Fiscal Policy and Aggregate Demand

This set of vocabulary flashcards covers key concepts, formulas, and historical examples related to fiscal policy’s influence on aggregate demand in both closed and open economies.

Fiscal Policy

The government’s choices regarding the overall level of government purchases or taxes.

Multiplier Effect

The additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Investment Accelerator

The positive feedback from higher levels of demand to higher demand for investment goods, such as firms buying more equipment to meet increased consumer demand.

Marginal Propensity to Consume (MPC)

The fraction of extra income that a household consumes rather than saves.

Marginal Propensity to Import (MPI)

The fraction of extra income that a household spends on imported goods.

Spending Multiplier (Closed Economy)

A formula representing the demand generated by each dollar of government purchases, expressed as $\frac{1}{1-MPC}$.

Spending Multiplier (Open Economy)

A formula calculating the demand for produced goods generated by additional government expenditure, expressed as $\frac{1}{(1-MPC) + MPI}$.

Crowding-out Effect on Investment

The reduction in aggregate demand that results when a fiscal expansion raises the interest rate and reduces investment spending.

Small Open Economy

An economy, such as Canada, characterized by perfect capital mobility where the domestic interest rate must eventually equal the world interest rate ($r^W$).

Crowding-out Effect on Net Exports

The reduction in net exports that results when a fiscal expansion in a small open economy with a flexible exchange rate causes the real exchange rate to rise.

Foreign Exchange Market Operations

Actions where the Bank of Canada buys and sells foreign currencies to influence the value of the exchange rate.

Coyne Affair (1961)

A serious conflict between the federal government and James Coyne, the Governor of the Bank of Canada, over the maintenance of a flexible exchange rate during a fiscal expansion.

Supply-siders

Economists who argue that tax cuts significantly increase the quantity of goods and services supplied by providing greater incentives to work.

Automatic Stabilizers

Changes in fiscal policy that stimulate aggregate demand without deliberate action from policymakers when the economy enters a recession, such as the tax system and Employment Insurance.

Theory of Liquidity Preference

A theory describing how the interest rate adjusts to balance the quantity of money supplied and demanded, given that money demand increases with the dollar value of transactions.