13.2 Fiscal Policy and the AD–AS Model

What is nondiscretionary fiscal policy?

Automatic changes in taxes and transfers that stabilize the economy without new legislation.

How do tax revenues respond to rising GDP?

They increase—especially income, corporate, sales, and payroll taxes.

What happens to tax revenues when GDP falls?

They decrease across all major sources.

What are transfer payments?

Government payments like unemployment and welfare—called “negative taxes.

How do transfer payments behave during expansion?

They decrease because fewer people need assistance.

How do transfer payments behave during contraction?

They increase as more people qualify for aid.

Why are these automatic changes important?

They help stabilize the economy by boosting demand in recessions and cooling it in booms

What is a built-in stabilizer?

A feature that automatically adjusts the budget deficit or surplus based on GDP changes.

How do tax revenues behave as GDP rises?

They increase, creating a budget surplus.
If tax revenue > government spending, the government runs a budget surplus.
This means it’s collecting more than it’s spending — automatically.

How do tax revenues behave as GDP falls?

They decrease, creating a budget deficit.
If the government is still spending the same (or more), but collecting less in taxes, it starts running a budget deficit.
A budget deficit means the government is spending more than it’s taking in.

Why is government spending considered fixed in this model?

Because it’s set by Congress and doesn’t vary with GDP.

What does the upward-sloping line T represent in Figure 13.3?

The direct relationship between tax revenues and GDP.

How do built-in stabilizers help during a recession?

They increase the deficit automatically, boosting demand and aiding recovery.

How do built-in stabilizers help during expansion?

They increase the surplus automatically, slowing demand and controlling inflation.

What happens to tax revenues when GDP rises?

They increase automatically because people earn more, spend more, and businesses make more profit.

What happens to tax revenues when GDP falls?

They decrease automatically due to lower incomes, spending, and business activity.

How do rising tax revenues affect the economy during expansion?

They reduce household and business spending, helping to cool inflation.

How do falling tax revenues affect the economy during recession?

They leave more money in people’s hands, helping to cushion the downturn.

What is a budget surplus?

When tax revenues exceed government spending.

What is a budget deficit?

When government spending exceeds tax revenues.

How does rising GDP affect the budget balance?

It moves the budget toward a surplus (contractionary effect).

How does falling GDP affect the budget balance?

It moves the budget toward a deficit (expansionary effect).

What determines the steepness of the tax revenue line (T) in Figure 13.3?

How responsive tax revenues are to changes in GDP — influenced by the tax system.

Which tax system provides the most built-in stability?

A progressive tax system, where the average tax rate rises with income.

How does a proportional tax system affect stability?

It provides moderate stability — the average tax rate stays constant.

How does a regressive tax system affect stability?

It provides weak or no stability — the average tax rate falls as income rises.

Can built-in stabilizers fully prevent recessions or inflation?

No — they dampen fluctuations, but discretionary fiscal or monetary policy is needed for major corrections.

When GDP goes up:

• People earn more → they pay more income taxes.

• Businesses make more profit → they pay more corporate taxes.

• People buy more stuff → more sales taxes.

• More people working → more payroll taxes.

TAX REVENUES GO UP

When GDP goes down..

• People earn less → less income tax.

• Businesses lose money → less corporate tax.

• People buy less → less sales tax.

• Job losses → less payroll tax.

TAX REVENUES GO DOWN

If tax revenues go up (GDP ↑) (government budget)

• The government collects more than it spends → budget surplus.

• This slows the economy down a bit (takes money out of people’s hands), which helps prevent inflation

If tax revenues go down (GDP ↓) (government budget)

• The government collects less than it spends → budget deficit.

• This supports the economy (leaves more money with people), which helps fight recession.

There is a(n) _________ relationship between U.S. net tax revenues and GDP.

Direct

Automatic changes in ______ provide built-in stability over the course of the business cycle.

tax revenues

Virtually any tax will yield more tax revenue as _____ rises

GDP

Which of the following are used to describe policy changes that occur without congressional action?

Passive, automatic, nondiscretionar

Personal income taxes have _______ rates and thus generate more-than-proportionate increases in tax revenues as GDP expands.

Progressive

Anything that increases the government's budget deficit (or reduces its budget surplus) during a recession and increases its budget surplus (or reduces its budget deficit) during an expansion without requiring explicit action by policymakers is called what?

A built-in stabilizer

Automatic changes in tax revenues over the course of the business cycle create what?

Built-in stability

As GDP rises during prosperity, what happens to tax revenues?

Tax revenues increase automatically.

Tax revenues automatically __________ and the budget moves from deficit toward surplus as the economy moves toward a higher GDP.

increases

Personal income taxes have progressive rates and generate what kind of increases in tax revenues as GDP expands?

More-than-proportionate

A built-in _________ is anything that increases the government's budget deficit (or reduces its budget surplus) during a recession and increases its budget surplus (or reduces its budget deficit) during an expansion without requiring explicit action by policymakers. (Enter one word in the blank.)

stabilizer

A falling GDP leads to a tax receipt decline and moves the government's budget from ____ to _____

surplus; deficit

Which of the following is an example of a built-in stabilizer?

The U.S tax system

The average tax rate rises with GDP in what kind of tax system?

Progressive

Tax revenues _____ as GDP rises during prosperity.

rise

A declining _________ leads to a tax receipt decline and moves the government's budget from surplus toward deficit.

GDP