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Focus: shift AD in the AD/AS model to achieve the goals of price stability, FE and economic growth.
Based on the idea that short-term fluctuations of Real
GDP are due to actions of firms and consumers that affect AD, causing inflationary and recessionary gaps.
They try to counteract the effect of those actions and bring AD to the FE level of real GDP.
D-side policies can also impact on economic growth, that is, increase potential GDP (shift LRAS curve to the right). IB exam question last year!!
Discretionary and non-discretionary policy.
Stabilization policies

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1.
Discretionary policy: active and purposeful government intervention to influence AD (the policy is at the discretion of the gov). Two types:
Fiscal Policy
2.
Monetary Policy
Non-discretionary policy. AD is also influenced by automatic stabilisers, which work to reduce the size of economic fluctuations.
Fiscal and monetary policies intended to reduce the size of short-run economic fluctuations are called
stabilisation policies.

 Sources of government revenue
1.
Taxes, both direct and indirect (T).
2.
3.
1.
Sales of goods and services (transportation, electricity, water, …)
Sale of state-owned enterprises (privatisation).
 Types of government expenditure
Current (day-to-day) expenditures
2.
3.
Capital expenditures, including public investments or the production of physical capital (building roads, airports, harbours,…)
Transfer payments for the purpose of income redistribution

 Current and capital expenditures are included under
G. Transfer payments do not represent value of new output produced.
 Government budget: a plan of a country’s tax revenues and expenditures over a period of time (a year).
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If G=T: balanced budget
If G>T: budget deficit Gov needs to borrow
 If G<T: budget surplus
 Public/Government Debt is the gov’s accumulation of deficits minus surpluses.

 Definition: manipulations by the government of its own expenditures and taxes in order to influence the level of AD.
 FP can affect AD through 3 components:
 G. Direct impact on AD
 C. FP, through changes in income taxes, affects the disposable income of consumers, which affects their consumption expenditures.
 I. Through changes in business taxes, FP affects the after tax profits of firms, which has an impact on their level of investment expenditures.

 In a recessionary gap (Y<Y
FE
), the gov can increase
AD with expansionary FP, which works to expand the level of economic activity.
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2.
3.
Expansionary FP can consist of:
↑ G
↓ personal income taxes
↓ business taxes
4.
a combination of the three.

 A decrease in T affects AD in a 2-step process:
↓ T → ↑ Disposable income Yd / ↑ After-tax businesses profits → ↑ C / ↑ I → ↑ AD
 The gov can increase G and lower taxes at the same time by borrowing to finance the excess of spending over tax revenues.
 The increase in real GDP will be smaller in the neoclassical model than in the Keynesian one, because of the upward sloping neoclassical AS curve.
 The increase in the P
L will be smaller in the Keynesian model, where the increase in AD may result in no increase in the P
L at all if the AD shift occurs entirely within the horizontal segment of the Keynesian AS curve.

 In an inflationary gap (Y>Y
FE
), the gov can decrease
AD with expansionary FP, which works to contract AD and the level of economic activity.
 Contractionary FP can consist of:
1.
↓ G
2.
↑ personal income taxes
3.
↑ business taxes
4.
a combination of the three.

 A decrease in G has a direct impact on AD
 An increase in T affects AD in a 2-step process:
↑ T → ↓ Disposable income Yd / ↓ After-tax businesses profits → ↓ C / ↓ I → ↓ AD
 Figures 12.1 (expansionary FP) and 12.2 (contractionary
FP).
 Keynesian model with the ratchet effect (Fig 12.2 c)

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Definition: factors that automatically, without any action by government authorities, work toward stabilising the economy by reducing the short-term fluctuations of the business cycle. They represent non-discretionary policy.
Progressive income taxes
2.
Unemployment benefits