Module 5: The Role of Fiscal Policy

Comprehensive vocabulary flashcards covering Module 5: The Role of Fiscal Policy, including Keynesian economics, the multiplier principle, crowding-out, the New Classical model, supply-side economics, and historical U.S. fiscal policies.

John Maynard Keynes

The British economist regarded as the father of modern macroeconomics and author of The General Theory of Employment, Interest, and Money (1936), who argued that deficient aggregate demand caused the Great Depression and advocated running budget deficits during recessions to restore full employment.

Keynesian Concept of Equilibrium

The macroeconomic condition in which total spending ($AD$) equals current output; if total spending is less than full-employment output ($Y_F$), unintended inventories accumulate, causing businesses to cut back production and employment.

Multiplier Principle

The concept that an independent change in spending (such as investment or government purchases) leads to an even larger cumulative change in aggregate output, because an initial expenditure generates income for other individuals who subsequently spend a fraction of it on consumption across successive rounds.

Marginal Propensity to Consume ($MPC$)

The proportion of additional disposable household income that is allocated toward consumption expenditures rather than saved.

Expenditure Multiplier ($M$)

The factor by which an initial change in spending is multiplied to yield the total resultant change in economic output, calculated using the formula $M = \frac{1}{1 - MPC}$.

Budget Deficit

The fiscal condition that occurs when total government spending exceeds total government revenue collected from all sources over a given period, requiring borrowing (such as the U.S. Treasury issuing bonds) when the money supply is constant.

Budget Surplus

The fiscal condition that occurs when total government revenue exceeds total government spending over a given period, which allows the government to reduce the magnitude of its outstanding debt.

Discretionary Fiscal Policy

Deliberate, legislative changes in government purchases, transfer payments, or tax rates designed specifically to alter the size of the federal budget deficit or surplus to influence aggregate economic activity.

Counter-cyclical Fiscal Policy

A stabilization approach that counters macroeconomic fluctuations by deliberately planning budget deficits during recessions to stimulate aggregate demand, and shifting toward budget surpluses during economic expansions to restrain inflationary demand.

Expansionary Fiscal Policy

A fiscal policy stance aimed at pulling an economy out of a recession by increasing government spending or reducing taxes to stimulate aggregate demand ($AD$) and direct output back to full employment ($Y_F$).

Restrictive Fiscal Policy

A fiscal policy stance aimed at cooling down an overheating economy by reducing government expenditures or increasing taxes to restrain aggregate demand ($AD$) and keep inflation under control when real output is operating beyond capacity.

Automatic Stabilizers

Built-in government fiscal mechanisms—such as progressive income taxes, corporate profit taxes, and unemployment compensation—that automatically expand the budget deficit during a downturn and expand the surplus during an economic boom without requiring new legislative action.

Timing Lags in Fiscal Policy

The administrative, legislative, and impact delays associated with fiscal changes, which require policymakers to forecast economic conditions $9$ to $18\text{ months}$ in advance and create the risk of exacerbating rather than smoothing instability.

Paradox of Thrift

The Keynesian concept proposing that if numerous households simultaneously attempt to increase their saving and reduce consumption during an economic downturn, total aggregate demand falls, causing firms to cut production, lay off workers, and deepen the recession.

Crowding-Out Effect

The theory that government borrowing to finance a budget deficit increases the demand for loanable funds, driving up real interest rates and thereby retarding private investment and consumption spending, which reduces the stimulative effect of expansionary fiscal policy.

Crowding-Out in an Open Economy

The process by which an increase in government borrowing drives up real interest rates, attracting foreign financial capital, causing the domestic currency to appreciate, and ultimately reducing net exports, offsetting the expansionary fiscal impact.

New Classical View of Fiscal Policy

The economic model asserting that deficit debt-financing merely substitutes higher future taxes for current taxes; anticipating these future liabilities, forward-looking households save the tax cut, leaving real interest rates, aggregate demand, and real output unchanged.

Deficit Bias (Public Choice Analysis)

The structural tendency identified by public choice theory wherein elected politicians eagerly approve popular spending projects that benefit constituents while avoiding tax increases, resulting in persistent budget deficits rather than counter-cyclical surpluses.

Supply-Side Economics

A macroeconomic approach focusing on long-run economic growth by cutting marginal tax rates to increase the rewards derived from work, saving, and capital investment, shifting both short-run aggregate supply ($SRAS$) and long-run aggregate supply ($LRAS$) to the right.

Marginal Tax Rate

The tax rate applied to an individual's additional dollar of income, which supply-siders argue critically affects total output by altering the relative attractiveness of productive economic activity compared to leisure and tax avoidance.

Permanent vs. Temporary Tax Cuts

The distinction in fiscal policy wherein permanent rate cuts sustainably enhance incentives to work, invest, and employ others, whereas temporary tax cuts or one-time rebates create uncertainty and a windfall that is largely saved or used to service existing debt.

COVID-19 Fiscal Response

The $\$5.2\text{ trillion}$ U.S. emergency legislative package consisting of multiple rounds of direct payments and economic relief, which was projected to drive the U.S. federal debt-to-GDP ratio to $110\%$ by 2023.