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Fiscal Policy

Fiscal Policy. Fiscal Policy. Gov. can affect AD through G or T Directly: increase or decrease G, AD shifts Indirectly: increase or decrease T and C and I will change, which will shift AD. Fiscal Policy. What’s the difference between actual and full employment?

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Fiscal Policy

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  1. Fiscal Policy

  2. Fiscal Policy • Gov. can affect AD through G or T • Directly: increase or decrease G, AD shifts • Indirectly: increase or decrease T and C and I will change, which will shift AD

  3. Fiscal Policy • What’s the difference between actual and full employment? • Draw an economy with a recessionary gap.

  4. Fiscal Policy • Expansionary Fiscal Policy • When AD is too low, the economy is not at full employment (or potential GDP) • Fiscal policy is expansionary to increase AD by increasing spending and/or reducing taxes • moves the economy toward full employment

  5. Fiscal Policy • Expansionary policy increases employment, but • can raise price level • Result in budget deficits

  6. Fiscal Policy • Draw an economy in with an inflationary gap.

  7. Fiscal Policy • Contractionary Policies • If the level of AD is too high, it creates inflationary pressures. • Fiscal policy is contractionary • Reduce taxes and/or decrease spending • Moves economy to full employment

  8. Fiscal Policy • Contractionary policies can reduce inflationary pressures, but • Can reduce output • Reduce employment level • Can also result in budget surpluses ( or smaller deficits)

  9. Fiscal Policy • The multiplier effect • Tax multiplier • Always negative • MPC/ (1-MPC) • Same as MPC/MPS • Any change in taxes has a greater effect on C and/or I

  10. Fiscal Policy • The multiplier effect • The spending multiplier • 1/(1-MPC) • Same as 1/MPS • Any change in government spending has a greater effect than the amount of the spending

  11. Fiscal Policy • Because of the multiplier effect the change in G or T to close a recessionary or inflationary gap (between the actual equilibrium level and the full employment level of output) will be smaller than the gap. • Change in G or T multiplied by the multiplier should equal the size of the gap.

  12. Fiscal Policy • Discretionary Fiscal Policy • When the government chooses to change G or T, at the discretion of Congress and the president.

  13. Fiscal Policy • Automatic Fiscal Policy • Policies that work to stabilize the economy through changes that happen automatically. • No one needs to make a decision about these; a system is already in place. • Progressive income tax, unemployment, income based-transfer payments,

  14. Policy Effects on Aggregate Supply • Any policy that changes a determinant of of SRAS will affect the macroeconomy through the supply side. • What are the determinants of SRAS?

  15. Policy Effects on Aggregate Supply • Determinants of SRAS ( things that will shift the SRAS): • Economy wide input prices (like wages and energy prices) • Productivity • Factors that affect LRAS: • Increase in available resources • Higher quality resources • Technological advances

  16. Policy Effects on Aggregate Supply • Draw 2 correctly labeled AS/AD graphs. • Show the effect of the following on eq. price and RGDP: • Graph 1 increase in AD • Graph 2 increase in AS • What are the differences in the results for graph 1 and 2?

  17. Policy Effects on Aggregate Supply • Goals of Monetary and Fiscal policy • Economic growth • Full employment • Price stability

  18. Policy Effects on Aggregate Supply • How might a shift in AS move the economy toward the main goals? • What might cause such a shift?

  19. Policy Effects on Aggregate Supply LRAS Price Level • Suppose the Fed increases the MS: • Interest rates decrease • Investment and interest sensitive consumption increases • Increase in AD • Output increases • PL increases SRAS PL1 PL AD 1 AD Y1 Y* RGDP

  20. Policy Effects on Aggregate Supply LRAS Price Level • New short run equilibrium has output above the full employment level. • As a result, nominal wages will rise (the demand for more workers to increase output allows workers to bargain for higher wages. SRAS PL1 PL AD1 AD Y1 Y* RGDP

  21. Policy Effects on Aggregate Supply • The higher wages lead to a leftward shift of the AS . • New long run-equilibrium at full-employment level • Higher price level • In the long run, increase in MS has NOT changed RGDP, only increase in PL. LRAS Price Level SRAS1 SRAS PL2 PL1 PL AD1 AD Y1 Y* RGDP

  22. Policy Effects on Aggregate Supply LRAS Price Level SRAS SRAS 1 PL PL1 AD Y1 Y* RGDP

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