Chapter 28: Fiscal Policy
Government Spending and Equilibrium Net Domestic Income
- In a closed economy with government spending, equilibrium
occurs when
Y=C+I+G
- Equilibrium occurs where the C + I + G line intersects the 45degree line.
Effect of an Increase in Government Spending
- An increase in government spending increases net domestic
income.
Effect of an Decrease in Government Spending
- - A reduction in government spending reduces net domestic
income.
The Government Spending Multiplier
- The Government Spending Multiplier, like the investment
multiplier, is the reciprocal of the MPS.
Taxation and Equilibrium Net Domestic Income
- The imposition of a tax reduces net domestic income.
- A Lump-Sum Tax is a fixed tax, independent of income level
- A tax reduces the aggregate expenditure line.
Effect of an Increase in Taxes
- An increase in taxes reduces net domestic income.
Effect of a Decrease in Taxes
- A decrease in taxes increase net domestic income.
Equilibrium Net Domestic Income with Government Spending and
Taxes
The Injections-Withdrawals Approach
- In a closed economy with government spending and taxation,
equilibrium net domestic income occurs when:
I+
G=S+T
(Saving and Taxes) = (Investment and
Government Spending)
- The intersection of the injections line and the withdrawals line
determines the equilibrium level of net domestic income.
A Proportional Tax and Equilibrium Net Domestic Income
- An increase in the tax rate reduces consumer spending and hence
desired aggregate expenditure. An increase in the tax rate also
reduces the slope of the consumption curve and hence reduces the
size of the multiplier.
Budget Positions
Budget Deficit
- A Budget Deficit occurs when the government spends more than
it collects in taxes
- Budget Deficit = G (Government Spending) – T (Taxes)
Budget Surplus
- A Budget Surplus occurs when the government collects in taxes
more then it spends.
- Budget Surplus = T (Taxes) – G (Government Spending)
Balanced Budget
- A Balanced Budget occurs when governments expenditures and
income from taxes are the same
- Functional Finance is intentional budget deficits and surpluses.
The Balanced Budget Multiplier
- A Balanced Budget Increase in Spending is expansionary
- The balanced budget theorem states that the balanced budget
multiplier is 1.
Automatic Stabilizers
- Automatic Fiscal Policy is built into the economy.
- Discretionary Fiscal Policy is deliberate change in government
spending and/or taxes.
- Automatic Stabilizers reduce economic fluctuations.
- Automatic stabilizers include progressive taxes, government
assistance to agriculture, and unemployment compensation.
- Progressive Tax, is when the tax rate increases as income
increases.
Fiscal Drag
- Fiscal Drag is when built-in stabilizers are a hinderance to
economic recovery.
Discretionary Fiscal Policy: Closing the Gaps
Anti-Inflationary Fiscal Policy
- A contractionary fiscal policy reduces inflation.
- Fiscal policy can reduce AE and thus close an inflationary gap.
- If the economy is experiencing inflation without unemployment,
the appropriate fiscal policy to eliminate the inflationary pressure
is a contractionary or restrictive fiscal policy.
Fiscal Policy to Combat Unemployment
- An expansionary fiscal policy reduces unemployment.
- Fiscal Policy can increase AE and thus close a recessionary gap.
Government Spending Or Taxes? The Pros and Cons
Government Spending
The Pros
- Government spending is more powerful then taxes and cam be
directed to certain regions.
The Cons
- Government spending include time lags and the difficulty of
reversing government spending programs.
Changes in Taxes
The Pros
- They may be more favouraby received, less wasteful, and faster
to implement than government spending.
The Cons
- Their effects are national rather then regional and they are less
effective then government spending.
The Full-Employment Budget
-
-
Full-Employment Budget (High-Employment Budget) is defined
as the position of the budget if the economy were at full
employment.
Changes in the budget do not necessarily indicate changes in the
fiscal policy. Changes in the full-employment budget, however,
do indicate changes in fiscal policy.
Limitations of Fiscal Policy
- Time lags reduce the effectiveness of fiscal policy.
- A Recognition Lags is the time required to recognize a problem.
- A Decision Lag is the time required to decide what to do.
- An Implementation Lag is the time required for decisions to be
implanted.
- An Impact Lag is the time required for decisions to take effect.
- Inflexability in government spending and tax measures may
reduce the impact of fiscal policy.
- Poor coordination between various levels of the government may
reduce the effectiveness of fiscal policy.