in net tax revenue in regional where the economy is most over-heated. ）

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Impact on spending it has a relatively direct impact on spending（ compare with monetary policy--Fiscal policy is easy to

control the trend of economy, making it closer the potential output and achieve the goal of stabilization)

• influences of a stabilization is tied to its initial effect on spending

During recession, government increase the government purchases, it decrease the spending

In contrast, government decreases the government purchases which increase the spending—alter the government purchases to make economy stability.

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a)Delays while automatic stabilizers to stabilize the economy, the discretionary measure are sometimes delayed.

Recognition lag: the amount of time it takes policy-makers to realize that a policy needed.( decided and realized the economy need adjusted )

Decision lag: the amount of time needed to formulate and implement an appropriate policy.(how to adjust)

Impact lag: the amount of time between a policy’s implementation and its having an effect on the economy.(already have move to a different point in the business cycle )

 

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b)Political visibility

Discretionary is highly visible element of government activity, therefore, it is often affected by political and economic considerations.

E.G vote: increases in government purchases and reduce the taxes, regardless of the appropriateness of these policies for the economy.(election is coming up)

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c)Public debt Public debt: the total amount owned by the federal

government as a result of its past borrowing.

Total government: include the debts of individuals’ provinces and territories and incorporates local government and hospital.

Public debt charges: the amounts paid out each year by the federal government to cover the interest charges on its public debt.

E.G. the federal government’s public charge were37.2billion, the government should pay 507.7 to bondholders. What is the average interest?

Average interest rate=public debt charge/public debt

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Balanced budget mean government’s expenditures and revenues are equal

• This situation is so uncommon.

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Balanced budget

Budget surplus is the government’s revenues exceed its expenditures

• government revenues- government expenditures = Budget surplus

• For example, government will cut defence spending and raising income taxes during the economic boom to suppress the inflationary.

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Budget deficit is the government’s expenditures exceed its revenues

government expenditure – government revenue=Budget deficit

For example, government will increase the spending on road and bridges, or institute a temporary sales-tax cut to stimulate household spending, during the downturn.

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The government’s debt represents the sum of all its past budget deficits minus any budget surpluses.

Budget deficits- Budget surpluses= government’s debt

When the government has a budget surplus, the the public debt reduced by the same amount.

When the government has a budget deficit, the public debt increases by the same amount.

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There are 3 principles that guide government fiscal policy:1 ） Annually balanced budgets2 ） Cyclically balanced budgets3 ） Functional Finance Critics of fiscal policy suggest that any fiscal policy that is

used must be guided by the principle of an annually balanced budget. In other words, revenues and expenditures should be balanced every year.

Critics also say that an annually balanced budget is not necessarily appropriate for society and state it is flawed reasoning.

Cyclically balanced budget is the principle that government revenues and expenditures should balance over the course of one business cycle.

 

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Functional Finance is the principle that government budgets should be geared to the yearly needs of the economy.

The choice of fiscal policy guidelines depends on the government’s belief in fiscal policy as an effective tool for stabilizing the economy.

Defenders of functional finance are those who see functional finance as a powerful stabilizing tool, while economist who support cyclically or annually balanced budget tend to be less convinced of fiscal policy’s effectiveness.

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In the 1970s and early 1980s, Canada believed in functional finance but recently had made unsuccessful attempts to move towards cyclically balanced budgets.

This change in view came from constant budget deficits and their impact on the economy as a whole.

Total government deficits were highest during the recessions in early 1980s and 1990s.

The 1980s deficits were largely optional, while the 1990s deficits were related to automatic stabilizers.

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Neoclassical theory is the view of economy that economic slow-downs such as the great depression were self correcting and is based on two assumptions: flexible labour markets and Say’s law.

Flexible labour markets: Neoclassical economists suggest that both the demand and supply of labour depend on real wage rate, or wages expressed in constant base-year dollars, rather than the nominal wage rate, which is valued in current dollars.

There are two types of unemployment:1 ） Voluntary unemployment2 ） Involuntary unemployment Voluntary unemployment exists whenever workers decide that real

wages are not high enough to make work worthwhile. Involuntary unemployment is when someone wants to work at the

current real wage rate but cannot find a job. Involuntary occurs when the market demand and supply creates a surplus.

 

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Say argued that supply automatically creates its own demand.

An example would be a tailor supplies clothes in order to have funds needed to purchase other products.

Keynes’s theory challenged both assumptions made by the neoclassical economists. Keynes believed that workers are influenced by nominal wages rather than real wages and purchasing power.

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