Fiscal Policy
By: Johnny, Faisal,
Nish, Bianca, &
Kalam
Welcome to Day 1!
Fiscal Policy
The Goal of Stabilization:
• Influence the amount spent and produced in an economy
• Meant to meet potential output
• To have less movements in the business cycle
Use of Fiscal Policy:
• Two Policies : Expansionary Policies and Contractionary Policies are
used to control output
• Injections and withdrawals helps or takes away from the circular flow
• Governments effects aggregate demand and aggregate supply
• Government purchases have immediate effect on aggregate demand while
tax cuts are less immediate
Automatic Stabilizers:
• Discretionary policies are intentional government intervention in the economy
• Automatic stabilizers are built-in measures that lessen the effects of the business
cycle
• Examples are taxation and transfer payment programs
Introduction to The Spending Multiplier:
• The impact policies have on the economy is like a ripple effect
• Assuming that price is constant, multiplier effect is the
magnified impact of a spending change on aggregate demand
• Marginal Propensity to Consume answers the question: “If
income increases this amount, how much extra will be spent on
domestic goods and services?”
•MPC = change in consumption on domestic items
change in income
Marginal Propensity to Withdraw is the effect on withdrawals of
a change in income
MPW = change in total withdraws
change in income
END OF DAY 1!
Have a fabulous day
Day 2: The Spending
Multiplier
The Multiplier Effect
• Government decision-makers estimate the impact
of their policies on the economy by using the
multiplier effect
• Multiplier Effect: the magnified impact of a
spending change on aggregate demand
500
250
Spender A ------> Spender B ------>
Spender C ------>
Increase in Income: (1000)
(500)
(250)
• Marginal Propensity to Consume (MPC): the effect on
domestic consumption of a change in income
• MPC answers the question: “If income increases this
amount, how much extra will be spent on domestic
goods and services?”
MPC= change in consumption on domestic items
-----------------------------------------------------change in income
• Marginal Propensity to Withdraw (MPW): the effect on
withdrawals of a change in income
• 3 types of withdrawals: savings, taxes, and imports
MPW= change in total withdrawals
-----------------------------------change in income
• 1.0 = MPC + MPW
Multiplier Effect in Detail
1st Round: Government pays Spender A $1000
Real Output: 1000
(not only income, but also economy’s output)
2nd Round: MPC is 0.5 (500/1000)
MPW is also (500/1000)
MPC=$500
MPW=$500
Real
Output: 1500
3rd Round: Spender B
MPC=$250
Output: 1750
MPW=$250
Later Spending Rounds:
Total MPC
Total MPW
Output: 2000
for later spending rounds
spending rounds
=$250
=$250
•
Real
Real
for later
Expansion continues until withdrawals equal initial
discretionary injection
• Injections and withdrawals are both $1000 higher than
they were before government purchases were increased
The Spending Multiplier
• Spending multiplier is the value by which the
initial spending change is multiplied to give the total
change in output
• Total Change =
initial change X spending
in spending
in spending
multiplier
• recall that the economy’s total output expands
until new withdrawals equal the initial government
purchase
• There is an inverse relationship between MPW and
the spending multiplier ( if MPW is ½, then the
multiplier equals 2) therefore spending multiplier is
the reciprocal of the MPW
• The multiplier effect can also be applied to
tax cuts
• Lower taxes allow others to have more funds
to spend and invest and therefore in this case
the spending multiplier is multiplied with the
initial spending from the tax cut
• Increases the total output and shifts
aggregate demand curve
• Tax adjustment has a small initial effect on
spending
• Since aggregate supply curve gets steeper as
it reaches the potential output level, an
increase in equilibrium makes the price level
rise proportionally more than output
• When economy is above its potential, both price level and total
output falls; price will fall proportionally more than output
•Multiplier effect is useful in indicating the maximum change in
equilibrium output following a certain fiscal policy
Benefits of Fiscal Policy
• Two benefits as a stabilization tool: its
regional focus, and the direct impact it has
on spending
• Regional Focus:
• Parts of Canada may be more affected than others
by the business cycle
• Discretionary fiscal policy can focus on particular
regions where, for example, unemployment rates
are the highest or inflation is at its worst
• Automatic stabilizers have the greatest effect in
regions that need them the most
• Impact on Spending:
• Fiscal policy has a more straightforward impact
when altering government purchases than monetary
policy, since the government itself initiates the
change
Drawbacks of Fiscal Policy
•
•
•
Delays:
• Recognition Lag – the amount of time it takes policymakers to realize that a policy is needed
• Decision Lag – the amount of time needed to formulate
and implement an appropriate policy
• Impact Lag – the amount of time between a policy’s
implementation and its having an effect on the economy
Political Visibility:
• Voters are likely to respond more favourably to increases
in government purchases and cuts in taxes
Public Debt:
• Public Debt - the total amount owed by the federal
government as a result of its past borrowing
• Public Debt Charges – are the amounts paid out each year
by the federal government to cover the interest charges
on its public debt
End of Day 2
Day 3: Impact of Fiscal
Policy
Impact of Fiscal Policy
• Balanced budget is the situation where a
government’s expenditure and revenues are equal
• A budget surplus is when a government’s revenues
exceed expenditures
• A budget deficit is when a government’s
expenditure exceeds revenues
• Size of a government’s surplus or deficit in relation
to the economy’s overall GDP gives clues to what
type of discretionary fiscal policy in operation, as
well as the automatic stabilizers
Budget Surpluses and
Deficits
• Rarely does budget surpluses relate to
discretionary fiscal policy. (Example of such would
be the government deciding to suppress the
inflationary effects of an economic boom by raising
income taxes and cutting defense spending
• Budget surpluses are more likely because of built
in factors (rising tax revenues might outweigh
transfer payment can show a surplus during
economic booms)
• Budget deficits may indicate active expansionary
policies that increase government expenditures
and reduce revenues
• Budget deficits occur often as a result of automatic
stabilizers (example: les jobs and spending during a
recession leads to rising Unemployment Insurance
and sagging income tax revenues)
Fiscal Policy Guidelines
• 3 principles that guide government fiscal policy:
1) Annually balanced budgets
2) Cyclically balanced budgets
3) Functional finance
• Annually balanced budget is the principle that
government revenues and expenditures should
balanced each year
• Critics of fiscal policy say annually balanced budget are
not necessary for the society and state it as faulty
reasoning
• Cyclically balanced budget is the principle that
government revenues and expenditures should
balanced over the course of one business cycle
Recent Fiscal Policy
•
•
•
•
•
•
Government revenues and expenditures don’t need to
balance every year but over one business cycle
Function finance is the principle that government
budgets should be geared to the yearly needs of the
economy
Defenders of functional finance are those who believe
fiscal policy is a powerful stabilization took
The choice of fiscal policy guideline depends on the
government’s belief in fiscal policy as an effective took
for stabilizing the economy
1970s and 1980s Canada believed in functional finance
but recently has made unsuccessful attempts to move
toward cyclically balanced budgets
Canada’s change of view came from constant budget
deficits and its impact on the economy as a whole
• Government deficits were highest during
recessions during the early 1980s and early 1990s
• Tax revenues fell with slumping incomes during
that time as a result of the automatic stabilizers
• Discretionary expansionary policy also contributed
since federal government increased purchases of
goods and services to counteract the effects of
sagging outputs and incomes
• Canada experienced a period of economic growth,
noticeably during 1988 where unemployment was
under 8%, the economy was at or above potential
output but still budgets didn’t show a surplus
• 1990s downturn caused a concern over increased
public debt and lowered confidence in
discretionary fiscal policies to counteract a
recession
End of Day 3