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Fiscal Policy
Taxes (ch 14)
Federal Budget & Debt (ch 15 sect 3)
Fiscal Basics (ch 15 Sect 1)
Policy Debate: Keynes, Classical, SupplySide (ch 15 sect 2)
Remember??? Circular Flow Model
• Expenditure Approach???
• Income Approach???
Y = ???
Y = C + I + G + Xn
• AS/AD Model???
– What causes the business cycle (recessions &
• Which ‘Shock’ is the most common?
AD = ??????????????
AD = C + I + G + Xn
*complete graphs
Circular Flow Model
C + I + G + Nx
Income: Y
What to do? What to do?
• What to do when we are in a recession???
• What to do when inflation is rising too
• Possible answers:
– Fiscal (government intervene: Keynesian)
– Classical (do nothing: Laissez-faire)
Fiscal Policy: Keynes
• “The use of government spending and
revenue collection to influence the
economy” (pg 392) Active Gov!
– Target the “G” part of GDP (expenditure
approach) via direct spending
– Target the “C” and/or “I” part of GDP
(expenditure approach) by adjusting the “Y”
(income approach) through changing tax levels
– A little of both
Policy Basics: Expansion & Contraction
• Expansionary Policy
–Used when economy is slow (recession)
–Goal: increase output: Grow AD
• Contractionary Policy
–Used when economy is growing too fast
(peak of cycle)
–Goal: Decrease output: shrink AD
Fiscal Basic Intro
Expansionary Policy
Three methods:
1. Increase spending (GDP = C + I + G + Xn)
2. Decrease taxes (GDP = Y: Tax decrease
increases income, thus C & I spending goes
up: AD = C + I + G + Xn)
3. Some combination of both
Open your textbook…
Look at page 395
• Figure 15.2 (the left side) shows the process
Contractionary Policy
Three methods:
1. Decrease spending (GDP = C + I + G + Nx)
2. Increase taxes (GDP = Y: Tax increase
decreases income, thus C & I spending goes
down: AD = C + I + G + Nx)
3. Some combination of both
Open your textbook…
Refer to page 396
• Figure 15.3 shows the process
Your Turn
Open your books to page 396 (Sullivan text)
Read pages 396-398: answer the following question on
your own paper.
There are five basic reasons why fiscal policy is often
“clumsy and difficult to put into practice.” Provide a
thorough explanation of each one. Make sure to
include key terms, examples, and major points of
a. Difficulty of changing spending levels
b. Predicting the future
c. Delayed Results
d. Political Pressures
e. Coordinating Fiscal Policy
Automatic Stabilizers
• Automatic Stabilizers
– Items that ‘kick in’ automatically
– No need of congressional action
– Examples:
• Welfare
• Food Stamps
• Automatic Stabilizers are forms of
government spending
When the economy slows
• Government revenue is down (fewer
taxes collected due to decline in
production levels)
• Due to Automatic Stabilizers,
government spending is up
• This results in budget deficits!!!
Multiplier Effect
• Spending ‘multiplies’
Think about people’s income: Do they spend
everything? Or do they save some?
• MPC = Marginal Propensity to Consume
• MPS = Marginal Propensity to Save (Save)
MPC + MPS = 100 % of income
MPC + MPS = 1
• Take what people spend (MPC) and that
expenditure becomes someone else’s
• That person saves some of their income
(MPS) and spends some of it (MPC)
• What that person spends becomes yet
another person’s income…
– And so on…
– And so on…
• Add up all the levels of spending and you will
find that the total amount spend has
Assume the MPC = .9
(90 % of income will be spent)
The government spends $ 100 to
buy some furniture from Fred
Fred saves 10 % of the $ 100.00 and Spends 90 %
(spends $ 90) to buy a Radio from Debbie
Debbie saves 10 % of the $ 90 and Spends 90 %
(spends $ 81) to buy a necklace from Sarah
And so on…
So far, a total of $ 271 has been
spend on goods & services!!!
Thus, when the government spends, it must consider
the multiplier effect or else it could spend too much
and spiral us into inflation!!!
Assume: The MPC is .75
Multiplier = 1/MPS
MPC + MPS = 1
1 – MPC = MPS
If the MPC = .75, then the MPS = .25
Assume: The GDP Gap is $4 Billion
Then whatever the government spends will grow by a
factor of 4! Thus the Government wants to increase
spending by $1 Billion!
1/.25 = 4
Open your books to page 391 (Sullivan text)
Read pages 391-394: answer the
following questions on your own paper.
How much does the government spend on
a daily basis?
What shapes the government’s taxing and
spending decisions?
What is fiscal policy used for?
4. What is the federal budget?
5. What are the months in our fiscal year (from when
to when)?
6. How long does it take to prepare the fiscal budget?
7. There are four basic steps in the federal budget
process. Provide a thorough explanation of each
step. Make sure to include key terms, date
deadlines, and major points of interest.
a. Write Spending Proposal
b. Create the budget
c. Congressional debate
d. On to the White House
Crowding Out Effect