Chapter 7 Fiscal Policy These slides supplement the textbook, but should not replace reading the textbook
Who were the classical economists? A group of the 18 th and 19 th centuries, including Adam Smith known as the father of modern day economics 2
What did Adam Smith and the Classical Economists believe? The economy was always tending toward a full employment equilibrium and stable prices 3
What does laissez-faire mean? Leave well enough alone, let the economy correct problems itself 4
What happened in the Depression of 1921? Even though it was serious the government practiced laissez-faire and the economy recovered in a short period of time 5
What were policies of President Herbert Hoover in the early 1930s to combat the depression? public works projects raised taxes loans to failing firms relief programs 6
What were policies of President Franklin Roosevelt in 1933 to combat the depression? public works projects and social welfare programs raised taxes and wages loans to failing firms relief programs 7
According to Thomas Woods author of Meltdown, what was the result of these government programs? These programs prevented the economy from seeking its equilibrium of full employment and prolonged the depression 8
What is a fiscal policy? The manipulation of government purchases, transfer payments, taxes, and borrowing in order to positively influence the economy 9
How did Keynes influence fiscal policies? He argued that fiscal policies may be necessary to bring about full employment 10
How did World War II affect fiscal policies? It showed that a government stimulus package can work 11
What is the Employment Act of 1946? This is the official act that gave the government responsibility for promoting full employment and price stability 12
What are the four phases of the business cycle? trough recovery peak recession 13
What is a liquidity trap? A lack of borrowing keeps money bottled up in savings institutions 14
What is the Keynesian solution to a liquidity trap? Government borrows the money that consumers and business do not borrow 15
What does crowding out mean? During periods of full employment the government can borrow money that otherwise would be spent or invested 16
How does the government borrow money? It sells bonds (securities) to the Fed or in the Open Market 17
What is the current national debt? Just over 14 trillion dollars 18
What does monetizing the debt mean? The federal government sells bonds (securities) to the Fed and the Fed creates the money to buy the bonds 19
What can monetizing the debt lead to? A fall in the value of the dollar and inflation 20
What is a discretionary fiscal policy? Government policies that require ongoing decisions by policy makers 21
What are some examples of fiscal policies? Government purchases Transfer payments Taxes 22
What are automatic stabilizers? Structural features of government spending and taxation smooth out fluctuations in booms and busts 23
What are some examples of automatic stabilizers? Unemployment payments Welfare Other govt. programs 24
What is the point of Keynesian Economics? The economy could be stuck at equilibrium below the potential output for a prolonged period of time 25
What is an expansionary fiscal policy? An increase in government purchases, decrease in net taxes, or some combination of the two aimed at increasing aggregate demand 26
When would the government use expansionary fiscal policy? To stimulate the economy when unemployment is greater than the natural rate 27
What is an contractionary fiscal policy? A decrease in government purchases, increase in net taxes, or some combination of the two aimed at reducing aggregate demand 28
When would the government use contractionary fiscal policy? To slow down the economy when inflation is more than desired 29
What is the typical Keynesian policy during recessions? To use discretionary fiscal policies to stimulate the economy to a full employment equilibrium 30
What is the multiplier? Any change in the level of spending has a multiple effect on GDP 31
What is the balanced budget multiplier? Spending is multiplied because the government does not save any of the money it receives whereas consumes and business does 32
What is the accelerator? Any increase in spending can lead to an increase in secondary spending, for example, a new highway may lead to more restaurants, hotels, and gas stations 33
When does the accelerator have most impact on spending? During periods of full employment 34
How did World War II affect fiscal policies? It showed that a government stimulus package can work 35
What is MPC? The marginal propensity to consume (MPC) is a measure of how much consumers will spend out of any addition to their income 36
What is MPS? The marginal propensity to save (MPS) is a measure of how much consumers will save out of any addition to their income 37
If MPC is ¾, what is MPS? MPS would be ¼ because MPC + MPS = 1 38
What is the value of the multiplier? 1 / MPS 39
If MPC is ¾, what is the value of the multiplier? 1 / ¼ = 4 40
$100.00 $75.00 $56.25 $42.19 original spent $31.64... total money $400.00 41
What effect does an increase in demand have on prices and output? The more steeply sloped the supply curve the greater impact on prices and the less impact on employment 42
Slightly sloped Supply Curve Price Level SRAS AD* AD Real GDP 43
Steeply sloped Supply Curve Price Level SRAS AD* AD Real GDP 44
What is a progressive income tax? A tax that levies a higher percentage on high income people than on low income people 45
How is a progressive income tax an automatic stabilizer? When the economy is in a slump incomes go down and people pay less taxes, during boom times incomes go up so taxes increase 46
What are transfer programs? Automatic stabilizers that aid with money people in need 47
What are examples of transfer programs? Unemployment benefits Welfare Food stamps Subsidized housing 48
What happens during economic contractions? Transfer payments increase 49
What will a cut in taxes do? It will stimulate both consumer demand and investment 50
How effective are fiscal polices? Automatic stabilizers are more effective than are discretionary fiscal policies 51
Should we rely on automatic stabilizers? The stronger and more effective the automatic stabilizers are, the less need there is for discretionary fiscal policies 52
How effective were fiscal policies during the stagflation of the 1970 s? Whatever we did to fight one problem we made the other problem worse 53
What is the natural rate of unemployment? The unemployment rate at which the economy is producing its potential GDP 54
What happens if the natural rate of unemployment is 6%, but the govt. thinks it s 5%? By stimulating the economy it will cause inflation over the long run 55
What are lag effects? Recognition lag Decision lag Action lag 56
Do lag effects influence discretionary fiscal polices? Yes, they weaken fiscal policies as a tool of economic stabilization 57
What is one s permanent income? Income that individuals expect to receive on average over the long term 58
Do consumers base their decisions on their permanent income or their short term income? Perceived long term income 59
What is one thing policy makers often overlook? How fiscal policies unintentionally affect individual incentive to work, save and invest 60
What is supply side economics? The belief that real GDP can be increased by giving people incentives to work 61
What was fiscal policy in the Reagan Administration of the 1980 s? Taxes were decreased to stimulate the economy by increasing aggregate supply 62
What effect does politics have on fiscal policies? There is always the danger that politicians can use discretionary fiscal policies to suit their short term political goals 63
Does the federal deficit affect fiscal policies? If we were to increase spending by borrowing, the national debt could become unmanageable 64
Watch video on the National Debt http://video.search.yahoo.com/video/pl ay?p=national+debt&n=21&ei=utf- 8&js=1&fr2=tabweb&tnr=20&vid=000165545891 65
If we raise taxes, will tax revenues increase or decrease? If the increase in taxes sufficiently dampens spending and investments, tax revenues would decline 66
What is the Laffer Curve? A curve that shows that starting from zero an increase in taxes will raise revenue but beyond a point an increase will lower revenues 67
What is the difference between a stock and a flow way of thinking? An example of a stock situation would be an increase in government spending has no opportunity costs 68
If we spend a dollar do we pay for that dollar here and now? Yes, either by higher taxes, higher interest rates if we borrow the money, or more inflation if we create the money 69
END 70