Fiscal Policy

1. Fiscal Policy Government Intervention in the Free Market?

2. Fiscal Policy • Fiscal Policy is Government’s attempt to moderate the “ups & downs” of business cycle by changing taxes & spending policies • If the Economy is too slow => Gov’t tries to “speed it up” • If the Economy is too fast => Gov’t tries to “slow it down”

3. LRAS1 Price Level SRAS1 Real GDP AD1 Fiscal Policy Introduction Worksheet ----------- P1 E1 --------- Y1

4. AD AD 2 Types of Fiscal Policy • Expansionary Policy • Used in recessionary gap • Contractionary Policy • Used in inflationary gap Increase Gov’t Spending Decrease Taxes => Decrease Gov’t Spending Increase Taxes =>

5. Recessionary Gap LRAS1 Price Level SRAS1 Real GDP AD1 Inflationary Gap Economy below full output Economy above full output Expansionary Fiscal Policy Gov’t would lower income taxes => (C↑) Increase Gov’t Spending (G↑) End result: AD shifts right, Gov’t debt rises Contractionary Fiscal Policy Gov’t would raise income taxes => (C↓) Decrease Gov’t Spending (G↓ ) End result: AD shifts left, Gov’t debt falls ------------------ E1 P1 ----------------- Y1

6. Inflationary Gap 2 Ways to get back to full potential Contractionary Fiscal Policy Gov’t would raise income taxes => (C↓) Decrease Gov’t Spending (G↓ ) End result: AD shifts left, deficit falls Classical Economics At E1 actual price level is HIGHER than expected price level Expected price level rises => SRAS decreases End result: SRAS shifts left