Key Concepts in Fiscal Policy: Definitions, Tools, and Effects

What is discretionary fiscal policy?

Government intentionally changes spending (G) or taxes (T) to influence the economy.

What is expansionary fiscal policy used for?

To address a recession when GDP < LRAS and unemployment is high.

What tools are used in expansionary fiscal policy?

Increase government spending or decrease taxes.

What effect does expansionary fiscal policy have on aggregate demand (AD)?

AD shifts to the right.

What is contractionary fiscal policy used for?

To address inflation when GDP > LRAS.

What tools are used in contractionary fiscal policy?

Decrease government spending or increase taxes.

What effect does contractionary fiscal policy have on aggregate demand (AD)?

AD shifts to the left.

How do taxes affect aggregate demand?

Decreasing taxes shifts AD right; increasing taxes shifts AD left.

What defines a recessionary gap?

GDP < LRAS due to low aggregate demand.

What is the problem associated with a recessionary gap?

Weak demand and high unemployment.

What is the fix for a recessionary gap?

Expansionary fiscal policy, increasing G or decreasing T.

What defines an inflationary gap?

GDP > LRAS due to high aggregate demand.

What is the problem associated with an inflationary gap?

Too much demand and inflation.

What is the fix for an inflationary gap?

Contractionary fiscal policy, decreasing G or increasing T.

What are the three types of time lags in fiscal policy?

Recognition lag, action lag, and effect lag.

What is the crowding-out effect?

Increased government spending raises interest rates, which decreases private investment.

What is Ricardian equivalence?

People save tax cuts in anticipation of future taxes, reducing the impact on aggregate demand.

What is the permanent income hypothesis?

People base spending on long-term income, so temporary tax cuts lead to small changes in spending.

What are supply-side effects of lower taxes?

Lower taxes can increase work, investment, and productivity, leading to higher GDP.

What is the Laffer Curve?

It illustrates the relationship between tax rates and tax revenue, indicating a maximum revenue point.

What happens to tax revenue during a recession?

Income and tax revenue decrease at all tax rates, causing the Laffer Curve to flatten.

What is the master formula for fiscal policy?

Problem → Identify gap → Shift AD → Move toward LRAS.