Simplifying Assumptions:

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1 Today s menu: Exploring Fiscal Policy i) Understand how spending and taxation affect equilibrium level of income. ii) dentify a budget deficit, a budget surplus, and a balanced budget. iii) Understand automatic stabilizers. iv) Understand limitations of fiscal policy. Remember our simplified model of macroeconomic activity? Firms PURHASES WAES / DVDENDS Labour oods & Services Households We will now begin working with a more complete macroeconomic model! Firms PURHASES WAES / DVDENDS Labour oods & Services Households Simplifying Assumptions:. closed economy (no foreign trade); 2. no taxing or spending; goods / services money 3. household spending/saving decisions are based entirely on income; 4. firms spend a fixed amount on investment, regardless of income; 5. there is always unused labour and resources; 6. price level is constant (no inflation). goods / services money overnment AE = onsumption Remember the good ol days... when there was just a curve? Then we added investment AE = onsumption + nvestment Remember the good ol days... when there was just a curve? Then we added investment. Well now we re going to add spending!

2 Remember the good ol days... when there was just a curve? Then we added investment. Well now we re going to add spending! AE = onsumption + nvestment + overnment Spending What if we increase spending? Let s take a look at an spending... Note the spending multiplier! Let s take a look at an spending... Note the spending multiplier! A $ million spending will ncome by $ Naturally, if we decrease overnment Spending Multiplier = - MP spending, it goes right back down! = = = 2 MPS.5 6 What if we increase spending? Note the spending multiplier! A $ million spending will ncome by $ Naturally, if we decrease spending, it goes right back down! What about taxation? 2

3 Aggr regate Expenditure (With overnment Taxation) Let s look at taxation... A $ million lump sum tax will lower disposable income by $ Based on our MP (.5) will fall by $ (Half of the tax.) Aggr regate Expenditure (With overnment Taxation) Let s look at taxation... A $ million lump sum tax will lower disposable + income by $ 8 Based on our MP (.5) 6 will fall by $ 4 (Half of the tax.) However, the multiplier effect will cause equilibrium income to fall by overnment Taxation Multiplier = -MP twice as much as - MP the drop in! = MPS =.5 = - Balanced Budget Theorem The balanced budget theorem states that a balanced budget will NOT leave aggregate income unchanged. Rather, aggregate income will actually increase by the amount of the spending! How is this possible?! Join me and all will be revealed Agg gregate Expenditure Note what happens if the budget stipulates spending of million dollars Note what happens if the budget stipulates spending of million dollars. This $ million aggregate expenditure will ncome by $4 3

4 Now look at what happens if the budget also stipulates taxation of million dollars. Note what happens if the budget stipulates spending of million dollars. This $ million aggregate expenditure will ncome by $ Thus, the taxation of $ million will invariably cause Net ncome to decrease by $ million! iven the MPS of 5%, this taxation policy will cause consumer spending to decrease by $ million, and savings to decrease by $ iven the multiplier of 2., the effect of this decrease in consumer spending will be multiplied by 2. MP =.5 with no spending & no taxation Wowsers! n the final analysis, a balanced budget will actually cause to increase by an amount equal to the spending! Desired onsumption Desired nvestment overnment Spending MP =.5 with million in spending, but no taxation. MP =.5 with million in spending, and million in taxation Desired onsumption Desired nvestment overnment Spending Desired onsumption Desired nvestment overnment Spending Yee haa!!! Aggregate ncome is increased by an amount equal to spending! 4

5 MP =.8 with no spending & no taxation. MP =.8 with million in spending, but no taxation Desired onsumption Desired nvestment overnment Spending Desired onsumption Desired nvestment overnment Spending MP =.8 with million in spending, and million in taxation Desired onsumption Desired nvestment overnment Spending Yee haa!!! Aggregate ncome is increased by an amount equal to spending! Fiscal Policy Automatic Stabilizers Vs Discretionary Policy Long-Run Aggregate Supply & aps e Level Price A Shift in Equilibrium AS LR AS SR A cornerstone of classical theory is that, in the long run, the economy will always adjust to full employment. Thus, in the long-run, the economy will achieve a certain level of output regardless of differences in the price level. Real Output AD recessionary gap For this reason, the long-run aggregate supply curve is a straight vertical line. Here we see a short-run run equilibrium below full employment. This depicts a recessionary gap. 5

6 e Level Price A Shift in Equilibrium nflationary ap AS LR AS SR Here we see a short-run run equilibrium above full employment. This depicts an inflationary gap. Automatic Stabilizers Definition: Aspects of a 's budget that will tend to reduce the severity of business cycle fluctuations without the need for legislative action. Key automatic stabilizers include income taxes and transfer payments: ncome Tax: During a contractionary period unemployment rises aggregate output declines people have less income less income tax less of a drain on than their might have been. Transfer Payments: Likewise, many who are unemployed get transfer payments in the form of unemployment compensation, welfare, or social security. This lets them consume more than they would have otherwise. Real Output inflationary gap AD During an expansion, both of these go in the other direction. As a result, a contraction sees more spending and fewer taxes, while an expansion has less spending and more taxes, all occurring quite automatically. Fiscal Drag: a term used to describe the effect that automatic stabilizers have on transitions through the economic cycle. Taxation, for example, will increase as incomes increase. This will tend to slow down an economic recovery. Naturally, automatic stabilizers will slow down economic decline as well. Discretionary Fiscal Policies: Deflationary and nflationary Deflationary fiscal policy involves using the level of expenditure and taxation to reduce the level of aggregate demand in the economy, whereas inflationary fiscal policy would increase the level of aggregate demand. Such policies would normally need to be legislated. Deflationary (ontractionary) fiscal policies could include: increasing the level of income tax reducing expenditure increasing value added taxes (VAT) and other indirect taxes nflationary (Expansionary) fiscal policies could include: decreasing the level of income tax increasing ing expenditure decreasing value added taxes (VAT) and other indirect taxes Objectives of discretionary fiscal policy usually address problems such as inflation and unemployment. Explanations for the Business ycle The Under- Theory: The greater income grows, the more people save. The Volatile nvestment Theory: nventory accelerator during times of low economic activity, businesses allow inventories to run down. Thus, business purchases fall drastically in response to minor reductions in consumer spending. The expectations theory (aka: Keynesian impulse animal spirits ): Business spending is often made with respect to expectations (rational or otherwise) of future economic activity. This creates a self-fulfilling fulfilling gp prophecy. p Real Business ycle theory (aka: nnovations theory): Real events, such as innovations (T for example) create a surge of business activity, which leads to high employment, spending and inflation. The monetary theory: More money is loaned out which expands via the multiplier effect. After a while all the money is loaned out. (Similar to rowding out, where borrowing drives interest rates up.) The multiplier-accelerator theory: Demand for consumer goods creates an induced demand for capital items. 6